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Finance: agency theory, book value per share of common stock, Du Pont system of analysis

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1. What issue does agency theory examine? Why is it important in a public corporation rather than in a private corporation?
The issues that agency theories examine are/is: Examines the relationship between the owners and the managers of the firm. It is important in a public corp. because, In privately owned firms, management and owners are usually the same people, and in public, as a company moves from private to public ownership, management now represents all the owners, This places management in the agency position of making decisions that will be in the best interests of all shareholders.
2. What changes can take place under restructuring? In recent times, what group of investors has often forced restructuring to take place?
? Changes to liabilities and equity on the balance sheet.
? Selling and reinvesting from divisions
? Changing management team and workforce.
? Institutional investors force restructuring
3. What is the difference between book value per share of common stock and market value per share? Why does this disparity occur?
Book Value per stock:
Common shareholders' equity divided by common shares outstanding at the end of the indicated annual period. Book value per share is one of many factors to be used when appraising a stock. There is no rule for an adequate book value per share, but the difference between book value and market value is usually accounted for by the actual or potential earning power of a company.
The disparity occurs because:

4. Explain how the Du Pont system of analysis breaks down return on assets. Also explain how it breaks down return on stockholders' equity.
Profit margin is Net Income / Sales

1. Asset Turnover is Sales / Total Assets
2. Return on Assets is Profit Margin * Asset turnover
3. Return on equity is return on assets / (1- debt / Assets)

The Du Pont system stresses that a satisfactory return on assets may be achieved through high profit margin or rapid turnover of assets or both. With the Du Pont system the use of debt is also important as this affects the return on equity.
5, Comparisons of income can be very difficult for two companies even though they sell the same products in equal volume. Why?
There are many different ways of recognizing data for financial reports which can affect the profit and other ratios for example;
? Timing of recording revenue (Enron)
? Cost of goods sold (Inventory, LIFO and FIFO)
? Extraordinary gains and losses (before or after taxes)
? Depreciation methods and rates
? Reserve accounts
? Management payment methods (options or cash)
? Of balance sheet loans
? Capitalizing certain expense then amortising over a longer time e.g. AOL.
? Aggressive accounting methods may be a sign of avaricious managers alone or may be part of the competitive culture of a particular industry.
6. What is the significance to working capital management of matching sales and production?

7. Explain why the bad debt percentage or any other similar credit-control percentage is not the ultimate measure of success in the management of accounts receivable. What is the key consideration?

8. What are three quantitative measures that can be applied to the collection policy of the firm?

9. What does the EOQ formula tell us? What assumption is made about the usage rate for inventory?

10. A borrower is often confronted with a stated interest rate and an effective interest rate. What is the difference, and which one should the financial manager recognize as the true cost of borrowing?

11. What is the difference between pledging accounts receivable and factoring accounts receivable?

12. What is meant by hedging in the financial futures market to offset interest rate risks?

13. In what two ways do security markets provide liquidity?

14. Discuss the benefits accruing to a company that is traded in the public securities markets. What are the disadvantages to being public?

15. Company A ships goods throughout the country and has determined that the establishment of local collection centers around the country, can speed up the collection of payments by one and one-half days. Furthermore, the cash management department of the bank has indicated to them that they can defer payments on accounts by one-half day without affecting suppliers. The bank has a remote disbursement center.

a. If the company has $4 million per day in collections and $2 million per day in disbursements, how many dollars will the cash management system free up?

b. If the company can earn 9 percent per annum on freed up funds, how much will the income be?

c. If the total cost of the new system is $700,000, should it be implemented?

16. The Holtzman Corporation has assets of $400,000, current liabilities of $50,000, and long-term liabilities of $100,000. There is $40,000 in preferred stock outstanding; 20,000 shares of common stock have been issued
a. Compute book values (net worth) per share.
400,000 -50,000-100,000= $250,000 40,000+60,000= 60,000
250,000/60= $4.17 net worth per share.
b. If there is $22,000 in earnings available to common stockholders and Holtzman's stock has a P/E of 18 times earnings per share, what is the current price of the stock?

c. What is the ratio of market value per share to book value per share?

17. A company has assets of $400,000 and turns over its assets 1.5 times per year. Return on assets is 12 percent. What is its profit margin (return on sales)?

18. Hazardous Toys Company produces boomerangs that sell for $8 each and have a variable cost of $7.50. Fixed costs are $15,000.

a. Compute the break-even point in units.
b. Find the sales (in units) needed to earn a profit of $25,000.

19. The Landis Corporation had 2004 sales of $100 million. The balance sheet items that vary directly with sales and the profit margin are as follows:

Cash.................................................. 5%
Accounts receivable.......................... 15
Inventory.......................................... 25
Net fixed assets................................ 40
Accounts payable.............................. 15
Accruals............................................ 10
Profit margin after taxes................... 6%

The dividend payout rate is 50 percent of earnings, and the balance in retained earnings at the beginning of the year 2005 was $33 million. Common stock and the company's long term bonds are constant at $10 million and $5 million, respectively. Notes payable are currently $12 million.

a. How much additional external capital will be required for next year if sales increase 15 percent? (Assume that the company is already operating at full capacity.)
b. What will happen to external fund requirements if Landis Corporation reduces the payout ratio, grows at a slower rate, or suffers a decline in its profit margin? Discuss each of these separately.
c. Prepare a pro forma balance sheet for 2005 assuming that any external funds being acquired will be in the form of notes payable. Disregard the information in part b in answering this question (that is, use the original information and part a in constructing your pro forma balance sheet).

20. Leno's Drug Stores and Hall's Pharmaceuticals are competitors in the discount drug chain store business. The separate capital structures for Leno and Hall are presented below.

Leno Hall
Debt @ 10%....................... $100,000 Debt @ 10%....................... $200,000
Common stock, $10 par...... 200,000 Common stock, $10 par...... 100,000
Total.................................. $300,000 Total.................................. $300,000
Shares.................................. 20,000
Common shares................... 10,000

a. Compute earnings per share if earnings before interest and taxes are $20,000, $30,000, and $120,000 (assume a 30 percent tax rate).
b. Explain the relationship between earnings per share and the level of EBIT.
c. If the cost of debt went up to 12 percent and all other factors remained equal, what would be the break-even level for EBIT?


Midland Chemical Co. is negotiating a loan from Manhattan Bank and Trust. The small chemical company needs to borrow $500,000.

The bank offers a rate of 8 ¼ percent with a 20 percent compensating balance requirement, or as an alternative, 9 ¾ percent with additional fees of $5,500 to cover services the bank is providing. In either case the rate on the loan is floating (changes as the prime interest rate changes). The loan would be for one year.

a. Which loan carries the lower effective rate? Consider fees to be the equivalent of other interest.
b. If the loan with a 20 percent compensating balance requirement were to be paid off in 12 monthly payments, what would the effective rate be? (Principal equals amount borrowed minus the compensating balance.)
c. Assume the proceeds from the loan with the compensating balance requirement will be used to take cash discounts. Disregard part b about installment payments and use the loan cost from part a.

If the terms of the cash discount are 1.5/10, net 50, should the firm borrow the funds to take the discount?

d. Assume the firm actually takes 80 days to pay its bills and would continued to do so in the future if it did not take the cash discount. Should the company take the cash discount?
e. Because the interest rate on the loans is floating, it can go up as interest rates go up. Assume that the prime rate goes up by 2 percent and the quoted rate on the loan goes up the same amount. What would then be the effective rate on the loan with compensating balances? Convert the interest to dollars as the first step in your calculation.
f. In order to hedge against the possible rate increase described in part e, the Midland Chemical Co. decides to hedge its position in the futures market. Assume it sells $500,000 worth of 12-month futures contracts on Treasury bonds. One year later, interest rates go up 2 percent across the board and the Treasury bond futures have gone down to $488,000. Has the firm effectively hedged the 2 percent increase in interest rates on the bank loan as described in part e? Determine the answer in dollar amounts.

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