Multiple Choice: True/False

(14-2) Operating and fin. leverage F Q Answer: b EASY

(14-2) Business risk F Q Answer: b EASY . Provided a firm does not use an extreme amount of debt, operating leverage typically
. A firm's business risk is largely determined by the financial characteristics of its affects only EPS, while financial leverage affects both EPS and EBIT.
industry, especially by the amount of debt the average firm in the industry uses.
a. True
a. True b. False
b. False
(14-4) Trade-off theory F Q Answer: a EASY
(14-2) Financial risk F Q Answer: a EASY . The trade-off theory states that capital structure decisions involve a tradeoff between
. Financial risk refers to the extra risk stockholders bear as a result of a firm's use of debt the costs and benefits of debt financing.
as compared with their risk if the firm had used no debt.
a. True
a. True b. False
b. False
(14-4) Bankruptcy costs F Q Answer: a EASY
(14-2) Financial risk F Q Answer: a EASY . Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt,
. A firms capital structure does not affect its free cash flows as discussed in the text, its lenders will probably not get back the full amount of funds that they loaned. Therefore,
because FCF reflects only operating cash flows, which are available to service debt, to lenders charge higher rates to borrowers judged to be more likely to go bankrupt.
pay dividends to stockholders, and for other purposes.
a. True
a. True b. False
b. False
(14-4) MM F Q Answer: a EASY
(14-2) Financial leverage F Q Answer: a EASY . Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.
. If a firm borrows money, it is using financial leverage.
a. True
a. True b. False
b. False
(14-4) MM F Q Answer: a EASY
(14-2) Financial leverage F Q Answer: a EASY . Modigliani and Miller's first article led to the conclusion that capital structure is
. Other things held constant, an increase in financial leverage will increase a firm's "irrelevant" because it has no effect on a firm's value.
market (or systematic) risk as measured by its beta coefficient.
a. True
a. True b. False
b. False
(14-4) MM F Q Answer: b EASY
. Modigliani and Miller's first article led to the conclusion that capital structure is
(14-2) Use of financial leverage F Q Answer: b EASY extremely important, and that every firm has an optimal capital structure that maximizes
. The graphical probability distribution of ROE for a firm that uses financial leverage its value and minimizes its cost of capital.
would tend to be more peaked than the distribution if the firm used no leverage, other
things held constant. a. True
b. False
a. True
b. False (14-2) Operating and financial leverage F Q Answer: a MEDIUM
 . It is possible for Firms A and B to have identical financial and operating leverage, yet . According to Modigliani and Miller (MM), in a world without corporate income taxes the
for Firm A to have more risk as measured by the variability of EPS. This would occur if use of debt has no effect on the firm's value.
Firm A has more business risk than Firm B.
a. True
a. True b. False
b. False (14-4) MM F Q Answer: a MEDIUM
. Modigliani and Miller's first article led to the conclusion that capital structure is
(14-2) Financial risk F Q Answer: b MEDIUM "irrelevant" because it has no effect on a firm's value. However, that article was criticized
. As the text indicates, a firm's financial risk can and should be divided into separate because it assumed that no taxes existed. MM then revised their original article to
market and diversifiable risk components. include corporate taxes, and this model led to the conclusion that a firm's value would be
maximized if it used (almost) 100% debt.
a. True
b. False a. True
b. False
(14-2) Business risk F Q Answer: b MEDIUM
. If two firms have the same expected earnings per share (EPS) and the same standard (14-4) MM F Q Answer: a MEDIUM
deviation of expected EPS, then they must have the same amount of business risk. . Modigliani and Miller's second article, which assumed the existence of corporate
income taxes, led to the conclusion that a firm's value would be maximized, and its cost
a. True of capital minimized, if it used (almost) 100% debt. However, this model did not take
b. False account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption
of an optimal capital structure where the debt ratio is less than 100%.
(14-4) MM F Q Answer: a MEDIUM
. In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure a. True
does not affect its value. However, when taxes are considered, MM show a positive b. False
relationship between debt and value, i.e., the firm's value rises as it uses more and more
debt, other things held constant. (14-4) Miller model F Q Answer: a MEDIUM
. The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes
a. True and then adds personal taxes.
b. False
a. True
(14-4) MM F Q Answer: b MEDIUM b. False
. According to Modigliani and Miller (MM), in a world without taxes the optimal capital
structure for a firm is approximately 100% debt financing. (14-4) Miller model F Q Answer: b MEDIUM
. The Miller model begins with the Modigliani and Miller (MM) model without corporate
a. True taxes and then adds personal taxes.
b. False
a. True
(14-4) MM F Q Answer: a MEDIUM b. False
. According to Modigliani and Miller (MM), in a world with corporate income taxes the
optimal capital structure calls for approximately 100% debt financing. (14-4) Trade-off theory F Q Answer: a MEDIUM
. The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not
a. True exist. That led to the development of the "trade-off" model, where the firm's value first
b. False rises with the use of debt due to the tax shelter of debt, but later falls as more debt is
added because the potential costs of bankruptcy begin to more than offset the tax shelter
(14-4) MM F Q Answer: a MEDIUM benefits. Under the trade-off theory, an optimal capital structure exists.
 a. True
a. True b. False
b. False
(14-5) Capital structure F Q Answer: a MEDIUM
. Other things held constant, firms with more stable and predictable sales tend to use
(14-4) Trade-off theory F Q Answer: b MEDIUM more debt than firms with less stable sales.
. Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy,
and other factors that were assumed away in their original article. Once they took a. True
account of all these assumptions, they concluded that every firm has a unique optimal b. False
capital structure. Moreover, a manager can use the second MM model to determine his
or her firm's optimal debt ratio.

a. True (14-5) Capital structure F Q Answer: a MEDIUM

b. False . Other things held constant, firms that use assets that can be sold easily (like trucks)
tend to use more debt than firms whose assets are harder to sell (like those engaged in
(14-4) Trade-off theory F Q Answer: a MEDIUM R&D").
. Some people--including the current chairman of the Federal Reserve Board of
Governors--have argued that one advantage of corporate debt from the stockholders' a. True
standpoint is that the existence of debt forces managers to focus on cash flow and to b. False
refrain from spending too much of the firm's money on private plane and other
"perks." This is one of the factors that led to the rise of LBOs and private equity firms. (14-5) Capital structure F Q Answer: b MEDIUM
. Other things held constant, the lower a firm's tax rate, the more logical it is for the firm
a. True to use debt.
b. False
a. True
(14-4) Signaling theory F Q Answer: a MEDIUM b. False
. The Modigliani and Miller (MM) articles implicitly assumed, among other things, that
outside stockholders have the same information about a firm's future prospects as its (14-5) Capital structure F Q Answer: a MEDIUM
managers. That was called "symmetric information," and it is questionable. The . A firm's treasurer likes to be in a position to raise funds to support operations whenever
introduction of "asymmetric information" led to the development of the "signaling" theory such funds are needed, even in "bad times". This is called "financial flexibility," and the
of capital structure, which postulated that firms are reluctant to issue new stock because lower the firm's debt ratio, the greater its financial flexibility, other things held constant.
investors will interpret such an act as a signal that the firm's managers are worried about
its future. Other actions give off different signals, and the end result is that capital a. True
structure is affected by managers' perceptions about how their financing decisions will b. False
affect investors' views of the firm and thus its value.
(14-2) Use of debt in financing F Q Answer: a HARD
a. True . If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes
b. False (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher
the debt ratio, the larger this difference will be.
(14-4) Signaling theory F Q Answer: b MEDIUM
. According to the signaling theory of capital structure, firms first use common equity for a. True
their capital, then use debt if and only if they can raise no more equity on "reasonable" b. False
terms. This occurs because the use of debt financing signals to investors that the firm's
managers think that the future does not look good.
Multiple Choice: Conceptual
 price.
(14-2) Business risk C Q Answer: a EASY
. An increase in the debt ratio will generally have no effect on which of these items? (14-3) Optimal capital structure C Q Answer: c EASY
. Based on the information below, what is the firm's optimal capital structure?
a. Business risk.
b. Total risk. a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
c. Financial risk. b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
d. Market risk. c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
e. The firm's beta. d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.
(14-2) Business risk C Q Answer: d EASY
. Business risk is affected by a firm's operations. Which of the following is NOT directly (14-3) Optimal capital structure C Q Answer: b EASY
associated with (or does not directly contribute to) business risk? . Which of the following statements best describes the optimal capital structure?

a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. The extent to which interest rates on the firm's debt fluctuate.
e. Input price variability.
(14-3) Capital structure and WACC C Q Answer: d EASY
. Which of the following statements is CORRECT?
a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will
always increase the WACC.
b. Since debt financing is cheaper than equity financing, raising a companys debt ratio
will always reduce its WACC.
c. Increasing a companys debt ratio will typically reduce the marginal costs of both debt
and equity financing. However, this action still may raise the companys WACC.
d. Increasing a companys debt ratio will typically increase the marginal costs of both debt
and equity financing. However, this action still may lower the companys WACC.
e. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage
does not affect the cost of equity.
(14-3) Optimal capital structure C Q Answer: d EASY
. Which of the following statements is CORRECT?
a. The capital structure that maximizes expected EPS also maximizes the price per share
of common stock.
b. The capital structure that minimizes the interest rate on debt also maximizes the
expected EPS.
c. The capital structure that minimizes the required return on equity also maximizes the
stock price.
d. The capital structure that minimizes the WACC also maximizes the price per share of
common stock.
e. The capital structure that gives the firm the best bond rating also maximizes the stock
a. The optimal capital structure is the mix of debt, equity, and preferred stock that
maximizes the companys earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred stock that
maximizes the companys stock price.
c. The optimal capital structure is the mix of debt, equity, and preferred stock that
minimizes the companys cost of equity.
d. The optimal capital structure is the mix of debt, equity, and preferred stock that
minimizes the companys cost of debt.
e. The optimal capital structure is the mix of debt, equity, and preferred stock that
minimizes the companys cost of preferred stock.
(14-5) Leverage and cap. struct. C Q Answer: a EASY
. Which of the following events is likely to encourage a company to raise its target debt
ratio, other things held constant?
a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. An increase in the companys operating leverage.
d. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company's stock price hits a new high.
(14-5) Leverage and cap. struct. C Q Answer: b EASY
. Which of the following would tend to increase a firm's target debt ratio, other things held
constant?
a. The costs associated with filing for bankruptcy increase.
b. The corporate tax rate is increased.
c. The personal tax rate is increased.
d. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company's stock price hits a new low.
(14-3) Optimal capital structure C Q Answer: e EASY/MEDIUM
. Which of the following statements is CORRECT?
a. As a rule, the optimal capital structure is found by determining the debt-equity mix that
maximizes expected EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the
WACC.
c. The optimal capital structure minimizes the cost of equity, which is a necessary
condition for maximizing the stock price.
d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of
equity, and the WACC.
e. The optimal capital structure simultaneously maximizes the stock price and minimizes
the WACC.
(14-3) Target capital structure C Q Answer: e EASY/MEDIUM
. The firms target capital structure should do which of the following?
a. Maximize the earnings per share (EPS).
b. Minimize the cost of debt (rd).
c. Obtain the highest possible bond rating.
d. Minimize the cost of equity (rs).
e. Minimize the weighted average cost of capital (WACC).
(Comp.) Capital structure concepts C Q Answer: b EASY/MEDIUM
. Which of the following statements is CORRECT?
a. A firms business risk is determined solely by the financial characteristics of its
industry.
b. The factors that affect a firms business risk include industry characteristics and
economic conditions, both of which are generally beyond the firm's control.
c. One of the benefits to a firm of being at or near its target capital structure is that this
generally minimizes the risk of bankruptcy.
d. A firms financial risk can be minimized by diversification.
e. The amount of debt in its capital structure can under no circumstances affect a
companys EBIT and business risk.
(14-2) Operating leverage C Q Answer: e MEDIUM
. Which of the following statements is CORRECT? As a firm increases the operating
leverage used to produce a given quantity of output, this
a. normally leads to an increase in its fixed assets turnover ratio.
b. normally leads to a decrease in its business risk.
c. normally leads to a decrease in the standard deviation of its expected EBIT.
d. normally leads to a decrease in the variability of its expected EPS.
e. normally leads to a reduction in its fixed assets turnover ratio.
(14-2) Financial leverage and EPS C Q Answer: a MEDIUM
. A firm's CFO is considering increasing the target debt ratio, which would also increase
the companys interest expense. New bonds would be issued and the proceeds would
be used to buy back shares of common stock. Neither total assets nor operating income
would change, but expected earnings per share (EPS) would increase. Assuming the
CFOs estimates are correct, which of the following statements is CORRECT?
a. Since the proposed plan increases the firms financial risk, the stock price might fall
even if EPS increases.
b. If the plan reduces the WACC, the stock price is likely to decline.
c. Since the plan is expected to increase EPS, this implies that net income is also
expected to increase.
d. If the plan does increase the EPS, the stock price will automatically increase at the
same rate.
e. Under the plan there will be more bonds outstanding, and that will increase their
liquidity and thus lower the interest rate on the currently outstanding bonds.
(14-5) Leverage and cap. struct. C Q Answer: c MEDIUM
. Your firm is currently 100% equity financed. The CFO is considering a recapitalization
plan under which the firm would issue long-term debt with a yield of 9% and use the
proceeds to repurchase some of its common stock. The recapitalization would not
change the companys total assets, nor would it affect the firms basic earning power,
which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC
and increase its stock price. Which of the following would be likely to occur if the
company goes ahead with the recapitalization plan?
a. The companys net income would increase.
b. The companys earnings per share would decline.
c. The companys cost of equity would increase.
d. The companys ROA would increase.
e. The companys ROE would decline.
(14-2) Cap. struct., ROA, and ROE C Q Answer: e MEDIUM
. Your firm has $500 million of total assets, its basic earning power is 15%, and it
currently has no debt in its capital structure. The CFO is contemplating a recapitalization
where it would issue debt at a cost of 10% and use the proceeds to buy back some of its
common stock, paying book value. If the company goes ahead with the recapitalization,
its operating income, total assets, and tax rate would remain unchanged. Which of the
following is most likely to occur as a result of the recapitalization?
a. The ROA would increase.
b. The ROA would remain unchanged.
c. The basic earning power ratio would decline.
d. The basic earning power ratio would increase.
e. The ROE would increase.
(14-2) Financial leverage and EPS C Q Answer: c MEDIUM
. Which of the following statements is CORRECT?
a. Increasing its use of financial leverage is one way to increase a firms basic earning
power (BEP).
b. If a firm lowered its fixed costs but increased its variable costs by just enough to hold
total costs at the present level of sales constant, this would increase its operating
leverage.
c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that
maximizes share price.
d. If a company were to issue debt and use the money to repurchase common stock, this
would reduce its basic earning power ratio. (Assume that the repurchase has no impact
on the companys operating income.)
e. If a change in the bankruptcy code made bankruptcy less costly to corporations, this
would tend to reduce corporations' debt ratios.
(14-2) Fin. leverage and ratios C Q Answer: b MEDIUM
. Companies HD and LD have identical tax rates, total assets, and basic earning power
ratios, and their basic earning power exceeds their before-tax cost of debt, rd. However,
Company HD has a higher debt ratio and thus more interest expense than Company
LD. Which of the following statements is CORRECT?
a. Company HD has a higher net income than Company LD.
b. Company HD has a lower ROA than Company LD.
c. Company HD has a lower ROE than Company LD.
d. The two companies have the same ROA.
e. The two companies have the same ROE.
(14-2) Fin. leverage and ratios C Q Answer: b MEDIUM
. Firms U and L each have the same amount of assets, and both have a basic earning
power ratio of 20%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L
is financed with 50% debt and 50% equity. Firm Ls debt has a before-tax cost of
8%. Both firms have positive net income. Which of the following statements is
CORRECT?
a. The two companies have the same times interest earned (TIE) ratio.
b. Firm L has a lower ROA than Firm U.
c. Firm L has a lower ROE than Firm U.
d. Firm L has the higher times interest earned (TIE) ratio.
e. Firm L has a higher EBIT than Firm U.
(14-2) Fin. leverage and ratios C Q Answer: c MEDIUM
. Companies HD and LD have the same total assets, operating income (EBIT), tax rate,
and business risk. Company HD, however, has a much higher debt ratio than LD. Also,
both companies' basic earning power (BEP) ratios exceed their cost of debt (rd). Which
of the following statements is CORRECT?
a. HD should have a higher return on assets (ROA) than LD.
b. HD should have a higher times interest earned (TIE) ratio than LD.
c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by
the standard deviation of ROE, should also be higher than LD's.
d. Given that BEP > rd, HD's stock price must exceed that of LD.
e. Given that BEP > rd, LD's stock price must exceed that of HD.
(14-4) Miller model C Q Answer: b MEDIUM
. A major contribution of the Miller model is that it demonstrates, other things held
constant, that
a. personal taxes increase the value of using corporate debt.
b. personal taxes lower the value of using corporate debt.
c. personal taxes have no effect on the value of using corporate debt.
d. financial distress and agency costs reduce the value of using corporate debt.
e. debt costs increase with financial leverage.
(14-5) Leverage and cap. struct. C Q Answer: e MEDIUM
. Which of the following statements is CORRECT, holding other things constant?
a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs,
hence they tend to use relatively little debt.
b. An increase in the personal tax rate is likely to increase the debt ratio of the average
corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then
this would likely lead to lower debt ratios for corporations.
d. An increase in the companys degree of operating leverage would tend to encourage
the firm to use more debt in its capital structure so as to keep its total risk unchanged.
e. An increase in the corporate tax rate would in theory encourage companies to use
more debt in their capital structures.
(14-5) Leverage and cap. struct. C Q Answer: e MEDIUM
. Other things held constant, which of the following events would be most likely to
encourage a firm to increase the amount of debt in its capital structure?
a. Its sales are projected to become less stable in the future.
b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to
the firm and its stockholders.
c. Management believes that the firms stock is currently overvalued.
d. The firm decides to automate its factory with specialized equipment and thus increase
its use of operating leverage.
e. The corporate tax rate is increased.
(Comp.) Capital struct. concepts C Q Answer: b MEDIUM
. Which of the following statements is CORRECT?
a. A firm can use retained earnings without paying a flotation cost. Therefore, while the
cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of
debt.
b. The capital structure that minimizes a firms weighted average cost of capital is also
the capital structure that maximizes its stock price.
c. The capital structure that minimizes the firms weighted average cost of capital is also
the capital structure that maximizes its earnings per share.
d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt
ratio must reduce its WACC.
e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller
tax-adjusted theory would suggest that firms should increase their use of debt.
(Comp.) Capital struct. concepts C Q Answer: d MEDIUM
. Which of the following statements is CORRECT?
a. The capital structure that maximizes the stock price is also the capital structure that
minimizes the cost of equity from retained earnings (rs).
b. The capital structure that maximizes the stock price is also the capital structure that
maximizes earnings per share.
c. The capital structure that maximizes the stock price is also the capital structure that
maximizes the firms times interest earned (TIE) ratio.
d. If a company increases its debt ratio, this will typically increase the marginal costs of
both debt and equity, but it still may reduce the companys WACC.
e. If Congress were to pass legislation that increases the personal tax rate but decreases
the corporate tax rate, this would encourage companies to increase their debt ratios.
(14-2) Capital struct. concepts C Q Answer: a MEDIUM/HARD
. Which of the following statements is CORRECT?
a. In general, a firm with low operating leverage also has a small proportion of its total
costs in the form of fixed costs.
b. There is no reason to think that changes in the personal tax rate would affect firms
capital structure decisions.
c. A firm with a relatively high business risk is more likely to increase its use of financial
leverage than a firm with low business risk, assuming all else equal.
d. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce
its WACC by increasing its use of debt.
e. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to
the point where it is at its optimal capital structure will decrease the costs of both debt
and equity.
(14-2) Fin. leverage and ratios C Q Answer: c MEDIUM/HARD
. Companies HD and LD have identical amounts of assets, operating income (EBIT), tax
rates, and business risk. Company HD, however, has a higher debt ratio than
LD. Company HDs basic earning power ratio (BEP) exceeds its cost of debt (rd). Which
of the following statements is CORRECT?
a. Company HD has a higher return on assets (ROA) than Company LD.
b. Company HD has a higher times interest earned (TIE) ratio than Company LD.
c. Company HD has a higher return on equity (ROE) than Company LD, and its risk as
measured by the standard deviation of ROE is also higher than LDs.
d. The two companies have the same ROE.
e. Company HDs ROE would be higher if it had no debt.
(Comp.) Capital struct. concepts C Q Answer: a MEDIUM/HARD
. Which of the following statements is CORRECT?
a. If Congress lowered corporate tax rates while other things were held constant, and if
the Modigliani-Miller tax-adjusted theory of capital structure were correct, this would tend
to cause corporations to decrease their use of debt.
b. A change in the personal tax rate should not affect firms capital structure decisions.
c. Business risk is differentiated from financial risk by the fact that financial risk reflects
only the use of debt, while business risk reflects both the use of debt and such factors as
sales variability, cost variability, and operating leverage.
d. The optimal capital structure is the one that simultaneously (1) maximizes the price of
the firms stock, (2) minimizes its WACC, and (3) maximizes its EPS.
e. If changes in the bankruptcy code made bankruptcy less costly to corporations, this
would likely reduce the average corporation's debt ratio.
(Comp.) Leverage and cap. struct. C Q Answer: c MEDIUM/HARD
. Which of the following statements is CORRECT?
a. When a company increases its debt ratio, the costs of equity and debt both
increase. Therefore, the WACC must also increase.
b. The capital structure that maximizes the stock price is generally the capital structure
that also maximizes earnings per share.
c. All else equal, an increase in the corporate tax rate would tend to encourage
companies to increase their debt ratios.
d. Since debt financing raises the firms financial risk, increasing a companys debt ratio
will always increase its WACC. b. 30,400
e. Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net c. 32,000
income. d. 33,600
e. 35,280
(14-6) Variations in cap. struct. C Q Answer: d HARD
. Which of the following statements is CORRECT? (14-2) Breakeven analysis C Q Answer: d EASY
. Southwest U's campus book store sells course packs for $15 each, the variable cost
a. Generally, debt-to-total-assets ratios do not vary much among different industries, per pack is $9, fixed costs to produce the packs are $200,000, and expected annual
although they do vary among firms within a given industry. sales are 50,000 packs. What are the pre-tax profits from sales of course packs?
b. Electric utilities generally have very high common equity ratios because their revenues
are more volatile than those of firms in most other industries. a. $72,900
c. Airline companies tend to have very volatile earnings, and as a result they generally b. $81,000
have high target debt-to-equity ratios. c. $90,000
d. Wide variations in capital structures exist both between industries and among d. $100,000
individual firms within given industries. These differences are caused by differing e. $110,000
business risks and also managerial attitudes.
e. Since most stocks sell at or very close to their book values, book value capital (14-2) Breakeven: FC C Q Answer: d EASY
structures are typically adequate for use in estimating firms' costs of capital. . Southwest U's campus book store sells course packs for $16 each. The variable cost
per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000
before taxes on course packs. How much are the fixed costs of producing the course
Problems packs?

Some of these problems are conceptually difficult, and they are designated as a. $164,025
HARD. Others are not conceptually difficult, but they require a good bit of b. $182,250
arithmetic. Please take this into account when making up timed tests. c. $202,500
d. $225,000
(14-2) Breakeven analysis C Q Answer: a EASY e. $247,500
. Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit
produced, and its product sells for $4.00 per unit. What is the company's breakeven (14-2) Breakeven: operating plans C Q Answer: d EASY
point, i.e., at what unit sales volume would income equal costs? . Assume that you and your brother plan to open a business that will make and sell a
newly designed type of sandal. Two robotic machines are available to make the sandals,
a. 391,667 Machine A and Machine B. The price per pair will be $20.00 regardless of which
b. 411,250 machine is used. The fixed and variable costs associated with the two machines are
c. 431,813 shown below. What is the difference between the breakeven points for Machines A and
d. 453,403 B? (Hint: Find BEB - BEA)
e. 476,073
Machine A Machine B
(14-2) Breakeven analysis C Q Answer: c EASY Price per pair (P) $20.00 $20.00
. Your uncle is considering investing in a new company that will produce high quality Fixed costs (F) $25,000 $100,000
stereo speakers. The sales price would be set at 1.5 times the variable cost per unit; the Variable cost/unit (V) $7.00 $4.00
variable cost per unit is estimated to be $75.00; and fixed costs are estimated at
$1,200,000. What sales volume would be required to break even, i.e., to have EBIT = a. 3,154
zero? b. 3,505
c. 3,894
a. 28,880 d. 4,327
e. 4,760 c. 7.00%
d. 7.35%
(14-2) Breakeven: operating plans C Q Answer: d EASY e. 7.72%
. Your company plans to produce a new product, a wireless computer mouse. Two
machines can be used to make the mouse, Machines A and B. The price per mouse will (14-2) ROEs and financing plans C Q Answer: a MEDIUM
be $25.00 regardless of which machine is used. The fixed and variable costs associated . You work for the CEO of a new company that plans to manufacture and sell a new
with the two machines are shown below. At the expected sales level of 75,000 units, how product, a watch that has an embedded TV set and a magnifying glass crystal. The issue
much higher or lower will the firm's expected EBIT be if it uses high fixed cost Machine B now is how to finance the company, with only equity or with a mix of debt and
rather than low fixed cost Machine A, i.e., what is EBITB - EBITA? equity. Expected operating income is $400,000. Other data for the firm are shown
below. How much higher or lower will the firm's expected ROE be if it uses some debt
Machine A Machine B rather than all equity, i.e., what is ROEL - ROEU?
Price per mouse (P) $25.00 $25.00
Fixed costs (F) $100,000 $400,000 0% Debt, U 60% Debt, L
Variable cost/unit (V) $15.25 $9.00 Oper. income (EBIT) $400,000 $400,000
Exp. unit sales (Q) 75,000 75,000 Required investment $2,500,000 $2,500,000
% Debt 0.0% 60.0%
a. $123,019 $ of Debt $0.00 $1,500,000
b. $136,688 $ of Common equity $2,500,000 $1,000,000
c. $151,875 Interest rate NA 10.00%
d. $168,750 Tax rate 35% 35%
e. $185,625
a. 5.85%
b. 6.14%
(14-2) ROEs and operating plans C Q Answer: b MEDIUM c. 6.45%
. Your company, which is financed entirely with common equity, plans to manufacture a d. 6.77%
new product, a cell phone that can be worn like a wristwatch. Two robotic machines are e. 7.11%
available to make the phone, Machine A and Machine B. The price per phone will be
$250.00 regardless of which machine is used to make it. The fixed and variable costs
associated with the two machines are shown below, along with the capital (all equity) that (14-2) EPS and financing plans C Q Answer: d MEDIUM
must be invested to purchase each machine. The expected sales level is 25,000 . You work for the CEO of a new company that plans to manufacture and sell a new type
units. Your company has tax loss carry-forwards that will cause its tax rate to be zero for of laptop computer. The issue now is how to finance the company, with only equity or
the life of the project, so T = 0. How much higher or lower will the project's ROE be if you with a mix of debt and equity. Expected operating income is $600,000. Other data for
select the machine that produces the higher ROE, i.e., what is ROEB - the firm are shown below. How much higher or lower will the firm's expected EPS be if it
ROEA? (Hint: Since the firm uses no debt and its tax rate is zero, ROE = EBIT/Required uses some debt rather than only equity, i.e., what is EPSL - EPSU?
investment.)
0% Debt, U 60% Debt, L
Machine A Machine B Oper. income (EBIT) $600,000 $600,000
Price per phone (P) $250.00 $250.00 Required investment $2,500,000 $2,500,000
Fixed costs (F) $1,000,000 $2,000,000 % Debt 0.0% 60.0%
Variable cost/unit (V) $200.00 $150.00 $ of Debt $0.00 $1,500,000
Expected unit sales (Q) 25,000 25,000 $ of Common equity $2,500,000 $1,000,000
Required equity investment $2,500,000 $3,000,000 Shares issued, $10/share 250,000 100,000
Interest rate NA 10.00%
a. 6.00% Tax rate 35% 35%
b. 6.67%
a. $1.00 b. 4,750
b. $1.11 c. 5,000
c. $1.23 d. 5,250
d. $1.37 e. 5,513
e. $1.50
(14-3) Calculating unlevered beta C Q Answer: e MEDIUM
(14-2) Debt and ROE C Q Answer: a MEDIUM . El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is
. Confu Inc. expects to have the following data during the coming year. What is the 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the
firm's expected ROE? firm's beta be if it used no debt, i.e., what is its unlevered beta?

Assets $200,000 Interest rate 8% a. 0.71

Debt/Assets, book value 65% Tax rate 40% b. 0.75
EBIT $25,000 c. 0.79
d. 0.83
a. 12.51% e. 0.87
b. 13.14%
c. 13.80% (14-3) WACC and recapitalization C Q Answer: a MEDIUM
d. 14.49% . Gator Fabrics Inc. currently has zero debt. It is a zero growth company, and it has the
e. 15.21% data shown below. Now the company is considering using some debt, moving to the new
debt/assets ratio indicated below. The money raised would be used to repurchase stock
(14-2) Operating income C Q Answer: b MEDIUM at the current price. It is estimated that the increase in risk resulting from the additional
. Senate Inc. is considering two alternative methods for producing playing cards. Method leverage would cause the required rate of return on equity to rise somewhat, as indicated
1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and below. If this plan were carried out, by how much would the WACC change, i.e., what is
variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine WACCOld - WACCNew?
with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per
deck. The sale price per deck would be the same under each method. At what unit New Debt/Assets 55% Orig. cost of equity, rs 10.0%
output level would the two methods provide the same operating income (EBIT)? New Equity/Assets 45% New cost of equity = rs 11.0%
Interest rate new = rd 7.0% Tax rate 40%
a. 12,600
b. 14,000 a. 2.74%
c. 15,400 b. 3.01%
d. 16,940 c. 3.32%
e. 18,634 d. 3.65%
e. 4.01%

(14-2) Required unit sales C Q Answer: c MEDIUM

. A group of venture investors is considering putting money into Lemma Books, which
wants to produce a new reader for electronic books. The variable cost per unit is
estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed
costs are estimated at $750,000. The investors will put up the funds if the project is likely
to have an operating income of $500,000 or more. What sales volume would be required
in order to meet the minimum profit goal? (Hint: Use the breakeven formula, but include
the required profit in the numerator.)
a. 4,513
(Comp.) Cap. struct. & firm value C Q Answer: e MEDIUM
. As a consultant to First Responder Inc., you have obtained the following data (dollars in
millions). The company plans to pay out all of its earnings as dividends, hence g =
0. Also, no net new investment in operating capital is needed because growth is
zero. The CFO believes that a move from zero debt to 20.0% debt would cause the cost
of equity to increase from 10.0% to 12.0%, and the interest rate on the new debt would
be 8.0%. What would the firm's total market value be if it makes this change? Hints:
Find the FCF, which is equal to NOPAT = EBIT(1 T) because no new operating capital
is needed, and then divide by
(WACC g). e. 6.61%
(14-3) ROE & capital structure C Q Answer: c MEDIUM/HARD
Oper. income (EBIT) $800 Tax rate 40.0% . Firm A is very aggressive in its use of debt to leverage up its earnings for common
New cost of equity (rs) 12.00% New debt ratio 20.0% stockholders, whereas Firm NA is not aggressive and uses no debt. The two firms'
Interest rate (rd) 8.00% operations are identical--they have the same assets, sales, operating costs, and
EBIT. Thus, they differ only in their use of financial leverage. Based on the following
a. $2,982 data, how much higher or lower is A's ROE than that of NA, i.e., what is ROEA -
b. $3,314 ROENA?
c. $3,682
d. $4,091 Applicable to Both Firms Firm A's Data Firm NA's Data
e. $4,545 Assets $150,000 Debt ratio 50% Debt ratio 0%
EBIT $40,000 Int. rate 12% Int. rate 10%
(14-3) EPS & capital structure C Q Answer: c MEDIUM/HARD Tax rate 35%
. You plan to invest in one of two home delivery pizza companies, High and Low, that
were recently founded and are about to commence operations. They are identical except a. 8.60%
for their use of debt and the interest rates on their debt--High uses more debt and thus b. 9.06%
must pay a higher interest rate. Based on the data given below, how much higher or c. 9.53%
lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh - EPSLow? d. 10.01%
e. 10.51%
Applicable to Both Firms Firm High's Data Firm Low's Data
Assets $3,000,000 Debt ratio 70% Debt ratio 20% (14-3) ROE & capital structure C Q Answer: c MEDIUM/HARD
EBIT $500,000 Shares 90,000 Shares 240,000 . Your firm's debt ratio is only 5.00%, but the new CFO thinks that more debt should be
Tax rate 35% Int. rate 12% Int. rate 10% employed. She wants to sell bonds and use the proceeds to buy back and retire some
stock, which sells at its book value. Other things held constant, and based on the data
a. $0.49 below, if the firm increases its debt ratio to 60.0%, by how much would the ROE change,
b. $0.54 i.e., what is ROENew - ROEOld?
c. $0.60
d. $0.66 Operating Data Other Data
e. $0.73 Assets $150,000 New debt ratio 60%
EBIT/Assets = BEP 20.00% Old debt ratio 5%
(14-3) ROE & capital structure C Q Answer: c MEDIUM/HARD Tax rate 35% New interest rate 12%
. Firms HD and LD are identical except for their use of debt and the interest rates they Old interest rate 10%
pay--HD has more debt and thus must pay a higher interest rate. Based on the data
given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is a. 6.73%
ROEHD - ROELD? b. 7.09%
c. 7.46%
Applicable to Both Firms Firm HD's Data Firm LD's Data d. 7.83%
Assets $3,000,000 Debt ratio 70% Debt ratio 20% e. 8.22%
EBIT $500,000 Int. rate 12% Int. rate 10%
Tax rate 35% (14-3) ROE & capital structure C Q Answer: c MEDIUM/HARD
. You have been hired by a new firm that is just being started. The CFO wants to finance
a. 5.41% with 60% debt, but the president thinks it would be better to hold the debt ratio to only
b. 5.69% 10%. Other things held constant, and based on the data below, if the firm uses the
c. 5.99% higher debt ratio, by how much would the ROE change, i.e., what is ROENew - ROEOld?
d. 6.29%
Operating Data Other Data of 10% on sales, and they want the store's managers to pay a royalty rate that will
Assets $4,000 Higher debt ratio 60% produce that profit margin. What royalty per pack would permit the store to earn a 10%
EBIT/Assets = BEP 20.00% Lower debt ratio 10% profit margin on course packs, other things held constant?
Tax rate 35% Higher interest rate 13%
Lower interest rate 9% a. $2.55
b. $2.84
a. 5.44% c. $3.15
b. 5.73% d. $3.50
c. 6.03% e. $3.85
d. 6.33%
e. 6.65%
(14-2) EPS & financing plans C Q Answer: e HARD (14-3) Levered beta and rs C Q Answer: b HARD
. Your girlfriend plans to start a new company to make a new type of cat litter. Her father . Dye Industries currently uses no debt, but its new CFO is considering changing the
will finance the operation, but she will have to pay him back. You are helping her, and capital structure to 40.0% debt by issuing bonds and using the proceeds to repurchase
the issue now is how to finance the company, with equity only or with a mix of debt and and retire some common stock at book value. Given the data shown below, by how
equity. The price per unit will be $5.00 regardless of how the firm is financed. The much would this recapitalization change the firm's cost of equity, i.e., what is rL - rU?
expected fixed and variable operating costs, along with other information, are shown
below. How much higher or lower will the firm's expected EPS be if it uses some debt Risk-free rate, rRF 6.00% Tax rate, T 40%
rather than only equity, i.e., what is EPSL - EPSU? Market risk premium, RPM 4.00% Current debt ratio 0%
Current beta, bU 1.15 Target debt ratio 40%
0% Debt, U 60% Debt, L
Expected unit sales 225,000 225,000 a. 1.66%
Price per unit $10.00 $10.00 b. 1.84%
Fixed costs $1,000,000 $1,000,000 c. 2.02%
Variable cost/unit $3.50 $3.50 d. 2.23%
Required investment $2,500,000 $2,500,000 e. 2.45%
Shares issued at $10/share 250,000 100,000
% Debt 0.00% 60.00% (14-3) Levered beta and rs C Q Answer: b HARD
Debt, $ $0 $1,500,000 . Dyson Inc. currently finances with 20.0% debt, but its new CFO is considering changing
Equity, $ $2,500,000 $1,000,000 the capital structure to 60.0% debt by issuing additional bonds and using the proceeds to
Interest rate NA 10.00% repurchase and retire some common stock at book value. Given the data shown below,
Tax rate 35.00% 35.00% by how much would this recapitalization change the firm's cost of equity? (Hint: You must
unlever the current beta and then use the unlevered beta to solve the problem.)
a. $0.54
b. $0.60 Risk-free rate, rRF 5.00% Tax rate, T 40%
c. $0.67 Market risk premium, RPM 6.00% Current debt ratio 20%
d. $0.75 Current beta, bL1 .15 Target debt ratio 60%
e. $0.83
a. 4.05%
(14-2) Breakeven analysis C Q Answer: d HARD b. 4.50%
. Southeast U's campus book store sells course packs for $15.00 each, the variable cost c. 4.95%
per pack is $11.00, fixed costs for this operation are $300,000, and annual sales are d. 5.45%
100,000 packs. The unit variable cost consists of a $4.00 royalty payment, VR, per pack e. 5.99%
to professors plus other variable costs of VO = $7.00. The royalty payment is
negotiable. The book store's directors believe that the store should earn a profit margin (14-3) Recapitalization C Q Answer: b HARD
 . Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of . (15-1) Target payout ratio F R Answer: b EASY
EBIT, and EBIT is expected to remain constant in the future. The company pays out all The higher the payout ratio, the less of its earnings the firm reinvests in the business, and
of its earnings, so earnings per share (EPS) equal dividends per shares (DPS), and its the lower the reinvestment rate, the lower the growth rate.
tax rate is 40%. The company is considering issuing $5,000,000 of 9.00% bonds and
using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk . (15-1) Dividend irrelevance F R Answer: a EASY
premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO believes the . (15-1) Dividend irrelevance F R Answer: b EASY
beta would rise to 1.10 if the recapitalization occurs. Assuming the shares could be . (15-1) Investors' div. preferences F R Answer: a EASY
repurchased at the price that existed prior to the recapitalization, what would the price per . (15-6) Stock dividends and splits F R Answer: a EASY
share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.) . (15-6) Reverse split F R Answer: a EASY
. (15-1) Dividends and stock prices F R Answer: b MEDIUM
a. $28.27 . (15-1) Dividends and stock prices F R Answer: b MEDIUM
b. $29.76 . (15-1) Dividends and stock prices F R Answer: b MEDIUM
c. $31.25 . (15-1) Dividends and stock prices F R Answer: a MEDIUM
d. $32.81 . (15-1) Dividend irrelevance F R Answer: a MEDIUM
e. $34.45 . (15-1) Dividend-growth tradeoff F R Answer: a MEDIUM
. (15-2) Dividends and stock prices F R Answer: a MEDIUM
. (15-2) Dividends and stock prices F R Answer: a MEDIUM
(14-3) ROE & financing plans C Q Answer: e HARD . (15-2) Dividends and stock prices F R Answer: b MEDIUM
. You were hired as the CFO of a new company that was founded by three professors at MM would disagree. They would say that investors took the dividend increase as a signal
your university. The company plans to manufacture and sell a new product, a cell phone that the firm's management expected higher earnings in the future. MM say dividends
that can be worn like a wrist watch. The issue now is how to finance the company, with have information content regarding future earnings.
equity only or with a mix of debt and equity. The price per phone will be $250.00
regardless of how the firm is financed. The expected fixed and variable operating costs, . (15-2) Signaling hypothesis F R Answer: a MEDIUM
along with other data, are shown below. How much higher or lower will the firm's . (15-3) Residual dividend model F R Answer: a MEDIUM
expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL - ROEU? . (15-3) Residual dividend model F R Answer: b MEDIUM
The higher the debt ratio, the more dollars of debt will be used to fund a given capital
0% Debt, U 60% Debt, L budget. So, the higher the debt ratio, the less equity will be needed, and this results in a
Expected unit sales (Q) 28,500 28,500 higher dividend payout ratio.
Price per phone (P) $250.00 $250.00
Fixed costs (F) $1,000,000 $1,000,000 . (15-3) Residual dividend model F R Answer: b MEDIUM
Variable cost/unit (V) $200.00 $200.00 . (15-3) Dividend payment procedures F R Answer: b MEDIUM
Required investment $2,500,000 $2,500,000 This is false. The stock price will drop on the ex-dividend date, which is two days prior to
% Debt 0.00% 60.00% the holder of record date, which is well before the actual January 31 payment date. Also,
Debt, $ $0 $1,500,000 because the dividend is taxable, the price decline is generally somewhat less than the full
Equity, $ $2,500,000 $1,000,000 amount of the dividend.
Interest rate NA 10.00%
Tax rate 35.00% 35.00% . (15-3) Dividend payment procedures F R Answer: a MEDIUM
This is true. The stock price will drop on the ex-dividend date, which is two days prior to
a. 5.68% the holder of record date, which is well before the actual January 31 payment date. Note,
b. 5.94% though, that because the dividend is taxable, the price decline may be somewhat less
c. 6.22% than the full amount of the dividend.
d. 6.52%
e. 6.83% . (15-4) Dividend reinvestment plans F R Answer: b MEDIUM
. (15-4) Dividend reinvestment plans F R Answer: a MEDIUM
. (15-1) Optimal distribution policy F R Answer: a EASY . (15-4) Dividend reinvestment plans F R Answer: a MEDIUM
This is true, because if the company retains its earnings rather than paying them out, Net income (NI) $11,500
investors should get capital gains rather than dividend income, and the taxes on those % Debt 40%
gains will be deferred until the stock is sold. Note that the money will be reinvested by % Equity = 1.0 %Debt = 60%
the company in either case, so the risk to stockholders under dividend reinvestment and Equity needed to support the capital budget = % Equity Capital budget $7,500
retained earnings should be the same. Dividends paid = NI - Equity needed if positive, otherwise $0.0. $4,000

. (15-6) Stock splits F R Answer: a MEDIUM Payout ratio = Dividends paid/NI = 34.78%
. (15-3) Residual dividend model F R Answer: a HARD
(1) The firm's WACC would increase, (2) this would cause fewer projects to be accepted, . (15-6) Stock splits C R Answer: c EASY
(3) this would lead to a smaller capital budget, (4) thus less money would be needed to Number of new shares 2
fund the capital budget, (5) thus less equity would be needed, so (6) the dividend payout Number of old shares 1
ratio would increase. Old (pre-split) price $80

. (15-5) WACC and dividend policy F R Answer: b HARD New price = Old price (Old shares/New shares) = $40.00
Firm U could fund its capital budget with varying amounts of debt without causing large
changes in its WACC and thus in its value and stock price. Firm V could not vary its debt . (15-6) Stock splits C R Answer: a EASY
ratio without increasing its WACC. Thus, Firm V would have to raise and lower its payout Number of new shares 3
in order to obtain the equity it needed to support its capital budget. Firm U, on the other Number of old shares 1
hand, could maintain a stable, steady dividend, and let the debt ratio vary without causing Pre-split stock price $90.00
much harm to its stock price.
Post-split stock price: P0/New per old = $30.00
. (15-3) Dividend payout C R Answer: a EASY
. (15-6) Stock splits C R Answer: b EASY . (15-6) Stock splits C R Answer: c EASY
. (15-1) Investors' div. preferences C R Answer: d MEDIUM Number of new shares 7
. (15-3) Residual dividend policy C R Answer: a MEDIUM Number of old shares 2
. (15-3) Residual dividend policy C R Answer: b MEDIUM Old (pre-split) price $80.00
. (15-3) Residual dividend policy C R Answer: c MEDIUM
. (15-5) Factors in div. policy C R Answer: d MEDIUM New price = Old price (Old shares/New shares) = $22.86
. (15-5) Factors in div. policy C R Answer: c MEDIUM
. (15-6) Stock dividends and splits C R Answer: e MEDIUM . (15-3) Residual dividend model C R Answer: b EASY/MEDIUM
. (Comp.) Dividend theories C R Answer: e MEDIUM Capital budget $650,000
. (Comp.) Repurchases and DRIPS C R Answer: c MEDIUM % Equity 60%
. (Comp.) Divs., DRIPs, and repurch. C R Answer: d MEDIUM Dividends to be paid $225,000
. (Comp.) Div. policy and repurchases C R Answer: d MEDIUM
. (Comp.) Dividend concepts C R Answer: c MEDIUM Required net income = Dividends + (Capital budget % Equity) = $615,000
. (Comp.) Dividend concepts C R Answer: e MEDIUM
. (Comp.) Dividend concepts C R Answer: b MEDIUM . (15-3) Residual dividend model C R Answer: b MEDIUM
. (Comp.) Dividend concepts C R Answer: b MEDIUM Capital budget $850,000
. (Comp.) Dividend concepts C R Answer: a MEDIUM Equity ratio 65%
. (Comp.) Dividend concepts C R Answer: e MEDIUM Dividends to be paid $400,000
. (Comp.) Repurchases and splits C R Answer: e MEDIUM
. (Comp.) Dividend concepts C R Answer: a MEDIUM/HARD Required net income = Dividends + (Capital budget % Equity) = $952,500
. (Comp.) Dividend concepts C R Answer: d MEDIUM/HARD
. (15-3) Residual dividend model C R Answer: d EASY . (15-3) Residual dividend model C R Answer: a MEDIUM
Capital budget $12,500 Capital budget $725,000
Equity ratio 55%
Dividends paid $500,000 Dividends paid = NI - Equity needed if positive (otherwise, $0.0) = $225,000

NI = Dividends + (Equity % Capital budget) = $898,750 . (15-3) Residual dividend model C R Answer: e MEDIUM
Payout = Dividends/NI = 55.63% Capital budget $1,500,000
Net income (NI) $550,000
. (15-3) Residual dividend model C R Answer: d MEDIUM % Debt 65%
% Debt 30% % Equity = 1.0 % Debt 35%
% Equity 70% Equity needed to support the capital budget = % Equity Capital budget $525,000
Net income $550,000
Max. capital budget = NI/% Equity $785,714 Dividends paid = NI - Equity needed if positive (otherwise, $0.0) = $25,000

Check: Is calculated Max. capital budget % Equity = NI? $550,000 = Net income . (15-3) Residual dividend model C R Answer: a MEDIUM
Capital budget $5,000
. (15-3) Residual dividend model C R Answer: d MEDIUM Net income (NI) $5,300
EBIT $2,000,000 Capital budget $850,000 % Debt 45%
Interest rate 10% % Debt 40% % Equity = 1.0 % Debt 55%
Debt outstanding $5,000,000 % Equity 60% Equity needed to support the capital budget = % Equity Capital budget $2,750
Shares outstanding 5,000,000 Tax rate 40% Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $2,550

EBIT $2,000,000 Payout ratio = Dividends paid/NI = 48.11%

- Interest expense = Interest rate Debt 500,000
Taxable income $1,500,000 . (15-3) Residual dividend model C R Answer: a MEDIUM
- Taxes = Tax rate Income 600,000 Capital budget $5,000
Net income (NI) $ 900,000 Net income (NI) $7,000
- Equity needed for capital budget = % Equity(Capital budget) 510,000 % Debt 45%
Dividends = NI - Equity needed $ 390,000 % Equity = 1.0 % Debt 55%
Equity needed to support the capital budget = % Equity Capital budget $2,750
Payout ratio = Dividends/NI = 43.33% Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $4,250

. (15-3) Residual dividend model C R Answer: c MEDIUM Payout ratio = Dividends paid/NI = 60.71%
% Debt 30%
% Equity 70% . (15-3) Residual dividend model C R Answer: d MEDIUM
Capital budget $500,000 Capital budget $7,500
Net income $400,000 Net income (NI) $6,500
Equity requirement = capital budget % Equity $350,000 % Debt 35%
% Equity = 1.0 % Debt 65%
Dividends = NI - Equity requirement = $50,000 Equity needed to support the capital budget = % Equity Capital budget $4,875
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $1,625
. (15-3) Residual dividend model C R Answer: e MEDIUM
Capital budget $1,000,000 Payout ratio = Dividends paid/NI = 25.00%
Net income (NI) $625,000
% Debt 60% . (15-6) Stock split C R Answer: c MEDIUM
% Equity = 1.0 % Debt 40% Current price $0.50
Equity needed to support the capital budget = % Equity Capital budget $400,000 Target price $25.00
 % Equity = 1.0 % Debt 60% 60%
Old shares surrendered per 1 new share = Target price/Old price = 50.00 Capital budget $3,000,000 $2,000,000
Net income (NI) $3,500,000 $3,500,000
. (15-6) Stock split C R Answer: b MEDIUM Equity needed to support the capital budget = % Equity Capital budget $1,800,000
Current price $175.00 $1,200,000
Target price $25.00 Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $1,700,000 $2,300,000

No. of new shares per 1 old share = Current price/Target price = 7.00 Increase in dividends paid = $600,000

. (15-6) Stock split C R Answer: b MEDIUM . (15-3) Residual dividend model C R Answer: e MEDIUM/HARD
New shares per 1 old share 4 Capital budget $2,000,000
Pre-split stock price $120 % Equity 60%
% value increase 5% Net income (NI) $900,000
Equity required for capital budget = % Equity Capital budget $1,200,000
Post-split stock price = (P0/[New shares per old shares)(1 + % Value increase)] = Dividends = NI Equity required if > 0 (otherwise, 0) = $0
$31.50 Required new stock = NI Equity required if < 0 (otherwise, 0) = $300,000

. (15-3) Residual dividend model C R Answer: c MEDIUM/HARD Dividends: or new stock:

Old New Dividends paid = NI - [% Equity(Cap. bud.)], stock issued if dividends zero or neg. $0
% Debt 15% 60% $300,000
% Equity = 1.0 % Debt 85% 40%
Capital budget $3,000,000 $3,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget = % Equity Capital budget $2,550,000
$1,200,000
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $950,000 $2,300,000

Increase in dividends paid = $1,350,000 . (15-6) Stock split C R Answer: b MEDIUM/HARD

Number of new shares 7
. (15-3) Residual dividend model C R Answer: a MEDIUM/HARD Number of old shares 3
Old New Old (pre-split) price $75.00
% Debt 15% 60% % Increase in value 5%
% Equity = 1.0 % Debt 85% 40% New price before value increase = Old price/(New shares/Old shares) $32.14
Capital budget $3,000,000 $3,000,000
Net income (NI) $3,500,000 $3,500,000 New price after value increase = Prior (1 + % Value increase) = $33.75
Equity needed to support the capital budget = % Equity Capital budget $2,550,000
$1,200,000 . (15-3) Residual dividend model C R Answer: c HARD
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $950,000 $2,300,000 Old New
Dividend payout ratio 27.1% 65.7% Net income (NI) $3,500,000 $3,500,000
% Debt 35% 35%
Increase in dividend payout ratio = 38.6% % Equity = 1.0 % Debt 65% 65%

. (15-3) Residual dividend model C R Answer: c MEDIUM/HARD New target payout ratio 70%
Old New Target dividend = Target payout NI $2,450,000
% Debt 40% 40% Target retained earnings (RE) = NI Dividends $1,050,000
Max. capital budget = RE/% Equity $1,615,385
Check: % Equity Capital budget consistent = Calculated RE? Yes $1,050,000
New capital budget Old capital budget = $1,615,385 $5,000,000 = -$3,384,615
. (15-3) Residual dividend model C R Answer: e HARD
EPS $3.00
Shares outstanding 500,000
DPS $2.00
Capital budget $800,000
Net income = EPS Shares outstanding $1,500,000
Dividends paid = DPS Shares outstanding $1,000,000
Retained earnings available $500,000
Capital budget - Retained earnings = Debt needed $300,000
Debt needed/Capital budget = % Debt financing = 37.5%
. (15-3) Residual dividend model C R Answer: e HARD
New Maximums:
Current If Increase If lower If Do
Found as: Maximum Debt Payout Both
NI Given $175.0 $175.0 $175.0 $175.0
% Debt " 25.0% 75.0% 25.0% 75.0%
% Equity " 75.0% 25.0% 75.0% 25.0%
% Payout " 65.0% 65.0% 20.0% 20.0%
Dividends Payout % NI $113.8 $113.8 $35.0 $35.0
Ret. earnings, RE NI Dividends $61.3 $61.3 $140.0 $140.0
Max. cap. budget RE/% Equity $81.7 $245.0 $186.7 $560.0
Increase: New max. - Current max. = $163.3 $105.0 $478.3
Percentage increase: New max./Current max. 1.0 = 200.0% 128.6% 585.7%
. (15-7) Repurchases vs. dividends C R Answer: c HARD
NI $625,000
No. of shares outstanding 100,000
Expected EPS $6.25
Current stock price $40.00
P/E ratio 6.40
Expected DPS if pay dividend = EPS $6.25
Expected stock price end of year = Current price + Expected DPS $46.25
Shares repurchased if use repurchase plan = NI/Expected price 13,514
New shares outstanding after repurchase 86,486
New EPS if use repurchase plan = NI/New shares $7.227
New price = P/E New EPS $46.25
Gain, 100 share owner, dividends = 100 DPS $625.00
Gain,100 share owner, repurchase = 100 (new price - current price) = $625.00
(16-1) Net working capital F S Answer: b EASY
. Net working capital, defined as current assets minus the sum of payables and accruals,
is equal to the current ratio minus the quick ratio.
a. True
b. False
(16-1) Net working capital F S Answer: b EASY
. Net working capital is defined as current assets divided by current liabilities.
a. True
b. False
(16-1) Working capital F S Answer: b EASY
. An increase in any current asset must be accompanied by an equal increase in some
current liability.
a. True
b. False
(16-2) Working capital policy F S Answer: a EASY
. Determining a firm's optimal investment in working capital and deciding how that
investment should be financed are elements of working capital policy.
a. True
b. False
(16-3) Permanent current assets F S Answer: a EASY
. The concept of permanent current assets reflects the fact that some components of
current assets do not shrink to zero even when a business is at its seasonal or cyclical
low. Thus, permanent current assets represent a minimum level of current assets that
must be financed.
a. True
b. False
(16-3) Conservative financing F S Answer: a EASY
. A conservative financing approach to working capital will result in permanent current
assets and some seasonal current assets being financed using long-term securities.
a. True
b. False a. True
b. False
(16-3) Current asset financing F S Answer: a EASY
. Although short-term interest rates have historically averaged less than long-term rates, (16-8) Receivables balance F S Answer: a EASY
the heavy use of short-term debt is considered to be an aggressive current asset . The average accounts receivables balance is a function of both the volume of credit
financing strategy because of the inherent risks of using short-term financing. sales and the days sales outstanding.

a. True a. True
b. False b. False

(16-4) Cash conversion cycle F S Answer: b EASY (16-8) Credit policy F S Answer: a EASY
. If a firm takes actions that reduce its days sales outstanding (DSO), then, other things . The four primary elements in a firm's credit policy are (1) credit standards, (2) discounts
held constant, this will lengthen its cash conversion cycle (CCC). offered, (3) credit period, and (4) collection policy.

a. True a. True
b. False b. False

(16-4) Cash conversion cycle F S Answer: b EASY (16-9) Taking discounts F S Answer: a EASY
. Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts . Not taking cash discounts is costly, and as a result, firms that do not take them are
payable, this will lengthen its cash conversion cycle (CCC). usually those that are performing poorly and have inadequate cash balances.

a. True a. True
b. False b. False

(16-5) Cash budget F S Answer: a EASY (16-9) Trade credit F S Answer: b EASY
. Shorter-term cash budgets--say a daily cash budget for the next month--are generally . If a firm buys on terms of 2/10, net 30, it should pay as early as possible during the
used for actual cash control while longer-term cash budgets--say monthly cash budgets discount period.
for the next year--are generally used for planning purposes.
a. True
a. True b. False
b. False
(16-9) Trade credit F S Answer: b EASY
(16-6) Lockbox F S Answer: a EASY . Trade credit can be separated into two components: free trade credit, which is credit
. Setting up a lockbox arrangement is one way for a firm to speed up the collection of received after the discount period ends, and costly trade credit, which is the cost of
payments from its customers. discounts not taken.

a. True a. True
b. False b. False

(16-9) Trade credit F S Answer: a EASY

(16-7) Inventory management F S Answer: b EASY . As a rule, managers should try to always use the free component of trade credit but
. Inventory management is largely self-contained in the sense that very little coordination should use the costly component only if the cost of this credit is lower than the cost of
among the sales, purchasing, and production personnel is required for successful credit from other sources.
inventory management.
a. True
b. False (16-10) Bank loans F S Answer: b EASY
. An informal line of credit and a revolving credit agreement are similar except that the
line of credit creates a legal obligation for the bank and thus is a more reliable source of
(16-9) Trade credit F S Answer: a EASY funds for the borrower.
. If a firm's suppliers stop offering discounts, then its use of trade credit is more likely to
increase than to decrease other things held constant. a. True
b. False
a. True
b. False
(16-10) Bank loans F S Answer: a EASY
(16-9) Trade credit F S Answer: a EASY . The maturity of most bank loans is short term. Bank loans to businesses are frequently
. When deciding whether or not to take a trade discount, the cost of borrowing from a made as 90-day notes which are often rolled over, or renewed, rather than repaid when
bank or other source should be compared to the cost of trade credit to determine if the they mature. However, if the borrower's financial situation deteriorates, then the bank
cash discount should be taken. may refuse to roll over the loan.

a. True a. True
b. False b. False

(16-9) Cost of trade credit F S Answer: a EASY (16-10) Line of credit F S Answer: a EASY
. The calculated cost of trade credit can be reduced by paying late. . A line of credit can be either a formal or an informal agreement between a borrower
and a bank regarding the maximum amount of credit the bank will extend to the borrower
a. True during some future period, assuming the borrower maintains its financial strength.
b. False
a. True
(16-9) Cost of trade credit C S Answer: a EASY b. False
. The calculated cost of trade credit for a firm that buys on terms of 2/10, net 30, is lower
(other things held constant) if the firm plans to pay in 40 days than in 30 days. (16-10) Revolving credit F S Answer: a EASY
. If a firm has set up a revolving credit agreement with a bank, the risk to the firm of
a. True being unable to obtain funds when needed is lower than if it had an informal line of credit.
b. False
a. True
(16-9) Cost of trade credit F S Answer: a EASY b. False
. One of the effects of ceasing to take trade credit discounts is that the firm's accounts
payable will rise, other things held constant. (16-12) Accruals F S Answer: a EASY
. Accruals are "free" capital in the sense that no explicit interest must normally be paid
a. True on accrued liabilities.
b. False
a. True
(16-9) Stretching payables F S Answer: b EASY b. False
. "Stretching" accounts payable is a widely accepted, entirely ethical, and costless
financing technique. (16-12) Accruals F S Answer: a EASY
. Accruals are "spontaneous," but unfortunately, due to law and economic forces, firms
a. True have little control over the level of these accounts.
b. False
a. True . If the yield curve is upward sloping, then short-term debt will be cheaper than long-term
b. False debt. Thus, if a firm's CFO expects the yield curve to continue to have an upward slope,
this would tend to cause the current ratio to be relatively low, other things held constant.
(16-12) Accruals F S Answer: b EASY
. The facts (1) that no explicit interest is paid on accruals and (2) that the firm can vary a. True
the level of these accounts at will makes them an attractive source of funding to meet b. False
working capital needs.
(16-3) Short-term financing F S Answer: a MEDIUM
a. True . The risk to the firm of borrowing using short-term credit is usually greater than if it used
b. False long-term debt. Added risk stems from (1) the greater variability of interest costs on
short-term than long-term debt and (2) the fact that even if its long-term prospects are
good, the firm's lenders may not be willing to renew short-term loans if the firm is
(16-3) Maturity matching F S Answer: a MEDIUM temporarily unable to repay those loans.
. Uncertainty about the exact lives of assets prevents precise maturity matching in an ex
post (i.e., after the fact) sense even though it is possible to match maturities on an ex a. True
ante (expected) basis. b. False
(16-3) Short-term financing F S Answer: b MEDIUM
a. True . Long-term loan agreements always contain provisions, or covenants, that constrain the
b. False firm's future actions. Short-term credit agreements are just as restrictive in order to
protect the interest of the lender.
(16-3) Maturity matching F S Answer: b MEDIUM
. The maturity matching, or "self-liquidating," approach to financing involves obtaining the a. True
funds for permanent current assets with a combination of long-term capital and short- b. False
term capital that varies depending on the level of interest rates. When short-term rates (16-3) Short-term financing C S Answer: a MEDIUM
are relatively high, short-term assets will be financed with long-term debt to reduce costs. . A firm constructing a new manufacturing plant and financing it with short-term loans,
which are scheduled to be converted to first mortgage bonds when the plant is
a. True completed, would want to separate the construction loan from its current liabilities
b. False associated with working capital when calculating net working capital.

(16-3) Aggressive financing F S Answer: a MEDIUM a. True

. A firm that follows an aggressive working capital financing approach uses primarily
short-term credit and thus is more exposed to an unexpected increase in interest rates
than is a firm that uses long-term capital and thus follows a conservative financing policy.
a. True
b. False
(16-3) Aggressive financing F S Answer: b MEDIUM
. The relative profitability of a firm that employs an aggressive working capital financing
policy will improve if the yield curve changes from upward sloping to downward sloping.
b. False
(16-4) Cash conversion cycle F S Answer: a MEDIUM
. The longer its customers normally hold inventory, the longer the credit period supplier
firms normally offer. Still, suppliers have some flexibility in the credit terms they offer. If
a supplier lengthens the credit period offered, this will shorten the customer's cash
conversion cycle but lengthen the supplier firm's own CCC.
a. True
b. False

a. True (16-4) Cash conversion cycle F S Answer: a MEDIUM

b. False . The cash conversion cycle (CCC) combines three factors: The inventory conversion
period, the receivables collection period, and the payables deferral period, and its
(16-3) Short-term financing F S Answer: a MEDIUM purpose is to show how long a firm must finance its working capital. Other things held
constant, the shorter the CCC, the more effective the firm's working capital management.
a. True
b. False
(16-5) Seasonal cash patterns F S Answer: b MEDIUM
. The target cash balance is typically (and logically) set so that it does not need to be
adjusted for either seasonal patterns or unanticipated random fluctuations.
a. True
b. False
(16-5) Cash budget F S Answer: b MEDIUM
. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash
budget on the assumption that both cash receipts and cash payments occur uniformly
over the month but in reality payments are concentrated at the beginning of each month.
a. True
b. False
(16-5) Cash budget F S Answer: a MEDIUM
. A firm's peak borrowing needs will probably be overstated if it bases its monthly cash
budget on the assumption that both cash receipts and cash payments occur uniformly
over the month but in reality receipts are concentrated at the beginning of each month.
a. True
b. False
(16-5) Cash and capital budgets F S Answer: b MEDIUM
. The cash budget and the capital budget are handled separately, and although they are
both important, they are developed completely independently of one another.
a. True
b. False
(16-5) Cash budget and depreciation F S Answer: b MEDIUM
. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the
cash budget. Thus, if the depreciation charge for the coming year doubled or halved, this
would have no effect on the cash budget.
a. True
b. False
(16-5) Cash flow synchronization F S Answer: a MEDIUM
. Synchronization of cash flows is an important cash management technique, as proper
synchronization can reduce the required cash balance and increase a firm's profitability.
a. True
b. False
(16-6) Lockbox C S Answer: b MEDIUM
. On average, a firm collects checks totaling $250,000 per day. It takes the firm
approximately 4 days from the day the checks were mailed until they result in usable
cash for the firm. Assume that (1) a lockbox system could be employed which would
reduce the cash conversion procedure to 2 1/2 days and (2) the firm could invest any
additional cash generated at 6% after taxes. The lockbox system would be a good buy if
it costs $25,000 annually.
a. True
b. False
(16-8) Receivables balance F S Answer: b MEDIUM
. Since receivables and payables both result from sales transactions, a firm with a high
receivables-to-sales ratio must also have a high payables-to-sales ratio.
a. True
b. False
(16-8) Receivables and growth C S Answer: b MEDIUM
. Dimon Products' sales are expected to be $5 million this year, with 90% on credit and
10% for cash. Sales are expected to grow at a stable, steady rate of 10% annually in the
future. Dimon's accounts receivable balance will remain constant at the current level,
because the 10% cash sales can be used to support the 10% growth rate, other things
held constant.
a. True
b. False
(16-8) Receivables and growth C S Answer: a MEDIUM
. For a zero-growth firm, it is possible to increase the percentage of sales that are made
on credit and still keep accounts receivable at their current level, provided the firm can
shorten the length of its collection period sufficiently.
a. True
b. False
(16-8) Collection policy F S Answer: a MEDIUM
. A firm's collection policy, i.e., the procedures it follows to collect accounts receivable,
plays an important role in keeping its average collection period short, although too strict a . If one of your firm's customers is "stretching" its accounts payable, this may be a
collection policy can reduce profits due to lost sales. nuisance but it does not represent a real financial cost to your firm as long as the
customer periodically pays off its entire balance.
a. True
b. False a. True
b. False
(16-8) Collection policy F S Answer: a EASY
. Changes in a firm's collection policy can affect sales, working capital, and profits. (16-10) Prime rate F S Answer: b MEDIUM
. The prime rate charged by big money center banks at any one time is likely to vary
a. True greatly (for example, as much as 2 to 4 percentage points) across banks due to banks'
b. False ability to differentiate themselves and because different banks operate in different parts of
the country.
(16-8) Cash vs. credit sales F S Answer: b MEDIUM
. Because money has time value, a cash sale is always more profitable than a credit a. True
sale. b. False

a. True (16-10) Revolving credit F S Answer: a MEDIUM

b. False . A revolving credit agreement is a formal line of credit. The firm must generally pay a
fee on the unused balance of the committed funds to compensate the bank for the
(16-8) DSO and past due accounts C S Answer: b MEDIUM commitment to extend those funds.
. If a firm sells on terms of 2/10, net 30 days, and its DSO is 28 days, then the fact that
the 28-day DSO is less than the 30-day credit period tell us that the credit department is a. True
functioning efficiently and there are no past due accounts. b. False

a. True (16-10) Promissory note F S Answer: b HARD

b. False . A promissory note is the document signed when a bank loan is executed, and it
specifies financial aspects of the loan. The bank can hold the note in its loan portfolio,
sell it to a permanent investor like a life insurance company or pension fund, or bundle it
(16-9) Trade credit F S Answer: b MEDIUM with other notes payable and use it as collateral for an asset-backed security that trades
. If a firm switched from taking trade credit discounts to paying on the net due date, this on the open market.
might cost the firm some money, but such a policy would probably have only a negligible
effect on the income statement and no effect whatever on the balance sheet. a. True
b. False
a. True
b. False

(16-9) Stretching payables F S Answer: a MEDIUM

. If a profitable firm finds that it simply must "stretch" its accounts payable, then this Multiple Choice: Conceptual
suggests that it is undercapitalized, i.e., that it needs more working capital to support its
operations. (16-1) Working capital C S Answer: c EASY
. Other things held constant, which of the following will cause an increase in net working
a. True capital?
b. False
a. Cash is used to buy marketable securities.
(16-9) Stretching payables F S Answer: b MEDIUM b. A cash dividend is declared and paid.
c. Merchandise is sold at a profit, but the sale is on credit. b. have widely disbursed manufacturing facilities.
d. Long-term bonds are retired with the proceeds of a preferred stock issue. c. have a large marketable securities portfolio, and cash, to protect.
e. Missing inventory is written off against retained earnings. d. receive payments in the form of currency, such as fast food restaurants, rather than in
the form of checks.
(16-3) Current asset financing C S Answer: a EASY e. have customers who operate in many different parts of the country.
. Firms generally choose to finance temporary current assets with short-term debt
because (16-8) Credit policy C S Answer: e EASY
. Which of the following is NOT commonly regarded as being a credit policy variable?
a. matching the maturities of assets and liabilities reduces risk under some
circumstances, and also because short-term debt is often less expensive than long-term a. Credit period.
capital. b. Collection policy.
b. short-term interest rates have traditionally been more stable than long-term interest c. Credit standards.
rates. d. Cash discounts.
c. a firm that borrows heavily on a long-term basis is more apt to be unable to repay the e. Payments deferral period.
debt than a firm that borrows short term.
d. the yield curve is normally downward sloping. (16-3) Current asset financing C S Answer: c MEDIUM
e. short-term debt has a higher cost than equity capital. . Swim Suits Unlimited is in a highly seasonal business, and the following summary
balance sheet data show its assets and liabilities at peak and off-peak seasons (in
(16-4) Cash conversion cycle C S Answer: b EASY thousands of dollars):
. Helena Furnishings wants to reduce its cash conversion cycle. Which of the following
actions should it take? Peak Off-Peak
Cash $ 50 $ 30
a. Increases average inventory without increasing sales. Marketable securities 0 20
b. Take steps to reduce the DSO. Accounts receivable 40 20
c. Start paying its bills sooner, which would reduce the average accounts payable but not Inventories 100 50
affect sales. Net fixed assets 500 500
d. Sell common stock to retire long-term bonds. Total assets $690 $620
e. Sell an issue of long-term bonds and use the proceeds to buy back some of its
common stock. Payables and accruals $ 30 $ 10
Short-term bank debt 50 0
(16-6) Lockbox C S Answer: d EASY Long-term debt 300 300
. A lockbox plan is Common equity 310 310
Total claims $690 $620
a. used to protect cash, i.e., to keep it from being stolen.
b. used to identify inventory safety stocks. From this data we may conclude that
c. used to slow down the collection of checks our firm writes.
d. used to speed up the collection of checks received. a. Swim Suits' current asset financing policy calls for exactly matching asset and liability
e. used primarily by firms where currency is used frequently in transactions, such as fast maturities.
food restaurants, and less frequently by firms that receive payments as checks. b. Swim Suits' current asset financing policy is relatively aggressive; that is, the company
finances some of its permanent assets with short-term discretionary debt.
c. Swim Suits follows a relatively conservative approach to current asset financing; that
(16-6) Lockbox C S Answer: e EASY is, some of its short-term needs are met by permanent capital.
. A lockbox plan is most beneficial to firms that d. Without income statement data, we cannot determine the aggressiveness or
conservatism of the company's current asset financing policy.
a. have suppliers who operate in many different parts of the country. e. Without cash flow data, we cannot determine the aggressiveness or conservatism of
the company's current asset financing policy.
a. Payments lags.
b. Payment for plant construction.
(16-3) Current asset financing C S Answer: b MEDIUM c. Cumulative cash.
. Which of the following statements is CORRECT? d. Repurchases of common stock.
e. Writing off bad debts.
a. Net working capital is defined as current assets minus the sum of payables and
accruals, and any increase in the current ratio automatically indicates that net working (16-5) Cash budget C S Answer: b MEDIUM
capital has increased. . Which of the following is NOT directly reflected in the cash budget of a firm that is in the
b. Although short-term interest rates have historically averaged less than long-term rates, zero tax bracket?
the heavy use of short-term debt is considered to be an aggressive strategy because of
the inherent risks associated with using short-term financing. a. Payments lags.
c. If a company follows a policy of "matching maturities," this means that it matches its b. Depreciation.
use of common stock with its use of long-term debt as opposed to short-term debt. c. Cumulative cash.
d. Net working capital is defined as current assets minus the sum of payables and d. Repurchases of common stock.
accruals, and any decrease in the current ratio automatically indicates that net working e. Payment for plant construction.
capital has decreased.
e. If a company follows a policy of "matching maturities," this means that it matches its (16-5) Cash budget C S Answer: a MEDIUM
use of short-term debt with its use of long-term debt. . Which of the following statements concerning the cash budget is CORRECT?

(16-4) Cash conversion cycle C S Answer: d MEDIUM
. Other things held constant, which of the following would tend to reduce the cash
conversion cycle?
a. Carry a constant amount of receivables as sales decline.
b. Place larger orders for raw materials to take advantage of price breaks.
c. Take all discounts that are offered.
d. Continue to take all discounts that are offered and pay on the net date.
e. Offer longer payment terms to customers.
(16-4) Cash conversion cycle C S Answer: a MEDIUM
. Which of the following actions would be likely to shorten the cash conversion cycle?
a. Depreciation expense is not explicitly included, but depreciation's effects are reflected
in the estimated tax payments.
b. Cash budgets do not include financial items such as interest and dividend payments.
c. Cash budgets do not include cash inflows from long-term sources such as the
issuance of bonds.
d. Changes that affect the DSO do not affect the cash budget.
e. Capital budgeting decisions have no effect on the cash budget until projects go into
operation and start producing revenues.
(16-5) Cash budget C S Answer: b MEDIUM
. Which of the following items should a company report directly in its monthly cash
budget?

a. Adopt a new manufacturing process that speeds up the conversion of raw materials to a. Its monthly depreciation expense.
finished goods from 20 days to 10 days. b. Cash proceeds from selling one of its divisions.
b. Change the credit terms offered to customers from 3/10, net 30 to 1/10, net 50. c. Accrued interest on zero coupon bonds that it issued.
c. Begin to take discounts on inventory purchases; we buy on terms of 2/10, net 30. d. New shares issued in a stock split.
d. Adopt a new manufacturing process that saves some labor costs but slows down the e. New shares issued in a stock dividend.
conversion of raw materials to finished goods from 10 days to 20 days.
e. Change the credit terms offered to customers from 2/10, net 30 to 1/10, net 60.
(16-5) Cash budget C S Answer: e MEDIUM
. Which of the following statements is CORRECT?
(16-5) Cash budget C S Answer: e MEDIUM
. Which of the following is NOT directly reflected in the cash budget of a firm that is in the a. Shorter-term cash budgets, in general, are used primarily for planning purposes, while
zero tax bracket? longer-term budgets are used for actual cash control.
b. The cash budget and the capital budget are developed separately, and although they
are both important to the firm, one does not affect the other.
c. Since depreciation is a non-cash charge, it neither appears on nor has any effect on
the cash budget.
d. The target cash balance should be set such that it need not be adjusted for seasonal
patterns and unanticipated fluctuations in receipts, although it should be changed to
reflect long-term changes in the firm's operations.
e. The typical cash budget reflects interest paid on loans as well as income from the
investment of surplus cash. These numbers, as well as other items on the cash budget,
are expected values; hence, actual results might vary from the budgeted amounts.
(16-6) Marketable securities C S Answer: c MEDIUM
. Which of the following is NOT a situation that might lead a firm to increase its holdings
of short-term marketable securities?
a. The firm must make a known future payment, such as paying for a new plant that is
under construction.
b. The firm is going from its peak sales season to its slack season, so its receivables and
inventories will experience a seasonal decline.
c. The firm is going from its slack season to its peak sales season, so its receivables and
inventories will experience seasonal increases.
d. The firm has just sold long-term securities and has not yet invested the proceeds in
operating assets.
e. The firm just won a product liability suit one of its customers had brought against it.
(16-6) Marketable securities C S Answer: d MEDIUM
. Which of the following statement completions is CORRECT? If the yield curve is
upward sloping, then the marketable securities held in a firm's portfolio, assumed to be
held for emergencies, should
a. consist mainly of long-term securities because they pay higher rates.
b. consist mainly of short-term securities because they pay higher rates.
c. consist mainly of U.S. Treasury securities to minimize interest rate risk.
d. consist mainly of short-term securities to minimize interest rate risk.
e. be balanced between long- and short-term securities to minimize the adverse effects of
either an upward or a downward trend in interest rates.
(16-7) Inventory management C S Answer: b MEDIUM
. Which of the following statements is most consistent with efficient inventory
management? The firm has a
a. below average inventory turnover ratio.
b. low incidence of production schedule disruptions.
c. below average total assets turnover ratio.
d. relatively high current ratio.
e. relatively low DSO.
(16-8) Receivables management C S Answer: b MEDIUM
. Which of the following statements is CORRECT?
a. A firm that makes 90% of its sales on credit and 10% for cash is growing at a constant
rate of 10% annually. Such a firm will be able to keep its accounts receivable at the
current level, since the 10% cash sales can be used to finance the 10% growth rate.
b. In managing a firm's accounts receivable, it is possible to increase credit sales per day
yet still keep accounts receivable fairly steady, provided the firm can shorten the length of
its collection period (its DSO) sufficiently.
c. Because of the costs of granting credit, it is not possible for credit sales to be more
profitable than cash sales.
d. Since receivables and payables both result from sales transactions, a firm with a high
receivables-to-sales ratio must also have a high payables-to-sales ratio.
e. Other things held constant, if a firm can shorten its DSO, this will lead to a higher
current ratio.
(16-8) Days sales outstanding (DSO) C S Answer: c MEDIUM
. Which of the following statements is CORRECT?
a. Other things held constant, the higher a firm's days sales outstanding (DSO), the
better its credit department.
b. If a firm that sells on terms of net 30 changes its policy to 2/10, net 30, and if no
change in sales volume occurs, then the firm's DSO will probably increase.
c. If a firm sells on terms of 2/10, net 30, and its DSO is 30 days, then the firm probably
has some past due accounts.
d. If a firm sells on terms of net 60, and if its sales are highly seasonal, with a sharp peak
in December, then its DSO as it is typically calculated (with sales per day = Sales for past
12 months/365) would probably be lower in January than in July.
e. If a firm changed the credit terms offered to its customers from 2/10, net 30 to 2/10, net
60, then its sales should increase, and this should lead to an increase in sales per day,
and that should lead to a decrease in the DSO.
(Comp.) Current asset financing C S Answer: b MEDIUM
. Which of the following statements is CORRECT?
a. Trade credit is provided only to relatively large, strong firms.
b. Commercial paper is a form of short-term financing that is primarily used by large,
strong, financially stable companies.
c. Short-term debt is favored by firms because, while it is generally more expensive than
long-term debt, it exposes the borrowing firm to less risk than long-term debt.
d. Commercial paper can be issued by virtually any firm so long as it is willing to pay the
going interest rate.
e. Commercial paper is typically offered at a long-term maturity of at least five years.
(Comp.) Current asset financing C S Answer: a MEDIUM
. Which of the following statements is NOT CORRECT?
a. Commercial paper can be issued by virtually any firm so long as it is willing to pay the
going interest rate.
b. Accruals are "free" in the sense that no explicit interest is paid on these funds.
c. A conservative approach to working capital management will result in most if not all
permanent assets being financed with long-term capital.
d. The risk to a firm that borrows with short-term credit is usually greater than if it
borrowed using long-term debt. This added risk stems from the greater variability of
interest costs on short-term debt and possible difficulties with rolling over short-term debt.
e. Bank loans generally carry a higher interest rate than commercial paper.
(Comp.) Short-term financing C S Answer: a MEDIUM
. Which of the following statements is CORRECT?
a. Under normal conditions, a firm's expected ROE would probably be higher if it financed
with short-term rather than with long-term debt, but using short-term debt would probably
increase the firm's risk.
b. Conservative firms generally use no short-term debt and thus have zero current
liabilities.
c. A short-term loan can usually be obtained more quickly than a long-term loan, but the
cost of short-term debt is normally higher than that of long-term debt.
d. If a firm that can borrow from its bank at a 6% interest rate buys materials on terms of
2/10, net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see
zero accounts payable on its balance sheet.
e. If one of your firm's customers is "stretching" its accounts payable, this may be a
nuisance but it will not have an adverse financial impact on your firm if the customer
periodically pays off its entire balance.
(Comp.) Working capital policy C S Answer: d MEDIUM
. Which of the following statements is NOT CORRECT?
a. A company may hold a relatively large amount of cash and marketable securities if it is
uncertain about its volume of sales, profits, and cash flows during the coming year.
b. Credit policy has an impact on working capital because it influences both sales and the
time before receivables are collected.
c. The cash budget is useful to help estimate future financing needs, especially the need
for short-term working capital loans.
d. If a firm wants to generate more cash flow from operations in the next month or two, it
could change its credit policy from 2/10, net 30 to net 60.
e. Managing working capital is important because it influences financing decisions and
the firm's profitability.
(Comp.) Working capital concepts C S Answer: b MEDIUM
. Which of the following statements is CORRECT?
a. Depreciation is included in the estimate of cash flows (Cash flow = Net income +
Depreciation), hence depreciation is set forth on a separate line in the cash budget.
b. If cash inflows from collections occur in equal daily amounts but most payments must
be made on the 10th of each month, then a regular monthly cash budget will be
misleading. The problem can be corrected by using a daily cash budget.
c. Sound working capital policy is designed to maximize the time between cash
expenditures on materials and the collection of cash on sales.
d. If a firm wants to generate more cash flow from operations in the next month or two, it
could change its credit policy from 2/10, net 30 to net 60.
e. If a firm sells on terms of net 90, and if its sales are highly seasonal, with 80% of its
sales in September, then its DSO as it is typically calculated (with sales per day = Sales
for past 12 months/365) would probably be lower in October than in August.
(Comp.) Working capital concepts C S Answer: c MEDIUM
. Which of the following statements is CORRECT?
a. Accruals are an expensive but commonly used way to finance working capital.
b. A conservative financing policy is one where the firm finances part of its fixed assets
with short-term capital and all of its net working capital with short-term funds.
c. If a company receives trade credit under terms of 2/10, net 30, this implies that the
company has 10 days of free trade credit.
d. One cannot tell if a firm has a conservative, aggressive, or moderate current asset
financing policy without an examination of its cash budget.
e. If a firm has a relatively aggressive current asset financing policy vis--vis other firms
in its industry, then its current ratio will probably be relatively high.
Problems
(16-3) Maturity matching C S Answer: e EASY
. Halka Company is a no-growth firm. Its sales fluctuate seasonally, causing total assets
to vary from $320,000 to $410,000, but fixed assets remain constant at $260,000. If the
firm follows a maturity matching (or moderate) working capital financing policy, what is
the most likely total of long-term debt plus equity capital?
a. $260,642
b. $274,360
c. $288,800
d. $304,000
e. $320,000 a. 63 days
b. 67 days
(16-4) Cash conversion cycle C S Answer: d EASY c. 70 days
. Cass & Company has the following data. What is the firm's cash conversion cycle? d. 74 days
e. 78 days
Inventory conversion period = 50 days
Receivables collection period = 17 days (16-5) Cash budget C S Answer: d EASY
Payables deferral period = 25 days . Singal Inc. is preparing its cash budget. It expects to have sales of $30,000 in January,
$35,000 in February, and $35,000 in March. If 20% of sales are for cash, 40% are credit
a. 31 days sales paid in the month after the sale, and another 40% are credit sales paid 2 months
b. 34 days after the sale, what are the expected cash receipts for March?
c. 38 days
d. 42 days a. $24,057
e. 46 days b. $26,730
c. $29,700
(16-4) Cash conversion cycle C S Answer: b EASY d. $33,000
. Romano Inc. has the following data. What is the firm's cash conversion cycle? e. $36,300

Inventory conversion period = 38 days (16-8) Accounts receivable balance C S Answer: a EASY
Receivables collection period = 19 days . Dyl Pickle Inc. had credit sales of $3,500,000 last year and its days sales outstanding
Payables deferral period = 20 days was DSO = 35 days. What was its average receivables balance, based on a 365-day
year?
a. 33 days
b. 37 days a. $335,616
c. 41 days b. $352,397
d. 45 days c. $370,017
e. 49 days d. $388,518
e. $407,944
(16-4) Cash conversion cycle C S Answer: e EASY
. Whittington Inc. has the following data. What is the firm's cash conversion cycle? (16-2) ROE and WC policy C S Answer: c MEDIUM
. Edwards Enterprises follows a moderate current asset investment policy, but it is now
Inventory conversion period = 41 days considering a change, perhaps to a restricted or maybe to a relaxed policy. The firms
Receivables collection period = 31 days annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls
Payables deferral period = 38 days for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%;
and its tax rate is 40%. With a restricted policy, current assets will be 15% of sales, while
a. 31 days under a relaxed policy they will be 25% of sales. What is the difference in the projected
b. 34 days ROEs between the restricted and relaxed policies?
c. 37 days
d. 41 days a. 4.25%
e. 45 days b. 4.73%
(16-4) Cash conversion cycle C S Answer: d EASY c. 5.25%
. Inmoo Companys average age of accounts receivable is 45 days, the average age of d. 5.78%
accounts payable is 40 days, and the average age of inventory is 69 days. Assuming a e. 6.35%
365-day year, what is the length of its cash conversion cycle?
 e. $11,151
(16-4) Days sales outstanding C S Answer: c MEDIUM
. Data on Shick Inc. for 2008 are shown below, along with the days sales outstanding of
the firms against which it benchmarks. The firm's new CFO believes that the company (16-4) Payables deferral period C S Answer: e MEDIUM
could reduce its receivables enough to reduce its DSO to the benchmarks' average. If . Data on Wentz Inc. for 2008 are shown below, along with the payables deferral period
this were done, by how much would receivables decline? Use a 365-day year. (PDP) for the firms against which it benchmarks. The firm's new CFO believes that the
company could delay payments enough to increase its PDP to the benchmarks'
Sales $110,000 average. If this were done, by how much would payables increase? Use a 365-day year.
Accounts receivable $16,000
Days sales outstanding (DSO) 53.09 Cost of goods sold = $75,000
Benchmarks' days sales outstanding (DSO) 20.00 Payables = $5,000
Payables deferral period (PDP) = 24.33
a. $8,078 Benchmark payables deferral period = 30.00
b. $8,975
c. $9,973 a. $764
d. $10,970 b. $849
e. $12,067 c. $943
d. $1,048
(16-4) Inventory conv. period C S Answer: d MEDIUM e. $1,164
. Your firm's cost of goods sold (COGS) average $2,000,000 per month, and it keeps
inventory equal to 50% of its monthly COGS on hand at all times. Using a 365-day year, (16-4) Cash conversion cycle C S Answer: e MEDIUM
what is its inventory conversion period? . Your consulting firm was recently hired to improve the performance of Shin-Soenen Inc,
which is highly profitable but has been experiencing cash shortages due to its high
a. 11.7 days growth rate. As one part of your analysis, you want to determine the firms cash
b. 13.0 days conversion cycle. Using the following information and a 365-day year, what is the firms
c. 14.4 days present cash conversion cycle?
d. 15.2 days
e. 16.7 days Average inventory = $75,000
Annual sales = $600,000
(16-4) Inventory conv. period C S Answer: e MEDIUM Annual cost of goods sold = $360,000
. Data on Shin Inc for 2008 are shown below, along with the inventory conversion period Average accounts receivable = $160,000
(ICP) of the firms against which it benchmarks. The firm's new CFO believes that the Average accounts payable = $25,000
company could reduce its inventory enough to reduce its ICP to the benchmarks'
average. If this were done, by how much would inventories decline? Use a 365-day a. 120.6 days
year. b. 126.9 days
c. 133.6 days
Cost of goods sold = $85,000 d. 140.6 days
Inventory = $20,000 e. 148.0 days
Inventory conversion period (ICP) = 85.88
Benchmark inventory conversion period (ICP) = 38.00 (16-4) Cash conversion cycle C S Answer: d MEDIUM
. Dewey Corporation has the following data, in thousands. Assuming a 365-day year,
a. $7,316 what is the firm's cash conversion cycle?
b. $8,129
c. $9,032 Annual sales = $45,000
d. $10,036 Annual cost of goods sold = $31,500
Inventory = $4,000 b. 37.4
Accounts receivable = $2,000 c. 41.2
Accounts payable = $2,400 d. 45.3
e. 49.8
a. 25 days
b. 28 days
c. 31 days (16-4) Cash conversion cycle C S Answer: b MEDIUM
d. 35 days . Edison Inc. has annual sales of $36,500,000, or $100,000 a day on a 365-day
e. 38 days basis. The firm's cost of goods sold is 75% of sales. On average, the company has
$9,000,000 in inventory and $8,000,000 in accounts receivable. The firm is looking for
ways to shorten its cash conversion cycle. Its CFO has proposed new policies that would
(16-4) Cash conversion cycle C S Answer: d MEDIUM result in a 20% reduction in both average inventories and accounts receivable. She also
. Desai Inc. has the following data, in thousands. Assuming a 365-day year, what is the anticipates that these policies would reduce sales by 10%, while the payables deferral
firm's cash conversion cycle? period would remain unchanged at 35 days. What effect would these policies have on
the company's cash conversion cycle? Round to the nearest whole day.
Annual sales = $45,000
Annual cost of goods sold = $30,000 a. -26 days
Inventory = $4,500 b. -22 days
Accounts receivable = $1,800 c. -18 days
Accounts payable = $2,500 d. -14 days
e. -11 days
a. 28 days
b. 32 days (16-4) Cash conversion cycle C S Answer: e MEDIUM
c. 35 days . Van Den Borsh Corp. has annual sales of $50,735,000, an average inventory level of
d. 39 days $15,012,000, and average accounts receivable of $10,008,000. The firm's cost of goods
e. 43 days sold is 85% of sales. The company makes all purchases on credit and has always paid
on the 30th day. However, it now plans to take full advantage of trade credit and to pay
(16-4) Cash conversion cycle C S Answer: a MEDIUM its suppliers on the 40th day. The CFO also believes that sales can be maintained at the
. Zervos Inc. had the following data for 2008 (in millions). The new CFO believes (1) that existing level but inventory can be lowered by $1,946,000 and accounts receivable by
an improved inventory management system could lower the average inventory by $4,000, $1,946,000. What will be the net change in the cash conversion cycle, assuming a 365-
(2) that improvements in the credit department could reduce receivables by $2,000, and day year?
(3) that the purchasing department could negotiate better credit terms and thereby
increase accounts payable by $2,000. Furthermore, she thinks that these changes would a. -26.6 days
not affect either sales or the costs of goods sold. If these changes were made, by how b. -29.5 days
many days would the cash conversion cycle be lowered? c. -32.8 days
d. -36.4 days
Original Revised e. -40.5 days
Annual sales: unchanged $110,000 $110,000
Cost of goods sold: unchanged $80,000 $80,000 (16-5) Cash budget C S Answer: c MEDIUM
Average inventory: lowered by $4,000 $20,000 $16,000 . Nogueiras Corps budgeted monthly sales are $5,000, and they are constant from
Average receivables: lowered by $2,000 $16,000 $14,000 month to month. 40% of its customers pay in the first month and take the 2% discount,
Average payables: increased by $2,000 $10,000 $12,000 while the remaining 60% pay in the month following the sale and do not receive a
Days in year 365 365 discount. The firm has no bad debts. Purchases for next months sales are constant at
50% of projected sales for the next month. Other payments, which include wages, rent,
a. 34.0 and taxes, are 25% of sales for the current month. Construct a cash budget for a typical
month and calculate the average cash gain or loss during the month.
(16-9) Trade credit: nom. cost C S Answer: b MEDIUM
a. $1,092 . Your company has been offered credit terms of 4/30, net 90 days. What will be the
b. $1,150 nominal annual percentage cost of its non-free trade credit if it pays 120 days after the
c. $1,210 purchase? (Assume a 365-day year.)
d. $1,271
e. $1,334 a. 16.05%
b. 16.90%
c. 17.74%
(16-6) Lockbox C S Answer: d MEDIUM d. 18.63%
. Whitmer Inc. sells to customers all over the U.S., and all receipts come in to its e. 19.56%
headquarters in New York City. The firm's average accounts receivable balance is $2.5
million, and they are financed by a bank loan at an 11% annual interest rate. The firm is
considering setting up a regional lockbox system to speed up collections, and it believes (16-9) Trade credit: EAR cost C S Answer: d MEDIUM
this would reduce receivables by 20%. If the annual cost of the system is $15,000, what . Bumpas Enterprises purchases $4,562,500 in goods per year from its sole supplier on
pre-tax net annual savings would be realized? terms of 2/15, net 50. If the firm chooses to pay on time but does not take the discount,
what is the effective annual percentage cost of its non-free trade credit? (Assume a 365-
a. $29,160 day year.)
b. $32,400
c. $36,000 a. 20.11%
d. $40,000 b. 21.17%
e. $44,000 c. 22.28%
d. 23.45%
(16-9) Trade credit: nom. cost C S Answer: a MEDIUM e. 24.63%
. A firm buys on terms of 3/15, net 45. It does not take the discount, and it generally
pays after 60 days. What is the nominal annual percentage cost of its non-free trade (16-9) Trade credit: EAR cost C S Answer: c MEDIUM
credit, based on a 365-day year? . A firm buys on terms of 2/8, net 45 days, it does not take discounts, and it actually pays
after 58 days. What is the effective annual percentage cost of its non-free trade credit?
a. 25.09% (Use a 365-day year.)
b. 27.59%
c. 30.35% a. 14.34%
d. 33.39% b. 15.10%
e. 36.73% c. 15.89%
d. 16.69%
(16-9) Trade credit: nom. cost C S Answer: e MEDIUM e. 17.52%
. Atlanta Cement, Inc. buys on terms of 2/15, net 30. It does not take discounts, and it
typically pays 60 days after the invoice date. Net purchases amount to $720,000 per (16-9) Free trade credit C S Answer: a MEDIUM
year. What is the nominal annual percentage cost of its non-free trade credit, based on a . Buskirk Construction buys on terms of 2/15, net 60 days. It does not take discounts,
365-day year? and it typically pays on time, 60 days after the invoice date. Net purchases amount to
$450,000 per year. On average, how much free trade credit does the firm receive
a. 10.86% during the year? (Assume a 365-day year, and note that purchases are net of discounts.)
b. 12.07%
c. 13.41% a. $18,493
d. 14.90% b. $19,418
e. 16.55% c. $20,389
d. $21,408 way of getting the needed funds would be to forgo the discount, and the firm's owner
e. $22,479 believes she could delay payment to 40 days without adverse effects. What would be the
effective annual percentage cost of funds raised by this action? (Assume a 365-day
(16-9) Costly trade credit C S Answer: a MEDIUM year.)
. Ingram Office Supplies, Inc., buys on terms of 2/15, net 50 days. It does not take
discounts, and it typically pays on time, 50 days after the invoice date. Net purchases a. 10.59%
amount to $450,000 per year. On average, what is the dollar amount of costly trade b. 11.15%
credit (total credit free credit) the firm receives during the year? (Assume a 365-day c. 11.74%
year, and note that purchases are net of discounts.) d. 12.36%
e. 13.01%
a. $43,151
b. $45,308
c. $47,574 (16-10) Revolving credit agreement C S Answer: b MEDIUM
d. $49,952 . Weiss Inc. arranged a $9,000,000 revolving credit agreement with a group of
e. $52,450 banks. The firm paid an annual commitment fee of 0.5% of the unused balance of the
loan commitment. On the used portion of the revolver, it paid 1.5% above prime for the
funds actually borrowed on a simple interest basis. The prime rate was 9% during the
(16-9) Costly trade credit C S Answer: a MEDIUM year. If the firm borrowed $6,000,000 immediately after the agreement was signed and
. Roton Inc. purchases merchandise on terms of 2/15, net 40, and its gross purchases repaid the loan at the end of one year, what was the total dollar annual cost of the
(i.e., purchases before taking off the discount) are $800,000 per year. What is the revolver?
maximum dollar amount of costly trade credit the firm could get, assuming it abides by
the suppliers credit terms? (Assume a 365-day year.) a. $612,750
b. $645,000
a. $53,699 c. $677,250
b. $56,384 d. $711,113
c. $59,203 e. $746,668
d. $62,163
e. $65,271 (16-4) Cash conversion cycle C S Answer: a HARD
. Soenen Inc. had the following data for 2008 (in millions). The new CFO believes that
(16-9) Total trade credit C S Answer: a MEDIUM the company could improve its working capital management sufficiently to bring its NWC
. Kirk Development buys on terms of 2/15, net 60 days. It does not take discounts, and it and CCC up to the benchmark companies' level without affecting either sales or the costs
typically pays on time, 60 days after the invoice date. Net purchases amount to $550,000 of goods sold. Soenen finances its net working capital with a bank loan at an 8% annual
per year. On average, what is the dollar amount of total trade credit (costly + free) the interest rate, and it uses a 365-day year. If these changes had been made, by how much
firm receives during the year, i.e., what are its average accounts payable? (Assume a would the firm's pre-tax income have increased?
365-day year, and note that purchases are net of discounts.)
Original Benchmarks
a. $90,411 Data Related CCC CCC
b. $94,932 Sales $100,000
c. $99,678 Cost of goods sold $80,000
d. $104,662 Inventory (ICP) $20,000 91.25 38.00
e. $109,895 Receivables (DSO) $16,000 58.40 20.00
Payables (PDP) $5,000 22.81 30.00
(16-9) Stretching accts payable C S Answer: e MEDIUM 126.84 28.00
. Affleck Inc.'s business is booming, and it needs to raise more capital. The company
purchases supplies on terms of 1/10, net 20, and it currently takes the discount. One a. 1,901
b. 2,092 (16-9) Fin. stmts. and trade credit C S Answer: d HARD
c. 2,301 . Gonzales Company currently uses maximum trade credit by not taking discounts on its
d. 2,531 purchases. The standard industry credit terms offered by all its suppliers are 2/10, net 30
e. 2,784 days, and the firm pays on time. The new CFO is considering borrowing from its bank,
using short-term notes payable, and then taking discounts. The firm wants to determine
(16-4) Cash conversion cycle C S Answer: c HARD the effect of this policy change on its net income. Its net purchases are $11,760 per day,
. Margetis Inc. carries an average inventory of $750,000. Its annual sales are $10 using a 365-day year. The interest rate on the notes payable is 10%, and the tax rate is
million, its cost of goods sold is 75% of annual sales, and its receivables collection period 40%. If the firm implements the plan, what is the expected change in net income?
is twice as long as its inventory conversion period. The firm buys on terms of net 30
days, and it pays on time. Its new CFO wants to decrease the cash conversion cycle by a. $32,964
10 days, based on a 365-day year. He believes he can reduce the average inventory to b. $34,699
$647,260 with no effect on sales. By how much must the firm also reduce its accounts c. $36,526
receivable to meet its goal in the reduction of the cash conversion cycle? d. $38,448
e. $40,370
a. $123,630
b. $130,137 (Comp.) Inventory turnover and DSO C S Answer: c HARD
c. $136,986 . Zarruk Constructions DSO is 50 days (on a 365-day basis), accounts receivable are
d. $143,836 $100 million, and its balance sheet shows inventory of $125 million. What is the
e. $151,027 inventory turnover ratio?

(16-9) Trade credit: EAR cost C S Answer: b HARD a. 4.73

. Suppose the credit terms offered to your firm by its suppliers are 2/10, net 30 b. 5.26
days. Your firm is not taking discounts, but is paying after 25 days instead of waiting until c. 5.84
Day 30. You point out that the nominal cost of not taking the discount and paying on Day d. 6.42
30 is approximately 37%. But since your firm is neither taking discounts nor paying on e. 7.07
the due date, what is the effective annual percentage cost (not the nominal cost) of its
costly trade credit, using a 365-day year?
(Comp.) Working capital, FCF C S Answer: b HARD
a. 60.3% . Madura Inc. wants to increase its free cash flow by $180 million during the coming year,
b. 63.5% which should result in a higher EVA and stock price. The CFO has made these
c. 66.7% projections for the upcoming year:
d. 70.0%
e. 73.5% EBIT is projected to equal $850 million.
Gross capital expenditures are expected to total to $360 million versus depreciation of
(16-9) Accounts payable balance C S Answer: e HARD $120 million, so its net capital expenditures should total $240 million.
. Aggarwal Inc. buys on terms of 2/10, net 30, and it always pays on the 30th day. The The tax rate is 40%.
CFO calculates that the average amount of costly trade credit carried is $375,000. What There will be no changes in cash or marketable securities, nor will there be any
is the firm's average accounts payable balance? Assume a 365-day year. changes in notes payable or accruals.

a. $458,160 What increase in net working capital (in millions of dollars) would enable the firm to meet
b. $482,273 its target increase in FCF?
c. $507,656
d. $534,375 a. $72
e. $562,500 b. $90
c. $108
d. $130
e. $156
CHAPTER 17
Multiple Part: FINANCIAL PLANNING AND FORECASTING
(Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard)
(The following data apply to Problems 126-128.)

Zorn Corporation is deciding whether to pursue a restricted or relaxed working capital Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the
investment policy. The firm's annual sales are expected to total $3,600,000, its fixed subject lines.
assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total
assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is Multiple Choice: True/False
40%. If the company follows a restricted policy, its total assets turnover will be
2.5. Under a relaxed policy its total assets turnover will be 2.2. (17-2) Sales forecast F K Answer: a EASY
. The first, and most critical, step in constructing a set of forecasted financial statements
(16-3) WC investment policy C S Answer: d MEDIUM is the sales forecast.
. If the firm adopts a restricted policy, how much lower would its interest expense be than
under the relaxed policy? a. True
b. False
a. $8,418
b. $8,861 (17-2) Sales forecast F K Answer: a EASY
c. $9,327 . A typical sales forecast, though concerned with future events, will usually be based on
d. $9,818 recent historical trends and events as well as on forecasts of economic prospects.
e. $10,309
a. True
(16-3) WC investment, ROE C S Answer: b MEDIUM b. False
. What's the difference in the projected ROEs under the restricted and relaxed policies?
(17-2) Sales forecast F K Answer: b EASY
a. 1.20% . Errors in the sales forecast can be offset by similar errors in costs and income
b. 1.50% forecasts. Thus, as long as the errors are not large, sales forecast accuracy is not critical
c. 1.80% to the firm.
d. 2.16%
e. 2.59% a. True
b. False

(16-3) WC investment, ROE C S Answer: a MEDIUM
. Assume now that the company believes that if it adopts a restricted policy, its sales will
fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate,
and tax rate will all remain the same. In this situation, what's the difference between the
projected ROEs under the restricted and relaxed policies?
(17-3) Spontaneously gen. funds F K Answer: a EASY
. As a firm's sales grow, its current assets also tend to increase. For instance, as sales
increase, the firm's inventories generally increase, and purchases of inventories result in
more accounts payable. Thus, spontaneously generated funds arise from transactions
brought on by sales increases.

a. 2.24% a. True
b. 2.46% b. False
c. 2.70%
d. 2.98% (17-3) Spontaneously gen. funds F K Answer: b EASY
e. 3.27% . The term "spontaneously generated funds" generally refers to increases in the cash
account that result from growth in sales, assuming the firm is operating with a positive . A firm's profit margin is 5%, its debt/assets ratio is 56%, and its dividend payout ratio is
profit margin. 40%. If the firm is operating at less than full capacity, then sales could increase to some
extent without the need for external funds, but if it is operating at full capacity with respect
a. True to all assets, including fixed assets, then any positive growth in sales will require some
b. False external financing.

a. True
(17-3) Asset increase F K Answer: a EASY b. False
. A rapid build-up of inventories normally requires additional financing, unless the
increase is matched by an equally large decrease in some other asset.

a. True (17-3) Capital intensity ratio F K Answer: a MEDIUM

b. False . Two firms with identical capital intensity ratios are generating the same amount of
sales. However, Firm A is operating at full capacity, while Firm B is operating below
(17-3) Additional funds needed F K Answer: b EASY capacity. If the two firms expect the same growth in sales during the next period, then
. If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales Firm A is likely to need more additional funds than Firm B, other things held constant.
growth rate of any amount, it will require some amount of external funding.
a. True
a. True b. False
b. False
(17-3) Capital intensity ratio F K Answer: b MEDIUM
(17-3) Additional funds needed F K Answer: b EASY . If a firm's capital intensity ratio (A*0/S0) decreases as sales increase, use of the AFN
. To determine the amount of additional funds needed (AFN), you may subtract the formula is likely to understate the amount of additional funds required, other things held
expected increase in liabilities, which represents a source of funds, from the sum of the constant.
expected increases in retained earnings and assets, both of which are uses of funds.
a. True
a. True b. False
b. False
(17-4) Financial forecasting F K Answer: b MEDIUM
(17-4) Forecasted statements F K Answer: a EASY . The fact that long-term debt and common stock are raised infrequently and in large
. One of the key steps in the development of the forecasted balance sheet is to identify amounts lessens the need for the firm to forecast those accounts on a continual basis.
those assets and liabilities that increase at the same rate as sales.
a. True
a. True b. False
b. False
(17-5) AFN formula and linear reg. F K Answer: a MEDIUM
(17-3) Additional funds needed F K Answer: a MEDIUM . When we use the AFN formula to forecast the additional funds needed (AFN), we are
. If a firm with a positive net worth is operating its fixed assets at full capacity, if its implicitly assuming that all financial ratios are constant. If financial ratios are not
dividend payout ratio is 100%, and if it wants to hold all financial ratios constant, then for constant, regression techniques can be used to improve the financial forecast.
any positive growth rate in sales, it will require external financing.
a. True
a. True b. False
b. False

(17-3) Additional funds needed F K Answer: b MEDIUM Multiple Choice: Conceptual


(17-1) Strategic planning C K Answer: c EASY
. Which of the following is NOT a key element in strategic planning as it is described in
the text?
a. The mission statement.
b. The statement of the corporations scope.
c. The statement of cash flows.
d. The statement of corporate objectives.
e. The operating plan.
(17-3) AFN formula method C K Answer: b EASY
. Which of the following assumptions is embodied in the AFN formula?
a. All balance sheet accounts are tied directly to sales.
b. Accounts payable and accruals are tied directly to sales.
c. Common stock and long-term debt are tied directly to sales.
d. Fixed assets, but not current assets, are tied directly to sales.
e. Last years total assets were not optimal for last years sales.
(17-3) Additional funds needed C K Answer: a EASY/MEDIUM
. Jefferson City Computers has developed a forecasting model to estimate its AFN for
the upcoming year. All else being equal, which of the following factors is most likely to
lead to an increase of the additional funds needed (AFN)?
a. A sharp increase in its forecasted sales.
b. A sharp reduction in its forecasted sales.
c. The company reduces its dividend payout ratio.
d. The company switches its materials purchases to a supplier that sells on terms of 1/5,
net 90, from a supplier whose terms are 3/15, net 35.
e. The company discovers that it has excess capacity in its fixed assets.
(17-3) Additional funds needed C K Answer: b EASY/MEDIUM
. The term additional funds needed (AFN) is generally defined as follows:
a. Funds that are obtained automatically from routine business transactions.
b. Funds that a firm must raise externally from non-spontaneous sources, i.e., by
borrowing or by selling new stock, to support operations.
c. The amount of assets required per dollar of sales.
d. The amount of internally generated cash in a given year minus the amount of cash
needed to acquire the new assets needed to support growth.
e. A forecasting approach in which the forecasted percentage of sales for each balance
sheet account is held constant.
(17-3) Capital intensity ratio C K Answer: e EASY/MEDIUM
. The capital intensity ratio is generally defined as follows:
a. Sales divided by total assets, i.e., the total assets turnover ratio.
b. The percentage of liabilities that increase spontaneously as a percentage of sales.
c. The ratio of sales to current assets.
d. The ratio of current assets to sales.
e. The amount of assets required per dollar of sales, or A*0/S0.
(17-1) Financial planning C K Answer: e MEDIUM
. Which of the following is NOT one of the steps taken in the financial planning process?
a. Assumptions are made about future levels of sales, costs, and interest rates for use in
the forecast.
b. The entire financial plan is reexamined, assumptions are reviewed, and the
management team considers how additional changes in operations might improve
results.
c. Projected ratios are calculated and analyzed.
d. Develop a set of projected financial statements.
e. Consult with key competitors about the optimal set of prices to charge, i.e., the prices
that will maximize profits for our firm and its competitors.
(17-3) Spontaneously gen. funds C K Answer: d MEDIUM
. Spontaneously generated funds are generally defined as follows:
a. Assets required per dollar of sales.
b. A forecasting approach in which the forecasted percentage of sales for each item is
held constant.
c. Funds that a firm must raise externally through borrowing or by selling new common or
preferred stock.
d. Funds that arise out of normal business operations from its suppliers, employees, and
the government, and they include spontaneous increases in accounts payable and
accruals.
e. The amount of cash raised in a given year minus the amount of cash needed to
finance the additional capital expenditures and working capital needed to support the
firms growth.
(17-3) Additional funds needed C K Answer: b MEDIUM
. A company expects sales to increase during the coming year, and it is using the AFN
equation to forecast the additional capital that it must raise. Which of the following
conditions would cause the AFN to increase?
a. The company previously thought its fixed assets were being operated at full capacity,
but now it learns that it actually has excess capacity.
b. The company increases its dividend payout ratio.
c. The company begins to pay employees monthly rather than weekly.
d. The companys profit margin increases.
e. The company decides to stop taking discounts on purchased materials.
(Comp.) Forecasting concepts C K Answer: b MEDIUM
. Which of the following statements is CORRECT?
a. Perhaps the most important step when developing forecasted financial statements is to
determine the breakdown of common equity between common stock and retained
earnings.
b. The first, and perhaps the most critical, step in forecasting financial requirements is to
forecast future sales.
c. Forecasted financial statements, as discussed in the text, are used primarily as a part
of the managerial compensation program, where managements historical performance is
evaluated.
d. The capital intensity ratio gives us an idea of the physical condition of the firms fixed
assets.
e. The AFN equation produces more accurate forecasts than the forecasted financial
statement method, especially if fixed assets are lumpy and economies of scale exist.
(17-1) Strategic planning C K Answer: c MEDIUM/HARD
. Which of the following statements is CORRECT?
a. Once a firm has defined its purpose, scope, and objectives, it must develop a strategy
or strategies for achieving its goals. The statement of corporate strategies sets forth
detailed plans rather than broad approaches for achieving a firm's goals.
b. A firms corporate purpose states the general philosophy of the business and provides
managers with specific operational objectives.
c. Operating plans provide management with detailed implementation guidance,
consistent with the corporate strategy, to help meet the corporate objectives. These
operating plans can be developed for any time horizon, but many companies use a 5-
year horizon.
d. A firms mission statement defines its lines of business and geographic area of
operations.
e. The corporate scope is a condensed version of the entire set of strategic plans.
(17-3) Additional funds needed C K Answer: d MEDIUM/HARD
. Which of the following statements is CORRECT?
a. Since accounts payable and accrued liabilities must eventually be paid off, as these
accounts increase, AFN as calculated by the AFN equation must also increase.
b. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no
excess current assets. Based on the AFN equation, its AFN will be larger than if it had
been operating with excess capacity in both fixed and current assets.
c. If a firm retains all of its earnings, then it cannot require any additional funds to support
sales growth.
d. Additional funds needed (AFN) are typically raised using a combination of notes
payable, long-term debt, and common stock. Such funds are non-spontaneous in the
sense that they require explicit financing decisions to obtain them.
e. If a firm has a positive free cash flow, then it must have either a zero or a negative
AFN.
(17-3) Additional funds needed C K Answer: d MEDIUM/HARD
. Which of the following statements is CORRECT?
a. Any forecast of financial requirements involves determining how much money the firm
will need, and this need is determined by adding together increases in assets and
spontaneous liabilities and then subtracting operating income.
b. The AFN equation for forecasting funds requirements requires only a forecast of the
firms balance sheet. Although a forecasted income statement may help clarify the
results, income statement data are not essential because funds needed relate only to the
balance sheet.
c. Dividends are paid with cash taken from the accumulated retained earnings account,
hence dividend policy does not affect the AFN forecast.
d. A negative AFN indicates that retained earnings and spontaneous capital are far more
than sufficient to finance the additional assets needed.
e. If assets and spontaneously generated liabilities are not projected to grow at the same
rate as sales, then the AFN method will provide more accurate forecasts than the
projected financial statement method.
(17-3) AFN equation C K Answer: a MEDIUM/HARD
. Which of the following statements is CORRECT?
a. The sustainable growth rate is the maximum achievable growth rate without the firm
having to raise external funds. In other words, it is the growth rate at which the firm's
AFN equals zero.
b. If a firms assets are growing at a positive rate, but its retained earnings are not
increasing, then it would be impossible for the firms AFN to be negative.
c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales
and earnings actually decrease, then the firms actual AFN must, mathematically, exceed
the previously calculated AFN.
d. Higher sales usually require higher asset levels, and this leads to what we call
AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to
have a zero dividend payout ratio.
e. Dividend policy does not affect the requirement for external funds based on the AFN
equation.
 . Last year Wei Guan Inc. had $350 million of sales, and it had $270 million of fixed
assets that were used at 65% of capacity. In millions, by how much could Wei Guan's
(17-5) Forecasting financial reqs. C K Answer: c MEDIUM/HARD sales increase before it is required to increase its fixed assets?
. Which of the following statements is CORRECT?
a. $170.09
a. When we use the AFN equation, we assume that the ratios of assets and liabilities to b. $179.04
sales (A*0/S0 and L*0/S0) vary from year to year in a stable, predictable manner. c. $188.46
b. When fixed assets are added in large, discrete units as a company grows, the d. $197.88
assumption of constant ratios is more appropriate than if assets are relatively small and e. $207.78
can be added in small increments as sales grow. (17-3) Excess capacity C K Answer: e MEDIUM
c. Firms whose fixed assets are lumpy frequently have excess capacity, and this should . Last year Handorf-Zhu Inc. had $850 million of sales, and it had $425 million of fixed
be accounted for in the financial forecasting process. assets that were used at only 60% of capacity. What is the maximum sales growth rate
d. For a firm that uses lumpy assets, it is impossible to have small increases in sales the company could achieve before it had to increase its fixed assets?
without expanding fixed assets.
e. Regression techniques cannot be used in situations where excess capacity or a. 54.30%
economies of scale exist. b. 57.16%
c. 60.17%
d. 63.33%
Problems e. 66.67%

(17-3) Excess capacity C K Answer: a EASY (17-3) Finding target FA/S ratio C K Answer: b MEDIUM
. Last year Godinho Corp. had $250 million of sales, and it had $75 million of fixed . Last year Jain Technologies had $250 million of sales and $100 million of fixed assets,
assets that were being operated at 80% of capacity. In millions, how large could sales so its FA/Sales ratio was 40%. However, its fixed assets were used at only 75% of
have been if the company had operated at full capacity? capacity. Now the company is developing its financial forecast for the coming year. As
part of that process, the company wants to set its target Fixed Assets/Sales ratio at the
a. $312.5 level it would have had had it been operating at full capacity. What target FA/Sales ratio
b. $328.1 should the company set?
c. $344.5
d. $361.8 a. 28.5%
e. $379.8 b. 30.0%
c. 31.5%
(17-5) Forecasting inv.--regression C K Answer: d EASY d. 33.1%
. Kamath-Meier Corporation's CFO uses this equation, which was developed by e. 34.7%
regressing inventories on sales over the past 5 years, to forecast inventory
requirements: Inventories = $22.0 + 0.125(Sales). The company expects sales of $400 (17-5) Forecasting inv. turnover C K Answer: a MEDIUM
million during the current year, and it expects sales to grow by 30% next year. What is . Fairchild Garden Supply expects $600 million of sales this year, and it forecasts a 15%
the inventory forecast for next year? All dollars are in millions. increase for next year. The CFO uses this equation to forecast inventory requirements at
different levels of sales: Inventories = $30.2 + 0.25(Sales). All dollars are in
a. $74.6 millions. What is the projected inventory turnover ratio for the coming year?
b. $78.5
c. $82.7 a. 3.40
d. $87.0 b. 3.57
e. $91.4 c. 3.75
d. 3.94
(17-3) Excess capacity C K Answer: c MEDIUM e. 4.14
 Last years profit margin = M 20.0% Initial payout ratio 10.0%
(17-3) Positive AFN C K Answer: d MEDIUM/HARD
. Clayton Industries is planning its operations for next year, and Ronnie Clayton, the a. $31.9
CEO, wants you to forecast the firm's additional funds needed (AFN). Data for use in b. $33.6
your forecast are shown below. Based on the AFN equation, what is the AFN for the c. $35.3
coming year? Dollars are in millions. d. $37.0
e. $38.9
Last years sales = S0 $350 Last years accounts payable $40
Sales growth rate = g 30% Last years notes payable $50 (17-3) Finding target FA/S ratio C K Answer: b HARD
Last years total assets = A*0 $500 Last years accruals $30 . Last year Emery Industries had $450 million of sales and $225 million of fixed assets,
Last years profit margin = M 5% Target payout ratio 60% so its FA/Sales ratio was 50%. However, its fixed assets were used at only 65% of
capacity. If the company had been able to sell off enough of its fixed assets at book
a. $102.8 value so that it was operating at full capacity, with sales held constant at $450 million,
b. $108.2 how much cash (in millions) would it have generated?
c. $113.9
d. $119.9 a. $74.81
e. $125.9 b. $78.75
(17-3) Negative AFN C K Answer: c MEDIUM/HARD c. $82.69
. Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you d. $86.82
to forecast the firm's additional funds needed (AFN). Data for use in your forecast are e. $91.16
shown below. Based on the AFN equation, what is the AFN for the coming year?

Last years sales = S0 $200,000 Last year's accounts payable $50,000

Sales growth rate = g 40% Last year's notes payable $15,000
Last years total assets = A*0 $135,000 Last year's accruals $20,000
Last years profit margin = M 20.0% Target payout ratio 25.0%

a. -$14,440
b. -$15,200
c. -$16,000
d. -$16,800
e. -$17,640

(17-3) AFN--changing div. payout C K Answer: b MEDIUM/HARD

. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and
the CEO wants you to forecast the firm's additional funds needed (AFN). Data for use in
the forecast are shown below. However, the CEO is concerned about the impact of a
change in the payout ratio from the 10% that was used in the past to 50%, which the
firm's investment bankers have recommended. Based on the AFN equation, by how
much would the AFN for the coming year change if HHW increased the payout from 10%
to the new and higher level? All dollars are in millions.

Last years sales = S0 $300.0 Last years accounts payable $50.0

Sales growth rate = g 40% Last years notes payable $15.0
Last years total assets = A0 $500.0 Last years accruals $20.0