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Question Description

CH 13

FINANCIAL LEVERAGE EFFECTS

1/ The Neal Company wants to estimate next year’s return on equity (ROE) under different financial leverage ratios. Neal’s total capital is $12 million, it currently uses only common equity, it has no future plans to use preferred stock in its capital structure, and its federal-plus-state tax rate is 40%. The CFO has estimated next year’s EBIT for three possible states of the world: $5.8 million with a 0.2 probability, $1.5 million with a 0.5 probability, and $0.9 million with a 0.3 probability. Calculate Neal’s expected ROE, standard deviation, and coefficient of variation for each of the following debt-to-capital ratios. Do not round intermediate calculations. Round your answers to two decimal places at the end of the calculations.

Debt/Capital ratio is 0.

RÔE =

%

σ =

%

CV =

Debt/Capital ratio is 10%, interest rate is 9%.

RÔE =

%

σ =

%

CV =

Debt/Capital ratio is 50%, interest rate is 11%.

RÔE =

%

σ =

%

CV =

Debt/Capital ratio is 60%, interest rate is 14%.

RÔE =

%

σ =

%

CV =

2/FINANCIAL LEVERAGE EFFECTS

Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $18 million in invested capital, has $3.6 million of EBIT, and is in the 40% federal-plus-state tax bracket. Firm HL, however, has a debt-to-capital ratio of 55% and pays 11% interest on its debt, whereas LL has a 30% debt-to-capital ratio and pays only 9% interest on its debt. Neither firm uses preferred stock in its capital structure.

  • Calculate the return on invested capital (ROIC) for each firm. Round your answers to two decimal places.

    ROIC for firm LL is %
    ROIC for firm HL is %

  • Calculate the rate of return on equity (ROE) for each firm. Round your answers to two decimal places.

    ROE for firm LL is %
    ROE for firm HL is %

  • Observing that HL has a higher ROE, LL’s treasurer is thinking of raising the debt-to-capital ratio from 30% to 60% even though that would increase LL’s interest rate on all debt to 15%. Calculate the new ROE for LL. Round your answer to two decimal places.

    %

Ch 15

3/Rentz Corporation is investigating the optimal level of current assets for the coming year. Management expects sales to increase to approximately $2 million as a result of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm plans to maintain a 45% debt-to-assets ratio. Rentz’s interest rate is currently 8% on both short-term and long-term debt (which the firm uses in its permanent structure). Three alternatives regarding the projected current assets level are under consideration: (1) a restricted policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 12% of total sales, and the federal-plus-state tax rate is 40%.

  • What is the expected return on equity under each current assets level? Round your answers to two decimal places.
  • In this problem, we assume that expected sales are independent of the current assets investment policy. Is this a valid assumption?
    • Yes, this assumption would probably be valid in a real world situation. A firm’s current asset policies have no significant effect on sales.
    • Yes, sales are controlled only by the degree of marketing effort the firm uses, irrespective of the current asset policies it employs.
    • Yes, the current asset policies followed by the firm mainly influence the level of long-term debt used by the firm.
    • Yes, the current asset policies followed by the firm mainly influence the level of fixed assets.
    • No, this assumption would probably not be valid in a real world situation. A firm’s current asset policies may have a significant effect on sales.
  • How would the firm’s risk be affected by the different policies?

    The input in the box below will not be graded, but may be reviewed and considered by your instructor.

Restricted policy

%

Moderate policy

%

Relaxed policy

%

4/RECEIVABLES INVESTMENT

McEwan Industries sells on terms of 3/10, net 35. Total sales for the year are $741,000; 40% of the customers pay on the 10th day and take discounts, while the other 60% pay, on average, 72 days after their purchases. Assume 365 days in year for your calculations.

  • What is the days sales outstanding? Round your answer to two decimal places.
    days
  • What is the average amount of receivables? Round your answer to the nearest cent. Do not round intermediate calculations.
    $
  • What is the percentage cost of trade credit to customers who take the discount? Round your answers to two decimal places.
    %
  • What is the percentage cost of trade credit to customers who do not take the discount and pay in 72 days? Round your answers to two decimal places. Do not round intermediate calculations.
  • What would happen to McEwan’s accounts receivable if it toughened up on its collection policy with the result that all nondiscount customers paid on the 35th day? Round your answers to two decimal places. Do not round intermediate calculations.
    Days sales outstanding (DSO) = days

    Average receivables = $

Nominal cost:

%

Effective cost:

%

5/Parramore Corp has $18 million of sales, $1 million of inventories, $2 million of receivables, and $2 million of payables. Its cost of goods sold is 70% of sales, and it finances working capital with bank loans at an 7% rate. Assume 365 days in year for your calculations. Do not round intermediate steps.

  • What is Parramore’s cash conversion cycle (CCC)? Do not round intermediate calculations. Round your answer to two decimal places.
    days
  • If Parramore could lower its inventories and receivables by 8% each and increase its payables by 8%, all without affecting sales or cost of goods sold, what would be the new CCC? Do not round intermediate calculations. Round your answer to two decimal places.
    days
  • How much cash would be freed up, if Parramore could lower its inventories and receivables by 8% each and increase its payables by 8%, all without affecting sales or cost of goods sold? Do not round intermediate calculations. Round your answer to the nearest cent. Write out your answer completely. For Example, 13.2 million should be entered as 13,200,000.
    $
  • By how much would pretax profits change, if Parramore could lower its inventories and receivables by 8% each and increase its payables by 8%, all without affecting sales or cost of goods sold? Do not round intermediate calculations. Round your answer to the nearest cent. Write out your answer completely. For Example, 13.2 million should be entered as 13,200,000.
    $

CH16

1/ AFN EQUATION

Carlsbad Corporation’s sales are expected to increase from $5 million in 2016 to $6 million in 2017, or by 20%. Its assets totaled $5 million at the end of 2016. Carlsbad is at full capacity, so its assets must grow in proportion to projected sales. At the end of 2016, current liabilities are $1 million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accrued liabilities. Its profit margin is forecasted to be 7%, and the forecasted retention ratio is 25%. Use the AFN equation to forecast Carlsbad’s additional funds needed for the coming year. Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest cent.

$

Now assume the company’s assets totaled $3 million at the end of 2016. Is the company’s “capital intensity” the same or different comparing to initial situation?

2/AFN EQUATION

Carlsbad Corporation’s sales are expected to increase from $5 million in 2016 to $6 million in 2017, or by 20%. Its assets totaled $5 million at the end of 2016. Carlsbad is at full capacity, so its assets must grow in proportion to projected sales. At the end of 2016, current liabilities are $1 million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accrued liabilities. Its profit margin is forecasted to be 7%, and the forecasted retention ratio is 25%. Use the AFN equation to forecast Carlsbad’s additional funds needed for the coming year. Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest cent.

$

Now assume the company’s assets totaled $3 million at the end of 2016. Is the company’s “capital intensity” the same or different comparing to initial situation?

3/AFN EQUATION

Carlsbad Corporation’s sales are expected to increase from $5 million in 2016 to $6 million in 2017, or by 20%. Its assets totaled $3 million at the end of 2016. Carlsbad is at full capacity, so its assets must grow in proportion to projected sales. At the end of 2016, current liabilities are $1 million, consisting of $250,000 of accounts payable, $500,000 of notes payable, and $250,000 of accrued liabilities. Its profit margin is forecasted to be 5%.

  • Assume that the company pays no dividends.
    Under these assumptions, what would be the additional funds needed for the coming year? Write out your answer completely. For example, 5 million should be entered as 5,000,000. Round your answer to the nearest cent.
    $
  • Why is this AFN different from the one when the company pays dividends?

    • Under this scenario the company would have a higher level of spontaneous liabilities, which would reduce the amount of additional funds needed.
    • Under this scenario the company would have a lower level of retained earnings, which would increase the amount of additional funds needed.
    • Under this scenario the company would have a lower level of retained earnings, which would decrease the amount of additional funds needed.
    • Under this scenario the company would have a higher level of retained earnings, which would reduce the amount of additional funds needed.
    • Under this scenario the company would have a higher level of retained earnings, which would reduce the amount of assets needed.

4/

PRO FORMA INCOME STATEMENT

Austin Grocers recently reported the following 2016 income statement (in millions of dollars):

Sales

$700

Operating costs including depreciation

500

EBIT

$200

Interest

40

EBT

$160

Taxes (40%)

64

Net income

$96

Dividends

$32

Addition to retained earnings

$64

For the coming year, the company is forecasting a 35% increase in sales, and it expects that its year-end operating costs, including depreciation, will equal 60% of sales. Austin’s tax rate, interest expense, and dividend payout ratio are all expected to remain constant.

  • What is Austin’s projected 2017 net income? Enter your answer in millions. For example, an answer of $13,000,000 should be entered as 13. Round your answer to two decimal places.
    $ million
  • What is the expected growth rate in Austin’s dividends? Do not round your intermediate calculations. Round your answer to two decimal places.
    %

5/ Williamson Industries has $4 billion in sales and $2.9 billion in fixed assets. Currently, the company’s fixed assets are operating at 95% of capacity.

  • What level of sales could Williamson Industries have obtained if it had been operating at full capacity? Write out your answer completely. For example, 25 billion should be entered as 25,000,000,000. Round your answer to the nearest cent.
    $
  • What is Williamson’s target fixed assets/sales ratio? Round your answer to two decimal places.
    %
  • If Williamson’s sales increase 13%, how large of an increase in fixed assets will the company need to meet its target fixed assets/sales ratio? Write out your answer completely. For example, 25 billion should be entered as 25,000,000,000. Round your answer to the nearest cent. Negative amount should be indicated by a minus sign. Do not round intermediate calculations.
    $

6/ LONG-TERM FINANCING NEEDED

At year-end 2016, total assets for Arrington Inc. were $1.2 million and accounts payable were $400,000. Sales, which in 2016 were $2.6 million, are expected to increase by 30% in 2017. Total assets and accounts payable are proportional to sales, and that relationship will be maintained; that is, they will grow at the same rate as sales. Arrington typically uses no current liabilities other than accounts payable. Common stock amounted to $395,000 in 2016, and retained earnings were $235,000. Arrington plans to sell new common stock in the amount of $80,000. The firm’s profit margin on sales is 5%; 35% of earnings will be retained.

  • What were Arrington’s total liabilities in 2016? Write out your answer completely. For example, 25 million should be entered as 25,000,000. Round your answer to the nearest cent.
    $
  • How much new long-term debt financing will be needed in 2017? Write out your answer completely. For example, 25 million should be entered as 25,000,000. Do not round your intermediate calculations. Round your answer to the nearest cent. (Hint: AFN – New stock = New long-term debt.)
    $

7/SALES INCREASE

Paladin Furnishings generated $4 million in sales during 2016, and its year-end total assets were $3.2 million. Also, at year-end 2016, current liabilities were $500,000, consisting of $200,000 of notes payable, $200,000 of accounts payable, and $100,000 of accrued liabilities. Looking ahead to 2017, the company estimates that its assets must increase by $0.80 for every $1.00 increase in sales. Paladin’s profit margin is 6%, and its retention ratio is 50%. How large of a sales increase can the company achieve without having to raise funds externally? Write out your answer completely. For example, 25 million should be entered as 25,000,000. Do not round intermediate calculations. Round your answer to the nearest cent.

$

8/EXCESS CAPACITY

Earleton Manufacturing Company has $3 billion in sales and $700,000,000 in fixed assets. Currently, the company’s fixed assets are operating at 85% of capacity.

  • What level of sales could Earleton have obtained if it had been operating at full capacity? Write out your answer completely. Round your answer to the nearest whole number.
    $
  • What is Earleton’s target fixed assets/sales ratio? Do not round intermediate calculations. Round your answer to two decimal places.
    %
  • If Earleton’s sales increase 35%, how large of an increase in fixed assets will the company need to meet its target fixed assets/sales ratio? Write out your answer completely. Do not round intermediate calculations. Round your answer to the nearest whole number.
    $

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