the corporation

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MSAF 670 Final Exam

Read the following information before proceeding with the exam:

• You must provide support for your responses to all questions.

• For all present value problems, supporting calculations must be rounded to four decimal places and final answers rounded to two decimal places.

• Prepare your answers in MS Excel and use formulas for all cells requiring calculations.

Below are the financial statements for The Corporation (aka The Firm) followed by other, more general information about the economy, stock market, and The Corporation.

The Corporation

Comparative Balance Sheet

For the 12 Months Ended December 31 20X11 20X10 20X9

Cash 710,000 625,000 560,000

Accounts Receivable 494,000 450,000 410,000

Inventory 526,000 487,000 443,000

Prepaid Insurance 46,000 51,000 43,000

Total Current Assets 1,776,000 1,613,000 1,456,000

Land 1,520,000 1,340,000 1,400,000

Buildings 2,530,000 2,440,000 2,350,000

Less: Accumulated Depreciation -550,000 -480,000 -420,000

Net Buildings 1,980,000 1,960,000 1,930,000

Total Long-Term Assets 3,500,000 3,300,000 3,330,000

Total Assets 5,276,000 4,913,000 4,786,000

Accounts Payable 284,000 277,000 240,000

Salaries and Wages Payable 83,000 74,000 67,000

Dividends Payable 47,044 37,995 44,000

Notes Payable—Line of Credit 212,000 230,000 210,000

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Total Current Liabilities 626,044 618,995 561,000

Notes Payable—Long Term 2,090,587 1,609,831 1,105,421

Bonds Payable 1,000,000 1,000,000 1,000,000

Less: Discount on Bonds Payable -249,244 -263,260 -275,973

Net Bonds Payable 750,756 736,740 724,027

Total Long-Term Liabilities 2,841,343 2,346,571 1,829,448

Total Liabilities 3,467,387 2,965,566 2,390,448

Contributed Capital 500,000 500,000 500,000

Retained Earnings 3,424,613 2,679,434 1,983,552

Treasury Stock -2,116,000 -1,232,000 -88,000

Total Stockholders’ Equity (SE)

1,808,613 1,947,434 2,395,552

Total Liabilities and SE 5,276,000 4,913,000 4,786,000

The Corporation Income Statement

For the 12 Months Ended December 31

20X11 20X10 20X9

Sales $6,150,000 $ 5,150,000 $ 3,450,000

Cost of Goods Sold -3,890,000 -3,215,000 -1,680,000

Salaries and Wages -912,000 -875,000 -823,000

Depreciation-Building -134,000 -123,000 -120,000

Insurance -78,000 -92,000 -89,000

Total Expenses -5,014,000 -4,305,000 -2,712,000

Operating Income 1,136,000 845,000 738,000

Interest Expense—Notes -134,757 -95,410 -43,917

Interest Expense - Bonds -74,016 -72,713 -71,531

Gain (Loss) Sale of Buildings -120,000 21,000 38,000

Gain (Loss) Sale of Land -31,000 27,000 -77,000

Total Other Revenues & Expenses -359,773 -120,123 -154,448

Net Income $ 776,227 $ 724,877 $ 583,552

Earnings Per Share (EPS) $ 6.16 $ 4.77 $ 2.98

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The Corporation

Statement of Cash Flows

For the 12 Months Ended December 31 20X11

20X11 20X10

Cash received from customers $ 6,106,000 $ 5,110,000

Cash paid to suppliers -3,922,000 -3,222,000

Cash paid for salaries and wages -903,000 -868,000

Cash paid for insurance -73,000 -100,000

Cash paid for interest—Bonds -60,000 -60,000

Cash paid for interest—Notes Payable -134,757 -95,410

Net Cash from Operating Activities $ 1,013,243 $ 764,590

Investment in Land -790,000 -980,000

Investment in Building -770,000 -720,000

Sale of Building 496,000 588,000

Sale of Land 579,000 1,067,000

Net Cash from Investing Activities $ (485,000) $ (45,000)

Proceeds (Payment) Notes Pay 462,757 524,410

Purchase of Treasury Stock -884,000 -1,144,000

Dividends Paid -22,000 -35,000

Net Cash from Financing Activities $ (443,243) $ (654,590)

Net Change in Cash 85,000 65,000

Beginning Cash 625,000 560,000

Ending Cash $ 710,000 $ 625,000

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The Corporation & Industry Financial Ratios

20X11 20X10 20X11/20X10 Industry

Return on Equity 0.41 0.33 0.16

Dividend Payout 0.04 0.04 0.12

Return on Assets 0.15 0.15 0.09

Return on Sales 0.13 0.14 0.09

Asset Turnover 1.21 1.06 0.90

Current Ratio 2.84 2.61 2.75

Quick Ratio 1.92 1.74 1.82

Debt/Assets 0.54 0.48 0.20

Accounts Receivable Days 28.01 30.48 32.01

Inventory Days 47.53 52.79 49.53

Accounts Payable Days 26.59 29.75 24.59

Summary: Cash Conversion Days 48.95 53.51 56.95

Other Information

Bonds Payable: On December 31, 20X1, the firm issued 1,000 bonds with a 20-year maturity. The bonds pay interest every six months (June 30 and December 31), and the yield to maturity/effective interest rate is 10 percent.

Stock Price-Firm: The market price of the stock (per the stock exchange) was $34 at year-end 20X11, $26 at year-end 20X10, $22 at year-end 20X9, and $17 at year-end 2006.

Market Information: The average return in the market over 20X9–20X11 is 12 percent, and its standard deviation 6.50 percent.

Treasury Bonds: The average rate on U.S. Treasury bonds was 5 percent.

Stock Shares: The firm has 600,000 authorized shares and 200,000 issued, and 126,000 outstanding at year-end 20X11.

Stock Valuation Data: The required rate of return demanded by investors approximates 17 percent. The

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firm’s beta is 1.75. The firm estimates that the growth rate in dividends is 20% for 20X12 and 20X13, and 14% for all years thereafter.

Treasury Stock: The firm had zero treasury stock at year-end 20X8. The firm purchased 4,000 treasury shares at year-end 20X9, 44,000 at year-end 20X10, and 26,000 at year-end 20X11. There were no sales of treasury stock during this period—only purchases of treasury stock.

Financial Ratio Formulas

Return on Equity: Net Income/Average Stockholders’ Equity Dividend Payout: Dividends Declared/Net Income

Return on Assets: Net Income/Average Total Assets Asset Turnover: Total Sales/Average Assets

Current Ratio: Current Assets/Current Liabilities Quick Ratio: (Cash + Marketable

Securities + AR)/Current Liabilities

Debt-Asset Ratio: Total Liabilities/Total Assets Accounts Receivable Days: 365/A/R Turnover Inventory Days: 365/Inventory Turnover Accounts Payable:

365/A/P Turnover Cash Conversion Days: A/R Days + Inventory Days - A/P

Days A/R Turnover: Total Sales/Average Accounts Receivable Inventory Turnover: Total Cost of Goods Sold

Expense/Average Inventory. Accounts Payable Turnover: Purchases/Average Accounts

Payable.

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Finance Formulas

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Respond to the following Stock and Bond questions:

Stock Questions (Questions 1–4; 48 Points)

1. An intern is confused. She is looking at the December 31, 20X10, balance sheet and focusing on the $1,232,000 treasury stock amount. She is trying to provide support that shows how the firm arrived at this amount. Provide this support. (4 points)

2. The firm believes that its stock price at December 31, 20X11, does not accurately reflect its intrinsic value on the same date. Assume that 20X11 dividends were $31,049.

a. Calculate the intrinsic value of stock at year-end 20X11. (9 points)

b. Explain the pros and cons of purchasing the treasury stock at year-end 20X11. (5 points)

c. What is the dividend and capital gains yield for 20X12? (2 points)

d. What is the dividend and capital gains yield for 20X14? (2 points)

3. Recalculate 20X11 total assets, 20X11 total liabilities, and 20X11 total stockholders’ equity assuming the firm did not purchase any treasury stock during 20X11. (5 points)

4. Please refer to the background information for some of these problems. During the period 20X9–20X11, the firm’s closest competitor had stock price activity that resulted in an average stock return of 25.7 percent with a standard deviation of 19.275 percent. This competitor’s beta is 1.20.

a. Based on stand-alone risk and using the Coefficient of Variation, which firm is riskier, our firm or our competitor? Explain your answer. (8 points)

b. Calculate the required rates of return for our firm and for our competitor. Show the detail to your work. (4 points)

c. If the return on the market were to fall from its current level of 12 percent to 9 percent, what would be the resulting impact on required return for our firm and for our competitor? What explains the difference between the two firms (be specific in your answer)? (6 points)

d. If an investor held a portfolio consisting of equal percentages of the market portfolio, the firm’s stock, and

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the competitor’s stock, what would the beta of this portfolio be? (3 points)

Bond Questions (Questions 5–12; 52 Points)

5. Prepare the journal entry to record the sale of bonds on December 31, 20X1. (5 points)

6. Calculate total interest expense that will be recorded on the books from January 2, 20X2, through December 31, 20X9 (assume zero interest expense during 20X1). (5 points)

7. Assume that the yield-to-maturity at December 31, 20X10, and December 31, 20X11, is still 10 percent. Also assume that an investor decides to purchase these bonds in the open market at December 31, 20X10, for $736,740, and then sell these bonds one year later (e.g., at December 31, 20X11). What is the dollar return (e.g., income/gains) that the investor will earn during 20X11 from this investment? How much of this return is attributed to interest and how much to change in price of the bond? (5 points)

8. a. Assume that the firm is contemplating purchasing its bonds in the open market on December 31, 20X14, for $748,485. What is the yield-to-maturity for these bonds on this date? (5 points)

9. b. Assume that the change in the yield to maturity is due solely to default risk, and this change in default risk is due to a change in the bond’s ratings. As a result, would this rating have increased (upgrade) or decreased (downgrade). Explain. (4 points)

10. This question is a continuation from Question 9.

a. Assume that the firm purchases the bonds on December 31, 20X14, for $748,485. Prepare the journal entry to record this purchase. (6 points)

b. Summarize how this purchase impacts total assets, total liabilities, total stockholders’ equity, net income, cash flow from operating activities, cash flow from investing activities, and cash flow from financing activities. (9 points)

11. Assume that on January 1, 20X12, the firm sold another bond issue (20 years, semi-annual interest). The coupon rate was 6 percent, yield-to-maturity is 4 percent, and face

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- ¼

value is $1,000,000 (1,000 bonds were sold that day).

a. Calculate the sales price of these bonds (4 points)

b. Prepare the journal entry to record interest expense for the first six months of 20X12 (January 1, 20X12, through June 30, 20X12). (5 points)

12. This problem is a general problem and not specific to The Corporation. The real risk-free rate, r*, is 2.75 percent. Inflation is expected to average 2.9 percent per year for the next four years, after which time inflation is expected to average 3.6 percent per year. The maturity risk premium equals 0.1 (t 1) percent, where t the bond’s maturity. A seven-year corporate bond has a yield (r) of 9.2 percent, which includes a liquidity premium of 0.75 percent. What is this bond’s default risk premium (DRP)? (4 points)