1. On the balance sheet, total assets must always equal the sum of total debt and equity.
a. True
b. False
2. The annual report contains four basic financial statements: the income statement, the balance sheet, the cash flow statement, and statement of stockholders' equity.
a. True
b. False
3. What is the type of conflict you may often see in a company?
a. Debtholder – Manager Conflicts
b. Stockholder – Debtholder Conflicts
c. Stockholder – Investor Conflicts
d. Board of Directors – Debtholder Conflicts
4. Other things held constant, which of the following actions would increase the amount of cash on a company's balance sheet?
a. The company repurchases common stock.
b. The company pays a dividend.
c. The company issues new common stock
d. The company gives customers more time to pay their bills.
e. The company purchases a new piece of equipment
5. If we are given a periodic interest rate, say a monthly rate, we can find the nominal annual rate by dividing the periodic rate by the number of periods per year.
a. True
b. False
6. What is the term that we use to refer to the true value of a company?
a. Market Value
b. Book Value
c. Intrinsic Value
d. Capital Value
7. When a loan is amortized, a relatively high percentage of the payment goes to reduce the outstanding principal in the early years, and the principal repayment's percentage declines in the loan's later years.
a. True
b. False
8. What is NOT in the current liabilities?
a. Accrual Wages and Taxes
b. Notes Payable
c. Market Securities
d. Accounts Payable
9. The 4 most fundamental factors that affect the cost of money are (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) opportunity cost.
a. True
b. False
10. What are the major components of shareholders’ equity on the balance sheet?
a. Retained Earnings + Net Income
b. Dividends + Net Income
c. Retained Earnings + Paid-in Capital
d. Dividends + Paid-in Capital
11. During periods when inflation is increasing, interest rates tend to decrease, while interest rates tend to fall when inflation is declining.
a. True
b. False
12. Which of the following factors would be most likely to lead to an increase in nominal interest rates?
a. A new technology like the Internet has just been introduced, and it increases investment opportunities.
b. There is a decrease in expected inflation.
c. The economy falls into a recession.
d. The Federal Reserve decides to try to stimulate the economy.
13. What is a non-cash charge on the income statement among the followings?
a. Costs of goods sold
b. Operating Expenses
c. Depreciation " Amortization
d. Dividends
e. Debt Interests
14. A call provision gives bondholders the right to demand, or "call for," repayment of a bond. Typically, companies call bonds if interest rates rise and do not call them if interest rates decline.
a. True
b. False
15. What does a “leveraged” firm mean? Choose the best answer
a. A firm is financing 100% by common equity
b. a firm has no long-term debt
c. a firm’s major owners are shareholders
d. a firm does not use 100% common equity
16. What is the process to get present value from future value?
a. Simple Interest Process
b. Discounting Factor Process
c. Compounding Process
d. Arithmetic Process
17. Which one of the followings is not the fundamental factors affecting the cost of money?
a. Opportunity Cost
b. Time Preferences for Consumption
c. Risk Tolerance
d. Inflation
18. Which one of the following bonds exposure the greatest maturity risk?
a. 10 Year AAA Corporate Bond
b. 1 Year Treasure Bill
c. 30 Year Treasury Bond
d. 15 Year BB Corporate Bond
e. 10 series of 1-year Treasure Bill
19. If the economy has continued growing, we shall expect to
a. Increase interest rate and expand money supply
b. Increase interest rate and reduce money supply
c. Decrease interest rate and expand money supply
d. Decrease interest rate and reduce the money supply
20. The market value of any real or financial asset, including stocks, bonds, or artwork purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present.
a. True
b. False
Part II (35%)
Case Study: John " Jon (J"J) Financial Statement Preparation " Analysis
You are recently hired as a senior financial analyst for John " Jon (J"J) and you are in charge of preparing the financial statements and presenting an annual analysis at the board meeting.
Overview of John " Jon’s Balance Sheet
The assets of John " Jon (J"J) in 2017 has both current assets and net plant and equipment. It has total assets of $ 7.5 million and net plan and equipment equals $5 million. J"J only finances with $2.5 million long-term debt, $500,000 notes payable and total common equity of $3.5 million. The firm does have $400,000 accounts payable and $600,000 accruals on its balance sheet. Now assume the firm’s current assets consist entirely of cash and cash equivalence, account receivables and inventories. If it has 1.5 million cash and cash equivalents and $400,000 account receivables.
John " Jon’s Income Statement in 2017 (dollars are in millions)
Sales
$15
Operating costs excluding depreciation and amortization
$5
EBITDA
$10
Depreciation " Amortization
$0.6
EBIT
$9.4
Interest
$0.4
EBT
$9
Taxes (40%)
$3.6
Net Income
Cash Dividends
$5.4
$2.0
Use the above information to answer the following questions. When you answer your question, make sure include the calculation steps or formula.
1. Prepare the balance sheet and present to the board of directors (5%)
Current assets in $
Cash and cash equivalents $1,500,000
Receivables 400,000
Inventories 600,000
Total current assets 2,500,000
Fixed assets
Net and equipment 5,000,000
Total fixed assets 5,000,000
Total assets 7,500,000
Current liabilities in $
Notes payable 500,000
Accounts payable 400,000
Accruals 600,000
Total current liabilities 1,500,000
Long term liabilities
Long term debt 2,500,000
Equity
Common equity 3,500,000
Total Liabilities
7,500,000
Total Assets 7,500,000
Liabilities " Shareholder’s Equity 7,500,000
2.What is the amount of total liabilities and equity that appears on the firm’s balance? (1%)
Total liabilities for the firm = notes payable + accruals+ accounts payable + long term liability or Liabilities = assets – Shareholders equity (Brigham and Houston, 2012).
= $ (500,000+ 600,000+ 400,000+ 2,500,000)
$4,000,000
Or
Liabilities = $ 7,500,000- 3,500,000
= $ 4,000,000
2. What is the amount of current assets (1%)
Current assets = total assets of the company – fixed assets (Brigham and Houston, 2012).
Current assets= $(7,500,000- 5,000,000)
$2,500,000
3. What is the balance of current liabilities? (1%)
Current liabilities = accruals + notes payable + accounts payable (Brigham and Houston, 2012).
Current liabilities = $(600,000+ 500,000+ 400,000)
= $1,500,000
4. What is the amount of company’s inventory? (1%)
Current assets = cash and cash equivalents + receivables + inventory
Inventory = current assets – cash and cash equivalents – receivables (Brigham and Houston, 2012).
Inventory = $(2,5000,000- 1,500,000-400,000)
Inventory = $600,000
5. What is the amount of total liabilities? (1%)
Total liabilities = current liabilities + long term liabilities (Brigham and Houston, 2012).
total liabilities = $(1,500,000+ 2,500,000)
total liabilities = $4,000,000
7. What is the amount of total debt? (1%)
Total debt = notes payable + long-term debt + accounts payable + accruals (Brigham and Houston, 2012).
Total debt = $(400,000+ 600,000+ 500,000+ 2,500,000)
Total debt = $4,000,000
8. What is the amount of total capital? (1%)
Total capital = long-term debt + common equity (Brigham and Houston, 2012).
Total capital = $2,500,000+ $3,500,000
Total capital = $ 6,000,000
9. What is the amount of net working capital? (1%)
Net working capital = current assets – current liabilities (Brigham and Houston, 2012).
Net working capital = $2,500,000 - $1,500,000
Net working capital = $ 1,000,000
10. What is the amount of net operating working capital? (1%)
Net Operating working capital = current operating assets – current operating liabilities (Brigham and Houston, 2012).
For current operating assets, we only consider cash, accounts receivables, and inventories. Also, in current operating liabilities, we do not consider notes payables and other liabilities (Brigham and Houston, 2012).
Therefore;
Net Operating working capital = cash + account receivables and inventories - accounts payable and accrued expenses (Brigham and Houston, 2012).
= $2,500,000- $1000,000
$1,500,000
11. If by the end of 2017, the retained earnings of John and Jon is $2.5 million, what is the amount of paid-in capital? (1%)
Paid-in-capital = stockholders equity- retained earnings + treasury stock (Brigham and Houston, 2012).
Paid-in –capital= 3,500.000-2,500,000
Paid-in capital = $ 1,000,000
12. If John " Jon decides to purchase $500,000 market securities by using its cash, how does this action would affect its current asset position? (2%)
If John and Jon decides to use the $ 500,000 to purchase the market securities, it will not affect the current assets. It is because the market securities are also under the category of current assets alongside cash and cash equivalents (Brigham and Houston, 2012). Therefore, the position of the current assets will remain the same.
13. As the Income of Statement shows in 2017, John " Jon actually gave out $2 million in cash dividends, what is the amount of retained earnings? (1%)
Retained earnings = net income- cash dividends
Retained earnings = $5,400,000-2,000,000
Retained earnings = $3,400,000
14. What is the amount of operating income? (1%)
Operating income also known as earnings before interest and taxes = revenues - the cost of goods (Brigham and Houston, 2012).
= sales – operating costs- depreciation and amortization
= 15,000,000- 5,000,000-600,000
$ 9,400,000
15. What are the operating margin and the profit margin? (1%)
Operating margin = operating income/ net sales
9,400,000/15,000,000* 100
=62.66%
Profit margin=Net income/net sales
= $ 5,400,000/ $ 15,000,000*100
36%
16. What is the average length of time that John " Jon must wait after making a sale before it receives cash? (1%)
Average collection period = (sales/ average receivable)/365 days (Brigham and Houston, 2012).
(15,000,000/400,000)/365
9.733 days
17. What is the ratio we generally use to estimate a firm’s ability to meet its annual interest payments? And calculate that ratio for John and Jon (1%)
It is called the interest coverage ratio
= earnings before interest and taxes/ interest expenses (Brigham and Houston, 2012).
= $ 9,400,000/ $ 400,000
23.5
18. What are the fixed assets turnover ratio and the total asset turnover ratio? (1%)
Fixed assets turnover = net sales/ fixed assets – accumulated depreciation (Brigham and Houston, 2012).
= $15,000,0000/ $ 5,000,000- 600,000
3. 409
Total assets turnover ratio = net sales / total average assets
15,000,000/ 7,500,000
= 2
19. What is the ratio of total debt to total capital? (1%)
Ratio = total debt/ total capital (Brigham and Houston, 2012).
=
4,000,000/ 6,000,000
2: 3
20. What is the ratio of return on common equity? (1%)
Net income/ common equity = $ 5,400,000: 3,500,000
5.4: 3.5
1.542: 1
21. Assume between 2016 and 2017, net operating working capital has increased by $500,000, calculate John " Jon’s free cash flow. (Hint: use this formula. FCF = [EBIT (1-T) +Depreciation " Amortization] – [Capital Expenditures + Change on Net Operating Working Capital]) (5%)
Change on Net Operating Working Capital = 500,000
FCF = $(9,400,000(1-0.4) + 600,000 – {400,000+ 500,000})
FCF = 5,640,000+ 600,000- 900,000
$ 5, 340,000
22. Now after you present your analysis on the meeting, the CEO would like to see higher sales and a forecasted net income of $10.8 million. Assume that operating costs (excluding depreciation and amortization) are still one third of sales and that depreciation and amortization and interest expenses will increase by 10%. The tax rate which is 40%, will remain the same. What level of sales would generate $10.8 million in net income? (5%)
Solution
Depreciation and amortization increase by 10%
1.10* 600,000 = $660,000
Interest expenses 10% increase, 1.10* 400,000= $440,000
Tax = 40%
Net income = $ 10, 800,000
Earnings before taxes =
EBT (1- 0.4) = 10.8
EBT = 10.8/ 0.6= $ 18,000,000
EBIT = EBT+ Interest
= 18,000,000+ 440,000
= $18,440,000
EBITDA = EBIT + Depreciation and Amortization
= 18,440,000+ 660,000
=$ 19, 100,000
Operating income is 1/3 of sales which means 19,100,000 = 2/3 sales
Sales 3/2 * 19,100,000
$ 28,650,000- this amount of sales will generate the net income of $ 10, 800,000
Part III (35%)
Case Study: Time Value of Money and Bonds Valuation
As Michelle’s new year resolution, she wants to begin saving for her retirement. She hired you as her financial advisor. Follow your suggestion, today Michelle will deposit $100,000, an inheritance from her parents, into 5-year savings account at Citi bank that pays 3.25% interest annually.
Use the above information to answer the following questions. When you answer your question, make sure include the calculation steps or formula. (Assume END mode)
1. How much will be in Michelle’s account after 5 years? (1%)
Amount = P (1+r)n (Brigham and Houston, 2012).
100,000(1.0325) 5
$ 117, 341.12
2.If Citi bank pays 3.25% interest monthly, how much will be in her account after 5 years? (2%)
Amount = P(1+ r/12) n*12
= 100,000(1+ 0.0325/12) 60
$ 117,7619.00
3. If Michelle wants to make 5 equal payments on each January 1 from 2018 through 2022 to accumulate $100,000, how large must each payment be if Citi banks pays 3.25 % interest annual? (Assume BEGIN mode for this question) (2%)
Number of periods = 5 years (begin mode)
Rate = 0.0325
Principle = P, Periodic payment
Amount total= 100,000= future value
Future value = {P [ (1+r) n -1]/r} * 1+r
To get P, we make it the subject of the formula
r*FV/[(1+r^n-1) *(1+r)]
0.0325*100000) / [(((1+0.0325) ^5)-1) *(1+0.0325)]
18,151.63. this is the amount that Michelle will have deposit every January.
4. Now with $100,000 bonus that will be saved today, Michelle will then make 4 additional equal payments each year from 2019 to 2022 to end up with $150,000 at the end of 2022. If Citi Bank still pays 3.25% interest annual, how large must each payment be? (5%)
Solution
Now she already has 100,000. To get the future value
1000,000(1.0325)5= 117,341.14
The balance is 150,000- 117, 341.14= $ 32,658.86
Therefore, this is a future value
We must get the annual payment for each payment
Additionally, we only have four installments to pay and it is for four years
From future value formula,
P= r*FV/[(1+r^n-1)
P= (0.0325*32658.86) / [(((1+0.0325) ^4)-1)
P= $ 7,777.30
6. Assume after 5 years, Michelle will be 40 years old and will have $150,000 in her saving account, and she is planning to retire at 65 years old and she will need $1,000,000 at retirement. What annual interest rate must she earn to reach her goal, assuming each year she will only save $20,000. (5%)
Solution
We need to get the future value of the savings and then get the rate
Future value = P ([ 1+r] n-1) + 150,000(1+r) n
1,000,000= 20,000 ((1+r) n-1))/r + 150,000 (1+r) n
Let (1+r) n be y.
N= 25 years
1000,000= 20,000(y-1)/ r + 150,000y
We will use linear estimation
We will take a rate for example 2%
Therefore
Amount = 20,000 ((1+0.02)
25-1))/r + 150,000 (1+0.02) 25
Amount = 640,605.99+ 246,090.8992
Amount= 886,696.8892
Take another rate like 4%
Amount = 20,000 ((1+0.04)
25-1))/0.04 + 150,000 (1+0.04) 25
Amount = $ 1,232,793.615
Let x be the rate that will result in Michelle having 1,000,000 in her account when she retires.
Estimation
=
=
-453,212.432+113,303.432x = 465,586 – 232,793x
346,096.432x = 951,798
X= 2.75%
The rate that she needs is 2.75%
Now Michelle asked you to help her invest in bonds market. You have the following three bonds good for investment. Assume all coupons are paid annually and END mode, can you please find the best option for Michelle?
Option One: Treasury bond has 4% annual coupon, matures in 10 years, and has a $10,000 face value. Its price is $9,550
Option Two: Corporate Bond A has a 9% annual coupon, matures in 5 years, and has a $10,000 face value. Its price is $10,500
Option Three: Corporate Bond B has a 10% annual coupon, matures in 8 years, and has a $10,000 face value. Its price is $9,950
5. Calculate YTM for each bond (3%)?
Bond price = C (1- (1- (1+r)-n)/ r + Maturity value (1+ r)-n
The solution is to get the value of r
Put (1+r)-n = y
Option one
9550 = 40 (1- (1-(1+R)-10)/R + 10,000 (1+R) -10
Approximate YTM= (C+((F-P)/n))/ (F+P)/2 (Foster, 2004)
Where n is the number of years to maturity,
p- price of the bond
F- face value and
C is the coupon payment
Approximate YTM = (400+ (10,000-9550)/10) / (10,000+ 9550)/2
YTM of the first is 4.57 %
Using the same formula for the second Option is
Approximate YTM= (C+((F-P)/n))/ (F+P)/2 (Foster, 2004)
= (900+ (10,000-10,500)/5))/ (10,000+ 10,500)/5
The YTM IS 7.76%
The third option using the same formula
Approximate YTM= (C+((F-P)/n))/ (F+P)/2 (Foster, 2004)
= (1000+ (10,000-9950)/8) (10,000+9950)/2
10.13%
6. Compare YTM with coupon rate, indicate whether each bond is trading at a premium, at a discount, or almost at par. (3%)
Option one is trading at a discount because its coupon rate (4%) is less than the yield to maturity (4.57%). Option two, on the other hand, is trading at a premium because its coupon rate (9%) is higher than its yield to maturity (7.76%) (Brigham and Houston, 2012). Finally, the third option is trading almost at par since its coupon rate (10%) is almost similar to its yield to maturity (10.13%).
7. Which one do you recommend Michelle to buy and why, assume Michelle has high-risk tolerance and the current market interest rate is around 6%, Corporate Bond A is rated as BB bond and Corporate Bond B is a high-yield risky bond? (4%)
I would advise Michelle to buy the bond that is trading at a premium (Option Two). It is because this bond will be able to offer her more money on the coupon payments compared to the ones that are selling at a discount. Since there is a greater cash flow it will also give her a reduced price volatility (Foster, 2004). The money cash flow gives her an increased chance of reinvestment in other bonds (Brigham and Houston, 2012). Finally, whenever she wants to sell she might be able to get a higher pricing. Since she is more risk tolerant I will advise her to get Corporate Bond B which is a high-yield risky bond.
8. Assume Michelle also told you her expected residual savings from 2019 to 2023 will be: $15,000, $20,000, $25,000, $30,000, $35,000. She wants to know the present values of these savings at an 8% discount rate. Calculate PVs of the streams. (10%)
To get the present values of the residual savings will involve discounting
PV= Principle
P.V = 15000 (1.08) ^- 1 = $ 13,888
PV= 20,000(1.08) ^2= $ 17, 146.77
P.V 25,000(1.08) ^-3= $ 19,845.80
P.V = 30,000(1.08) ^-4= $ 22,050
PV = 35,000(1.08) ^-5 = $ 23,820.41
Part IV (10%)
Essay Question
1. Why Interest Rate is important to the Economy and the Financial Market? What do you think the economic performance in the next five years in the United States? (5%)
The interest rate in the economy is very important as it determines the amount of money in circulation. If the interest rate is low, more people will be able to afford the loans and therefore, borrow more for investments (Brigham and Houston, 2012). However, if it is higher, very few people will be willing to borrow thus will reduce the amount of money in supply. The interest rate also affects the general inflation rate of the economy. If the rate is low, it will result in a demand push inflation (Brigham and Houston, 2012).
The united states’ economy will rise steadily as 2018 has so far been a year with no economic troubles However, the country exceeded the 21 trillion debt which might result in increased inflation and affect the economy. Also, President trump has weakened the Obamacare which makes the healthcare costs to increase significantly. It will reduce the investment ability of most individuals thus reduce economic development.
2. If you are given a $100,000 as an inheritance, how would you invest it? (5%)
I have always been interested in trading option at the exchange market. With that money, I will be able to invest in a number of option and take up a few short and long positions. Later if the conditions are favorable I will call the options and make my profit.
References
Brigham, E. F., " Houston, J. F. (2012). Fundamentals of financial management. Cengage Learning.
Foster, G. (2004). Financial Statement Analysis, 2/e. Pearson Education India.
Muralidhar, S., " Muralidhar, A. (2003). U.S. Patent Application No. 10/271,056.
