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SOUTHERN NEW HAMPSHIRE UNIVERSITYPRIVATE
Graduate School of Business
Fall Term, 2019
FIN610: Case (Graded Problem Set) #1 Assignment INSTRUCTOR: Dr. Gary P. Tripp
INSTRUCTIONS: The questions below are focused on the various topics we have covered in Chapters 1, 2, and 3. Please answer all parts of each these questions. Your report should be well-organized, type-written/word processed (although any equations or formulations may be “hand written”), and independently prepared. As indicated on our course syllabus, the case report is due by the end of our class period on Wednesday October 9, 2019. Good luck!
1. Assume a company’s cash conversion period (CCP or CCC) is known to be 25 days. Using a 365-day year and also assuming the company’s receivables turnover ratio is 11.75x and its payables turnover ratio is 14x, answer the following:
a.) What is this firm’s inventory turnover ratio?
b.) What is this firm’s accounts receivable (AR) if its sales are $1,500,000 per year?
2. Use the following balance sheet and simplified income statement in answering parts (a) – (c) below:
Accounts receivables 100,000
Fixed assets $500,000
Total assets $770,000
Account payable $135,000
Other current liabilities 50,000
Long-term debt 150,000
Stockholders’ equity (75,000 shares) $435,000
Total liability and equity $770,000
Less: Cost of goods sold 635,000
Less: All expenses (incl. taxes) 370,000
Net Income $245,000
a.) Based on the financial information above, conduct a liquidity analysis for this firm by determining the current ratio, net working capital, the ratio of current assets/total assets, and the cash conversion period.
b.) What is the current market price of the firm’s stock (P0) if the firm’s P/E ratio is 11.5?
Hint: Note that a firm’s earnings per share = NI/S, where NI = earnings. Therefore P0 = P/E x E/S.
c.) A proposal is made by this firm’s CFO to increase the current ratio to 2x. The CFO suggests that the firm issue 5,000 new shares of common stock (ignore any flotation costs) and the estimated price per share based on secondary market conditions will be $28.50. The proceeds from the equity issue will be added to the firm’s cash account. Assuming everything else remains the same, determine:
i) The impact on the firm’s liquidity position by re-calculating the current ratio, net working capital, the ratio of current assets/total assets, and the cash conversion period as you did in part (a) above.
ii) The new market price (assume the P/E ratio is constant at 11.5).
iii) Based on your estimate of the new price per share of this company’s stock, should the firm adopt the changes suggested by the CFO? Briefly explain.
3. Suppose a firm needs to borrow $5 million and is considering two funding options:
Option I. A five-year bank loan at a fixed rate of 12 percent per year. Each year the interest expense will be $600,000 (= 0.12 x $5,000,000). At the end of Year 5 the firm will need to make a balloon payment of $5,000,000 to re-pay the principal.
Option II. Borrow $5 million on a floating (adjustable) rate basis. The firm’s CFO believes that inflation will be falling over the loan period and she forecasts that the borrowing costs (interest rate) will be 14 percent in Year 1; 12 percent in Year 2; 11 percent in Year 3; and then 10 percent in Years 4 and 5. This option will also require the firm to make a $5,000,000 payment at the end of Year 5.
a.) Determine the total amount of interest to be paid over the five year period under Option I and Option II. Which loan option is preferred?
b.) It occurs to you that the CFO may have overlooked some important considerations. Specifically, she did not take into account the effect of taxes as well as the time value of money. To account for these effects, first determine the total amount of interest paid over the five year period under each option in after-tax cash flows by using a tax rate of 40 percent. Next, using the after-tax cash flows and a 8.5 percent cost of capital (or discount rate), determine the present value of the total interest paid under each option. Note: When finding the PV in this step, use the compound-interest (discount) formula and not the simple interest approximation method presented in Chapter 1 and discussed in class. Finally, based on your after-tax and present value adjustments, which loan option is preferred?
4. Assume a company has the following turnover ratios: Receivables turnover (R/T) = 7.5x; Inventory turnover (I/T) = 10x; Payables turnover (P/T) = 12.75x.
a.) Find this firm’s cash conversion period (CCP or CCC) based on a 365-day year.
b.) Now determine the firm’s cash conversion period if the receivables turnover decreases to 4.75x and its inventory turnover ratio increases to 13.5x. Has ongoing liquidity improved or declined? Briefly explain.
c. Now assume that the firm’s days inventory held (DIH) holds constant at the value you obtained in (b) above (when the inventory turnover increased to 13.5x), but the payables turnover increases to 14.5x. If the firm wants its CCP (or CCC) to be no greater than 30 days, what must be the firm’s new receivables turnover?
5. A company is considering various options with respect to its current asset policy. In all instances the firm’s fixed assets will be $1,000,000 and the firm plans to use a debt ratio of 60 percent (so D/TA = 0.6). The market interest rate is 8 percent on all debt used (both long-term and short-term debt). Three current asset strategies are under consideration: Option I: to hold current assets equal to 40 percent of projected sales; Option II: to hold current assets equal to 50 percent of projected sales; and Option III: to hold current assets to 60 percent of projected sales. The firm forecasts that it will earn 25 percent of sales before it pays interest (so that EBIT = 0.25 x Sales), and it projects sales will be $3 million. Finally, the firm’s average federal and state tax rate is 35 percent. What will be expected ROE under each of Options I, II, and III?
6. Suppose that a company’s cash outflows are stable and may be predicted with certainty so the Baumol (“inventory cash management”) model will be used by this company. Assume that the firm’s annual opportunity cost of funds (i) to be 9%, the fixed cost per security transaction (F) is $50, and the annual disbursements (TCN) is $4,500,000.
a. What is the optimal dollar amount of securities to be sold in order to replenish cash holdings (that is, determine Z* to the nearest whole dollar).
b. What is the annual total annual dollar cost of maintaining this optimal cash balance (TCCASH)?
c. What is the average cash balance held by your firm?
d. How many cash transfers must you make over the year and how many days will each cash transfer last?