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# Estimating Free Cash Flow, Return, Financial Leverage etc.

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11-1 Meltzer Electronics estimates that its total financing needs for the coming year will be \$34.5 million. During the coming fiscal year, the firm's required financing payments on its debt-and-equity financing will toal \$12.9 million. The firm's financial manager estimates that operating cash flows for the coming year will total \$33.7 million and that the following changes will occur in the accounts noted.

Account Forecast Change
Gross fixed assets \$8.9 million
Change in current assets +2.3 million
Change in accounts payable +1.3 million
Change in accrued liabilities +0.8 million

Use the data provided to estimate Meltzer's free cash flow in the coming year.
How much of the free cash flow will the firm have available as a source of new internal financing in the coming year?
How much external financing will Meltzer require during the coming year to meet its total forecast financing need?

11-2 West Coast Manufacturing Company (WCMC) is executing an initial public offering with the following characteristics. The company will sell 10 million shares at an offer price of \$25 per share, the underwriter will charge a 7 percent underwriting fee, and the shares are expected to sell for \$32 per share by the end of the first-day's trading. Assuming this IPO is executed as expected, answer the following:

Calculate the initial return earned by investors who are allocated shares in the IPO.
How much will WCMC receive from this offering?
What is the total cost (underwriting fee and under pricing) of this issue to WCMC?

What is Financial Leverage and why do firms Use it?

12-1 As Chief Financial Officer of the Magnificent Electronics Corporation (MEC), you are considering a recapitalization plan that would convert MEC from its current all-equity capital structure to one including substantial financial leverage. MEC now has 500,000 shares of common stock outstanding, which are selling for \$60 each, and you expect the firm's EBIT to be \$2,400,000 per year, for the foreseeable future. The recapitalization proposal is to issue \$15,000,000 worth of long-term debt, at an interest rate of 6.0 percent, and use the proceeds to repurchase 250,000 shares of common stock worth \$15,000,000. Assuming there are no market frictions such as corporate or personal income taxes, calculate the expected return on equity for MEC shareholders, under both the current all-equity capital structure and under the recapitalization plan.

12-2 The ALL-Star Production Corporation (APC) is considering a recapitalization plain that would convert APC from its current all-equity capital structre to one including some financial leverage. APC now has 10,000,000 shares of common stock outstanding, which are selling for \$40.00 each, and you expect the firm's EBIT to be \$50,000,000 per year, for the foreseeable future. The recapitalization proposal is to issue \$1000,000,000 worth of long-term debt, at an interest rate of 6.50 percent, and use the proceeds to repurchase as many shares as possible, at a price of \$40.00 per share. Assume there are no market frictions such as corporate or personal income taxes. Calculate the expected return on equity for APC shareholders, under both the current all-equity capital structure and under the recapitalization plan.

a. Calculate the number of shares outstanding, the per-share price, and the debt-to-equity ratio for APC if the proposed recapitalization is adopted.
b. Calculate the earnings per share (EPS) and the return on equity for APC shareholders, under both the current all-equity capitalization and the proposed mixed debt/equity capital structure.
c. Calculate the breakeven level of EBIT, where earnings per share for APC stockholders are the same, under the current and proposed capital structures.
d. At what level of EBIT will APC shareholders earn zero EPS, under the current and the proposed capital structures?

#### Solution Preview

See the attached file for a hard copy of the solution (the text here may not be copied exactly as some of the symbols / tables may not print).

11-1 Meltzer Electronics estimates that its total financing needs for the coming year will be \$34.5 million. During the coming fiscal year, the firm's required financing payments on its debt-and-equity financing will total \$12.9 million. The firm's financial manager estimates that operating cash flows for the coming year will total \$33.7 million and that the following changes will occur in the accounts noted.

Account Forecast Change
Gross fixed assets \$8.9 million
Change in current assets +2.3 million
Change in accounts payable +1.3 million
Change in accrued liabilities +0.8 million

Use Equation 2.3 and the data provided to estimate Meltzer's free cash flow in the coming year.
How much of the free cash flow will the firm have available as a source of new internal financing in the coming year?
Operating cash flows = \$33.7 million
Less: Increase in gross fixed assets = \$8.9 million
Less: Increase in current assets = \$2.3 million
Add: increase in accounts payable = \$1.3 million
Add: Increase in accrued liabilities = \$0.8 million
Free cash flow in coming year = \$24.6 million

Less: Financing payments on debt and equity financing = \$12.9 million
Free cash flow available as a source of internal financing = 11.7 million

How much external financing will Meltzer require during the coming year to meet its total forecast financing need?
External financing needed = 34.5 million - 11.7 million = \$22.8 million

11-2 West Coast Manufacturing Company (WCMC) is executing an initial public offering with the following characteristics. The company will sell 10 million shares at an offer price of \$25 per share, the underwriter will charge a 7 percent underwriting fee, and the shares are expected to sell for \$32 per share by the end of the first-day's trading. Assuming this IPO is executed as expected, answer the ...

#### Solution Summary

Some of the concepts explained in this post include initial return, expected return, earnings per share (EPS), breakeven level of EBIT, number of shares outstanding, etc. There are four questions solved and it could be used as a good learning exercise. Full solution attached in Word for formatting reasons.

\$2.19

## Financial questions relating to Business Organization, Shareholders' wealth, Cash flow statement, financial ratios, time value of money, CAPM, Bonds, payback, NPV, IRR, IOS and MCC schedule, WACC, Leverage, EBIT-EPS approach, Cash Conversion cycle.

1) Explain the three principal forms of business organization. Outline their respective advantages and disadvantages. How do taxes, risk, scale, and ownership liquidity affect the selection of one of these three methods?

2) Compare the shareholder-wealth-maximization model with the corporate-wealth- maximization model. What is the proxy for shareholder wealth? How does the role of the shareholder conflict with that of other stakeholder? Who are some of the stakeholder and give examples of potential conflicts. Additionally, what is meant by the agency problem, why does it arise, and what may be done to address it?

3) Discuss the three components of a cash flow statement. What is another name for the statement of cash flows and why is the cash flow statement important? How is the statement of cash flows similar or different from a cash budget?

4) Outline the five classes of financial ratios (you do not need to give the formulas). What are the advantages and disadvantage to using ratio analysis? What do you need to be mindful of when doing ratio analysis? What is the DuPont ratio, what are its components, and why is it important?

5) Time value of money

a) What is the difference between compounding and discounting?

b) What are the five variables in a time value calculation?

c) What is the difference between an annuity and a mixed cash flow?

d) What is the difference between an ordinary annuity and an annuity due? Which has a greater future value and why?

e) Give examples where you may use time value in your own life.

6) How do you measure the return and total risk for a single asset? What is the difference between portfolio risk and stand alone risk? What is the difference between systematic risk and unique risk? What is the tradeoff between risk and return? How does risk change (absolutely and incrementally) as you randomly add assets to a portfolio? What effect does
the risk of a single asset and the correlation between assets in a portfolio have on portfolio risk?

7) What is the capital asset pricing model (CAPM); what does it show; why is it important: and how do you use it? What are some of the practical and theoretical limitations of the CAPM?

8) Describe and compare the zero-growth, constant-growth, and multi-stage dividend growth models for equity valuation. What assumptions must you make? How do changes in the growth rate and the cost of capital affect valuation?

11) Bonds

a) Using a bond price yield curve, discuss in detail the relationship between bond prices and the yield to maturity.

b) How do maturity and the size of the coupon affect the shape of the bond price yield curve? Explain. What does the shape of the bond price yield curve mean for interest rate risk?

c) Assuming no change in interest rates, what happens to the price of a bond as it approaches maturity? Show this graphically for a par, premium, and discount bond.

d) If you expect interest rates to rise (decline), what kind of bond should you buy? Why?

12) Compare and contrast the payback, NPV and IRR techniques for capital budgeting. What are their respective advantages and disadvantages of each? Will they ever give you different recommendations? If so, which would you prefer and why?

13) Draw and label an NPV profile? What does the profile show? How can you use it to assess an individual project or multiple projects? What factor(s) explains the shape of the NPV profile? What other curve does it resemble?

14) Explain the IOS and MCC schedules. What are they; how are they computed; and how can you use them? What is a break point? Use a graph to illustrate your work. Carefully label this graph.

15) Describe and discuss the following terms. Be sure to include where/why they are important and/or how you can use them.

b) Annualized net present value

c) Scenario analysis

d) Sensitivity analysis

e) Capital rationing

16) Discuss the weighted average cost of capital: what is it, how do you compute it, why it is important, and what it does it mean for new projects. Is the weighted average cost of capital constant over time? Why or why not?

What are the different ways to determine the weights? Why do some firms use a hurdle rate that is higher than the WACC? What are the implications of using a higher hurdle rate to shareholder wealth maximization?

17) Define operating, financial and total leverage as well as the degree of operating, financial, and total leverage. How do you use them and why are they important? Is the degree of operating, financial, and total leverage constant? Explain why or why not. How do operating and financial leverage affect a company's target capital structure and earnings per share? How and why do businesses adjust for the tradeoff between financial and operating
leverage?

18) Conceptually and graphically discuss how you would determine the optimal capital structure for a specific firm. Include a discussion of the EBIT-EPS approach.

19) Describe the cash conversion cycle, its funding requirements, and the strategies for managing it.

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