FM

Short Questions
9-1 DPS CALCULATION Warr Corporation just paid a dividend of $1.50 a share (that is, D0 $1.50).
The dividend is expected to grow 7% a year for the next 3 years and then at 5% a year thereafter.
What is the expected dividend per share for each of the next 5 years?

Solution:

D0 = 1.50; g1-3 = 7%; gn = 5%; D1 through D5 = ?

D1 = 1.50(1.07) = 1.6050.
D2 = 1.50(1.07)2 = 1.7174.
D3 = 1.50(1.07)3 = 1.8376.
D4 = 1.50(1.07)3(1.05) = 1.9294.
D5 = 1.50(1.07)3(1.05)2 = 2.0259.

9-6 PREFERRED STOCK VALUATION Fee Founders has perpetual preferred stock outstanding
that sells for $60 a share and pays a dividend of $5 at the end of each year. What is the
required rate of return?
Solution:

16-6 What are two techniques that are used to help monitor accounts receivable? How
would an easy versus tight credit policy affect the results of these two monitoring
techniques?

Methods for Monitoring Accounts Receivable Two common methods of

receivables monitoring are:
1.Days sales outstanding (DSO) and 2. Aging fraction statistics. Unfortunately,
both of these approaches are seriously flawed. DSO indicates the average length
of time it takes the firm to collect for credit sales. A low DSO number means that
it takes a company fewer days to collect its A/R.
16-10 Why are accruals called spontaneous sources of funds, what are their costs, and why
dont firms use more of them?
Accruals are the accrued liabilities that arise out of business operations. Unpaid wages and
taxes are the most common accruals as they are usually paid in the next month and the next
year, respectively. They arise automatically from operations and hence they are termed as
spontaneous funds.

17-1 What are the key factors on which external financing depends, as indicated in the AFN
equation?
The need for external financing depends on the following key factors:

1. Sales growth
2. Capital intensity
3. Spontaneous liabilities-to-sales ratio (L0*/S0)
4. Profit margin (M)
5. Retention ratio (RR)

12-6 What are some differences in the analysis for a replacement project versus that for a new
expansion project?

In replacement projects, the benefits are generally cost savings, although the new machinery
may also permit additional output. The data for replacement analysis are generally easier to
obtain than for new products, but the analysis itself is somewhat more complicated because
almost all of the cash flows are incremental, found by subtracting the new cost numbers from
the old numbers.
 Long Questions
Solution 17-13
16-1 CASH CONVERSION CYCLE Primrose Corp has $15 million of sales, $2 million of
inventories, $3 million of receivables, and $1 million of payables. Its cost of goods sold is 80%
of sales, and it finances working capital with bank loans at an 8% rate. What is Primroses
cash conversion cycle (CCC)? If Primrose could lower its inventories and receivables by 10%
each and increase its payables by 10%, all without affecting sales or cost of goods sold, what
would be the new CCC, how much cash would be freed up, and how would that affect pretax
profits?
Solution:
Sales = $15,000,000; Inventory = $2,000,000; A/R = $3,000,000; A/P = $1,000,000; COGS = 0.8(Sales);
Interest on bank loan = 8%

CCC = Inventory conversion period + Average collection period Payables deferral period.

Inventory
Inventory conversion period =
Cost of goods sold per day

$2,000,000
=
[(0.8)($15,000,000)]/365

$2,000 ,000
=
$32 ,876 .7123

= 60.83 days

Receivables
Average collection period =
Sales/365

$3,000 ,000
=
$15 ,000 ,000 /365

= 73 days.

Payables
Payables deferral period =
Cost of goods sold/365

$1,000 ,000
=
$32 ,876 .7123

= 30.42 days.

CCC = 60.83 + 73 30.42 = 103.41 days.

 Inventory = 2,000,000 0.9 = 1,800,000.

A/R = 3,000,000 0.9 = 2,700,000.

A/P = 1,000,000 1.1 = 1,100,000.

$1,800 ,000
Inventory conversion period =
$32 ,876 .7123

= 54.75 days.

$2,700 ,000
Average collection period =
$15 ,000 ,000 /365

= 65.70 days.

$1,100 ,000
Payables deferral period =
$32 ,876 .7123

= 33.46 days.

New CCC = 54.75 + 65.70 33.46 = 86.99 days 87 days.

Cash freed up:

Inventory = (60.83 54.75) $32,876.7123 = $199,890.41.

Receivables = (73 65.70) $41,095.8904 = $300,000.

Payables = (33.46 30.42) $32,876.7123 = $99,945.2055.

Cash freed up = $199,890.41 + $300,000 $99,945.2055 = $399,945.2045 $400,000.

$400,000 0.08 = $32,000 increase in pre-tax profit.

12-6 NEW PROJECT ANALYSIS You must evaluate a proposed spectrometer for the R&D
Department. The base price is $140,000, and it would cost another $30,000 to modify the equipment
for special use by the firm. The equipment falls into the MACRS 3-year class and would be sold after 3
years for $60,000. The applicable depreciation rates are 33%, 45%, 15%, and 7% as discussed in
Appendix 12A. The equipment would require an $8,000 increase in working capital (spare parts
inventory). The project would have no effect on revenues, but it should save the firm $50,000 per year
in before-tax labor costs. The firms marginal federal-plus-state tax rate is 40%.

a. What is the net cost of the spectrometer; that is, what is the Year 0 project cash flow?
b. What are the projects annual net cash flows in Years 1, 2, and 3?
c. What is the terminal cash flow?
d. If the WACC is 12%, should the spectrometer be purchased?

Solution
a. The net cost is:
Cost of investment at t = 0:
Base price ($140,000)

Modification (30,000)

Increase in NOWC (8,000)

Cash outlay for new machine ($178,000)

b. The operating cash flows follow:

Year 1 Year 2 Year 3

After-tax savings $30,000 $30,000 $30,000

Depreciation tax savings 22,440 30,600 10,200

Net operating cash flow $52,440 $60,600 $40,200

c. The terminal cash flow is $48,760:

Salvage value $60,000

Tax on SV* (19,240)

Return of NOWC 8,000

$48,760
*Tax on SV = ($60,000 $11,900)(0.4) = $19,240.

Remaining BV in Year 4 = $170,000(0.07) = $11,900.

d. The project has an NPV of ($19,549). Thus, it should not be accepted.

Year Net Cash Flow PV @ 12%

0 ($178,000) ($178,000)

1 52,440 46,821

2 60,600 48,310

3 88,960 63,320

NPV = ($ 19,549)