9.10 Chapters Eight & Nine: Review Questions
Chapters 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.
- 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.
- 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 will the company’s financial ratios change next year?
Sample answer to question #3:
Why is FCF important? Give two reasons.
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It is a measure of growth and hence the advisability of investing in the firm – whether to lend or buy equity.
- How do we use this model – for individual projects, for the entire corporation, or both? Explain.
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For both. When evaluating a potential investment project, we wish to know whether it will generate FCF with which the firm can invest in still more investment projects or use the funds to pay dividends, pay down debt etc. (See below.) Also, a firm on the whole is a better investment if it generates FCF. We assume, in the abstract, that the firm has a never-ending appetite for growth and FCF is a measure of that. It is used for both “project finance” and “corporate finance.”
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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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Purchase more P, P , & E, and expand its inventory
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Invest in Mergers and Acquisitions (using shares when high-priced)
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Increase Research & Development
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Pay discretionary (common stock) dividends
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Buy back common shares (when the shares are cheap)
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- Pay off Debt
Selected Answers To Chapters 8 and 9
#4. 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)
#11. EFN Formula
($ Millions)
I have assumed, in the question itself, that the B/S and I/S data are stated in Thousands, rather than Millions. This is more palpable. Note that here, the numbers are simplified to Millions; it’s shorter. Assume that PR = 20%. Beware the differences!
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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 = [(A0/S0) ΔS] – [(AP0/S0) ΔS] – [(M0) (S1) (RR0)]
- 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.
