FINAL EXAM PREPARATION RESULTS

INSTRUCTOR: Mr. Konstantinos Kanellopoulos, MSc (L.S.E.), M.B.A.

COURSE: FINC-5000 Financial Management
SEMESTER: Spring 2 Term, 2018

Final Exam

SECTION A

INSTRUCTIONS

Students are required to complete the following 2 parts. The first part consists of True-
False and multiple choice questions while the second part consists of three problems. The
first part counts towards 40% of the final exam, while the second part counts towards
60% of the final exam. The first part consists of questions from the textbook “Financial
Management, Theory and Practice”, Fifteenth Edition, by Brigham, Eugene F. and
Michael C. Ehrhardt” and lectures while the second part consists of self-made problems
based on the textbook and lectures.

Answer ALL QUESTIONS in PART 1 and ONE OF THE TWO PROBLEMS in

PART 2.

GOOD LUCK!

Konstantinos Kanellopoulos
30th April 2018
 SECTION B
PART 1
1. According to the signaling theory of capital structure, the issuance of equity for a firm with
various financing alternatives signals that the firm has very favorable prospects which it
wants to share with new shareholders.

a. True
b. False

2. If a firm has high current and quick ratios, this always is a good indication that a firm is
managing its liquidity position well.

a. True
b. False

3. In terms of the cash conversion cycle, a restricted investment policy would tend to reduce the
inventory conversion and receivables collection periods, which would result in a relatively
short cash conversion cycle.

a. True
b. False

6. If you receive some goods on April 1 with the terms 3/20, net 30, June 1 dating, it means
that you will receive a 3 percent discount if the bill is paid on or before June 20 and that
the full amount must be paid 30 days after receipt of the goods

a. True
b. False
7. The maturity of most bank loans is short-term. Bank to business loans are frequently 90-day
notes which are often rolled over, or renewed, at the end of their maturity.

a. True
b. False
4. The firm's weighted average cost of capital (WACC) is
a. set by the board of directors of the firm because it is the benchmark they use to
evaluate upper management.
b. regulated by the Internal Revenue Service (IRS) because tax-deductible debt is
included in the computation.
c. determined by the financial markets because investors provide the funds used by
firms and these funds have costs, which are the returns demanded by investors.
d. the same as the firm's internal rate of return (IRR).
e. the total net present value (NPV) of all the capital budgeting projects in which the
firm invests in any year.
5. Allyson, who is the CFO of Mundane Minerals & Mining (MMM), is trying to decide
whether to issue debt or common stock to finance the capital budgeting projects she has
evaluated as acceptable (that is, the projects have positive net present values, NPV). Because
MMM is a relatively small company, Allyson believes that the type of capital she uses to
finance the projects will send a signal to investors. As a result, which of the following actions
would you recommend Allyson take?
a. Issue equity, because investing in positive NPV projects is not in the best interests
of the firm, and the existing stockholders will want to share such "bad news" with
new stockholders.
b. Issue equity so as to dilute ownership and share the increase in wealth that results
from investing in positive NPV projects with new stockholders.
c. Issue debt, because debt is riskier than common stock, thus the value of existing
stockholders' stock will increase more than if new equity is issued.
d. Issue debt, because investing in positive NPV projects increases the value of the
firm, and the existing stockholders probably prefer not to share such good fortune
with new stockholders.
e. Investors do not care which source of funds the firm uses as long as the funds are
invested in positive NPV projects; therefore it shouldn't matter which type of
capital is used.

6. Other things held constant, which of the following will not affect the current ratio, assuming
an initial current ratio greater than 1.0?
a. Fixed assets are sold for cash.
b. Long-term debt is issued to pay off current liabilities.
c. Accounts receivable are collected.
d. Cash is used to pay off accounts payable.
e. A bank loan is obtained, and the proceeds are credited to the firm's checking
account.

7. The cash conversion cycle is the length of time from the __________ raw materials to
manufacture a product until the __________ of accounts receivable associated with the sale
of the product.
a. ordering of; creation
b. ordering of; collection
c. payment for; creation
d. payment for; collection
e. none of the above
8. Which of the following statements is correct?
a. The optimal credit policy is determined primarily by the industry in which the firm
operates and by current economic conditions.
b. Normally, when a credit sale is made, inventory is reduced by the cost of goods
sold and an equal amount is credited to accounts receivable.
c. A typical business credit report provides sufficient information to eliminate the
 need for informed human judgment in the credit decision.
d. A customer's credit quality is usually determined in terms of the probability of the
customer's default.
e. Computers have had a significant effect in increasing efficiency in the areas of
payroll and inventory, but have had little impact in accounts receivable
management.

9. Which of the following is not a common type of short term financing?

a. Commercial paper.
b. Accruals.
c. Trade credit.
d. Corporate bonds.
e. Bank loans.

PART 2
Problem 1:
Gallinger Corporation projects an increase in sales from $1.5 million to $2 million but it
needs an additional $300,000 of current assets to support this expansion. The money can
be obtained from the bank at an interest rate of 13 percent discount interest; no
compensating balance is required. Alternatively. Gallinger can finance the expansion by
no longer taking discounts, thus increasing accounts payable. Gallinger purchases under
terms of 2/10, net 30, but it can delay payment for an additional 35 days paying in 65
days and thus becoming 35 days past due--without a penalty because of its suppliers'
current excess capacity problems.
(a) Based strictly on effective annual interest rate comparisons, how should Gallinger
finance its expansion?
(b) What additional qualitative factors should Gallinger consider before reaching a
decision?

SOLUTION TO PROBLEM 1
Cost of = Principal 0.13 = 0.13 = 0.1494 = 14.94%
a. bank loan Principal(1 - 0.13) 0.87

Terms: 2/10, net 30. But the firm plans delaying payments 35 additional days,
which is the equivalent of 2/10, net 65.

Effective rate = (1 + 2/98)(360/55) - 1.0 = 14.14%.

Comparing interest costs, the Gallinger Corporation might be tempted to expand its
payables rather than obtain financing from a bank. (For reason see solution to part
b.)
b. The interest rate comparison favors trade credit. But, Gallinger Corporation should
take into account how its trade creditors would look upon a 35-day delay in making
payments. Gallinger would become a “slow pay” account, and in times when
suppliers were operating at full capacity, Gallinger would be given poor service
and also would be forced to pay on time.

Problem 2
Wired Communications Corporation (WCC) supplies headphones to airlines for use with
movie and stereo programs. The company plans to raise a net amount of $1,200,000 in
order to finance new equipment in early 2018. Two alternatives are being considered:
Common stock can be sold to net 30 per share or raise the required capital by borrowing
$1,200,000 at 10 percent. The balance sheet and income statement of the Wired
Communications Corporation prior to financing is as follows:

The Wired Communications Corporation: Balance Sheet as of December 31, 2017

(values in dollars)

__________
Current assets $12,900,000
Net fixed assets 3,608,000
___________
Total assets $16,508,000

Accounts payable $1,752,000

Notes payable to bank $2,250,000
Other current liabilities $1,400,000
__________
Total current liabilities $5,402,000
Long-term debt 4,246,120
Common Stock, ($20 par) 4,600,000
Retained earnings 2,259,880
___________
Total liabilities and equity $16,508,000

The Wired Communications Corporation: Income Statement for year ended

December 31, 2017 (values in dollars)

Sales $38,500,000
Operating costs (36,960,000)
__________
Earnings before interest and taxes $1,540,000
Interest on short-term debt (260,000)
Interest on long-term debt (500,000)
___________
 Earnings before taxes (EBT) $780,000
Taxes (40%) (312,000)
___________
Net income $468,000
The probability distribution for annual sales is as follows:

Probability Annual Sales

0.35 $36,500,000
0.65 40,500,000

a. Assuming that EBIT is equal to 4% of sales, calculate earnings per share under
both the debt financing and the stock financing alternatives at the two possible
level of sales (number of shares 4,600,000/20=230,000).
b. Calculate expected earnings per share and σEPS under both debt and stock
financing.
c. Calculate the debt ratio at the expected sales level under each alternative. The old
debt will remain outstanding.
d. Which financing method would you recommend and why? Suppose you discovered
that WCC had more business risk than you originally estimated. Would this affect
your analysis?

SOLUTION TO PROBLEM 2

(a)

Use of debt ($ millions):

Probability 0.35 0.65

Sales $36.5 $40.5
EBIT (4%) 1.46 1.62
Interest* ( 0.88) ( 0.88)
EBT 0.58 0.74
Taxes (40%) ( 0.232) ( 0.296)
Net income $ 0.348 $ 0.444
Earnings per share
(0.23 million shares) $ 1.51 $ 1.93
*Interest on debt= ($1.2 x 0.1) + Current interest expense
= $0.12 + ($0.26 + $0.5) = $0.88

Use of stock (Millions of dollars):

Probability 0.35 0.65

Sales $36.5 $40.5
EBIT 1.46 1.62
Interest (0.76) (0.76)
EBT 0.7 0.86
 Taxes (40%) (0.28) (0.344)
Net income $ 0.42 $ 0.516
Earnings per share
(0.27 million shares)* $ 1.56 $ 1.91
*Number of shares = ($1.2 million/$30) + 0.23 million
= 0.04 million + 0.23 million = 0.27 million.
(b)

Use of debt ($ millions):

Expected EPS = (0.35)($1.51) + (0.65)($1.93) = $1.783 if debt is used.

 Debt  0.35($1.51- $1.783)2  0.65($1.93- $1.783)2

 0.040131  $0.2

Use of stock (Millions of dollars):

Expected EPS = (0.35)($1.56) + (0.65)($1.91) = $1.7875

 Equity  0.35($1.56 - $1.7875) 2  0.65($1.91 - $1.7875) 2

 0.7260  $0.17
(c)

Use of debt:

Debt/Assets = ($5,402,000 + $4,246,120 + $1,200,000) / ($16,508,000 + $1,200,000) =

61.26%.

Use of stock:

Debt/Assets = ($5,402,000 + $4,246,120) / ($16,508,000 + $1,200,000) = 54.48%

(d)

Under Debt financing the expected EPS is $1.783, the standard deviation is $0.2, the CV
is 0.11, and the debt ratio increases to 61.26%. Under Equity financing the expected EPS
is $1.7875, the standard deviation is $0.17, the CV is 0.095, and the debt ratio decreases
to 54.48 percent. At this interest rate, debt financing provides a similar expected EPS
such as equity financing; however, the debt ratio is significantly higher under the debt
financing situation as compared with the equity financing situation. Because EPS is not
significantly greater under debt financing, but the risk is noticeably greater, equity
financing should be recommended.

If the firm had higher business risk, then, at any debt level, its probability of financial
distress would be higher. Investors would recognize this, and both kd and ks would be
higher than originally estimated. It is not shown in this analysis, but the end result would
be an optimal capital structure with less debt. Conversely, lower business risk would lead
to an optimal capital structure that included more debt.