Corporate Finance Study Guide Problems -Part 1

Time Value of Money

PV of a single payment Answer: e

i. You can earn 15 percent interest, compounded annually. How much must you deposit today to
withdraw $4,000 in 10 years?

a. $525.11

b. $842.51

c. $869.57

d. $957.57

e. $988.74

Growth rate Answer: d

ii. In 1958 the average tuition for one year at an Ivy League school was $1,800. Thirty years later,
in 1988, the average cost was $13,700. What was the growth rate in tuition over the 30-year
period?

a. 12%

b. 9%

c. 6%

d. 7%

e. 8%

Solving for the interest rate for a single payment Answer: e

iii. Suppose you invested $1,000 in stocks 10 years ago. If your account is now worth $2,839.42,
what rate of return did your stocks earn?

a. 15%

b. 14%

c. 13%

d. 12%

e. 11%

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Effective annual rate Answer: c
iv. Gomez Electronics needs to arrange financing for its expansion program. Bank A offers to lend
Gomez the required funds on a loan where interest must be paid monthly, and the quoted rate
is 8 percent. Bank B will charge 9 percent, with interest due at the end of the year. What is the
difference in the effective annual rates charged by the two banks?

a. 0.25%

b. 0.50%

c. 0.70%

d. 1.00%

e. 1.25%

Effective annual rate Answer: d

v. Steaks Galore needs to arrange financing for its expansion program. One bank offers to lend the
required $1,000,000 on a loan which requires interest to be paid at the end of each quarter.
The quoted rate is 10 percent, and the principal must be repaid at the end of the year. A second
lender offers 9 percent, daily compounding (365-day year), with interest and principal due at the
end of the year. What is the difference in the effective annual rates (EFF%) charged by the two
banks?

a. 0.31%

b. 0.53%

c. 0.75%

d. 0.96%
e. 1.25%
FV under daily compounding Answer: a

vi. You have $2,000 invested in a bank account that pays a 4 percent nominal annual interest with
daily compounding. How much money will you have in the account at the end of July (i.e., in
132 days)? (Assume there are 365 days in each year.)

a. $2,029.14

b. $2,028.93

c. $2,040.00

d. $2,023.44

e. $2,023.99

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Free cash flow Answer: a

vii. Giglio Inc. has the following information for the previous year: Net income = $400; Net
operating profit after taxes (NOPAT) = $500; Total assets = $2,000; and Total operating capital =
$1700. The information for the current year is: Net income = $800; Net operating profit after
taxes (NOPAT) = $700; Total assets = $2,300; and Total operating capital = $2100. What is the
free cash flow for the current year?

a. $300
b. $400
c. $500
d. $600
e. $700

Economic value added (EVA) Answer: a

viii. Spencer Inc. has the following information for the current year: Net income = $600; Net
operating profit after taxes (NOPAT) = $500; Total assets = $4,000; Short-term investments =
$500; Stockholders equity = $2,000; Debt = $1,000; and Total net operating capital = $2500. If
Spencer’s cost of capital is 10%, what is its Economic value added (EVA)?

a. $250
b. $300
c. $350
d. $375
e. $400

Net cash flow Answer: d

ix. Coolidge Cola is forecasting the following income statement:

Sales $30,000,000
Operating costs excluding depreciation 20,000,000
Depreciation 5,000,000

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Operating income (EBIT) $ 5,000,000
Interest expense 2,000,000
Taxable income (EBT) $ 3,000,000
Taxes (40%) 1,200,000
Net income $ 1,800,000

Assume that, with the exception of depreciation, all other non-cash revenues and expenses sum
to zero.

Congress is considering a proposal which will allow companies to depreciate their equipment at
a faster rate. If this provision were put in place, Coolidge’s depreciation expense would be
$8,000,000 (instead of $5,000,000). This proposal would have no effect on the economic value
of the company’s equipment, nor would it affect the company’s tax rate, which would remain at
40 percent. If this proposal were to be implemented, what would be the company’s net cash
flow?

a. $2,000,000
b. $4,000,000
c. $6,800,000
d. $8,000,000
e. $9,800,000

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Sales level Answer: e

x. Hebner Housing Corporation has forecast the following numbers for this upcoming year:

Sales $1,000,000
Cost of Goods Sold 600,000
Interest Expense 100,000
Net Income 180,000

The company is in the 40 percent tax bracket. Its cost of goods sold always represents 60
percent of its sales. That is, if the company’s sales were to increase to $1.5 million, its cost of
goods sold would increase to $900,000.

The company’s CEO is unhappy with the forecast and wants the firm to achieve a net income
equal to $240,000. Assume that Hebner’s interest expense remains constant. In order to
achieve this level of net income, what level of sales will the company have to achieve?

a. $ 400,000
b. $ 500,000
c. $ 750,000
d. $1,000,000
e. $1,250,000

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 Financial Planning and
Forecasting Financial Statements

Additional funds needed--positive AFN Answer: d

xi. Clayton Industries is planning its operations for next year, and Ronnie Clayton, the CEO, wants you to

forecast the firm's additional funds needed (AFN). Data for use in your forecast are shown below.

Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions.

Last year's sales = S0 $350 Last year's accounts payable $40

Sales growth rate = g 30% Last year's notes payable (to bank) $50

Last year's total assets = A0 $500 Last year's accruals $30

Last year's profit margin = M 5% Target payout ratio 60%

a. $102.8

b. $108.2

c. $113.9

d. $119.9

e. $125.9

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xii. Upton Computers makes bulk purchases of small computers, stocks them in conveniently

located warehouses, and ships them to its chain of retail stores. Upton’s balance sheet as of

December 31, 2007, is shown here (millions of dollars)

Cash $ 3.5 Accounts payable $ 9.0

Accounts receivable 26.0 Notes payable 18.0
Accruals 8.5
Inventory 58.0 Current liabilities 35.5
Current assets 87.5 Mortgage Loan 6.0
Net fixed assets 35.0 Common stock 15.0
Retained earnings 66.5

Total assets $122.5 Total liab. & equity $122.5

Sales for 2007 were $350 million, while net income for the year was $10.5 million. Upton paid

dividends of $4.2 million to common stockholders. The firm is operating at full capacity. Assume that

all ratios remain constant.

a. If sales are projected to increase by $70 million, or 20%, during 2008, use the AFN equation to

determine Upton’s projected external capital requirements.

b. . Construct Upton’s pro forma balance sheet for December 31, 2008. Assume that all external capital

requirements are met by bank loans and are reflected in notes payable. Assume Upton’s profit margin

and dividend payout ratio remain constant.

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 Working Capital Management

Cash conversion cycle Answer: a

xii. For the Cook County Company, the average age of accounts receivable is 60 days, the average
age of accounts payable is 45 days, and the average age of inventory is 72 days. Assuming a
365-day year, what is the length of the firm’s cash conversion cycle?

a. 87 days
b. 90 days

c. 65 days

d. 48 days
e. 66 days

Cash conversion cycle Answer: d

xiii. Porta Stadium Inc. has annual sales of $80,000,000 and keeps average inventory of $20,000,000.
On average, the firm has accounts receivable of $16,000,000. The firm buys all raw materials on
credit, its trade credit terms are net 35 days, and it pays on time. The firm’s managers are
searching for ways to shorten the cash conversion cycle. If sales can be maintained at existing
levels but inventory can be lowered by $4,000,000 and accounts receivable lowered by
$2,000,000, what will be the net change in the cash conversion cycle? Use a 365-day year.
Round to the closest whole day.

a. +105 days
b. -105 days

c. +27 days

d. -27 days
e. -3 days

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Maturity matching Answer: e

xiv. Wildthing Amusement Company’s total assets fluctuate between $320,000 and $410,000, while
its fixed assets remain constant at $260,000. If the firm follows a maturity matching or
moderate working capital financing policy, what is the likely level of its long-term financing?

a. $ 90,000

b. $260,000
c. $350,000

d. $410,000

e. $320,000

Cost of trade credit Answer: a

xv. A firm is offered trade credit terms of 3/15, net 45 days. The firm does not take the discount,
and it pays after 67 days. What is the nominal annual cost of not taking the discount? (Assume
a 365-day year.)

a. 21.71%
b. 22.07%

c. 22.95%

d. 23.48%
e. 24.52%

EAR cost of trade credit Answer: e

xvi. Hayes Hypermarket purchases $4,562,500 in goods over a 1-year period from its sole supplier.
The supplier offers trade credit under the following terms: 2/15, net 50 days. If Hayes chooses
to pay on time but not to take the discount, what is the average level of the company’s accounts
payable, and what is the effective annual cost of its trade credit? (Assume a 365-day year.)

a. $208,333; 17.81%

b. $416,667; 17.54%
c. $416,667; 27.43%

d. $625,000; 17.54%

e. $625,000; 23.45%

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Costly trade credit Answer: a
xvii. Phranklin Pharms Inc. purchases merchandise from a company that gives sales terms of 2/15,
net 40 days. Phranklin Pharms has gross purchases of $819,388 per year. What is the maximum
amount of costly trade credit Phranklin could get, assuming it abides by the supplier’s credit
terms? (Assume a 365-day year.)

a. $88,000

b. $33,000
c. $55,000

d. $50,000

e. $44,000

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 Answers

i. PV of a single payment Answer: e

Time Line:
0 15% 1 2 3 4 5 …… 10 Years
├──────-───┼────-─────┼────────┼─────────┼─────────┼────────┤
PV = ? FV = 4,000

Numerical solution:
PV = $4,000 /(1.1510) = $4,000 /(4.0456) = $988.74.

Financial calculator solution:

Inputs: N = 10; I = 15; PMT = 0; FV = -4,000.
Output: FV = $988.74.

ii. Growth rate Answer: d

Time Line:
1958 i = ? 1959 1988
├──────────────┼──────── ·· ·─────────┤
1,800 13,700

Numerical solution:
$13,700 = $1,800(1+i)30
(1+i)30=13,700/1,800=7.6111
(1+i)=7.6111(1/30) = 1.070
i  7%.

Financial calculator solution:

Inputs: N = 30; PV = -1,800; PMT = 0; FV = 13,700. Output: I = 7.0%.

iii. Solving for the interest rate for a single payment Answer: e

Time Line:
0 i = ? 1 10
├──────────────┼──────── ·· ·─────────┤
1,000 2,839.42

Numerical solution:
$2,839.42 = $1,000(1+i)10
10
(1+i) =2,839.42/1,000=2.8394
(1+i)=2.8394(1/10) = 1.11
i  11%.

Financial calculator solution:

Inputs: N = 10; PV = -1,000; PMT = 0; FV = 2,839.42. Output: I =
11.0%.
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iv. Effective annual rate Answer: c

Bank A: 8%, monthly.

m
 r 
EARA = 1  Nom   1
 m 
12
 0 .08 
= 1    1 = 8.30%.
 12 

Bank B: 9%, interest due at end of year

EARB = 9%.

9.00% - 8.30% = 0.70%.

v. Effective annual rate Answer: d

4
 0.10 
EARQtr = 1 +  - 1 = 10.38%.
 4 
365
 0.09 
EARDly = 1 +  - 1 = 9.42%.
 365 

Difference = 10.38% - 9.42% = 0.96%.

Alternatively, with a financial calculator, for the quarterly loan

enter P/YR = 4, NOM% = 10, and press EFF% to get EAR = 10.38%.

For the daily loan, enter P/YR = 365, NOM% = 9, and press EFF% to get
EAR = 9.42%.

vi. FV under daily compounding Answer: a

The answer is a. Solve for FV as N = 132, I = 4/365 = 0.0110,

PV = -2,000, PMT = 0, and solve for FV = ? = $2,029.14.

vii. Free cash flow Answer: a

Free cash flow = NOPAT - Net investment in total operating capital

= $700 - ($2100 - $1700)

= $700 - $400 = $300.

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viii. Return on invested capital (ROIC) Answer: a

EVA = NOPAT – (WACC x Total net operating capital)

= $500 – (0.10)($2,500)

= $500 - $250 = $250.

ix. Net cash flow Answer: d

The income statement would show:

Sales $30,000,000
Oper. costs (excl. depr.) 20,000,000
Depreciation 8,000,000
EBIT 2,000,000
Interest exp. 2,000,000
EBT 0
Taxes 0
NI $ 0

NCF = NI + Dep
NCF = 0 + $8,000,000 = $8,000,000.

x. Sales level Answer: e

This question requires working backwards through the income statement

from net income to sales. The income statement will look like this:

Sales $1,250,000 $500,000/(1 - 0.6)

CGS (60%)
EBIT $ 500,000 $100,000 + $400,000
Interest 100,000 (Given)
EBT $ 400,000 $240,000/(1 - 0.4)
Tax (40%)
NI $ 240,000

xi. Additional funds needed--positive AFN Answer: d

Last year's sales = S0 $350

Sales growth rate = g 30%

Forecasted sales = S0  (1 + g) $455

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 ΔS = change in sales = S1 – S0 = S0  g $105

Last year's total assets = A0 = A* since full capacity $500

Forecasted total assets = A1 = A0  (1 + g) $650

Last year's accounts payable $40

Last year's notes payable. Not spontaneous, so does not enter AFN calculation$50

Last year's accruals $30

L* = payables + accruals $70

Profit margin = M 5.0%

Target payout ratio 60.0%

Retention ratio = (1 – Payout) 40.0%

AFN = (A*/S0)ΔS – (L*/S0)ΔS – Margin  S1  (1 – Payout)

= $150 – $21 – $9.1 = $119.9

xii. a. AFN = (A*/S)(S) – (L*/S)(S) – MS1(1 – d)

$122.5 $17.5 $10.5

= ($70) - ($70) - ($420)(0.6) = $13.44 million.
$350 $350 $350

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b. Upton Computers

Pro Forma Balance Sheet

December 31, 2008

(Millions of Dollars)

Forecast Pro Forma

Basis % after

2007 2008 Sales Additions Pro Forma Financing Financing

Cash $ 3.5 0.0100 $ 4.20 $ 4.20

Receivables 26.0 0.7430 31.20 31.20

Inventories 58.0 0.1660 69.60 69.60

Total current

assets $ 87.5 $105.00 $105.00

Net fixed assets 35.0 0.100 42.00 42.00

Total assets $122.5 $147.00 $147.00

Accounts payable $ 9.0 0.0257 $ 10.80 $ 10.80

Notes payable 18.0 18.00 +13.44 31.44

Accruals 8.5 0.0243 10.20 10.20

Total current

liabilities $ 35.5 $ 39.00 $ 52.44

Mortgage loan 6.0 6.00 6.0

Common stock 15.0 15.00 15.00

Retained earnings 66.0 7.56* 73.56 73.56

Total liab.

and equity $122.5 $133.56 $147.00

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 AFN = $ 13.44

*PM = $10.5/$350 = 3%.

Payout = $4.2/$10.5 = 40%.

NI = $350  1.2  0.03 = $12.6.

Addition to RE = NI - DIV = $12.6 - 0.4($12.6) = 0.6($12.6) = $7.56.

xii. Cash conversion cycle Answer: a

Cash conversion Inv. conversion Rec. collection Pay. deferral

cycle = period + period – period

= 72 + 60 - 45 = 87 days.

xiii. Cash conversion cycle Answer: d Diff: M

Old With Change

365 365 365 365
ICP = = = 91.25 = = 73.000
$80 4 $80 5
$20 $16
+ +
$16 $14
DSO = = 73.00 = 63.875
$80 $80
365 365
DP = 35 days -35.00 DP -35.000
CCC = 129.25 days New CCC = 101.875 days

Change in CCC = 101.875 – 129.25 = -27.375 days  -27 days.

Net change is –27 days (CCC is 27 days shorter).

xiv. Maturity matching Answer: e

A maturity matching policy implies that fixed assets and permanent

current assets are financed with long-term sources. Thus, since the
minimum balance that total assets approach is $320,000, and $260,000 of
that balance is fixed assets, permanent current assets equal $60,000.
The likely level of long-term financing is $320,000.

Long-term debt financing = Permanent cash assets + Fixed assets.

Permanent cash assets = Low end of total assets - Fixed assets

= $320,000 - $260,000 = $60,000.

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 Long-term debt financing = $60,000 + $260,000 = $320,000.

xv. Cost of trade credit Answer: a

3 365
Nominal percentage cost =  = 21.71%.
97 52

xvi. EAR cost of trade credit Answer: e

The company pays every 50 days or 365/50 = 7.3 times per year. Thus,
the average accounts payable are $4,562,500/7.3 = $625,000. The
effective cost of trade credit can be found as follows:
EAR = (1 + 2/98)365/35 - 1 = 1.2345 - 1 = 0.2345 = 23.45%.

xvii. Costly trade credit Answer: a

Phranklin’s net purchases are $819,388  (1 - 0.02) = $803,000.

Purchases per day are $803,000/365 = $2,200.00. Total trade credit is
40  $2,200 = $88,000. Free trade credit is 15  $2,200 = $33,000.
Thus, costly trade credit, assuming discounts are taken, is $88,000 -
$33,000 = $55,000. If discounts are not taken, then the maximum amount
of costly trade credit is $88,000.

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