1. Project will produce operating cash flows of $60,000 a year for four years.

During the life

of the project, inventory will be lowered by $20,000 and accounts receivable will increase
by $25,000. Accounts payable will decrease by $10,000. The project requires the
purchase of equipment at an initial cost of $200,000. The equipment will be depreciated
straight-line to a zero book value over the life of the project. The equipment will be
salvaged at the end of the project creating a $30,000 after-tax cash flow. At the end of the
project, net working capital will return to its normal level. What is the net present value
of this project given a required return of 12 percent?

A. $17,759.04
B. $13,693.50
C. $4,160.73
D $2,194.46
E. $10,839.27

2. Which of the following is NOT considered a relevant concern in determining incremental

cash flows for a new product?

a. The use of high quality factory floor space that is currently unused but is available for
production of other products.
b. Revenues from an existing product that would be lost as a result of customers
switching to the new product.
c. Shipping and installation costs associated with preparing the machine to be used to
produce the new product.
d. The cost of a marketing study completed last year related to the new product. This
cost was expensed for tax purposes last year.
e. The land to be used in the project could be sold to another firm.
3. Yummy Foods is considering a new salsa product whose data are shown below. The
equipment that would be used has a 3-year tax life, would be depreciated by the straight
line method over the project's 3-year life, would have zero salvage value, and no new
working capital would be required. Revenues and other operating costs are expected to be
constant over the project's 3-year life. However, this project would compete with other
Yummy products and would reduce their pre-tax annual cash flows. What is the project's
NPV? (Hint: Cash flows are constant in Years 1-3.)

WACC 10%
Annual pre-tax cannibalization cost $5,000
Net investment cost (depreciable basis) $65,000
Straight line depr’n rate 33.33%
Sales revenues $70,000
Operating costs excl. depr’n $25,000
Tax rate 35%

A. $17,455.87 Answer: t=0 t=1 t=2 t=3

B. $18,516.78 Investment -$65,000
Sales revenues $70,000 $70,000 $70,000
C. $19,892.34 - Cannibalization cost -$5,000 -$5,000 -$5,000
- Operating costs (x-depr) -$25,000 -$25,000 -$25,000
D. $20,118.78 - Basis x rate = depreciation = -$21,667 -$21,667 -$21,667
Operating income (EBIT) $18,333 $18,333 $18,333
E. $21,214.55
- Taxes -$6,417 -$6,417 -$6,417
After-tax EBIT $11,917 $11,917 $11,917
+ Depreciation $21,667 $21,667 $21,667
Operating cash flow -$65,000 $33,583 $33,583 $33,583
NPV $18,516.78
4. Jayhawk Jets must choose one of two mutually exclusive projects. Project A has an up-front
cost (t = 0) of $120,000, and it is expected to produce cash inflows of $80,000 per year at the
end of each of the next two years. Two years from now, the project can be repeated at a
higher up-front cost of $125,000, but the cash inflows will remain the same. Project B has an
up-front cost of $100,000, and it is expected to produce cash inflows of $41,000 per year at
the end of each of the next four years. Project B cannot be repeated. Both projects have a
WACC of 10%. Jayhawk wants to select the project that provides the most value over the next
four years. What is the net present value (NPV) of the project that creates the most value for
Jayhawk?

A. $34,425
B. $30,283
C. $29,964
D. $29,240
E. $24,537

Step 1: Determine each project’s cash flows during the 4-year period.
Year Project A Cash Flows Project B Cash Flows
0 ($120,000) ($100,000)
1 80,000 41,000
2 80,000 – 125,000 = (45,000) 41,000
3 80,000 41,000
4 80,000 41,000
Step 2: Determine each project’s NPV by entering the cash flows into the cash flow register
and using a 10% WACC.

NPVA = $30,283.45  $30,283.

NPVB = $29,964.48  $29,964.
Jayhawk should select Project A since it adds more value.

5. Ellison Products is considering a new project that develops a new laundry detergent, WOW.
The company has estimated that the project’s NPV is $3 million, but this does not consider
that the new laundry detergent will reduce the revenues received on its existing laundry
detergent products. Specifically, the company estimates that if it develops WOW the
company will lose $500,000 in after-tax cash flows during each of the next 10 years because
of the cannibalization of its existing products. Ellison’s WACC is 10%. What is the net
present value (NPV) of undertaking WOW after considering externalities?
 A. $2,927,716.00
Step 1: Calculate the NPV of the negative externalities
B. $3,000,000.00
due to the cannibalization of existing projects:
C. -$72,283.55
Enter the following input data in the calculator:
D. $2,807,228.00
CF0 = 0; CF1-10 = -500000; I/YR = 10; and then solve
E.-$3,072,283.55
for NPV = $3,072,283.55.
Step 2: Recalculate the new project’s NPV after
considering externalities: +$3,000,000 - $3,072,283.55 =
-$72,283.55.

6. Global Resorts is considering a new project whose data are shown below. The equipment
that would be used has a 3-year tax life, would be depreciated by the straight-line method
over the project's 3-year life, and would have zero salvage value. No new working capital
would be required. Revenues and other operating costs are expected to be constant over
the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years
1-3.)

WACC 10%
Net investment cost (depreciable basis) $65,000
Straight line depr’n rate 33.33%
Sales revenues $70,000
Operating costs excl. depr’n $25,000
Tax rate 35%

A. $22,156.24
B. $23,791.14
C. $24,354.87
D. $25,189.71
E. $26,599.05

Answer: t=0 t=1 t=2 t=3

Investment cost -$65,000
Sales revenues $70,000 $70,000 $70,000
- Operating costs (x-depr) -$25,000 -$25,000 -$25,000
- Basis x rate = depreciation = -$21,667 -$21,667 -$21,667
Operating income (EBIT) $23,333 $23,333 $23,333
- Taxes -$8,167 -$8,167 -$8,167
After-tax EBIT $15,167 $15,167 $15,167
+ Depreciation $21,667 $21,667 $21,667
Operating cash flow -$65,000 $36,833 $36,833 $36,833
NPV $26,599.05
7. Last year Emery Industries had $450 million of sales and $225 million of fixed assets, so, its
FA/Sales ratio was 50%. However, its fixed assets were used at only 65% of capacity. If the
company had been able to sell off enough of its fixed assets at book value so that it was
operating at full capacity, with sales held constant at $450 million, how much cash (in
millions) would it have generated?

A.$74.81
Sales $450
B. $78.75
Fixed assets $225
C. $82.69
% of capacity utilized 65%
D. $86.82
E. $91.16
Sales at full capacity = Actual sales/% of capacity used = $692
Target FA/Sales ratio = Full capacity FA/Sales = FA/capacity sales = 32.50%
Optimal FA = Sales  target FA/Sales ratio = $146.25
Cash generated = Actual FA – Optimal FA = $78.75

8. Jefferson City Computers has developed a forecasting model to estimate its AFN for the
upcoming year. All else being equal, which of the following factors is most likely to increase
its additional funds needed (AFN)?

a. A sharp increase in its forecasted sales.

b. A sharp reduction in its forecasted sales.
c. The company reduces its dividend payout ratio.
d. The company decides to switch its materials purchases to a supplier that sells on terms
of 1/5, net 90, from a supplier whose terms are 3/15, net 35.
e. The company discovers that it has excess capacity in its fixed assets.

Note that with purchase terms of 1/5 net 90, the cost of non-free credit is only
4.34%, whereas with 3/15, net 35, the cost of trade credit is 56.4%. Therefore, the
firm should have been taking discounts originally, hence should have had few
accounts payable, whereas it would probably not take discounts and thus have
more accounts payable with the new supplier. That change would lower its AFN.
9. You are comparing the current income statement of a firm to the pro forma income
statement for next year. The pro forma is based on a four percent increase in sales. The firm
is currently operating at 85 percent of capacity. Net working capital and all costs vary directly
with sales. The tax rate and the dividend pay-out ratio are fixed. Given this information, which
one of the following statements must be true?

A. The projected net income is equal to the current year's net income.
B. The tax rate will increase at the same rate as sales.
C. Retained earnings will increase by four percent over its current level.
D. Total assets will increase by less than four percent.
E. Total liabilities and owners' equity will increase by four percent.

10. All else constant, which one of the following will increase the internal rate of growth?

A. decrease in the retention ratio ROA x b

B. decrease in net income Internal Growth Rate =
1 − (ROA x b)
C. increase in the dividend pay-out ratio NI
D. decrease in total assets ROA = TA; decreasing in total assets will
E. increase in costs of goods sold increase the ROA and IGR will also increase

11. If a firm equates its pro forma sales growth to the rate of sustainable growth, and has
positive net income and excess capacity, then the:
A. maximum capacity level will have to increase at the same rate as sales growth.
B. total assets will have to increase at the same rate as sales growth.
C. debt-equity ratio will increase.
D. retained earnings will increase.
E. number of common shares outstanding will increase.

For SGR,
Required increase in assets - increase in RE = 0 since EFN=0
If FA is not operating at full capacity and capacity sales are greater than projected
sales, then no new FA is required. The required increase in assets will be lower
hence, the firm will have surplus internally generated fund, i.e., RE
12. A firm's net working capital and all of its expenses vary directly with sales. The firm is
operating currently at 96 percent of capacity. The firm wants no additional external financing
of any kind. Which one of the following statements related to the firm's pro forma statements
for next year must be correct?
A. Total liabilities will remain constant at this year's value.
B. The maximum rate of sales increase is 4 percent.
C. The firm cannot exceed its internal rate of growth.
D. The projected owners' equity will equal this year's ending equity balance.
E. Fixed assets must remain constant at the current level.

AFN = (A*/S)S – (L*/S)S – MS1( 1 – d)

In words,
AFN = required increase in asset – increase in spontaneous liability – change in retained
earnings

For internal rate of return, required increase in asset is purely funded by increase in retained
earnings, so
Required increase in asset = Change in retained earnings
If fixed asset is not operating at full capacity, the required increase in fixed assets will be
smaller, since the firm may require lesser new fixed asset or if the capacity sales is greater
than forecasted sales, the firm does not have to buy new fixed asset. If follows that if the
fixed asset is not operating at full capacity, the required increase in asset is less than
increase in retained earnings. Hence, the firm is growing at less than the internal growth
rate.
13. Which one of the following will cause the sustainable growth rate to equal to internal
growth rate?

A. dividend payout ratio greater than 1.0

B. debt-equity ratio of 1.0
C. retention ratio between 0.0 and 1.0 SGR=IGR when ROE=ROA.
D. equity multiplier of 1.0 EM = TA/E if EM=1, then TA=E,
E. zero dividend payments hence ROA=ROE

14. Which of the following can affect a firm's sustainable rate of growth?

I. capital intensity ratio

II. profit margin
III. dividend policy ROE x b
IV. debt-equity ratio Sustainable Growth Rate =
1 − (ROE x b)
A. III only
1 Debt
B. I and III only ROE = Profit margin x x [1 + ]
C. II, III, and IV only Capital intensity ratio Equity
D. I, II, and IV only
E. I, II, III, and IV

15. Kenney Corporation recently reported the following income statement for 2005 (numbers
are in millions of dollars):

Sales $7,000
Operating costs 3,000
EBIT $4,000
Interest 200
Earnings before taxes (EBT) $3,800
Taxes (40%) 1,520
Net income available to
common shareholders $2,280

The company forecasts that its sales will increase by 10% in 2006 and its operating costs will
increase in proportion to sales. The company’s interest expense is expected to remain at $200
million, and the tax rate will remain at 40%. The company plans to pay out 50% of its net
income as dividends, the other 50% will be additions to retained earnings. What is the
forecasted addition to retained earnings for 2006?
 A. $1,140
B. $1,260
C. $1,440
D. $1,790
E. $1,810

Forecasting addition to retained earnings

2002 Forecast Basis 2003
Sales $7,000  1.1 $7,700
Operating costs 3,000  1.1 3,300
EBIT $4,000 $4,400
Interest 200 200
Earnings before taxes (EBT) $3,800 $4,200
Taxes (40%) 1,520 1,680
Net income available to
common shareholders $2,280 $2,520
Dividends to common (50%) $1,260
Addition to retained earnings (50%) $1,260

16. A company is forecasting an increase in sales and is using the percent of sales (AFN model)
to forecast the additional capital that it must raise. Which of the following conditions
would be most likely to increase the AFN?

A. The company previously thought its fixed assets were being operated at full capacity,
but now it learns that it actually has excess capacity.
B. The company increases its capital intensity ratio.
C. The company begins to pay employees monthly rather than weekly.
D. The company’s profit margin increases.
E. The company decides to forego discounts on purchased materials.

AFN= (A*/S)S – (L*/S)S – MS1( 1 – d),

(A*/S) is the capital intensity ratio. All else the same, higher
capital intensity ratio will result in higher AFN
17. Martell-Webb Inc. sells to customers all over the U.S., and payment checks come in to its
headquarters in New York City. The firm's average accounts receivable balance is $2.5
million, and they are financed by a bank loan at an 11% annual interest rate. The firm is
considering a regional lockbox system to speed up collections, and it believes the
lockboxes will reduce receivables by 20%. If the annual cost of the system is $15,000,
what would the estimated pre-tax net annual savings be if the firm implements the
lockbox system?
Calculate the net reduction in A/R:
Current A/R = $2,500,000. New A/R with 20% reduction:
a. $500,000 $2,500,000 – 0.20($2,500,000) = $2,000,000.
b. $60,000 Net reduction in A/R = $500,000.
c. $55,000
Calculate the interest savings and net savings:
d. $40,000 Interest savings = $500,000(0.11) = $55,000.
e. $30,000
Net savings = Interest savings – Annual lockbox cost
= $55,000 – $15,000 = $40,000.

18. Your firm generally receives 4 checks a month. The check amounts and the collection
delay for each check is shown below. Given this information what is the amount of the
average daily float? Assume a 30 day month.

A. $1,070
B. $2,333
Average daily float = [($1,200 x 2) + ($3,900 x 1) + ($5,800 x 3) + ($4,200
C. $2,640
D. $2,900 x 2)]/30 = $1,070
E. $3,416
 19. Murtaugh Manufacturing sells on terms of 2/15, net 40. Total annual sales are $950,000. 40%
of the customers pay on the 15th day and take discounts, and the remainder pay, on average,
50 days after their purchases. All sales and receivables are recorded net of discounts,
regardless of whether or not discounts are actually taken. What is the firm's accounts
receivable balance?
Length of discount period 15
Discount percentage 2%
Total days for payment 40
A. $82,708 Annual sales $950,000
% of customers taking the discount 40%
B. $85,123 % of customers not taking the discount 60%
Average days until non-discounters pay 50
C. $88,526 Days sales outstanding 36
Receivables $93,699
D. $90,834

E. $93,6994.

20. You are considering implementing a lockbox system for your firm. The system is expected
to reduce the average collection time by 1.2 days. On an average day, your firm receives
320 checks with an average value of $99 each. The daily interest rate on Treasury bills is
0.014 percent. What is the anticipated amount of the daily savings if this system is
implemented?

A. $2.61
B. $3.29
Daily savings = 320  $99  1.2  0.00014 = $5.32
C. $4.45
D. $5.32
E. $5.78
21. On an average day, your firm receives $11,800 in checks from customers. These checks
clear the bank in an average of 2.1 days. The applicable daily interest rate is 0.015
percent. What is the highest daily fee your firm should pay to completely eliminate the
collection float? Assume each month has 30 days.

A. $3.42

B. $3.72
Maximum daily fee = $11,800 x 2.1 x 0.00015 = $3.72
C. $17.78

D. $34.18

E. $37.20

22. Your firm generally receives 3 checks a month. The check amounts and the collection
delay for each check is shown below. Given this information, what is the amount of the
average daily float? Assume that a month has 30 days.
Item Number Item Amount Delay
1 $12,700 3
2 $ 8,200 4
3 $ 4,500 5
a. $705.56
b. $934.00
c. $3,113.33
Average daily float = [($12,700  3) + ($8,200  4) + ($4,500  5)]  30 =
d. $7,783.33
$3,113.33
e. $8,466.67

23. Helena Furnishings wants to reduce its cash conversion cycle. Which of the following steps
would help it accomplish that goal?

A. It increases its average inventory while holding sales constant.

B. It tightens its credit policy, and this reduces the DSO.
C. It starts paying its bills faster, thus reducing its average accounts payable. Sales are not
affected by this action.
D. It loosens its credit policy, and this increases the DSO.
E. It changes its capital structure, increasing the debt ratio.
 24. Currently, your firm requires 2 days to process the checks which customers mail in to
pay for their credit purchases. The average mail time associated with these payments is
2.3 days and the check clearing time is 2.1 days. If your firm adopts a lockbox system,
the mail time will be cut in half. In addition, if employees are reassigned, checks could
be processed the same day they are received. How long will your collection time be if
both the lockbox system and the job reassignments are implemented?

A. 3.85 days

B. 4.10 days

C. 4.25 days Collection time = (2.3 x 0.5) + 1 + 2.1 = 4.25

D. 4.40 days days

E. 4.55 days

25. When Chris balanced her business checkbook, she had an adjusted bank balance of
$11,418. She had 2 outstanding deposits worth $879 each and 11 checks outstanding with
a total value of $3,648. What is the amount of the collection float on this account?
A. -$1,890
B.- $1,758
C.- $3,648
D. -$5,406 Collection float = -$879  2 = $1,758
E. -$6,012
26. Which of the following will increase the operating cycle?
I. increasing the inventory turnover rate
II. increasing the payables period
III. decreasing the receivable turnover rate
IV. decreasing the inventory level
A. I only
B. III only Operating cycle = Inventory period + AR period
Increasing inventory turnover period will shorten the
C. II and IV only
Inventory period.
D. I and IV only For a given operating cycle, increasing the payables period
E. II and III only has no effect on operating cycle.
Decreasing the receivable turnover rate will increase the
AR period thus increasing the operating cycle.