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theory of corporate finance

Questions and Answers of Theory Of Corporate Finance

The current ratio is the ratio of current assets over current liabilities. A firm is less precarious if this ratio is high. (However, too high of a current ratio may mean that the firm is investing
A common financial-debt-to-equity ratio computes the sum of long-termdebt plus debt in current liabilities, divided by the sum of the market value of the firm’s equity.
The price/cash ratio, price/sales ratio, and price/dividend ratio are usually calculated without debt adjustment—the equivalent of surgery without anesthesia. This is a huge problem, but it also
Firms can increase sales at the expense of profitability. (Just sell goods for a very low price.) Moreover, you should never compute a P/S ratio for equity. You should only compute one for the entire
You would use a price/sales ratio if earnings are negative and/or you believe that sales aremore representative than earnings of the future value of the firm.
Yahoo! Germany reported an actual market value of $10.52 billion euros and an earnings yield of 36.9%(P/E of 27). The easy part is supplementing the table:Manufacturer Market Cap Earnings P/E Ratio
This question about the unlevered P/E ratio cannot be answered if you do not know the different costs of capital. For example, if the firm’s cost of capital is equal to the debt cost of capital,
Earnings (in millions of dollars): The TTM earnings for KO is 3,979 + (801 − 873) + (1,290 − 1,118) =4,079. The TTM earnings for PEP is 2,662 + (651 − 570) + (888 − 798) = 2,833. Assets (in
If only one among a dozen industry comps has a negative P/E ratio, you can ignore this firmwith nonpositive earnings, you can use the median industry ratio, you can work with E/P yields and invert
Averaging P/E ratios is very hazardous because it can easily lead to misleading estimates, as explained in Section 14.3B.We called it the “1/X domain problem.” The main problem is that earnings
Let’s do an example. The acquirer has value of $100, so it needs to have earnings of $5. The target has value of $50, so it needs to have earnings of $1. This means that the combined firm will have
The P/E ratio of the merged A and B company is neither the equal-weighted nor the value-weighted average!See Section 14.3B.
With a P/E ratio of 20 on the S&P 500, its E/P yield would be around 5%. The real earnings growth rate has been around 2%. Thus, the real stock market rate of return would be around 7%. Add
The relation between earnings multiples and earnings growth rates is usually negative. It is not always so, because it is not stable over the business cycle. During recessions, cash cow firmsmay
Using the formula in Table 14.1, PVGO 1 1- 80% Price 10% -50 PVGO 1 Price E(F). P/E ratio
For the stable firm:(a) The P/E ratio is $1,000/$100 = 10.(b) The debt now has to receive $500 . 7.5% = $37.50 in interest every month. Therefore, there is $62.50 available to the equity. Therefore,
If PVGO is positive, E(g) is also positive.
Rearranging Formula 14.2,It states that firms with zero PVGOs have E/P yields equal to their costs of capital. Firms that are growing have E/P yields below their costs of capital. Firms that are
E/P = E(˜r) − E( ˜ g) ⇒ E(˜r) = E/P + E( ˜ g) = 1/40 + 6% = 8.5%. Therefore, E/P = 8.5% − 7% = 1.5%and its P/E ratio would shoot from 40 to 66.7. The percentage change in value would
Google is growing faster than PepsiCo, so it would have a higher P/E ratio.
It is more common to compute a price/earnings ratio than a price/cash flow ratio because the earnings measure incorporates some forward-looking information, and is therefore less “spiky.”
Comparable projects enter the NPV formula through the (opportunity) cost of capital, also called the discount rate, usually abbreviated E(r).
The law of one price states that items with similar attributes should be priced similarly.
What is the difference between the dividend/price ratio and the dividend payout ratio?
A firm has sales of $30,000 and receivables of $6,000.What is its receivables turnover?What is its DRO?
What is the “current ratio”? Is a firm more or less precarious if this ratio is high?
How would you measure a financial-debt-to-equity ratio?
On July 28, 2003 (all quoted dollars are in billions):Firm Cash Sales Dividends Value D/E CSG N/A $9.2 $0.4 $12.2 153%KO $3.6 $20.3 $2.2 $110.8 43%PEP $1.8 $25.9 $1.1 $81.0 22%Hansen Natural had
Why are price/sales ratios problematic?
When would you use a price/sales ratio?Why?
On October 9, 2002, the seven auto manufacturers publicly traded in the United States were as follows:Manufacturer Market Cap Earnings Manufacturer Market Cap Earnings Volvo (ADR) $5.7 −$0.18
A firm has a P/E ratio of 12 and a debt/equity ratio of 2:1 (66.7%).What would its unlevered P/E ratio (i.e., the P/E ratio of its underlying business) approximately be?
The following are quarterly earnings and assets for Coca-Cola and PepsiCo(in millions of dollars) from 2002 financial reports, including restated figures for 2001 (for PepsiCo):a. A onetime
What can you do if only one among a dozen industry comparables has a negative P/E ratio?
Why can it be most hazardous to work with P/E ratio averages? What would you call this problem (and where does it come from)?
A firm with a P/E ratio of 20 wants to take over a firm half its size with a P/E ratio of 50.What is the P/E ratio of the merged firm?
Is the P/E ratio of a merged company with two divisions, A and B, the value-weighted or equal-weighted average of the P/E ratios of these divisions?
If the P/E ratio on the S&P 500 is 20, given historical earnings growth patterns, what would be a reasonable estimate of long-run future expected rates of return on the stock market?
Is the relation between earnings multiples and earnings growth rates usually positive or negative? Is it always so? If not, why not?
Confirmthe PVGO/price ratio for Google that is reported in Table 14.1.(Use the formula below the table.)
Consider a stable firm with a market value of $1,000 that produces cash of $100 per year forever. The prevailing cost of capital for the firm is 10%.(a) Assume that the firm is financed with 100%
If PVGO is positive, is E(g) positive or negative?
Rearrange Formula 14.2 into its price/earnings form.What does this say about the earnings/price yield for firms with no PVGO? About firms with positive PVGO? Negative PVGO?
A firm has earnings of $230 this year, grows by about 6% each year, and has a price/earnings ratio of 40. What would its price/earnings ratio be if it could grow by 7% each year instead? How much
Which is likely to have a higher price/earnings ratio: Google or PepsiCo?
Why is it more common to compute a price/earnings ratio than a price/cash flow ratio?
How do comparable projects enter the NPV formula?
Preferably answer this question from memory:If you have access to a firm’s cash flow statement and net income statement, how would you compute the economic cash flows that accrue to shareholders?
Coca-Cola’s financials are in the appendix.(a) Put together a table equivalent to Table 13.10 for Coca-Cola for 2001.(b) Explain how your table handles long-term and short-term accruals.(c) Show
Among PepsiCo’s working capital items in 2001, which items allowed PepsiCo to pull cash out of the business, and which items forced PepsiCo to put more back into the business?
Explain why EBITDA is more difficult to manipulate than EBIT.
Give some examples of how a firm can depress the cash flows that it reports in order to report higher cash flows later.
Coca-Cola reported the following information(in million dollars):Income Statement Year 2003 2004 2005 Net Income $4,347 $4,847 $4,872 Balance Sheet Year 2003 2004 2005 Accounts Receivable $2,244
PepsiCo reported the following information(in million dollars):Income Statement Year 1999 2000 2001 Net Income $2,505 $2,543 $2,662 Balance Sheet Year 1999 2000 2001 Accounts Receivable $2,129 $2,142
Consider the following project:Project Real Physical Lifespan 6 years Cost $150 Gross Output $50 in year 1$80 in year 2$90 in year 3$50 in year 4$25 in year 5$0 in year 6− Input Costs (cash)
Construct the financials for a firm that has quarterly sales and net income of $100, $200,$300, $200, $100. One-quarter of all customers pay immediately, while the other threequarters always pay two
PepsiCo’s balance sheet lists its deferred income taxes as $1,367 million in 2000 and$1,496 million in 2001. Its net income statement further listed income tax payments of$1,367 million in 2001.
Repeat the previous question, but assume that you finance the entire car with a loan that charges 10% interest per annum.
Consider purchasing a $50,000 SUV that you expect to last for 10 years. The IRS uses an MACRS 5-year depreciation schedule on cars. It allows depreciating 20% in year 1, 32%, 19.2%, 11.52%, 11.52%,
What is an accrual? How do long-term and short-term accruals differ?
What would be the most common accounting value of residential investment property that you purchased for $3 million in each of the next 50 years? (Hint: Use a straight line 40-year depreciation
Use an appropriate website to find out how MACRS works. How would you depreciate$10,000 in computer equipment?
Which statements on the firm’s financial reports are about flows, and which are about stocks?
ForMicrosoft (http://www.microsoft.com/msft/reports/ar05/staticversion/10k_fr_cas.html), the underlying project cash flows would have been as follows:Microsoft has no debt, so all cash flows accrue
The easiest ways to compute cash flows to residual equity shareholders are Formulas 13.4 and 13.5. PepsiCo’s project cash flows, available for satisfaction of both creditors and shareholders, are
To compute the cash flows (in millions) produced by the firm (project), use the long formula in Table 13.10:a. Note that the balance sheet gave the level of deferred taxes and the level of working
The main components for a cash flow analysis are in Table 13.10. Start with EBIT. Then undo accruals for taxes: Subtract off corporate income tax and add changes in deferred taxes. Then undo
If a firm assumes that fewer of its customers will actually pay their bills in the future (i.e., more will default), then its earnings are (too) conservative. There are also many other ways in which
Short-term accruals are easier to manipulate. To manipulate long-term accruals, you would have to manipulate the depreciation schedule, and though this may be possible a few times, if it is done
In February, Amazonia has cash inflows of $100 ($25 net income plus $75 change in accounts payable). In March, Amazonia has another $100 in sales, but payables stay the same. (It has to pay its old
The cash flows are as follows:It is easier to obtain the change in A/R first: You know that net income minus the change in A/R must add up to cash flows (change in A/R = net income − cash flows).
To find the cash flows, work out the change in accounts receivable each year. Then subtract these changes from the net income.The firm’s customers did not all pay the next period. Therefore, the
The deferred tax account increased $109 from 2005 to 2006. This means that the cash outflow was not as large as the income statement would have you believe. Thus, we add that back to the GAAP cash
Deferred taxes is an account that represents the cumulated difference between taxes indicated on the firm’s income statement and the (lower) amount of taxes that the firm has actually paid. They
The (summarized) cash flows using monthly discounting are as follows:Tax is calculated as 40% . (EBIT − Depreciation − Interest Expense). For discounting, this uses a 1%monthly rate for project
The income statement is now as follows:The cash flow statement excerpt is now as follows:The cash flow formula is EBIT plus depreciation (or use EBITDA instead) minus capital expenditures, minus
Analogous to the cash flows in Table 13.7, a 10% instead of a 12% cost of capital on the tax liability would increase the NPV of the tax obligation from $46.77 toTherefore, the project value would
Completing the calculations in Table 13.7 beyond years 1 and 2 (which are illustrated in the chapter text), years 3 through 6 are as follows: Formula 13.1: EBIT + Depreciation Years 345 6 $10 $35 $60
Basically yes: The lifetime sum of net income should be approximately equal to the firm’s lifetime cash flows.Cash flows just have different timing. For example, a firm’s capital expenditures are
The main difference between how accountants see income and how financiers see cash flows is accruals.Examples are the treatment of depreciation (versus capital expenses) and the delayed
There are many reasons. For example, Uncle Sam uses accounting methods to compute corporate income taxes. Secondary influences come from the fact that many contracts are contingent on accounting
Do a financial analysis for Microsoft. Obtain the past financial statements from a website of your choice (e.g., Yahoo! Finance orMicrosoft’s own website). Compute the cash flows that you would use
What are the cash flows produced by PepsiCo’s projects in 1999, 2000, and 2001? What are the cash flows available to residual equity shareholders in 1999, 2000, and 2001?
A new firm reports the following financials (in million dollars):(You will need to compute changes in deferred taxes, which are $20 −$16 = $4 in 2001, as well as changes in working capital.) Can
From memory, can you recall the main components of economic cash flows that are used in an NPV analysis? Do you understand the logic?
Give some examples of how a firm can depress the earnings that it currently reports in order to report higher earnings later.
Are short-term accruals or long-term accruals easier to manipulate?
ADVANCED: Amazonia can pay suppliers after it has sold to customers.Amazonia has 25% margins and is reporting the following Month Jan Feb Mar Apr May Reported Sales $0 $100 $100 $400 $0 Reported Net
Construct the financials for a firm that has quarterly sales and net income of $100, $200, $300, $200, and $100. Half of all customers pay immediately, while the other half always pay two quarters
A firm reports the following financials.Year 0 1 2 3 4 5 6 Reported Sales (=Net Income) $0 $100 $100 $300 $300 $100 $0 Reported Accounts Receivable $0 $100 $120 $340 $320 $120 $0 Can you describe the
Assume a firm reports the following information:2007 2006 2005 Deferred Tax Liability $110 $332 $223 You have calculated the after-tax cash flows for a project based on GAAP to be $300 in 2007
What are “deferred taxes”? On which of the four financial statements do they appear?
For the machine example in the text, do both the financials and the cash flow analysis using monthly discounting. Assume that the loan is taken at the beginning of the year, and most expenses and
Using the same cash flows as in the NPV analysis in Table 13.7, how would the project NPV change if you used a 10% cost of capital (instead of 12%) on the tax liability?
Show that Formulas 13.1 through 13.3 yield the cash flows in years 3 through 6 in Table 13.7.
Is the firm’s lifetime sum of net income roughly equal to the firm’s lifetime sum of cash flows?
What is the main difference between the depiction of a project in accounting(net income) and in finance (economic cash flows)?
Although accounting numbers are sometimes thought of as imaginary presentations, why is a firmnot just a firm, and accounting numbers not just “funny numbers”? That is, what is the most important
You own a plant that has $90 of production costs. To close an open plant costs $0. To open a closed plant costs $0. The production can be sold for $100 in year 0 (now). Next year, the selling value
Tree problems like this one need to be solved “backwards.” You can start in year 2 with a prevailing price of$0.45, $0.90, $1.80, $3.60, or $7.20, and your factory can be either open or closed.

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