(AFN) in a given year?

Question 1.
Which of the following is likely to increase the additional funds needed
(AFN) in a given year?
a. The company reduces its dividend payout ratio.
b. The company’s profit margin increases.
c. The company decides to reduce its reliance on accounts payable as a
form of financing.
d. The company is operating well below full capacity.
e. All of the statements above are correct.
Question 2.
A firm has the following balance sheet:
Cash
$ 10
Accounts receivable
10
Inventories
10
Fixed assets
90
Total assets
$120
Accounts payable
Notes payable
Long-term debt
Common stock
Retained earnings
Total liabilities
and equity
$ 10
20
40
40
10
$120
Fixed assets are being used at 80 percent of capacity; sales for the
year just ended were $200; sales will increase $10 per year for the
next 4 years; the profit margin is 5 percent; and the dividend payout
ratio is 60 percent. Assume that underutilized fixed assets cannot be
sold. What are the total external financing requirements for the entire
4 years, that is, the total AFN for the 4-year period?
a. $ 4.00
b. $ 2.00
c. -$ 0.80 (surplus)
d. -$14.00 (surplus)
e. $
0
Question 3.
Jayhawk Jets must choose one of two mutually exclusive projects.
Project A has an up-front cost (t = 0) of $120,000, and it is
expected to produce cash inflows of $80,000 per year at the end of
each of the next two years. Two years from now, the project can be
repeated at a higher up-front cost of $125,000, but the cash inflows
will remain the same. Project B has an up-front cost of $100,000, and
it is expected to produce cash inflows of $41,000 per year at the end
of each of the next four years. Project B cannot be repeated. Both
projects have a cost of capital of 10 percent. Jayhawk wants to
select the project that provides the most value over the next four
years. What is the net present value (NPV) of the project that
creates the most value for Jayhawk?
a.
b.
c.
d.
e.
$34,425
$30,283
$29,964
$29,240
$24,537
Question 4.
Which of the following statements is most correct?
Question 9.
What is Rollins'
premium approach?
a.
b.
c.
d.
e.
cost
of
common
stock
using
the
bond-yield-plus-risk-
13.6%
14.1%
16.0%
16.6%
16.9%
Question 10.
What is Rollins' WACC?
a.
b.
c.
d.
e.
13.6%
14.1%
16.0%
16.6%
16.9%
NO ANSWERS FOR THE FOLLOWING:
Question 11.
Write down the Market Value Added formula. How do the WACC affect MVA? How
does an increase in capital requirements affect MVA?
Question 12.
What is operating leverage?
Question 1.
Answer: c
Remember the AFN formula is stated as:
AFN = (A*/S)S - (L*/S)S (M)(S1)(RR). If the firm’s dividend payout decreases, RR will increase
and AFN will decrease, not increase. Therefore, statement a is false.
If M increases, AFN will decrease. Therefore, statement b is false. If
the company reduces its reliance on accounts payable, then spontaneous
liabilities will decrease.
Thus, AFN will increase.
Therefore,
statement c is correct. If the company is operating well below full
capacity, then it will not need new fixed assets.
Therefore,
spontaneous assets will be smaller and AFN will decrease. Therefore,
statement d is false.
Question 2.
Answer: d
S0 = $200; S1 = $210; S2 = $220; S3 = $230; S4 = $240.
$200
SCapacity =
= $250. Fixed assets will not need to be increased since
0.80
S4 < SCapacity; $240 < $250.
Balance sheet solution:
Cash
Accounts receivable
Inventories
Fixed assets
$ 12
12
12
90
Total assets
$126
Accounts payable
Notes payable
Long-term debt
Common stock
Retained earnings
Total liabilities
and equity
$ 12
20
40
40
28
$140
Addition to retained earnings:
(S1 + S2 + S3 + S4)  0.05  0.40 =
$18.00.
AFN = $126 - $140 = -$14 Surplus.
Formula solution:
$30
$10
AFN =
($40) ($40) - (0.05)($900)(0.4) = -$14 (Surplus).
$200
$200
The $900 is the sum of sales over the 4-year period. Fixed assets are
not included in the formula equation since full capacity sales ($250)
are never reached.
Question 3.
Step 1:
Answer: b
Determine each project’s cash flows during the 4-year
period.
Year
0
1
2
3
4
Step 2:
Project A Cash Flows
($120,000)
80,000
80,000 – 125,000 = (45,000)
80,000
80,000
Project B Cash Flows
($100,000)
41,000
41,000
41,000
41,000
Determine each project’s NPV by entering the cash flows into
the cash flow register and using 10 percent for the cost of
capital.
NPVA = $30,283.45  $30,283.
NPVB = $29,964.48  $29,964.
Therefore, Jayhawk should select Project A since it adds
more value.
Question 4.
Answer: e
Statement a is false; if you are to the left of the firm's optimal capital
structure on the WACC curve, raising a company's debt ratio will actually
decrease the firm's WACC. Statement b is false; if you are to the right of
the firm's optimal capital structure on the WACC curve, raising a company's
debt ratio will actually increase the firm's WACC. Statement c is false; as
you increase the firm's debt ratio the cost of debt will increase because
you're using more debt. Because you're using more debt the cost of equity
increases because the firm's financial risk has increased. From statements
a and b you can see that whether the WACC is increased depends on where you
are on the WACC curve relative to the firm's optimal capital structure.
Therefore, the correct answer is statement e.
Question 5.
Answer: e
Diff: M
Time line:
0
1
2
3
4
40 6-month
rd / 2  ?
├───────────┼─────┼────────┼─────────┼───∙∙∙───────┤ Periods
PMT = 60
VB = 1,000
60
60
60
60
FV = 1,000
Since the bond sells at par of $1,000, its YTM and coupon rate (12
percent) are equal. Thus, the before-tax cost of debt to Rollins is
12 percent. The after-tax cost of debt equals:
rd,After-tax = 12.0%(1 - 0.40) = 7.2%.
Financial calculator solution:
Inputs: N = 40; PV = -1,000; PMT = 60; FV = 1,000;
Output: I = 6.0% = rd/2.
rd = 6.0%  2 = 12%.
rd(1 - T) = 12.0%(0.6) = 7.2%.
Question 6.
Cost of preferred stock:
Answer: d
rps = $12/$100(0.95) = 12.6%.
Question 7.
Answer: c
Cost of common stock (CAPM approach):
rs = 10% + (5%)1.2 = 16.0%.
Question 8.
Answer: c
Cost of common stock (DCF approach):
$2.00(1.08)
rs =
+ 8% = 16.0%.
$27
Question 9.
Cost of common stock (Bond yield-plus-risk-premium approach):
rs = 12.0% + 4.0% = 16.0%.
Answer: c
Question 10.
Answer: a
WACC = wdrd(1 - T) + wpsrps + wcers
= 0.2(12.0%)(0.6) + 0.2(12.6%) + 0.6(16.0%) = 13.56%  13.6%.

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