Comm 370 Exam

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Commerce 370 – Midterm Exam – Sep-Dec-2011 – Solutions Name: ______________________________________________________ Student ID: __________________________________________________ Section (circle one): M-W 2:30pm ; Tu-Th 11:00am ; Tu-Th 2:00pm

Write your name and student ID at the top of this front page, and circle your section. Check the number of pages in the exam. You should have X pages. This is a 100-point exam with 7 questions. You have 2 hours to complete the exam. Carefully administer your time! No books or notes are permitted. You may use a non-programmable calculator. Only exams written in ink will be eligible for formal re-grading. Please answer the questions in the space provided after the question. Write your answers clearly and legibly. Show all details of your work. A formula sheet is provided in the last page, but be aware that the formulas given may or may not be useful to solve the questions in this exam. Do not use formulas without carefully thinking whether they are useful in a particular problem. GOOD LUCK! ______________________________________________________________________________ Instructor use only:

Problem 1 ( 8 points): Problem 2 (18 points): Problem 3 (18 points): Problem 4 (18 points): Problem 5 (15 points): Problem 6 (13 points): Problem 7 (10 points): Total (of 100 points): 1

Question 1 (8 points) Answer the following two independent multiple choice questions. Clearly circle your answer. a) (4 points) A firm’s customers are cash constrained and can borrow from the bank at 18% per year. Other things equal (e.g., assuming no changes in sales), if the firm changes the terms of credit it offers to its customers from “1/15 net 40” to “2/10 net 50”, then the firm’s Accounts Receivable Period will _______________. A. decrease B. increase C. either increase or decrease D. stay the same E. none of the above Answer: A. With “1/15 net 40”, EAR = (1 + 1/99)365/25 – 1 = 15.8% < 18%. So, before the change in credit policy, customers forego the discount and pay on day 40, i.e., borrow from the firm at 15.8% instead of from the bank at 18%. The ARP is 40 days. With the new credit policy “2/10 net 50”, EAR = (1 + 2/98)365/40 – 1 = 20.2% > 18%. So customers will take the discount and pay on day 10, i.e., borrow from the bank at 18% instead of from the firm at 20.2%. The ARP will drop to 10 days. FYI: This is similar to the discussion in Lecture 3 (Clarkson Lumber case) on Clarkson’s cost of payables financing and change in APP as he starts taking the discounts for early payment. b) (4 points) Suppose that all the assumptions required in the derivation of the formulas for the internal and the sustainable growth rates listed in class are valid. Also assume that a firm’s sales will grow at the internal growth rate (gi) next year, that the firm will not raise any external financing next year, and that the firm’s retention ratio (R) will be unchanged. In this case, the growth rate of the firm’s equity for next year (gE) is equal to ___________________. A. gi B. ROE x R x gi C. ROA x R x (1+ gi) D. NI x R x gi E. ROE x R x (1+gi) F. none of the above Answer: E. By definition of a growth rate gE = ∆E/E. But the firm does not issue stock, so ∆E = ∆RE, and with the assumptions ∆RE = NI x R x (1+ gi). Since ROE=NI/E, gE = ∆RE/E = ROE x R x (1+ gi). FYI: This is from Lecture 2 and associated practice questions, where we wrote the addition to retained earnings as ∆RE = NI × r × (1+g), and said equity grows with RE if no equity is issued. 2

Question 2 (18 points) Purdy’ CEO is considering the complete elimination of trade credit from the firm’s operations, and switching to an “all cash transactions policy”: the firm would not give any credit to its customers and it would not take any credit from its suppliers. Assume that Purdy’s inventory turnover and sales will not be affected by the change in trade credit policy. a) (6 points) Write an equation for the change in Purdy’s operating cycle as a result of the...
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