POLYTECHNIC UNIVERSITY OF THE PHILIPPINES

SAN JUAN BRANCH

Practice Problems on Financial Analysis & Reporting (FIMA 30033)

Midterm Period

https://docs.google.com/spreadsheets/d/1YGXdvbL4KBiX3oU_McejHro91RI_8_-0mNFp_1
ikZ94/edit#gid=0

Problem 1. Jane McDonald, a financial analyst for Carroll Company, has prepared the following sales and cash
disbursement estimates for the period February to June of the current year.

McDonald notes that historically, 30% of sales have been for cash. Of credit sales, 70% are collected 1 month after
the sale, and the remaining 30% are collected 2 months after the sale. The firm wishes to maintain a minimum ending
balance in its cash account of $25. Balances above this amount would be invested in short-term government
securities (marketable securities), whereas any deficits would be financed through short-term bank borrowing (notes
payable). The beginning cash balance at April 1 is $115.
a. Prepare cash budgets for April, May, and June.

Cash Budget February March April May June

Sales Forecast $500 $600 $400 $200 $200
Cash sales (30%) $150 $180 $120 $60 $60
Credit Sales $350 $420 $280 $140 $140
Collections of A/R:
Lagged 1 month (70%) $245 $294 $196 $98
Lagged 2 months (30%) $105 $126 $84
Total Cash receipts $150 $845 $519 $382 $242

b. How much financing, if any, at a maximum would Carroll Company require to meet its obligations during this
3-month period?
The amount of financing that Caroll Company require to meet its obligations during this 3-month period is $176.

April May June

Cash Receipts $519 $382 $242
Less: Cash Disbursements $600 $500 $200
Net Cash Flow -$81 -$118 $42
Add: Beginning Cash $115 $34 -$84
Ending Cash $34 -$84 -$42
Less: Minimum Cash Balance $25 $25 $25
Required Total Financing -$109 -$67
Excess Cash Balance $9

c. A pro forma balance sheet dated at the end of June is to be prepared from the information presented. Give
the size of each of the following: cash, notes payable, marketable securities, and accounts receivable.

Pro Forma Balance Sheet

Current Assets
Cash $25
Marketable Securities $9
Accounts Receivables $182
Total Current Assets $216

Current Liabilities
Notes Payable $176
Total Current Liabilities $176

Problem 2. Euro Designs, Inc., expects sales during 2013 to rise from the 2012 level of $3.5 million to $3.9 million.
Because of a scheduled large loan payment, the interest expense in 2013 is expected to drop to $325,000. The firm
plans to increase its cash dividend payments during 2013 to $320,000. The company’s year-end 2012 income
statement follows.
 a. Use the percent-of-sales method to prepare a 2013 pro forma income statement for Euro Designs, Inc.

Cost of Goods Sold Operating Expenses

Sales Sales
$1,925,000 $420,000
$3,500,000 $3,500,000
= 55% = 12%

Pro Forma Income Statement Using

Percent-of-Sales Method for Euro Designs Inc. for
the Year ended 2013

Sales Revenue $3,900,000

Less: Cost of goods sold (0.55) $2,145,000
Gross profits $1,755,000
Less: Operating expenses (0.12) $468,000
Operating profits $1,287,000
Less: Interest expense $325,000
Net profits before taxes $962,000
Less: Taxes (0.40) $384,800
Net profits after taxes $577,200
Less: Cash dividends $320,000
To retained earnings $257,200

b. Explain why the statement may underestimate the company’s actual 2013 pro forma income.
If the company has fixed costs that do not increase in line with its sales, the statement may underestimate the
company's actual 2013 pro forma income. Everything is predicated on the assumption that the financial relationships
indicated in the firm's previous financial statements will not alter in the future.

Problem 3. Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in the 40% tax
bracket. Current investigation has gathered the following data:
Debt. The firm can raise debt by selling $1,000-par-value, 10% coupon interest rate, 10-year bonds on
which annual interest payments will be made. To sell the issue, an average discount of $30 per bond must
be given. The firm must also pay flotation costs of $20 per bond.

Preferred stock. The firm can sell 11% (annual dividend) preferred stock at its $100-per-share par value.
The cost of issuing and selling the preferred stock is expected to be $4 per share.
 Common stock. The firm’s common stock is currently selling for $80 per share. The firm expects to pay
cash dividends of $6 per share next year. The firm’s dividends have been growing at an annual rate of 6%,
and this rate is expected to continue in the future. The stock will have to be underpriced by $4 per share,
and flotation costs are expected to amount to $4 per share.

Retained earnings. The firm expects to have $225,000 of retained earnings available in the coming year.
Once these retained earnings are exhausted, the firm will use new common stock as the form of common
stock equity financing.

a. Calculate the individual cost of each source of financing. (Round to one decimal place.)
Cost of Long-term Debt
Given:
- $1,000-par-value
- 10% coupon interest rate
- 10-year bonds
- discount of $30
- flotation costs of $20
- 40% tax

Net proceeds
1,000 – 30 - 20 = 950’

Before–Tax Cost of debt

par-value - Nd
I+
n
rd =
Nd + par-value
2

1,000 - 950
100 + 100 + 5
10
rd = rd = rd = 0.10769 or 10.8%
950 + 1,000
975
2

After–tax cost of debt

ri = rd x (1-T)
= 10.8% x (1 - 0.40)
ri = 0.0648 or 6.5%

Cost of Preferred Stock

Given:
- 11% preferred stock
- $100-per-share
- $4 flotation costs
Dollar amount of the annual preferred dividend = 11% x 100 = $11
Net proceeds per share from the proposed sale of stock = 100 - 4 = $96
equation: rp = Dp / Np
= 11/96
rp = 0.11458 or 11.5%

Cost of Common Stock

Given:
- $80 per share.
- cash dividends of $6 per share
- annual rate of 6%
- underpriced by $4 per share
- $4 per share, flotation costs
Nn = 80 - 4 - 4 = 72
equation: rn = (D1 / Nn) + g
= (6/72) + 0.06
= 0.08 + 0.06
rn = 0.14 or 14%

Cost of retained earnings

equation: rs = (D1 / P0) + g
= (6/80) + 0.06
= 0.075 + 0.06
rs = 0.135 or 13.5%

b. Calculate the firm’s weighted average cost of capital using the weights shown in the following table, which
are based on the firm’s target capital structure proportions. (Round to one decimal place.)

Cost of debt = 6.5%

Cost of preferred stock = 11.5%
Cost of common stock = 14%
Cost of retained earnings = 13.5%
 Source of capital Weight Cost Weighted Cost
Long-term debt 0.4 6.5% 2.6%
Preferred stock 0.15 11.5% 1.7%
Common stock equity 0.45 13.5% 6.1%
Totals 1 10.4%

c. In which, if any, of the investments shown in the following table do you recommend that the firm invest?
Explain your answer. How much new financing is required?

If I were going to recommend the firm to invest on those investments listed in table above, I would pick the
investment opportunity letters A, C, D, and E. Since the firm’s weighted average cost of capital (WACC) is 10.4%, it is
preferred to invest in investment opportunities with an expected rate of return higher than the WACC of the firm. We
can also consider the investment opportunity G since it has .1 percent higher than the firm’s WACC. The total new
financing required would be the amount of all the initial investments of the listed investment opportunity letters that
would be $900,000 or $1,200,000 if the firm considers the investment opportunity letter G.

A = $100, 000
C = $150,000
D = $200,000
E = $450,000
Total financing required = $900,000
(including G)
G = $300,000
Total financing required = $1,200,000