UT FIN 357 - Review Test 1Solutions (16 pages)

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Review Test 1Solutions



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Review Test 1Solutions

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Pages:
16
School:
University of Texas at Austin
Course:
Fin 357 - Business Finance
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Review Test 1 Questions created by Mary Lou Poloskey for another text can be used as part of your review for test 1 Solution Why is value maximization superior to profit maximization as a goal for management While profit maximization appears to be a logical goal at first glance it has some serious drawbacks First since profit is the difference between revenues and expenses it can be distorted by some creative accounting measures Second accounting profits are quite different from cash flows Cash flows are the focus of investors and therefore managers Third profit maximization does not recognize when cash flows occur Finally profit maximization as a goal ignores the risk involved in generating the cash flows To determine the value of a firm s stock consider 1 the size of the expected cash flows 2 the timing of the cash flows and 3 the riskiness of the cash flows Thus value maximization as a goal overcomes all the shortcomings of profit maximization as a goal 2 Which of the following is are advantages of the corporate form of organization a Reduced start up costs b Greater access to capital markets c Unlimited liability d Single taxation Solution b Shares in a corporation can be sold to raise capital from investors who are not involved in the business This greatly increases the amount of capital that can be raised to fund the business 3 Drayton Inc has current assets of 256 312 and total assets of 861 889 It also has current liabilities of 141 097 common equity of 200 000 and retained earnings of 133 667 How much long term debt does the firm have Solution Assets Total current Liabilities and Equity 256 312 00 Total current liabilities Long term debt 141 097 00 assets 387 125 00 Total assets Common stock 200 000 00 Retained earnings 133 667 00 861 889 00 stockholders Total liabilities and 861 889 00 equity 861 889 141 097 200 000 133 667 387 125 long term debt 4 Ellicott Testing Company produced revenues of 745 000 in 2011 It had expenses excluding depreciation of 312 640 depreciation of 65 000 and interest expense of 41 823 It pays an average tax rate of 34 percent What was the firm s net income after taxes Solution Amount Revenues Costs EBITDA Depreciation EBIT Interest 745 000 00 312 640 00 432 360 00 65 000 00 367 360 00 41 823 00 EBT 5 325 537 00 Taxes 34 110 682 58 Net income 214 854 42 What is the difference between book value balance sheets and market value balance sheets Which provides better information to investors and management Solution Book value balance sheets are accounting statements that use historical information Market value statements contain current information and show what line items are worth today Although market values can be harder to identify they provide better economic information than book value 6 What are agency costs Explain Solution Agency costs are the costs that result from a conflict between a firm s management agents and its owners or shareholders principals When management acts in ways that do not benefit shareholders it results in agency costs These costs could be either direct or indirect When a management action results in a loss of cash flow to the firm it is an indirect cost Direct costs result from inappropriate actions or expenses by management that lower the firm s income and cash flows 7 If the nominal rate of interest is 7 5 percent and the real rate is 4 percent what is the expected inflation premium Solution Using the Fisher equation i r Pe r Pe where i 0 075 and r 0 04 solving for Pe 3 37 Use the following Greenfern Corporation Financial Statements for Questions 8 10 Greenfern Corporation Income Statement for the Fiscal Year Ended July 31 2013 Net sales 73 236 Cost of products sold 52 092 Gross margin 21 144 Marketing research administrative exp 9 333 Depreciation 1 060 Operating income loss 10 751 Interest expense 649 Earnings loss before income taxes 10 102 Income taxes 3 536 6 566 Net earnings loss Greenfern Corporation Balance Sheet as of 7 31 2013 Assets Cash and marketable securities Liabilities and Stockholders Equity 8 302 Accounts payable 6 379 Investment securities 816 Accrued and other liabilities 5 663 4 821 Accounts receivable 7 844 Taxes payable Total inventories 8 900 Debt due within one year Deferred income taxes Prepaid expenses other receivables Total current assets 10 778 878 2 803 29 543 Total current liabilities 27 641 Property plant and equip at cost 62 467 Long term debt Less Accumulated depreciation 22 196 Deferred income taxes 6 903 Other non current liabilities 5 608 Net plant and equipment Net goodwill other intangible assets Other non current assets 40 271 13 345 Total liabilities 24 280 64 432 2 925 Common stock Retained earnings 3 667 17 985 21 652 Total stockholders equity deficit Total liabilities and stockholders equity Total assets 8 86 084 86 084 Refer above to the balance sheet and income statement for Greenfern Corporation for the year ended July 31 2013 What are the company s current ratio and quick ratio What do these ratios tell us about Greenfern Solution Current assets Current ratio Current liabilities 29 543 1 07 27 641 Current assets Inventory Quick ratio Current liabilities 29 543 8 900 0 75 27 641 The current ratio of just over one tells us that Greenfern s cash and other current assets such as accounts receivable and inventory if liquidated are just enough to cover the short term liabilities or obligations Since inventory can be much less liquid then other current assets the quick ratio of Greenfern indicates that if we exclude inventory the remaining current assets can cover 75 of the short term liabilities 9 Refer above to the balance sheet and income statement for Greenfern Corporation for the year ended July 31 2013 Calculate the following ratios Note Formulas might be slightly different from current text Inventory turnover ratio Days sales outstanding Total asset turnover Fixed asset turnover Total debt ratio Debt to equity ratio Times interest earned ratio Cash coverage ratio Solution Ratio 10 Calculation Value Inventory turnover ratio 52 092 8 900 5 85 Days sales outstanding 7 844 73 236 365 Total asset turnover 73 236 86 084 0 85 Fixed asset turnover 73 236 40 271 1 82 Total debt ratio 64 432 86 084 0 75 Debt to equity ratio 64 432 21 652 2 98 Times interest earned ratio 10 751 649 16 57 Cash coverage ratio 10 751 1 060 649 18 20 39 1 days Refer above to the balance sheet and income statement for Greenfern Corporation for the year ended July 31 2013 Use the DuPont identity to


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