Financial Ratios and Sustainable Growth Rate

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FIN 470 Exam 1NAME________________________

1. What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.

Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm’s credit collection policy with its customers).

2. Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.

Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false.

3. Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows and outflows that occurred during a period?

The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to do it.

4. Jetson Spacecraft Corp. shows the following information on its 2009 income statement: sales $ 196,000; costs $104,000; other expenses $6,800; depreciation expense $9,100; interest expense $14,800; taxes $21,455; dividends $10,400. In addition, you’re told that the firm issued $5,700 in new equity during 2009 and redeemed $7,300 in outstanding long-term debt.

a. What is the 2009 operating cash flow?

OCF = EBIT + Depreciation – Taxes = $76,100 + 9,100 – 21,455 = $63,745

b. What is the 2009 cash flow to creditors?

CFC = Interest – Net new LTD = $14,800 – (–7,300) = $22,100

c. What is the 2009 cash flow to stockholders?

CFS = Dividends – Net new equity = $10,400 – 5,700 = $4,700

d. If net fixed assets increased by $27,000 during the year, what was the addition to NWC?

We know that CFA = CFC + CFS, so:

CFA = $22,100 + 4,700 = $26,800

CFA is also equal to OCF – Net capital spending – Change in NWC. We already know OCF. Net capital spending is equal to:

Net capital spending = Increase in NFA + Depreciation = $27,000 + 9,100 = $36,100

Now we can use:

CFA = OCF – Net capital spending – Change in NWC

$26,800 = $63,745 – 36,100 – Change in NWC

Solving for the change in NWC gives $845, meaning the company increased its NWC by $845.

5. Explain what it means for a firm to have a current ratio equal to .50. Would the firm be better off if the current ratio were 1.50? What if it were 15.0? Explain your answers.

A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50% more current assets than it does current liabilities. This probably represents an improvement in liquidity; short-term obligations can generally be met completely with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess funds sitting in current assets generally earn little or no return. These excess funds might be put to better use by investing in productive long-term assets or distributing the funds to shareholders.

6. Y3K, Inc., has sales of $5,276, total assets of $3,105, and a debt–equity ratio of 1.40. If its return on equity is 15 percent, what is its net income?...
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