Financial Management Notes

Review Problems for Exam #1

Chapter 1.

1. Agency costs refer to:

d. The costs of the conflict of interest between stockholders and management and
between the stockholders and bondholders.

2. Which of the following is a true statement concerning corporations?

b. The life of the corporation is unlimited.

3. Which of the following is a true statement concerning a general partnership?

I. Partners are not responsible for the debts of the partnership.

II. Partners generally do not manage the partnership.

III. The income of a partnership is taxed at the partners' income tax rate.

b. III only

4. Which of the following actions are likely to reduce agency conflicts between
stockholders and managers?

b. Increasing the threat of corporate takeover.

5. Which of the following statements is most correct?

c. A good example of an agency relationship is the one between stockholders and

managers.

Chapter 2.

1. Which of the following statements is CORRECT?

a. The NYSE does not exist as a physical location. Rather it represents a loose
collection of dealers who trade stock electronically.

b. An example of a primary market transaction would be your uncle transferring 100

shares of Walmart stock to you as a birthday gift.
c. If your uncle in New York sold 100 shares of Microsoft through his broker to an
investor in Los Angeles, this would be a primary market transaction.

d. While the two frequently perform similar functions, investment banks generally
specialize in lending money, whereas commercial banks generally help companies raise
large blocks of capital from investors.

e. None of the statement are correct.

2. Which of the following statements is CORRECT?

a. If you purchase 100 shares of Disney stock from your brother-in-law, this is an
example of a primary market transaction.

b. If Disney issues additional shares of common stock through an investment banker, this
would be a secondary market transaction.

c. The NASDAQ relies on market makers (dealers) to facilitate trading.

d. Only institutions, and not individuals, can engage in derivative market transactions.

e. The fewer market makers (dealers) that exist for a company – the smaller the bidask
spread for that company’s stock (all other things equal).

3. Which of the following statements is CORRECT?

a. Hedge funds are legal in Europe and Asia, but they are not permitted to operate in the
United States.

b. Hedge funds are legal in the United States, but they are not permitted to operate in
Europe or Asia.

c. As discussed in class, John Paulsen’s hedge funds have consistently posted (positive)
double-digit returns over the past 10 years.

e. Hedge funds are not as highly regulated as most other types of financial
institutions.

The justification for this light regulation is that only "sophisticated" investors (i.e.,
those with high net worths and high incomes) are permitted to invest in these funds,
and these investors supposedly can do any necessary "due diligence" on their own
rather than have it done by the SEC or some other regulator.

Chapter 3.
1. Which of the following would be considered a use of cash?

I. Accounts receivable increase.

II. Accounts payable decrease.

III. Common stock increases.

IV. Net fixed assets decrease by the amount of depreciation.

c. I and II only

2. Which of the following is a true statement?

a. Accounting income is generally equal to firm cash flow.

b. The balance sheet equity account represents the market value of the firm to
shareholders.

c. The balance sheet tells investors exactly what the firm is worth.

d. Assets are usually listed on the balance sheet at market value.

e. None of the statements are true.

3. Which of the following is NOT typically characterized as a current asset?

a. Inventory

b. Cash on hand

c. Accounts receivable

d. Marketable securities

e. Accruals

4. Which of the following statements is most correct?

a. Accounts receivable show up as current liabilities on the balance sheet.

b. Dividends paid reduce the net income that is reported on a company’s income

statement.
c. If a company pays more in dividends than it generates in net income, its balance
of retained earnings reported on the balance sheet will fall.

d. Statements a and b are correct.

e. All of the statements above are correct

5. Using the financial statements below, determine how much FIN 317 Corp. paid its
shareholders in dividends during the year 2011. FIN 317 Corp.

c. $425 – Look at handwritten notes. Difference between Net Income and change in
Retained Earnings.

Chapter 4.

1. Ratios that measure how efficiently a firm's management uses its assets in
operations to generate bottom line net income are known as:

A) Asset management ratios.

2. Trade credit is an arrangement between businesses to buy goods or services on

account, that is, without making immediate cash payment. Vendors providing trade
credit to a firm tend to be most interested in the firm's __________ ratios.

A) liquidity

3. Given a profit margin = 10%, ROE = 20%, D/E = 1.5, and assets = $200, calculate
sales.

A) $10

B) $160

C) $250

D) $640

E) $1,000

4. Nelson Company is thinking about issuing new common stock. The proceeds
from the stock issue will be used to reduce the company’s outstanding debt and
interest expense. The stock issue will have no effect on the company’s total assets,
EBIT, or tax rate. Which of the following is likely to occur if the company goes
ahead with the stock issue?

a. The company’s net income will increase.

b. The company’s times interest earned ratio will increase.

c. The company’s ROA will increase.

d. All of the above statements are correct.

5. Which of the following statements is most correct?

a. An increase in a firm’s debt ratio, with no changes in its sales and operating costs,
could be expected to lower its profit margin on sales.

6. A firm has a profit margin of 15 percent on sales of $20,000,000. If the firm has
debt of $7,500,000, total assets of $22,500,000, and an after-tax interest cost on total
debt of 5 percent, what is the firm’s ROA? (This would be a problem on the exam –
not a multiple choice question.)

a. 8.4%

b. 10.9%

c. 12.0%

d. 13.3%

e. 15.1%

7. The Jordan Company has net income of $75,500. DSO is 14.20. Total Assets are
$560,000, total receivables are $86,600 and the debt-to-equity ratio is 0.65. What is
Jordan company’s profit margin, total asset turnover and ROE?

Debt ratio = Total Debt/TA

.65 = Total Debt/ 560,000

Total Debt = 364,000

Days Sales Outstanding (DSO) = Receivables/(Sales/365)
14.2 = 86,600 / (sales/365)
Sales =

Profit Margin = NI/Sales

PM = 75,500/ 2225985.92

Total Asset Turnover = Sales/TA

TAT = 2225985.92/560,000

ROE = NI/Common equity

ROE = 75,500/

Chapter 5.

1. You inherited a painting from your Great-Aunt Minnie, that she bought in 1920 for
$2,000. You have the painting appraised to find, to your great surprise, that the painting
is now worth $12,000,000. How much annual return did your Great Aunt
Minnie earn on this investment? If Minnie had invested the $2,000 in a money market
account that paid 6% APR compounded monthly, how many years would it have taken
her to reach the $12,000,000 value of the painting?

9.9175%

2. What is the PV of $1,000 per year, at a discount rate of 12%

APR, if the first payment is received 8 years from now and the
last payment is received 20 years from now?

Discou

3. You want to buy a new sports car from Muscle Motors for $48,000. The contract is in
the form of a 48 month annuity due at 9.25% APR. What will your monthly payment be?

Make sure to pay attention when plugging into the calculator

4. Your friend is celebrating her 35th birthday today and wants to start saving for her
anticipated retirement at age 65. She wants to be able to withdraw $80,000 from her
savings account on each birthday for 15 years following her retirement; the first
withdrawal to be on her 66th birthday. Your friend intends to invest her money in the
local credit union, which offers 9% interest per year. She wants to make equal annual
payments on each birthday into the account established at the credit union for her
retirement fund.

a) If she starts making these deposits on her 36th birthday and continues to make deposits
until she is 65 (the last deposit will be on her 65th birthday), what amount must she
deposit annually to be able to make the desired withdrawals at retirement?

b) Suppose you friend has just inherited a large sum of money. Rather than making equal
annual payments, she has decided to make one lump-sum payment on her 35th birthday to
cover her retirement needs. What amount does she have to deposit?

c) Suppose your friend’s employer will contribute $1,500 to the account every year as
part of the company’s profit-sharing plan. In addition, your friend expects a $30,000
contribution from a family trust fund on her 55th birthday, which she will also put into the
same retirement account. What amount must she deposit annually now to be able to
make the desired withdrawals at retirement?

NOTE: Questions 5-8 would be problems on the exam – not multiple choice questions.

5. Andy promises Paul that he will give him $5,000 upon his graduation from college.
How much must Andy invest today to make good on his promise, if Paul is expected to
graduate in 12 years and Andy can earn 5% on his money?

A) $2,135.32

B) $2,784.19

C) $2,881.11

D) $3,012.88

E) $8,979.28

6. An account was opened with an investment of $1,000 10 years ago. The ending
balance in the account is $1,500. If interest was compounded annually, what rate was
earned on the account?

A) 1.0%

B) 2.2%

C) 2.9%

D) 3.8%

E) 4.1%

7. Many economists view a 3% annual inflation rate as "acceptable". Assuming a 3%

annual increase in the price of automobiles, how much will a new Suburban cost you 5
years from now, if today's price is $38,000?

A) $32,779

B) $36,110

C) $40,575

D) $42,813

E) $44,052
8. You need $2,000 to buy a new stereo for your car. If you have $800 to invest at 5%
compounded annually, how long will you have to wait to buy the stereo?

A) 6.58 years

B) 8.42 years

C) 14.58 years

D) 15.75 years

E) 18.78 years

Solutions.

7. PM = 0.0339, TATO = 3.97, ROE = 0.2223

Chapter 5.

1. You inherited a painting from your Great-Aunt Minnie, that she bought in 1920 for
$2,000. You have the painting appraised to find, to your great surprise that the painting is
now worth $12,000,000. How much annual return did your Great Aunt Minnie earn on
this investment?

PV = -2000

FV = 12,000,000

N = (2012-1920) = 92

I/Y = ?  9.9175%

If Minnie had invested the $2,000 in a money market account that paid 6% APR

compounded monthly, how many years would it have taken her to reach the

$12,000,000 value of the painting?Solution: Use Period Rate: 6%/12 = 0.5%

Time periods are months.

N = ?, I/Y = 0.5%, PV = -$2,000, PMT = 0, FV = $12,000,000

N = 1,744.25 months which corresponds to approximately 145.35 years.

2. What is the PV of $1,000 per year, at a discount rate of 12% APR, if the first payment
is received 8 years from now and the last payment is received 20 years from now?

Look at the thing online

3. You want to buy a new sports car from Muscle Motors for $48,000. The contract is in
the form of a 48 month annuity due at 9.25% APR. What will your monthly payment be?

Use calculator in BEGIN mode with

Step 1:

PMT = 1000

N = 13

I/Y = 12

PV = ?  6423.55

Step 2:

FV = 6423.55

N=7

I/Y = 12

PV = ?  2905.69

PV = 47,633.22

N = 48

I/Y = .77

FV = 0

PMT = ?  1190.79
Calculator -> BEGIN mode

PV = 48,000

N = 48

I/Y = .77

PMT = ?  1190.79

FV = 04. Your friend is celebrating her 35th birthday today and wants to start saving for
her anticipated retirement at age 65. She wants to be able to withdraw $80,000 from her
savings account on each birthday for 15 years following her retirement; the first
withdrawal to be on her 66th birthday. Your friend intends to invest her money in the
local credit union, which offers 9% interest per year. She wants to make equal annual
payments on each birthday into the account established at the credit union for her
retirement fund.

a) If she starts making these deposits on her 36th birthday and continues to make deposits
until she is 65 (the last deposit will be on her 65th birthday), what amount must she
deposit annually to be able to make the desired withdrawals at retirement?

LOOK AT WRITTEN THING AND ONLINE EXPLANATION

b) Suppose you friend has just inherited a large sum of money. Rather than making equal
annual payments, she has decided to make one lump-sum payment on her 35th birthday to
cover her retirement needs. What amount does she have to deposit?
LOOK ONLINE
c) Suppose your friend’s employer will contribute $1,500 to the account every year as
part of the company’s profit-sharing plan. In addition, your friend expects a $30,000
contribution from a family trust fund on her 55th birthday, which she will also put into the
same retirement account. What amount must she deposit annually now to be able to
make the desired withdrawals at retirement?
Initial Cash Flow = delta NOWC, capital expenditures,

Cash Flow During = OCF = EBIT (1-T) + Depreciation

Terminal Cash Flow = salvage value, tax on salvage value,

1 2 3 4 5 6 7
Sales 190,000 228,000 273,600 328,320
Var. Cost 121,600 145,920…
Fix Cost 7,000 7,000…
Deprec. 12,000…
EBIT 49,400 63,080

EBIT (1-T) + Dep. =

41,640 49,848

The above represents the cash flow during the duration of the project

Initial Cash Flow:

Delta NOWC = -10,000
Equipment = -84,000

Terminal Cash Flow:

Salvage Value = 5,000
Tax on Salvage Value = Tax (SV – BV) .4(5,000 – 0) = -2,000
Recovery of NOWC = Assume 100% unless otherwise stated so 10,000

Take the terminal cash flow numbers and add them to the operating cash flow.

Use rate and cash flows to find NPV

If NPV is greater than 0, do the project

Initial Cash Flow:

NOWC = -20,000
Equipment = -200,000
Total Initial Cost = -220,000

Operating Cash Flow:

1 2 3
Sales 700,000 700,000 700,000
Externality 100,000 100,000 100,000
Variable Costs 360,000 360,000 360,000
Fixed Costs 5,000 5,000 5,000
Depreciation 40,000 40,000 40,000
EBIT 195,000 195,000 195,000
EBIT (1-T) + Dep. 168,700 168,700 168,700

Terminal Cash Flow:

Salvage Value = 50,000
Tax on SV = .34(50,000 – 80,000) = 10,200
Recovery of NOWC = 20,000
Total Terminal Cash Flow = 80,200

NCF = -220,000 168,700 168,700 248,900

NPV = (220,000,15,{168,700, 168,700, 248,900}) =

Discounted Payback Period =
Should we accept the project or not?
Yes

Chapter 9
1. D1 / Po = dividend yield
g = capital gain

so that answer is E.

4.