9.10: Chapters Eight and Nine- Review Questions
Chapter s 8 – 9 : Review Questions
- Define each of the following terms: Incrementalism, Sunk Costs, and Cannibalization.
- In words, explain what is meant by Free Cash Flow.
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Why is
FCF
important? Give two reasons.
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- How do we use this model – for individual projects, for the entire corporation, or both? Explain.
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- What options does the company have regarding how it may choose to utilize its Free Cash Flow?
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Create a
Free Cash
Flow
template
and spread the forecasted numbers based on the following assumptions:
- Last year’s sales were $15.5 million and are expected to grow for the next two years at 15% per year, followed by three years of 8% growth.
- Cost of Goods Sold last year were $12.6 million and are expected to grow at a 7% rate per year indefinitely.
- Depreciation is $550,000 per year at a straight-line rate; in the fifth year, the building will have been fully depreciated. This company has no depreciable equipment.
- There is no amortization.
- Selling and General Administrative expenses last year were $200,000 and will grow modestly at an annual 2% rate.
- This company is in the 30% tax bracket, including Federal and State. There are no local taxes.
- The company expects to spend $2 million each year on “ CapEx , ” all of which will be necessary.
- Last year’s Current Assets, excluding Cash, were $2.5 million, and is expected to grow at a 5% rate per year indefinitely.
- Last year’s Current Liabilities were $2 million and are expected to grow at a 3% rate for at least five years.
- How does the analyst handle depreciation in the FCF Model? Why does s/he handle it that way? Note that depreciation occurs twice in the formula.
- Can you list all four capital items , which are included in the Balance Sheet?
- Why don’t we include capital costs in the FCF Model?
- An increase in Current Assets provides for/uses funds. Which is it? Why?
- On what basis do we distinguish between “internal” and “external” funds?
- List some internal and external funds.
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Calculate the
External Funds Needed
formula for the LCM Company (below), based on the following assumptions.
- Last year’s sales were $5,000 million.
- Next year’s objective is to increase sales by 30%.
- Variable costs will be 70% of sales . (Variable costs change with sales volume.)
- Fixed Costs are expected to run 30% of P, P, & E (Fixed costs do not change and are unrelated to sales volume.)
- Interest Expense is 5% of Notes Payable and 7% of Long-term debt.
- Taxes are 40%.
- The company expects to maintain its Payout Ratio at 20% of income.
What is the company’s EFN if it is to meet its growth objective?
- What do this year’s three Solvency ratios look like?
- Why w ill the company’s financial ratios change next year ?
Selected Answers To Chapters 8 and 9
FCF Table
- You are ill-advised to do this by XL . Do it by hand. Place it in a Word table.
- One needs to figure EBIT by adding in the Income Statement data to the template in the chapter.
- “Last Year’s” numbers are not illustrated in this Spread Sheet .
- “Year 1’s” numbers follow “Last Year’s.” For example, Last Year’s Sales were $15.5 Million. “This Year’s” sales increased by 15%. Therefore: (15.5) (1. 15 ) = $17.825.
- Be careful about the Current Assets and Current Liabilities numbers. We first calculate increases or decreases, not the gross numbers. Which data add to FCF ?
($ Millions)
EFN Formula
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- D/E = (900 + 475) / 1,415 = 0.97
- D / TA = (900 + 475) / (900 + 475 + 1,415) = 0.4828
- TIE = EBIT / I = 1.050 / 0.068 = 15.44x
- EFN = [(A 0 /S 0 ) Δ S ] – [ (AP 0 /S 0 ) Δ S ] – [ (M 0 ) (S 1 ) ( RR 0 )]
- We will assume “Static Analysis.”
($ Millions)
- Sales and VC will change next year, but FC will remain the same. Therefore, we should see a change in the net profit margin, and changes in the dividend paid and retention rates – assuming no change in payout (percent of earnings) policy.