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C214- Chpt 9/10/11
| Question | Answer |
|---|---|
| The income statement is usually regarded as the most | difficult to analyze and interpret |
| Accounting income, calculated using accrual accounting principles (GAAP), offers the most | comprehensive view of a firm’s operations, despite its complexity |
| Why must users of financial statements be skeptical? | Management may use discretion to “manage” reported results. |
| Gordon growth model can be used to | approximate the return required by shareholders |
| the three methods for calculating the cost of equity are the | Gordon growth model, the CAPM, and historical mean returns, |
| Increases in a firm’s exposure to systematic risk will increase the expected return according to CAPM, which may increase the cost of | capital. |
| The object of forecasting these pro forma statements is to | calculate the firm’s future DFN. |
| The percent of sales method consists of six steps: | Project sales revenues and expenses Forecast change in spontaneous balance sheet accounts Deal with discretionary accounts Calculate retained earnings (RE) Determine total financing need/assets Calculate DFN We will discuss each step |
| 1. Project sales revenues and expenses begins with | begins with a projection of sales revenue |
| The second step of financial forecasting is to | determine the change in balance sheet accounts, given the change in sales. |
| Growth requires increased | investment |
| . As sales grow, the company asset base will have to expand to support the new | higher level of sales |
| On both sides of the balance sheet, assets and financing, some accounts will | increase automatically with sales while others will not |
| Spontaneous accounts are those that | of necessity, vary automatically with sales |
| . Line items on the income statement are also, generally, | spontaneous. |
| The opposite of spontaneous accounts are called non-spontaneous accounts or | discretionary accounts |
| Spontaneous Accounts | Most Current Assets (usual assumption) Accounts Payable Accruals (accrued wages, accrued taxes, etc.) |
| Once we determine which accounts are spontaneous and which are not, we need to determine by how much the spontaneous accounts will change | as sales rise |
| discretionary accounts only change when management takes deliberate actions to make | them change |
| 4. Calculate retained earnings (RE)- Having calculated the increase in spontaneous assets and liabilities and keeping discretionary financing constant, the only balance sheet account remaining to be forecasted is | retained earnings (RE) |
| RE must be independently | forecasted. |
| RE are the earnings that the company has retained since its | inception and are used to finance the assets that are in place |
| the calculation of RE depends upon | net income (earnings) |
| plowback ratio, is the portion of earnings the | firm retains |
| 5. Determine total financing need- According to the balance sheet equation (Assets = Liabilities + Owner’s Equity), all assets on a firm’s balance sheet have to be financed through either | liabilities or equity. |
| 6. Calculate DFN- If DFN is negative, then it means the forecast indicates | If DFN is negative, then it means the forecast indicates |
| Achieving DFN is the end result of our | forecast |
| What is DFN? | The difference between the forecasted asset accounts and the combination of the liability and equity accounts |
| A positive DFN indicates that __________. | external financing is needed |
| Management can dictate how spontaneous accounts should change. | True |
| How do we compute DFN? | FN = Projected total assets – projected total liabilities – projected owners’ equity |
| DFN is computed by subtracting the firm’s projected total liabilities and owners’ equity from it | projected total assets |
| What does a negative DFN indicate? | The firm has adequate financing to fund growth and may have surplus assets. |
| In the context of DFN, what is the “plug”? | The account adjusted to balance the pro forma balance sheet |
| Which of the following are real methods to manage sales growth? | Raise prices, Decrease/eliminate dividend payments, Reduce costs through economies of scale, , |
| Capacity constraints are usually examined carefully when DFN is too high. | true |
| Firms can always find ways to finance their growth. | False |
| Capital constraints are a real | problem for many firms. |
| Slow sales growth and Examine capacity constraints and Lower dividend payout Increase net margin- re ways to manage | sales growth |
| Accounts that vary directly with sales | spontaneous accounts |
| Generally speaking, as a firm grows it | Increased financing to fund the growth |
| If DFN is negative, what does it indicate? | If DFN is negative, what does it indicate? |
| Which of the following is usually NOT a spontaneous account? | Long-term debt |
| Firms should grow their sales as fast as possible | False |
| What is typically covered by discretionary accounts? | DFN |
| Discretionary accounts typically cover DFN, which stands for | discretionary financing needed. |
| When using the percent of sales method, accounts like accounts receivable always have to vary with sales. | False |
| Forecasting is vulnerable to the inputs that we put into the model. What is the acronym for this concern? | GIGO |
| GIGO, which stands for | “Garbage In, Garbage Out,” reflects the vulnerability of forecasting to the quality of input data; poor inputs result in unreliable outputs. |
| Which of the following is NOT one of the four factors of growth according to the DuPont and SGR? | According to the DuPont and sustainable growth rate (SGR) models, all listed options (profitability, asset utilization, leverage, and dividend policy) are factors of growth. |
| What is Dividends/Net Income called? | Dividend payout ratio |
| The amount of product or service a firm can produce with its given fixed assets is known as ________. | capacity |
| What are pro forma statements? | Forecasted financial statements |
| When we talk about discretionary accounts, whose discretion is being exercised? | Management |
| How do we compute future levels of spontaneous accounts? | Multiply projected level of sales by historical percent of sales |
| Growth typically requires increased ________ in the firm (for forecasting purposes). | investment |
| Sometimes we multiply “net margin” times projected sales to get forecasted net income. What is the ratio for net margin? | NI/S = Net Income/Sales |
| You perform an analysis and determine the net profit margin (NI/S) is 8%, the total asset turnover (S/A) is 5, and the equity multiplier (A/E) = 1. If the firm pays no dividends because it is a high-growth start-up, what is the sustainable growth rate? | 40% |
| Which of the following is NOT a non-spontaneous (discretionary) account? | Accounts payable |
| If sales are $1,000,000, then what are the total current assets given the following? | $455,000- cash $250,000 + A/R $130,000 + Inventory (0.15 × COST OF GOODS SOLD of $500,000) = $250,000 + $130,000 + $75,000 = $455,000 |
| sales of $450 million. following percentages of spontaneous accounts: 5% of cash, 17% of A/R, 11% of inventory, 48% of PP&E, and 18% of A/P. It holds a mortgage of $30 million, bonds of $50 million, equity of $150 million, and earnings of $35 million. | $18.5 million |
| $750,000. the following forecast percentages based on historical averages: cash, 11%; A/R, 8%; inventory, 13%; and accounts payable, 14%. PP&E is $210,000. The company has long-term debt of $120,000 and equity of $85,000. It estimates profits at $55,000. | $85,000 |
| Jaunty Coffee Co. had sales of $70 million and expenses of $50 million, and it paid 40% in taxes. It has equity of $42 million. The board approved dividends totaling $4,500,000. What is the company’s sustainable growth rate? | 0.6015 Net income = $70 million – $50 million = $20 million × (1 – 0.40) = $12 million net income ROE = $12 million / $42 million = 0.2857 Dividend payout ratio = $4.5 million / $12 million = 0.375 SGR = 0.2857 (1 – 0.375) = 0.1786 |
| Freedom Rock Bicycles earned $25 million after tax in the last year. The company has $100 million in assets and $85 million in equity. It has a policy of paying 12% of earnings as dividends. What is the sustainable growth rate of Freedom Rock? | 0.2588 |
| What is the increase in retained earnings given the following? Sales are $10 million Net earnings pre-tax are $1 million Dividend payout ratio is 0.12 Tax rate is 40% | $528,000 |
| What is the sustainable growth rate given the following? Sales are $2.5 million Total expenses (including cost of goods sold through taxes) are $2.0 million Total assets are $3.0 million Equity is $1.3 million Dividend payout ratio is 0.25 | 0.2885 |
| What is capital budgeting? | The process of deciding which projects increase firm value |
| When evaluating a potential capital project, which of the following should be considered? | Timing of the cash flows Size of the initial investment Riskiness of the projec |
| What is the terminal cash flow? | the cash flows associated with unwinding the project |
| Which of the following is NOT part of the capital budgeting calculation? | Calculating the estimated value of the stock when the firm terminates the project |
| What is the term for decisions about how a firm builds the asset side of the balance sheet by allocating funds, time, and other resources? | Investment decisions |
| Why is the payback method one of the most popular capital budgeting techniques used by firms? | It is simple and intuitive |
| Incidental cash flows are not directly from the project but are attributable to the | project |
| he opportunity cost of using an asset such as land or equipment for a project implies the loss of the ability to use the | asset on another project |
| Sunk costs represent past outlays of cash that cannot | be recouped, such as the cost of a marketing study completed last year |
| Sunk costs are NOT incremental to the current decision and should be excluded from your | analysis |
| Which type of cash flows should be excluded from capital budgeting analysis? | The cost of scrapping an old machine to replace with a new machine |
| Which type of cash flows should be excluded from capital budgeting analysis? | Sunk costs |
| Which skills are required to estimate the cash flows of a project? | Understanding opportunity costs and calculating taxes |
| Working capital investment represents which type of cash flow? | A cash outflow at the beginning of the project that is recaptured by the end of the project |
| The initial cash outlay is the time 0 cost of the | project |
| Which of the following does NOT go into the calculation of the initial cash outlay of a project? | After-tax proceeds from the sale of the new equipment |
| Which of the following would increase the initial cash outlay of a project? | Increase initial inventory needed to start the project from $150,000 to $200,000 |
| What is the total dollar amount required to begin a project? | Expenses that do not flow directly to the income statement but appear as assets on the balance sheet |
| What is terminal cash flow? | The cash flows at the end of a project’s life that are incurred as a result of concluding the project |
| Terminal cash flows result from winding down a | project at the end of its life. |
| firm is considering a project. It estimates that the realizable salvage value of the equipment for the project is $50,000. The equipment will be depreciated down to $10,000 when the project is terminated. | $50,000 minus $10,000, multiplied by the tax rate |
| The firm is required to have $250,000 in working capital at all times during the project. In the terminal year, how will the required working capital affect the terminal cash flows? | It will increase the terminal cash flows by $250,000. |
| What is realizable salvage value? | An economic forecast of sale proceeds for a new asset at the end of its life |
| Realizable salvage value is the term used for the expected market value of a | ew asset at the end of its life. |
| How is the final year’s cash flow of a project determined? | differential cash flows plus terminal cash flows |
| Which of the following is NOT essential for evaluating projects? | All of these choices are essential parts of evaluating projects. The required rate of return considers risk, the timing of cash flows can affect the overall value of a project, and it is important to include all cash flows of the project. |
| What is the payback period of a project? | The number of years required to recoup the initial cash outlay |
| Payback period is a capital budgeting method that calculates how long it takes to | recoup the initial investment without considering the time value of money. |
| Which of the following is NOT a problem associated with payback period? | All of these choices are problems associated with payback period. |
| Suppose that the net present value of a project is $265,342. The initial cash flow of the project is $300,000, and the terminal cash flow of the project is $50,000. Based on the given information, what decision should be made on the project? | The project should be accepted since NPV > 0. |
| l rate of return of a project is 13.55%. The cost of capital for the project is 15%, the cost of equity is 18%, and the marginal tax rate of the firm is 13%. Based on the given information, what decision should be made on the project? | The project should be rejected since IRR < Cost of Capital. |
| What is the connection between NPV and IRR? | The NPV solves for present value of all cash flows, and the IRR solves for the rate of return that makes the NPV equal to zero. |
| What is the internal rate of return (IRR) decision rule? | If IRR is greater than the required return, accept. If IRR is less than the required return, reject. |
| What is the net present value (NPV) decision rule? | If NPV is positive, accept. If NPV is negative, reject |
| Which capital budgeting evaluation technique finds the dollar value added to the firm due to a project? | Net present value |
| Net present value is a capital budgeting method that finds the dollar value added to | the firm due to a project. |
| Which capital budgeting technique does not use the cost of capital in the calculation but requires the cost of capital to make a decision whether to accept or reject the project? | Internal rate of return |
| Which statement is correct regarding the profitability index (PI)? | A PI of 1.25 implies that the NPV of the same project is positive. |
| Capital structure can be defined as: | The mixture of a firm’s debt and equity |
| Using debt is less costly than using equity to finance a capital investment project. | True |
| One of the benefits of using equity is the associated tax benefits | False |
| Debt, not equity, has tax benefits associated | with its use |
| Higher debt levels are generally associated with more risk. | True |
Created by:
mnapole