Corporate Valuation and Financial Planning - Testbank

CORPORATE VALUATION AND FINANCIAL PLANNING TRUE/FALSE 1. 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, spontaneous liabilities that reduce AFN arise from transactions brought on by sales increases. ANS: T 2. Firms pay a low interest rate on spontaneous liabilities so these funds are its cheapest source of capital. Consequently, the firm should make arrangements with its suppliers to use as much of this credit as possible. ANS: F 3. A firm will use spontaneous funds to the extent possible; however, due to credit terms, contracts with workers, and tax laws there is little flexibility in their usage. ANS: T 4. As long as a firm does not pay out 100% of its earnings, the firm's annual profit that is retained in the business (i.e., the addition to retained earnings) is another source of funds for a firm's expansion. ANS: T 5. A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally large decrease in some other asset. ANS: T 6. A firm's AFN must come from external sources. Typical sources include short-term bank loans, long-term bonds, preferred stock, and common stock. ANS: T 7. If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it will require some amount of external funding. ANS: F 8. To determine the amount of additional funds needed (AFN), you may subtract the expected increase in liabilities, which represents a source of funds, from the sum of the expected increases in retained earnings and assets, both of which are uses of funds. ANS: F 9. The capital intensity ratio is the amount of assets required per dollar of sales and it has a major impact on a firm's capital requirements. ANS: T 10. One of the first steps in arriving at a firm's forecasted financial statements is a review of industry-average operating ratios relative to these same ratios for the firm to determine whether changes to the ratios need to be made. ANS: T 11. Operating plans sketch out broad approaches for realization of the firm's strategic vision. These plans usually are developed for a period no longer than a 1-year time horizon because detail is "lost" by extending out the time horizon by more than 1 year. ANS: F 12. One of the necessary steps in the financial planning process is a forecast of financial statements under each alternative version of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. ANS: T 13. If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100%, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it will require external financing. ANS: T 14. A firm's profit margin is 5%, its debt/assets ratio is 56%, and its dividend payout ratio is 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 to all assets, including fixed assets, then any positive growth in sales will require some external financing. ANS: F 15. Companies with relatively high assets-to-sales ratios require a relatively large amount of new assets for any given increase in sales; hence, they have a greater need for external financing. There are currently no alternatives for these types of firms to lower their asset requirements. ANS: F 16. Firms with high capital intensity ratios have found ways to lower this ratio permitting them to achieve a given level of growth with fewer assets and consequently less external capital. For example, just-in-time inventory systems, multiple shifts for labor, and outsourcing production are all feasible ways for firms to reduce their capital intensity ratios. ANS: T 17. 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 capacity. If the two firms expect the same growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant. ANS: T 18. If a firm's capital intensity ratio (A0*/S0) decreases as sales increase, use of the AFN formula is likely to understate the amount of additional funds required, other things held constant. ANS: F 19. The minimum growth rate that a firm can achieve with no access to external capital is called the firm's sustainable growth rate. It can be calculated by using the AFN equation with AFN equal to zero and solving for g. ANS: F 20. The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the need for the firm to forecast those accounts on a continual basis. ANS: F 21. The AFN equation assumes that the ratios of assets and liabilities to sales remain constant over time. However, this assumption can be relaxed when we use the forecasted financial statement method. Three conditions where constant ratios cannot be assumed are economies of scale, lumpy assets, and excess capacity. ANS: T MULTIPLE CHOICE a. b. c. d. e. 22. Which of the following assumptions is embodied in the AFN equation? Accounts payable and accruals are tied directly to sales. Common stock and long-term debt are tied directly to sales. Fixed assets, but not current assets, are tied directly to sales. Last year's total assets were not optimal for last year's sales. None of the firm's ratios will change. ANS: A 23. F. Marston, 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. ANS: E 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. a. b. c. d. e. 24. The term "additional funds needed (AFN)" is generally defined as follows: Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations. The amount of assets required per dollar of sales. 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. A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant. Funds that are obtained automatically from routine business transactions. ANS: A a. b. c. d. 25. The capital intensity ratio is generally defined as follows: The percentage of liabilities that increase spontaneously as a percentage of sales. The ratio of sales to current assets. The ratio of current assets to sales. The amount of assets required per dollar of sales, or A0*/S0. e. Sales divided by total assets, i.e., the total assets turnover ratio. ANS: D 26. Which of the following is NOT one of the steps taken in the financial planning process? a. Monitor operations after implementing the plan to spot any deviations and then take corrective actions. b. Determine the amount of capital that will be needed to support the plan. c. Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. d. 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. e. Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external capital can be raised. ANS: D a. b. c. d. e. 27. Spontaneous funds are generally defined as follows: A forecasting approach in which the forecasted percentage of sales for each item is held constant. Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes. 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 firm's growth. Assets required per dollar of sales. ANS: C 28. 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 increases its dividend payout ratio. b. The company begins to pay employees monthly rather than weekly. c. The company's profit margin increases. d. The company decides to stop taking discounts on purchased materials. e. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. ANS: A a. b. c. 29. Which of the following statements is CORRECT? The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management's historical performance is evaluated. The capital intensity ratio gives us an idea of the physical condition of the firm's fixed assets. d. e. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings. ANS: A a. b. c. d. e. 30. Which of the following statements is CORRECT? 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. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth. 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. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN. 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. ANS: C a. b. c. d. e. 31. Which of the following statements is CORRECT? The AFN equation for forecasting funds requirements requires only a forecast of the firm's 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. Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy does not affect the AFN forecast. A negative AFN indicates that retained earnings and spontaneous liabilities are far more than sufficient to finance the additional assets needed. If the ratios of assets to sales and spontaneous liabilities to sales do not remain constant, then the AFN equation will provide more accurate forecasts than the forecasted financial statements method. 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. ANS: C a. 32. Which of the following statements is CORRECT? If a firm's assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm's AFN to be negative. b. c. d. e. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm's actual AFN must, mathematically, exceed the previously calculated AFN. 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. Dividend policy does not affect the requirement for external funds based on the AFN equation. 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. ANS: E a. b. c. d. e. 33. Which of the following statements is CORRECT? When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the financial forecasting process. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. The Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner. ANS: B 34. The Besnier Company had $250 million of sales last year, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity? a. $312.5 b. $328.1 c. $344.5 d. $361.8 e. $379.8 ANS: A Sales Fixed assets % of capacity utilized $250 $75.0 80.0% Full capacity sales = Actual sales/% of capacity used = $312.5 35. Last year Baron 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 Baron's sales increase before it is required to increase its fixed assets? a. $170.09 b. $179.04 c. $188.46 d. $197.88 e. $207.78 ANS: C Sales Fixed assets (not used in calculations) % of capacity utilized Sales at full capacity = Actual sales/% of capacity used = $350 $270 65% $538.46 Additional sales without adding FA = Full capacity sales − Actual sales = $188.46 36. North Construction had $850 million of sales last year, and it had $425 million of fixed assets that were used at only 60% of capacity. What is the maximum sales growth rate North could achieve before it had to increase its fixed assets? a. 54.30% b. 57.16% c. 60.17% d. 63.33% e. 66.67% ANS: E Sales Fixed assets (not used in calculations) % of capacity utilized Sales at full capacity = Actual sales/% of capacity used = Additional sales without adding FA = Full capacity sales − Actual sales = $850 $425 60% $1,416.67 $566.67 Percent growth in sales = Additional sales/Old sales = 66.67% 37. Last year National Aeronautics 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? a. 28.5% b. 30.0% c. 31.5% d. 33.1% e. 34.7% ANS: B Sales Fixed assets % of capacity utilized Sales at full capacity = Actual sales/% of capacity used = $250 $100 75% $333.33 Target FA/Sales ratio = Full capacity FA/Sales = FA Capacity sales = 30.0% 38. Daniel Sawyer, the CEO of the Sawyer 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 Last year's total assets = A0* 30% Last year's notes payable $500 Last year's accruals $50 $30 Last year's profit margin = PM a. b. c. d. e. 5% Target payout ratio 60% $102.8 $108.2 $113.9 $119.9 $125.9 ANS: D Last year's sales = S0 Sales growth rate = g Forecasted sales = S0 × (1 + g) $350 30% $455 ΔS = change in sales = S1 − S0 = S0 × g $105 Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, so does not enter AFN calculation Last year's accruals $500 $40 $50 $30 L0* = payables + accruals $70 Profit margin = M Target payout ratio 5.0% 60.0% AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout) AFN = $150.0 − $21.0 − $9.1 = $119.9 39. In your internship with Lewis, Lee, & Taylor Inc. you have been asked to forecast the firm's additional funds needed (AFN) for next year. 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? Last year's sales = S0 $200,000 Last year's accounts payable $50,000 Sales growth rate = g Last year's total assets = A0* 40% Last year's notes payable $135,000 Last year's accruals $15,000 $20,000 Last year's profit margin = PM a. b. c. d. e. 20.0% Target payout ratio 25.0% −$14,440 −$15,200 −$16,000 −$16,800 −$17,640 ANS: C Last year's sales = S0 Sales growth rate = g Forecasted sales = S0 × (1 + g) ΔS = change in sales = S1 − S0 = S0 × g Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, so does not enter AFN calculation Last year's accruals L0* = payables + accruals Profit margin = M Target payout ratio AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout) AFN = $54,000 − $28,000 − $42,000 = −$16,000 $200,000 40% $280,000 $80,000 $135,000 $50,000 $15,000 $20,000 $70,000 20.0% 25.0% 40. You have been asked to forecast the additional funds needed (AFN) for Houston, Hargrove, & Worthington (HHW), which is planning its operation for the coming year. The firm is operating at full capacity. 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 year's sales = S0 Sales growth rate = g Last year's total assets = A0* $300.0 Last year's accounts payable $50.0 40% Last year's notes payable $500.0 Last year's accruals $15.0 $20.0 Last year's profit margin = PM 20.0% Initial payout ratio a. b. c. d. e. 10.0% $31.9 $33.6 $35.3 $37.0 $38.9 ANS: B Last year's sales = S0 Sales growth rate = g Forecasted sales = S0 × (1 + g) $300 40% $420 ΔS = change in sales = S1 − S0 = S0 × g $120 Last year's total assets = A0* = A0* since full capacity Last year's accounts payable Last year's notes payable. Not spontaneous, so does not enter AFN calculation Last year's accruals L0* = payables + accruals Profit margin = M Initial payout ratio New payout ratio $500 AFN = (A0*/S0)ΔS − (L0*/S0)ΔS − Profit margin × S1 × (1 − Payout) Old AFN = $200.0 − $28.0 − $75.6 = $96.4 New AFN = $200.0 − $28.0 − $42.0 = $130.0 Change in AFN = $33.6 $50 $15 $20 $70 20% 10% 50% 41. Weber Interstate Paving 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? a. $74.81 b. $78.75 c. $82.69 d. $86.82 e. $91.16 ANS: B Sales Fixed assets % of capacity utilized Sales at full capacity = Actual sales/% of capacity used = Target FA/Sales ratio = Full capacity FA/Sales = FA/Capacity sales = Optimal FA = Sales × Target FA/Sales ratio = Cash generated = Actual FA − Optimal FA = $450 $225 65% $692.31 32.50% $146.25 $78.75