Financial Management: Comprehensive Final Exam

Friday, 1:30; Fall, 2006

Instructor: Jim Wehrley

1. (10 points) Develop the three following statements from the information provided below: 1) 12/31/06 Balance Sheet; 2) 12/31/07 Balance Sheet; and 3) Fiscal Year 2007 Income Statement (Jan 1, 2007 - December 31, 2007). All the major classification categories (e.g., current assets, gross profit) should be used.

At fiscal year end, December 31, 2006, Denver Clothing Retail, Inc. has $20,000 cash, $2,000 in short term debt, $90,000 in inventory, $60,000 Accounts Payable, $98,000 long term mortgage loan due in 2015, and $150,000 Property Plant and Equipment.

For the next fiscal year ending December 31, 2007, the company's sales equaled $800,000. The cost of the clothing sold equaled $400,000 and selling general and administrative expense equaled $200,000.

For simplification, there is no depreciation expense. The $98,000 and $2,000 debt stayed the same all year. The company keeps its cash in a non-interest bearing checking account. The interest rate was 10% for both loans. The income tax rate equaled 50%. The company paid a $15,000 dividend at the end of fiscal year December 31, 2007. As of December 31, 2007, all balance sheet items remained the same unless information is provided that would change a category.

Problems (2 points each)

1. You deposit $100 in a bank on January 1, 2000 and you want to find the value of that deposit January 1, 2006. If the interest rate is 5%, what is the future value of the deposit on January 1, 2006?

2. You deposit $100 in a bank on January 1, 2000. If the interest rate is 5% nominal annual rate, compounded quarterly, what is the future value of the deposit on January 1, 2006

3. You have $15,000 in cash. You expect inflation to equal 12 percent annually for the next 15 years. How much cash will you need in 15 years to equal the buying power of the current $15,000?

4. You notice that all your neighbors seem to need various items (e.g., tree limbs, construction debris) hauled away. You are thinking of buying a dump truck for $35,000. You estimate you could generate $10,000 a year cash flow (end of year) after paying for all expenses including hiring someone to drive the truck. The estimated life of the truck is 7 years with no salvage value. You would like an annual return of 12%. Should you buy the dump truck?

5. Cemex, a large cement provider, issued a 10 percent coupon interest rate, 10-year bond with a $1,000 par value. The market rate for a bond like this (risk level of company and maturity rate) is 11 percent. The company is selling 100,000 of these bonds. How much should these bonds sell for in the marketplace?

6. Alligators R Us is contemplating expansion through the issuance of debt/bonds. Your broker calls you and suggests that you buy 10 bonds—price $1,150 for each bond, 11 percent coupon rate, $1,000 par value, interest paid annually. The bonds mature in 12 years. Calculate the Yield-to-Maturity (YTM). Are the bonds selling at a discount or premium?

7. You forecast that Google’s P/E ratio will be 30 in five years. You also estimate that Google’s EPS will be $14.00. Using the P/E ratio, how much will Google be worth in five years?

For question 8 and 9, assume the company has a cost of capital of 10 percent.

Year / Project A Cash Flows
Initial Investment (Year 0) / ($840,000)
Year 1 / $280,000
Year 2 / $280,000
Year 3 / $280,000
Year 4 / $280,000
Year 5 / $280,000

8. What is the NPV of project A? Is the project acceptable? Why?

9. What is the IRR of Project A? Is the project acceptable? Why?

10. The cash flow of an investment is $100 today. You expect cash flow to grow at 4% annually. Furthermore, your required return is 11%. What is the value of the investment today?

Short Answer (2 points each)

1. Why should a financial manager care about the company’s cost of capital?

2. List four factors that determine a company’s cost of capital? Hint: There was no list provided in class. Think about the definition of cost of capital and use logic to answer this question. There are many more than four factors.

3. What does buying back bonds do to a company’s capital structure? Explain.

4. What is the difference between a junk bond and secured bonds?

5. How does collateral relate to risk and return?

6. A company retires $100 of long-term debt and issues $100 of stock. How does the current ratio change? Explain.

7. A company buys a building for $1 million. In order to buy the building, the company uses $500,000 of cash and sells another building for $500,000. How does the debt ratio change? Explain.

8. A company has a debt ratio of .1 and times interest earned ratio of 1.0. The financial manager goes to the bank and takes out a loan. The debt ratio is now .9. Do you think the company’s cost of debt (%) will increase? Explain.

  1. A company could have positive net income but run out of cash. Agree? Explain.

10. How might a company’s capital budgeting decisions change from an improvement in its debt rating? Explain your answer.

  1. How might a financial manager use the yield curve to help him/her determine what financing alternatives to use?
  1. How might you determine the before-tax cost of debt for a publicly traded company?

13. How does a small business owner determine the company’s before-tax cost of debt?

14. Is the after-tax cost of debt equal to the before-tax cost of debt? Explain.

15. Is finance fun? Explain.

16. Is the cost of equity easy to determine? Explain.

17. What is a venture capitalist? Do venture capitalists require a greater return than a “typical” individual who invests in “typical” stocks (e.g., General Electric)? Explain.

18. The stock price of Starbucks increased from$40 per share to $45 per share? How does the company’s capital structure change? Explain.

19. From an investor’s viewpoint, what is more risky—Home Depot common stock or Home Depot bond? Explain.

20. From a company’s perspective, is the cost of debt higher than the cost of equity? Explain.

21. How does a commercial lender at a bank or other financial institution determine whether a company should be approved for a commercial (i.e., business) loan? Hint: The seven 7 C’s of lending may help you answer this questions-- Credit, Capacity, Capital, Character, Conditions, Collateral, and Commitment.

22. A company’s ROE and ROA are the same. What does this tell you about the company’s capital structure?

23. The gross profit margin is increasing and the net profit margin is decreasing. Why or how might this happen?

24. A company’s average age of inventory is increasing and gross profit margin is decreasing. Why or how might this happen?

25. How does the capital structure affect the cost of capital?

26. What does it mean, “. . . ability to service debt”? What is debt service? What portion of debt service is on the income statement?

27. What could happen if a company violates its covenants?

28. Different industries have different (average) capital structures. Why?

29. Company A has a stock price of $10 with 100,000 shares outstanding. Company B’s stock price is $50 and has a market capitalization of $2,000,000. Which company has the higher value? Explain.

  1. If a company is having liquidity problems, would buying back bonds and issuing stock in the same amount be a good idea? Explain.
  1. If a company is adjusting its capital structure by issuing more stock, what is the importance of the stock price?
  1. A company would like to finance inventory. What type of debt or loan would you recommend?
  1. Define the following types of risk:
  1. Business
  1. Liquidity
  1. Default
  1. Market
  1. Interest rate
  1. Purchasing power

34. What is the purpose of a cash budget?

35. When making capital budgeting decisions, a company will project future cash flow. However, depreciation is not a cash inflow or outflow. Explain why depreciations is calculated when making capital budgeting decisions (e.g., Project A or B in the FinGame simulation)?