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BUS 635 Quiz 3

Chapter 12 and Chapter 9

Name:

Instructions:
1. Make sure you write your name on the test above.
2. Attempt all questions and show detailed steps to get any partial credit.
*If you used a financial calculator, show the work (Example: N = 20, .)
*If you solved any questions with Excel, copy your work from Excel with a brief
explanation regarding which function or formula you used.
*Providing answer only (except multiple choice questions) will get a ZERO point.
3. The completed test is due by midnight Sunday PST
4. Email your responses to me at dpark2@laverne.edu. I will send you a receipt on Monday
after I download the submissions. If you do not receive a receipt by Monday midnight
then I did not receive your submission. Please resend it.
1. The term "additional funds needed (AFN)" is generally defined as follows:
a. Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or
by selling new stock to support operations.
b. The amount of assets required per dollar of sales.
c. 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.
d. A forecasting approach in which the forecasted percentage of sales for each balance sheet account is
held constant.
e. Funds that are obtained automatically from routine business transactions.

2. Best Export, Inc. 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 switch to a just-in-time inventory system and outsourcing production.
b. The company reduces its dividend payout ratio.
c. 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.
d. The company discovers that it has excess capacity in its fixed assets.
e. A sharp increase in its forecasted sales.
Answer e is obviously correct. A switch to a just-in-time inventory system and outsourcing production
would lower the firm's capital intensity ratio, which would lower AFN. Note that with purchase terms of
1/5 net 90, the nominal cost of non-free trade credit is only 4.34%, whereas with 3/15, net 35, the nominal
cost of trade credit is over 56%. Therefore, the firm should have been taking discounts originally, hence
should have had few accounts payable, whereas it would probably not take discounts and thus have more
accounts payable with the new supplier. That change would lower its AFN.

3. Last year Parks Enterprises had $350 million of sales, and it had $270 million of fixed assets that were used
at 65% of capacity last year. In millions, by how much could Parks sales increase before it is required to
increase its fixed assets?
Sales

$350

Fixed assets (not used in calculations)

$270

% of capacity utilized

65%

Sales at full capacity = Actual sales / % of capacity used =

$538.46

Additional sales without adding FA = Full capacity sales Actual sales = $188.46

4. Last year World Export had a FA/Sales ratio of 40%, comprised of $250 million of sales and $100
million of fixed assets. However, its fixed assets were used at only 75% of 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 level it would have had had it been operating at full capacity. What
target FA/Sales ratio should the company set?
Sales

$250

Fixed assets

$100

% of capacity utilized

75%

Sales at full capacity = Actual sales / % of capacity used =

$333.33

Target FA/Sales ratio = Full capacity FA/Sales = FA Capacity sales = 30.0%


5. Chris Perez , the CEO of the Perez Group, is initiating planning for the company's operations next year, and
he wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data
for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year?
Dollars are in millions.
Last year's sales = S0

$350

Last year's accounts payable

$40

Sales growth rate = g

30%

Last year's notes payable

$50

Last year's total assets = A0*

$500

Last year's accruals

$30

Last year's profit margin = PM

5%

Target payout ratio

60%

Last year's sales = S0

$350

Sales growth rate = g

30%

Forecasted sales = S0 (1 + g)

$455

S = change in sales = S1 S0 = S0 g

$105

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

$500

Last year's accounts payable

$40

Last year's notes payable. Not spontaneous,


so does not enter AFN calculation
Last year's accruals

$50
$30

L0 = payables + accruals

$70

Profit margin = M

5.0%

Target payout ratio

60.0%

AFN = (A0*/S0) S (L0*/S0) S Profit margin x S1 x (1 Payout)


AFN = $150.0 $21.0 $9.1 = $119.9

6. Strong Packing Co. had $450 million of sales and $225 million of fixed assets last year, 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 value so that it was operating at full capacity, with sales held constant
at $450 million, how much cash (in millions) would it have generated?
Sales

$450

Fixed assets

$225

% of capacity utilized

65%

Sales at full capacity = Actual sales/% of capacity used =

$692.31

Target FA/Sales ratio = Full capacity FA/Sales = FA/Capacity sales =

32.50%

Optimal FA = Sales x Target FA/Sales ratio =

$146.25

Cash generated = Actual FA Optimal FA =

$78.75

7. Joe Baker Company's noncallable bonds were issued several years ago and now have 20 years to
maturity. These bonds have a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has
a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the
WACC calculation?
Coupon rate

9.25%

Periods/year

Maturity (yr)

20

Bond price
Par value
Tax rate

$1,075.00
$1,000
40%

Calculator inputs:
N=40 PV = $1,075.00

PMT = $46.25 FV = 1000

I/Y (I%) =4.23% semi-annual


3

Annual rate = YTM = 2 x (I/YR) = Before-tax cost of debt = 8.47%


Cost of debt (After tax) = rd (1 T) for use in WACC = 8.47% (1-0.4) = 5.08%
8. You have been hired by the CFO of Socal Industries to help estimate its cost of common equity. You
have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its
own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g =
8.00% (constant). You were asked to estimate the cost of common equity based on the three most
commonly used methods and then to indicate the difference between the highest and lowest of these
estimates. What is that difference?
Bond yield = 7.00%
Risk premium over debt = 4.00%
rs = Bond + risk prem over bond = 11.00%
D1 = $1.20, P0 = $35.00, g= 8.00%
rs = D1 / P0 + g = 11.43%
rRF = 5.00%
RPM = 6.00% B = 1.25
rs = rRF + B (RPM) = 12.50%
Max= 12.50%, Min= 11.00%, Difference= 1.50%
9. Mike Wong Enterprises stock trades for $52.50 per share. It is expected to pay a $2.50 dividend at year
end (D1 = $2.50), and the dividend is expected to grow at a constant rate of 5.50% a year. The before-tax
cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55%
common equity. What is the company's WACC if all the equity used is from reinvested earnings?
D1
$2.50
g
5.50%
rd
7.50%
Tax rate40%
wd
45%
ws
55%
rd(1 T)
4.50%
rs = D1/P0 + g 10.26%
WACC = wd(rd)(1 T) + ws(rs) = 7.67%

P0

$52.50

10. The president and CFO of Speedy Transportation are having a disagreement about whether to use
market value or book value weights in calculating the WACC. Speedy's balance sheet shows a total of
noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%.
This debt currently has a market value of $50 million. The company has 10 million shares of common
stock, and the book value of the common equity (common stock plus retained earnings) is $65 million.
The current stock price is $22.50 per share; stockholders' required return, r s, is 14.00%; and the firm's tax
rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president
thinks book weights are more appropriate. What is the difference between these two WACCs?
Debt book value : $45 million,
Stock book value: $65 million
Debt: 41%, Equity: 59%

Debt market value = $50 million,


Stock: 10 million shares, $22.50 per share
Market value $225 million

Debt: 18%, Equity: 82%


YTM = before tax cost of debt = 6%,

rd = 6% x (1-0.4) = 3.6%

WACC (book value basis) = 0.41 x 3.6%

+ 0.59 x 14% = 9.75%

WACC (market value basis) =0.18 x 3.6%

+ 0.82 x 14% = 12.11%

rs = 14%

Difference = 2.36%