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# Analysis of recessionary cash flows

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Company A is undertaking a thorough cash flow analysis. It has been proposed by management that the firm expand by raising \$6million in long term debt markets. All of this would be immediately invested in new fixed assets. The proposed bond issue would carry a 10 percent interest rate and have a maturity period of 20 years. The bond issue would have the sinking fund provision that 0ne-twentieth of the principal would be retired annually. Next year is expected to be a poor one for company A. The firm believes that the upcoming year would serve as the model for the worst possible operating conditions that the firm can be expected to encounter. Next year, sales collections are forecast to be \$3.5 million. Miscellaneous cash receipts will total \$200,000. Wages and salaries will amount to \$1.2 million. Payment for raw material used in production process will be \$1.5 million. In addition, the firm will pay \$500,000 in nondiscretionary expenditures including taxes. The firm faces 50 percent tax rate.

Question 1: Company A currently has no debt, pr preferred stock outstanding. What will be the total fixed financial charges that the firm must fix next year?

Question 2: What is the expected cash balance at the end of the recessionary period (next year), assuming debt is issued?

Question 3: Based on this information, should company A issue proposed bonds?

What I need help with is the formula and run down of the process to figure out this problem, the explicit answer is not necessary.

#### Solution Preview

1. Since there is no debt or preferred stock, the fixed financial charges would be from the new bond issue. The financial charges will be the interest and the sinking fund. The interest amount would be 6,000,000 X 10%=600,000 for the first year. The sinking fund is 6,000,000/20=300,000. The ...

#### Solution Summary

The solution explains how to evaluate an issue of bonds under recessionary conditions

\$2.19

## Finance: cash flow, FV, discount rate, bonds,dividends, working capital, break-even

1. An increase in which one of the following will cause the operating cash flow to increase?

a. depreciation
b. change in net working capital
c. net working capital
d. taxes
e. costs

2. A firm has net working capital of \$400, net fixed assets of \$2,400, sales of \$6,000, and current liabilities of \$800. How many dollars worth of sales are generated from every \$1 in total assets?

a. \$1.33
b. \$1.67
c. \$1.88
d. \$2.33
e. \$2.50

3. The Ajax Co. just decided to save \$1,500 a month for the next five years as a safety net for recessionary periods. The money will be set aside in a separate savings account which pays 3.25% interest compounded monthly. It deposits the first \$1,500 today. If the company had wanted to deposit an equivalent lump sum today, how much would it have had to deposit?

a. \$82,964.59
b. \$83,189.29
c. \$83,428.87
d. \$83,687.23
e. \$84,998.01

4. You borrow \$5,600 to buy a car. The terms of the loan call for monthly payments for four years at a 5.9% rate of interest. What is the amount of each payment?

a. \$103.22
b. \$103.73
c. \$130.62
d. \$131.26
e. \$133.04

5. You are considering a job offer. The job offers an annual salary of \$52,000, \$55,000, and \$60,000 a year for the next three years, respectively. The offer also includes a starting bonus of \$2,000 payable immediately. What is this offer worth to you today at a discount rate of 6%?

a. \$148,283.56
b. \$148,383.56
c. \$150,283.56
d. \$150,383.56
e. \$152,983.56

6. You own a bond that has a 7% coupon and matures in 12 years. You purchased this bond at par value when it was originally issued. If the current market rate for this type and quality of bond is 7.5%, then you would expect:

a. the bond issuer to increase the amount of each interest payment on these bonds.
b. the yield to maturity to remain constant due to the fixed coupon rate.
c. to realize a capital loss if you sold the bond at the market price today.
d. today's market price to exceed the face value of the bond.
e. the current yield today to be less than 7%.

7. Which of the following amounts is closest to the value of a bond that pays \$55 semiannually and has an effective semiannual interest rate of 5%? The face value is \$1,000 and the bond matures in 3 years. There are exactly six months before the first interest payment.

a. \$ 888
b. \$1,000
c. \$1,014
d. \$1,025
e. \$1,055

8. The Merriweather Co. just announced that it will pay a dividend next year of \$1.60 and is establishing a policy whereby the dividend will increase by 3.5% annually thereafter. How much will one share be worth five years from now if the required rate of return is 12%?

a. \$21.60
b. \$22.36
c. \$23.14
d. \$23.95
e. \$24.79

9. Changes in the net working capital:

a. can affect the cash flows of a project every year of the project's life.
b. only affect the initial cash flows of a project.
c. are included in project analysis only if they represent cash outflows.
d. are generally excluded from project analysis due to their irrelevance to the total project.
e. affect the initial and the final cash flows of a project but not the cash flows of the middle years.

10. A project will produce operating cash flows of \$45,000 a year for four years. During the life of the project, inventory will be lowered by \$30,000 and accounts receivable will increase by \$15,000. Accounts payable will decrease by \$10,000. The project requires the purchase of equipment at an initial cost of \$120,000. The equipment will be depreciated straight-line to a zero book value over the life of the project. The equipment will be salvaged at the end of the project creating a \$25,000 after-tax cash flow. At the end of the project, net working capital will return to its normal level. What is the net present value of this project given a required return of 14%?

a. \$3,483.48
b. \$16,117.05
c. \$27,958.66
d. \$32,037.86
e. \$49,876.00

11. A firm is reviewing a project with labor cost of \$8.90 per unit, raw materials cost of
\$21.63 a unit, and fixed costs of \$8,000 a month. Sales are projected at 10,000 units
over the three-month life of the project. What are the total variable costs of the project?

a. \$216,300
b. \$297,300
c. \$305,300
d. \$313,300
e. \$329,300

12. A proposed project has fixed costs of \$3,600, depreciation expense of \$1,500, and a sales quantity of 1,300 units. What is the contribution margin if the projected level of sales is the accounting break-even point?

a. \$3.92
b. \$4.14
c. \$4.50
d. \$4.80
e. \$5.00

13. The Zolo Co. just declared that it is increasing its annual dividend from \$1.00 per share to \$1.25 per share. If the stock price remains constant, then:

a. the capital gains yield will decrease.
b. the capital gains yield will increase.
c. the dividend yield will increase.
d. the dividend yield will also remain constant.
e. neither the capital gains yield nor the dividend yield will change.

14. One year ago, you purchased a stock at a price of \$32.50. The stock pays quarterly dividends of \$.40 per share. Today, the stock is worth \$34.60 per share. What is the total amount of your dividend income to date from this investment?

a. \$0.40
b. \$1.60
c. \$2.10
d. \$2.50
e. \$3.70

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