FN1 Exam Review
Module 1:
1-1. Which one of the following expenses is not tax-deductible for a corporation?
1)
2)
3)
4)
Interest payments
Call premiums on the early retirement of bond issues
Expenses of selling securities
Rent or lease payments
1-2. Which of the following statements best describes a retraction feature in a bond
indenture?
1)
2)
3)
4)
It protects the investor from interest rate risk.
It protects the issuer from interest rate risk.
It can protect either the investor or the issuer, depending on the interest rates.
It protects both the investor and the issuer regardless of interest rates.
Who can act on a retraction feature? The investor can. S/He will only act on this feature
if it improves his/her position. A retraction feature allows the holder (investor) the option
for the early retirement of a bond, while a call feature allows the borrower (issuer) the
option of buying the bond back at a fixed price, at some date prior to the maturity of the
bond.
Interest rate risk: the downside risk is all we are concerned with here; from the investor’s
point of view, the downside risk would occur if prevailing interest rates rise – this would
decrease the present value of the investment.
From the borrower’s point of view (the borrower issues the bond), the
downside risk would occur if prevailing interest rates decrease. Why? Because if the
bonds were issued today, they would require a lower % interest payment.
1-3. Briefly explain the difference between a retractable bond and an extendible bond.
A. A retractable bond is one where the holder has the option of selling the bond back
to the borrower at face value at some date prior to the bond’s maturity. An extendible
bond gives the holder the option of not returning the bond to the borrower for its face
value at maturity, but rather extending the maturity on the bond by some fixed
amount.
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1-4. Which of the following statements about income taxes is true?
1) For large Canadian corporations, the basic federal plus provincial taxes are
progressive taxes.
2) The different tax treatments of individual investment income is important to
the financial executive in deciding what type of new security to sell
3) If corporate taxable income is negative, the corporation can only carry forward
those losses.
4) With the new lower capital gains inclusion rate, investors prefer capital gains to
dividend income.
For large Cdn corporations, tax rates are not progressive;
2 is true, but let’s look at the other choices
3 is false – the corp can also carry back losses
4 would only be true for those investors in a higher marginal tax bracket.
Remember: Tax on div. Income from CCPC (1.45)(TF – 0.1897) + Provincial tax rate
on dividend income
Tax on CG Income ½ * (1+Tp)*Tf
1-5.. Briefly explain why the different tax treatment of investment income for
individual investors is important to the financial executive in deciding what type of
new security to sell.
Solution:
It is important because, all else being equal, investors would like to minimize the
taxes they pay (an investor looks at the after-tax yield). The different sources of
investment income are taxed at different marginal rates. The interest income from debt
securities is taxed at a higher rate than either capital gains or dividend income.
Furthermore, high-income investors prefer capital gains to dividend income.
1-6. You have been asked to assist an investor who is trying to decide whether to invest
in bonds, preferred shares, or common shares. Briefly explain the relevant differences
between these financial assets from the investor’s perspective.
Solution:
A bond represents a contractual obligation to return a regular, fixed interest payment plus
a lump-sum repayment at the maturity of the bond. The interest income is taxed as
regular income in the hands of the investor.
Preferred shares and common shares are ownership certificates. Cash distributions are
provided to investors in the form of dividends but the firm does not have a contractual
obligation to make dividend payments. Preferred shares have a stated dividend rate
whereas common share dividends are not fixed in amount. Dividends from both
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FN1 Exam Review
preferred shares and common shares will be taxed at a lower rate in the hands of investors
than interest income if they qualify for the dividend tax credit.
1-7. Conflicts of interests can arise among the various contracting parties in a
corporation, including between shareholders and creditors, between managers and
shareholders, and between shareholders and government. Two sources of conflict
between shareholders and government relate to taxes and social responsibility.
i)
ii)
Briefly describe these two sources of conflict between shareholders and
government. In your answer, you should identify which party has the
incentives to take actions that are not in the other party’s best interest.
Briefly describe the mechanisms that can be used to mitigate these conflicts.
Solution:
A i)In order to maximize the present value of the net cash flows to the corporation
(consistent with the stated objective of maximizing shareholders’ wealth), the corporation
has incentives to take steps to both defer and minimize the taxes paid to government.
In a similar fashion, corporations pursuing the objective of maximizing shareholders’
wealth may have incentives to, for example, spend less on pollution abatement equipment
than is deemed socially optimal, or to make selective financial disclosure when selling
new securities.
ii) Mechanisms that the government can employ to mitigate the (illegitimate) deferral or
minimization of taxes paid include “random” tax audits and other reporting requirements
designed to encourage honest tax reporting.
In order to ensure that corporations act in a socially responsible manner,
governments can impose regulations to ensure desirable types of behaviours. For
example, governments can regulate pollution. In addition, through securities
commissions, governments can regulate securities transactions, including imposing
disclosure requirements.
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1-8. (6 marks) Identify and briefly describe the three tasks of the CFO (chief
financial officer).
Solution
The three tasks are the following:
(2) Controller function (asset eficiency)
This task includes running the internal accounting system and managing net working
capital.
(2) Treasury function ( funds acquisition)
This task involves the decision of whether to sell debt or equity, and when to sell.
2) Capital budgeting (capital asset acquisition)
This task involves decisions about the composition of the firm’s capital assets.
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FN1 Exam Review
Module 2:
2-1. Which of the following statements about effective interest rates is true?
1) The yield to maturity on a bond is higher than its effective interest rate.
2) Shorter compounding intervals raise the effective annual interest rate.
3) There is no difference between the effective annual interest rate and the nominal
rate if the nominal rate is compounded semi-annually.
4) Banks prefer to quote the effective yield on loans rather than the nominal yield.
1)The yield to maturity is quoted as a nominal, semi-annual rate, so the effective interest
rate would be higher.
2) True, but let’s look at all the choices
3) False; if nominal rate is compounded semi-annually, effective rate higher.
4) False; banks prefer to quote nominal yield on loans, b/c the stated rate is lower then the
effective rate, if repayments occur more than once per year.
2-2. You have decided to purchase a new car with a list price of $30,000 and are now
trying to decide which of the following two deals is better.
#1 The dealer has offered to take 10% off the list price if you pay cash.
#2 The dealer will finance the purchase, offering to sell the car to you for $1,000 down
and 48 equal monthly payments of $600.
Assuming that you can borrow from the bank at a stated interest rate of 6% compounded
monthly, which deal should you take? Show your calculations.
Solution:
Choice #1: Pay $27,000 now, by borrowing from bank at 6% cm, repay over 48 months.
Choice #2: Pay $1,000 now, borrow balance and repay at $600 / month.
Assume the $1,000 down payment would have to be borrowed from the bank; the
relevant difference is then a loan of $26,000 from the bank. What would the required
payments be for choice #2?
FV = 0
PV = 26,000
I/Y = 0.5
For both options you would be borrowing $1000
from the bank – we need to determine
Incremental differences only.
N = 48
PMT = 610.61
Answer: Choice 2 is the better deal; payments of 600 < payments of 610.61.
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2-3. State whether shortening the compounding interval would increase or decrease the
effective annual interest rate. Support your answer with a simple illustration.
Solution:
Shortening the compounding interval increases the effective interest rate. To illustrate,
an account that pays 10% (stated) interest offers the following effective annual interest
rates for different compounding intervals:
Compounding Interval
Annual
Semi-Annual
Quarterly
Monthly
Effective Interest Rate
10%
(1+0.10/2)2 – 1 =10.25%
(1+0.10/4)4 – 1 = 10.38%
(1+0.10/12)12 – 1 = 10.47%
2-4. In order to set up her medical practice, Jenny borrowed $200,000 from her bank at a
stated interest rate of 12% and agreed to repay the loan in equal monthly instalments over
10 years. Calculate Jenny’s required payments.
Solution:
For these kinds of problems, first determine the relevant time period. Then determine
whether the interest rate is given as the effective annual rate, or the nominal (stated)
interest rate. You must use the appropriate period rate in your calculations.
“Stated interest rate of 12%” = Nominal rate
Payment interval = monthly, therefore nominal rate is 12% compounded monthly.
Effective monthly rate = (0.12/12) = 1%
Effective annual rate = (1.01)12 – 1 = 12.68%
Formula method:
200,000 = PMT * 1 – (1+0.01) -120
0.01
PMT = 2,869.42
Calculator Method:
FV = 0
PV = 200,000
I/Y = 1
N = 120
CPT PMT = -2,869.42
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2-5. An electronics store is currently offering a special deal on the purchase of a
home theatre system. If you make the purchase today, you will not need to make
your first payment for 18 months. You will then have to make 15 monthly payments
of $200 each, with the payments starting 19 months from today. If the effective
annual interest rate is 12.68%, what is the equivalent cash price today for the
system?
1)
2)
3)
4)
$2,295.33
$2,318.28
$2,741.85
$2,773.01
Solution:
Step 1: Determine the monthly effective rate that is economically equivalent to an EAR
of 12.68%; WHY? Payments are monthly, so we need the monthly rate
rmonthly = (1.1268)1/12 – 1 = 0.01
Step 2: Determine the present value of the annuity end (ordinary annuity), discounted
18 periods to determine the equivalent cash price today.
PV = (200 a15 1%) / (1.01)18 = $2,318.28
2-6 Kumfort Car Rentals Inc. issued $10 million in long-term bonds 7 years ago.
The bonds, which had a 10-year maturity at issue, carry an annual coupon rate of
8%, payable semi-annually. They are currently trading in the market for $97.42
per $100 face value bond. What is the bonds’ yield to maturity?
Up-dated to 2007-2008 material.
Solution:
If the bonds were issued 7 years ago, then there are 3 more years until they mature,
and in this remaining time frame, 6 interest payments will be made.
Remember, YTM is to be expressed as a nominal, semi-annual rate.
FV = 100
PV = -97.42
N=6
PMT = 0.08*100* ½ = 4
CPT I/Y = 4.5%
4.5% is the effective semi-annual rate – to determine the YTM, we just multiply
4.5% * 2 = 9%
Answer: The YTM is 9%.
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FN1 Exam Review
2-7: T-Bills. Note that T-Bill rates on past examinations were quoted as effective annual
rates – for this year, the bond equivalent yield (quoted yield) may be given, which is not
equal to the effective annual rate, for T-Bills with a term < 1 year. The compounding
period for the bond equivalent yield corresponds to the term of the T-Bill. You may be
asked to determine the current price, the kBEY (bond equivalent yield) or the effective
annual interest rate. Also note that bond prices are quoted on a basis of $100 face value.
For these questions, use the equations provided on page 240 of your text,
Example 2.5-6 from your module notes:
Find the bond equivalent yield and effective rate of return on a 91-day T-Bill selling for
$98.
kBEY = F – P * 365
P
n
= 100 – 98 * 365
98
91
= 8.1857%
This rate represents a nominal annual rate, compounded 365/91 times per year.
Effective annual rate: r = [1 + .081857] 365/91 – 1 = 8.4406%.
365/91
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FN1 Exam Review
Module 3:
3-1. Which of the following terms refers to the relationship between bond rating and
yield to maturity for bonds with similar maturities?
1)
2)
3)
4)
Expectations theory
Liquidity preference theory
Term structure
Risk structure
Bond ratings: Yield will increase with increasing maturity and increasing risk
Expectations theory; investors can expect the same return in the long run, regardless of
whether multiple short term investments are made, or one long term investment.
Liquidity preference theory; on ave., long term interest rates are greater than short-term
interest rates. Investors perceive less risk in short-term securities.
Term structure: the relationship between interest rates and maturities
Risk structure: the relationship between interest rates and risk
3-2. Suppose that interest rates are currently 5% in New Zealand and 2% in Canada, and
are expected to remain constant over the next couple of years. If the current spot
exchange rate is C$1 = NZ$1.25, what is the 6-month forward exchange rate?
1)
2)
3)
4)
C$1 = NZ$1.2143
C$1 = NZ$1.2320
C$1 = NZ$1.2682
C$1 = NZ$1.2868
Time frame = 6 months – as interest rates are given as effective annual rates, you must
express n in terms of years; n = 0.5.
If you use this formula: Fab
Sab
= (1 + ra) n
(1 + rb) n
Then, C$1 = base rate rb
Fab = (1.05) 0.5* 1.25 = 1.2682
(1.02) 0.5
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3-3. Interest rates are currently 3% in Germany and 5% in Canada, and are expected to
remain constant over the next couple of years. If the 2-year forward exchange rate is $C1
= DM0.80, what should the current spot exchange rate be?
1)
2)
3)
4)
C$1 = DM0.770
C$1 = DM0.785
C$1 = DM0.816
C$1 = DM0.831
C$1 = base rate rb
Time frame: 2 years – set n=2
Fab = (1+ra)n
Sab (1+rb)n
0.80 = (1+.03) 2
Sab
(1+.05) 2
Sab = (1.05)2
0.80 (1.03)2
Sab = (1.05)2*0.80
(1.03)2
Sab = 0.8314
3-4. Briefly explain what a bond sinking fund is and describe the procedure it involves.
Solution:
A bond sinking fund is a lender-mandated, periodic loan principal repayment during the
life of the bond. If there is only one lender, such as a bank, the sinking fund payment can
be made directly to the lender. If there are many lenders, as in a bond issue, then either
the borrower could use the sinking fund payments to buy back bonds in the market and
retire them or the borrower could set the sinking fund payments aside in a separate trust
account monitored by a trustee to be used to repay the principal of the loan at maturity.
3-5. Uncertainty about future inflation may make potential lenders and potential
borrowers reluctant to enter agreements. Explain why this is the case and under what
conditions this reluctance is more likely to be observed.
Solution:
Inflation may turn out to be higher or lower than anticipated. If actual inflation exceeds
expected inflation, the borrower “wins” because the lender is paid back in dollars that are
worth less than the lender expected. Conversely, if actual inflation is less than expected
inflation, the lender “wins” because the lender is paid back in dollars that are more
valuable than the lender anticipated. As a consequence, uncertainty about future inflation
may make both potential lenders and potential borrowers reluctant to enter loan
agreements.
The reluctance is more likely to be observed with long-term debt because inflation is
harder to predict over more distant time spans. In addition, the present value of a security
is more sensitive to changes in interest rates as the term increases. Consider a $1,000, 2
year bond, and a 5 year $1,000 bond, both with 10% annual coupon rate, purchased when
prevailing market rates = 10%. Assume market rates increase to 11%, end of year 1.
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FN1 Exam Review
FV = 1000
I/Y = 11
PMT = 100
N = 1 PV = 990.99
N=4
PV = 968.98
3-6.(5 marks) Typically, the required rate of return on a firm’s bonds is higher than the
required rate of return on its preferred shares even though bonds are less risky.
(2)i) Briefly explain why bonds are less risky.
(3)ii) Given the fact that bonds are less risky, explain why they have a higher
required rate of return.
Solution:
(2) i) Bonds are less risky because they have priority of payment over preferred shares.
That is, interest payments represent a contractual obligation of the fi rm that must be paid
before anything is paid to the preferred shareholders.
(3) ii) The required rate of return is higher on bonds because bond interest income will be
taxed at a higher rate in the hands of investors than will the dividend income from
preferred shares
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Module 4:
4-1. Which of the following statements about an efficient portfolio is true?
1) An efficient portfolio is a portfolio that provides the highest level of risk for a
given rate of return
2) An efficient portfolio is a portfolio that provides the lowest rate of return for a
given level of risk.
3) An efficient portfolio is a portfolio that provides the lowest rate of return and the
lowest level of risk.
4) An efficient portfolio is a portfolio that provides the highest rate of return for
a given level of risk.
Remember: Investors want to maximize return, but are risk adverse. Each individual
will have a different tolerance to risk however. The best any investor can do, for any
given level of risk, is maximize his/her return; and for any given return, minimize his/her
risk.
4-2.. Rocky Inc. common shares paid a dividend of $2.20 per share last year, an amount
that investment analysts believe will grow at an average rate of 8% for the foreseeable
future. The current price of one common share is $42, and analysts have forecasted a
share price of $44 in one year’s time. What is the required rate of return on Rocky’s
common shares?
1)
2)
3)
4)
4.76%
10.00%
10.42%
18.80%
If you are given the price in one year’s time, USE IT.. Why are we given the growth rate
for dividends? Because the current price of $42 is based on future dividends and capital
gain income, so we must determine the future dividend. Past dividend payments do not
influence current share price.
k = 2.20*1.08 + 44-42 = 10.42%
42
42
4-3. JJ Ltd., an electronics manufacturer, currently has 70 million common shares
outstanding. The beta on the shares is 1.20 and JJ paid a dividend of $0.60 per share last
year. Investment analysts have informed you that the dividends should grow by 3%
annually for the foreseeable future and that the shares are expected to be trading at a price
of $10.50 per share in one year’s time. The risk-free rate of return is 4% and the
expected return on the market is 10%. What should the current market price of a share of
JJ be? Show your calculations.
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FN1 Exam Review
Soln: The current market price will be that price where ER = k
k = 0.04 + 1.2*(0.10-0.04) = 11.2%
k = ER = D1 + P1 – P0
P0
0.112 = 0.60*1.03 + 10.50
P0
P0 = 9.9982
= D1 + P1 - 1
P0
- 1
The current market price of JJ’s shares should be $10.00
4-4. The common shares of Coolum Inc. paid a dividend of $0.80 per share last year.
Investment analysts have suggested that Coolum’s historical average growth in dividends
of 4% per year should continue for the foreseeable future, and that the shares are
expected to have a market price of $23.25 in 1 year. The analysts have also informed you
that the beta on Coolum’s common stock is 0.7, the risk-free rate of return is 3 ½%, and
the market price of risk is 6%. Based on the required rate of return, should the common
shares of Coolum be purchased? Show your calculations.
Determine the required rate of return using the CAPM:
k = 0.035 + 0.70(0.06) = 0.077
Determine the current price:
Given: P1 = 23.25 k = 0.077
g = 0.04 D0 = 0.80
P0 = D1/[k-g]
= 0.80(1.04)/[0.077 – 0.04]
= $22.29
If the share is currently priced at $22.29, the next dividend is expected to be $0.832, and
the price in 1 year is expected to be $23.25, will you earn your required return of 7.7% on
this investment?
The expected return (based on expected cash flows) is:
ER = dividend yield + capital gain yield
= 0.832/22.29 + [23.25 – 22.29]/22.29 = 0.0708 = 7.08%
As the expected return is less than the required return, you should not purchase these
shares.
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4-5. The valuation of common shares can be thought of as a 3-step process. Indicate the
three steps.
Solution:
The three steps are:
• Assess the risk of the security
• Determine the rate of return required to compensate for this risk
• The current price of the security will be determined to ensure that the expected rate of
return equals the required rate of return.
Remember that the expected rate of return is determined by analyzing the company’s
ability to pay future dividends (amount and timing of expected cash flows).
The required rate of return is determined by analyzing the investment returns, for this
level of risk, available in the investment marketplace today (opportunity return).
4-6. When will combining two assets in a portfolio create diversification benefits?
Under what conditions will there be no benefits?
Solution:
In general, holding a portfolio of shares reduces the risk of the portfolio because the
shares’ returns do not all move together in the same direction. Some shares will perform
poorly, but other shares will do well; the effect of these outcomes will tend to “cancel
each other out,” reducing the variability of the portfolio return. There will be no benefits
if the returns to the two shares are perfectly correlated.
4-7: Define “efficient capital market” and briefly explain why it is important for
capital markets to be efficient.
Solution:
Efficient capital market” means that the market price of a security reflects all
relevant information about the security. Thus, in an efficient capital market, new
information about a security is rapidly reflected in the market price of the security.
A basic requirement for the smooth functioning of a capital market is that all traders
believe that the price at which they trade is in some sense “fair” or “correct”. If a
market is efficient, it will give investors the confidence to buy long -term securities
because they know that they can sell those securities before maturity, if they wish, at a
fair price.
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4-8. (11 marks)
The common shares of Cypress Ltd. Are currently trading at $5 each and
are expected to pay a dividend of $0.50 per share in the next year. Your
investment analyst has informed you that there is a 60% chance that the
shares will trade at $6 at the end of the year and a 40% chance that they
will trade at $4.50. The common shares of Elm Inc., an alternative
investment opportunity, offer an expected return of 12% with a standard
deviation of return of 11%.
In addition, the investment analyst has informed you that the beta on the
Cypress common shares is 0.75, the beta on the Elm common shares is
1.25, the risk-free rate of return is 3%, and the market price of risk is 6%.
Required
3
a. Determine the expected return and the risk of return on an investment in
Cypress common shares.
4
b. Would an investor who can invest in only the shares of 1 company
prefer the shares of Cypress or the shares of Elm? Explain.
5
c. Would a well-diversified investor prefer to invest in the shares of
Cypress or the shares of Elm? Explain.
Solution:
a.
ER = 0.60 [(6.00 + 0.50 – 5.00) / 5.00] + 0.40 [(4.50 + 0.50 – 5.00) /
5.00] = 0.18
σ2 = 0.60 [(0.30 – 0.18)2] + 0.40 [(0.00 – 0.18)2] = 0.0216
σ = 0.1470
b.
The shares of Cypress offer a higher expected return than those of Elm
(18% versus 12%) but also have higher risk (14.70% versus 11%).
Thus, it is not possible to make the choice only on the basis of expected
return and risk.
c.
For Cypress: k = 0.03 + 0.75 (0.06) = 0.075
ER = 0.18
For Elm: k = 0.03 + 1.25 (0.06) = 0.105
ER = 0.12
Thus, a well-diversified investor would be willing to invest in the
shares of both companies.
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4-9. (3 marks) Briefly explain why a firm’s beta risk should increase when the
firm increases it reliance on debt financing.
Solution:
Beta depends upon that component of a firm’s business risk that is related to the overall
market or economy, and is magnified by operating and financial lever age. As the firm
increases its debt financing, its financial leverage increases and thereby so does its beta.
4-10 (6 marks) Two measures of risk potentially of interest to investors are total risk and
systematic risk.
(2) i) Explain the difference between total risk and systematic risk.
(2) ii) Explain how each can be measured.
(2) iii) Which one is the relevant measure of risk for a well-diversified investor? Explain
why.
Solution:
i) Risk reflects uncertainty about returns derived from investing in a financial asset such
as common shares. As new information becomes available, share prices will change. This
information can be firm -specific, industry -specific, or economy -wide news. Total risk
reflects uncertainty associated with news at all three levels. Conversely, systematic risk or
market risk reflects only economy -wide risk. The impacts of firm -specific and industry specific news tend to be cancelled out within diversified port folios.
ii) Total risk is measured by the variance (or standard deviation) of returns. The beta of
a common stock is the relevant measure of systematic risk for that stock.
iii) The relevant measure for a well -diversified investor is systematic risk. Given
diversification opportunities, the investor can diversify away unsystematic risk but is left
exposed to systematic or market risk.
4-11 (3 marks). Briefly explain why operating leverage and financial leverage serve
to magnify business risk.
Solution:
Business risk is defined as the variability of sales. Sales fluctuate with both economy
wide factors and firm-specific events. These fluctuations in sales translate into
fluctuations in operating profit and ultimately in earnings per share. As operating and
financial leverage increase, a given change in unit sales (business risk) results in
increasingly large fluctuations in earnings per share.
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Module 5:
5-1. (3 marks) Briefly explain why cash flows need to be projected in nominal terms
when market discount rates are used.
Solution:
Market discount rates reflect expected inflation. Thus, the project’s estimated cash flows
must incorporate inflation so that they are comparable
5-2. Trail Holdings, a winemaker located in the Okanagan Valley, is considering opening
a distribution center in Toronto. The proposed site for the center is a block of land that
Trail purchased 2 years ago for $500,000. Building the center is projected to cost
$750,000. In addition, Trail would have to spend $100,000 on new equipment and make
an investment of $250,000 in net working capital. In making its capital budgeting
decision, Trail has decided to use a 5-year planning horizon that coincides with the
estimated life of the new equipment.
Both the building and the equipment will be amortized on a straight-line basis to zero
salvage value, the building over 20 years and the equipment over 5 years. An
independent appraiser has indicated that the value of the land is currently $600,000 and
that it should be worth $800,000 in 5 years. The appraiser also believes that the building
will be worth 70% of its original cost in 5 years.
Trail’s marginal tax rate is 36%, its weighted-average cost of capital is 15%, and the
applicable CCA rates on the new building and the new equipment are 7 ½% and 25%
respectively.
Finally, based upon market analysis, Trail has developed the following proforma income
statements for the center:
Year 1
Revenues
$500,000
COGS
250,000
Amortization
57,500
Income before
Taxes
$192,500
Year 2
Year3`
Year4
Year 5
$550,000
275,000
57,500
$600,000
300,000
57,500
$600,000
300,000
57,500
$650,000
325,000
57,500
$217,500
$242,500
$242,500
$267,500
Required (15 marks)
Based on the net present value (NPV) method, determine if Trail should open the new
distribution center. Show your calculations.
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Solution: Determine all actual, incremental, nominal, after tax cash flows:
We are given 3 values that pertain to the land:
Cost 2 years ago = $500,000
SUNK COST – IGNORE
Current market value = $600,000
If we sell today, we must report a gain of $100,000, and pay capital gains tax on this gain.
Tax we would have to pay = 100,000*.36*1/2 = (18,000)
The opportunity cost for the land = 600,000 – 18,000 = 582,000
Value in 5 years = $800,000
SALVAGE VALUE AT PLANNING
HORIZON END
When the land is sold in 5 years, we will receive more than we paid for it – capital gains
tax applies. The gain = (800,000 – 500,000) = 300,000
The tax we have to pay = 300,000*0.36*1/2 = 54,000
The actual net cash we receive = 800,000 – 54,000 = 746,000
Building: Need to know initial cost, CCA tax savings, and salvage value
Initial cost = $750,000
Amortization = 750,000/20 = 37,500
This is not a cash outlay, nor does it result in tax savings – The CRA determines how
much can be deducted for tax purposes. The applicable rate for the building is 7.5% = d
Salvage value = 0.7 * 750,000 = 525,000
Equipment: Need to know initial cost, CCA tax savings, and salvage value
Initial cost = 100,000
Amortization = 100,000/5 = 20,000
This is not a cash outlay, nor does it result in tax savings – the CRA determines how
much can be deducted. The applicable rate for the equipment is 25% = d
Salvage value = 0
Any working capital requirements?
Yes = $250,000
Recovery value = $250,000
Identify incremental, actual, nominal after tax cash inflows:
Revenues, Cost of goods sold ARE included
Amortization IS NOT INCLUDED.
Revenues
COGS
Net cash
Year1
$500,000
250,000
$250,000
Year2
$550,000
275,000
$275,000
Year3
$600,000
300,000
$300,000
Year4
$600,000
300,000
$300,000
Year5
$650,000
325,000
$325,000
Do these cash inflows represent an annuity payment stream? NO; equal intervals, but
payment amounts are different, so must do PV on each amount separately.
IF INTEREST EXPENSE IS GIVEN. DO NOT INCLUDE!!!
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FN1 Exam Review
Now set up the template:
Rates: T = 36%
d = 7.5% (building)
k = 15%
d = 25% (equipment)
- Initial investment
Land
Building
Equipment
Working Capital
(
(
(
(
+ CCA tax shield
Building
750,000,*.075*.36*(1+.5*.15)
(.15+.075)*(1.15)
Equipment
100,000*.25*.36*(1+.5*.15)
(.15+.25)*(1.15)
582,000)
750,000)
100,000)
250,000)
+ 84,130
+ 21,033
+ Increase in After tax Net Revenues
= (1-.36)* 250,000 + 275,000 + 300,000 + 300,000 + 325,000
(1.15)
(1.15)2
(1.15)3
(1.15)4
(1.15)5
= 0.64*(217,391 + 207,940 + 197,255 + 171,526 + 161,582)
+611,644
+Salvage:
+ Land (Cap Gains Tax?)
= 800,000 – (800,000-500,000)*.36*1/2
(1.15)5
+370,894
+ Building
= 525,000
(1.15)5
+261,018
-Lost tax shield due to sale of assets
Building
= 525,000 * .075*.36
(.15+.075)*(1.15)5
( 31,322)
+ Recover Working Capital
= 250,000
(1.15)5
+124,294
NPV =
(240,309)
Now answer the qn.: Trail should not open this distribution center, as NPV < 0.
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FN1 Exam Review
Module 6:
6-1. Which of the following is the relevant discount for evaluating a risk-free project?
1)
2)
3)
4)
The firm’s weighted average cost of capital
Zero rate
The rate of return on the market portfolio
The risk-free rate of return
Project discount rates must be adjusted for differences in risk. For projects in the same
risk class as current operations, WACC is the appropriate discount rate to use. For
projects riskier than the current operations, a higher discount rate should be used. For
projects with no risk, then the appropriate discount rate would be the risk-free rate of
return. Remember that the price of money over time is never 0 – at the very least, an
investor must be compensated for waiting, even if there is no risk.
6-2. Which of the following is a potential disadvantage of the internal rate of return
(IRR) method?
1)
2)
3)
4)
It favours projects with early cash flows.
It does not consider all cash flows
It ignores the issue of scale
It does not discount all cash flows.
The IRR method does consider all relevant cash flows (nominal, actual, incremental,
after-tax cash flows), and does discount all cash flows, but may produce conflicting
results to the NPV decision rule when considering mutually exclusive projects, as it
ignores the issue of scale.
6-3 The Tasting Orange Juice Company is considering investing in a new juicing
machine that will cost $16,000. The new juicer will generate positive net end -of-year cash
flows of $5,000 per year for the next 4 years. In what range is the internal rate of return
for the juicer?
1) Between 7% and 8%
2) Between 8% and 10%
3) Between 10% and 12%
4) Between 12% and 15%
IRR is where NPV = 0.
We can either use the formulae to determine r, so that the present value of the annuity end
cash flows of 5,000 per year is equal to the initial investment of 16,000, or we can use
our financial calculators as shown below:
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FN1 Exam Review
PV = -16,000
N=4
PMT = 5,000
FV = 0
CPT I/Y = 9.56%
6-4. (6 marks) In addition to the NPV rule, there are several alternative criteria
available for use in making a capital budgeting decision, including the internal rate of
return (IRR) method and the payback period (PBP) method. Briefly describe each of
these t w o alternative methods, indicate how each can be used to make the capital
budgeting decision, and identify the shortcomings of each.
Solution
IRR : The internal rate of return is the discount rate at which a project’s NPV is equal to
zero. The IRR criterion entails acceptance of a project if the IRR is greater than the
project’s risk -adjusted discount rate. The shortcoming of the IRR method is the fact
that it can be misleading in some cases, even though it will typically coincide with the
NPV rule. Specifically, there may be multiple IRRs or crossing NPV profiles.
PBP: The payback period calculates the number of years required for a project to recoup
its initial investment. Earlier payback is preferred. Shortcomings of the PBP method
include the facts that it ignores post -PBP cash flows, it often ignores time value, and
there is no standard against which to judge a project’s PBP.
6-5 (4 marks) One of the important rules for estimating project cash flows in a capital
budgeting analysis is to use corporate -after-tax cash flows. State t w o reasons why this
rule is important.
Solution:
Corporate -after-tax cash flows should be used for at least two reasons:
Shareholder s can benefit only from after -tax cash flows. Dividends or capital gains can
only be paid out of corporate -after-tax cash flows.
Different projects have different tax exposures.
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FN1 Exam Review
Module 7:
7-1. :
1) Explain what a firm’s cost of capital is.
2) State what the weights employed in the weighted average cost of capital are
meant to reflect
Solution:
1) A firm’s cost of capital is the cost of raising additional investment capital, in
terms of required payments to investors. Since it is the required return on a
dollar contributed today, it reflects current market costs and values, and is
developed on an after-corporate-tax basis.
2) The weights are meant to reflect the optimal mix of sources of funds that the
firm can employ, where the optimal mix is the mix that minimizes the WACC.
7-2. When is the firm’s weighted average cost of capital the appropriate discount rate to
use in a capital budgeting analysis? Briefly explain why.
Solution:
WACC is the appropriate rate to use when the project under consideration is in the same
risk class as the firm. In general, the discount rate to be used for a project should reflect
the opportunity cost to the firm of considering the project. By undertaking the project,
the firm is foregoing the rate of return on an equivalent-risk alternative investment. Thus,
once we know the risk of the project, we can estimate what return the firm could earn on
an investment of that risk. The project under question must then offer a rate of return at
least equal to the foregone rate of return.
7-3 (6 marks) Identify and briefly describe the three uses of a firm’s weighted
average cost of capital (WACC).
Solution:
The three uses are:
Investment valuation WACC is the appropriate hurdle rate for new investment
projects that match the firm’s overall risk.
Choice of capital structure WACC can be used to identify the firm’s optimal
financing structure (its mix of debt and equity financing).
Setting prices in regulated industries WACC can be used by regulators to set
prices for regulated industries.
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FN1 Exam Review
7-4 . Identify t w o factors that might cause a company’s cost of debt to differ from its yield
in capital markets, and explain the effect of each factor.
Solution:.
The two factors are flotation costs and taxes. Flotation costs raise the cost of debt
because issuing costs are paid from the gross proceeds. Taxes lower the cost of debt
because interest is a tax -deductible expense.
7-5. Trail Ltd. has 25 million common shares outstanding, which have a current market
price of $23 per share. The shares paid a dividend of $1.10 per share last year, and
investment analysts expect the dividends to grow at an average annual rate of 2% for the
foreseeable future. Flotation costs on new common s hares are expected to be 3% after
tax, Trail’s tax rate is 35%, and Trail intends to finance new projects using retained
earnings. What is the component cost of Trail’s common shares?
1) 6.78%
2) 6.88%
3) 7.03%
4) 7.09%
If the firm can finance new projects using retained earnings, flotation costs are
irrelevant, and the cost of common shares = required return for common shares.
Using the Dividend growth model:
ke = re = D1 + g
P0
= 1.10*(1.02) + 0.02
23
= 6.88%
NOTE: if the company intends to finance new projects with the issue of new shares,
then the flotation costs, after tax are relevant, so you must use NP in formula
NP = P0 *(1-fat) = 23*(1 -.03) = 22.31.
ke
ke
= D1 + g
NP
= 1.10*(1.02) + 0.02 = 7.03%
23(1-.03)
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FN1 Exam Review
7-6. Note: Changes have been made to this past exam question to up-date to
current materials.
You have been asked by KK Corporation, a manufacturer of digital satellite television
systems, to evaluate its capital structure. As a first step, you need to estimate KK’s
current weighted average cost of capital (WACC). You have been provided with the
following information to complete this task.
KK currently has a $12 million face value long-term debt issue outstanding. The bonds
have 8 years remaining until maturity, and carry a 10% coupon, payable semi-annually.
New bonds could be sold at par to provide for a quoted YTM of 14%. KK also has 1
million preferred shares outstanding. These shares have a stated par value of $5, carry a
7% dividend rate, and are currently priced to yield 10%.
Finally, KK has 5 million common shares outstanding. The beta on the common shares
is 1.40. KK paid a dividend of $0.25 per share on its common shares last year and
investment analysis have projected these dividends to grow at an average annual rate of 2
½ % for the foreseeable future.
KK has been advised by its underwriters that flotation costs would be 3% after tax on
new debt and 5% before-tax on new preferred and common shares. KK’s tax rate is 45%.
The risk-free rate of return is 4 ½% and the market price of risk is 7 ½ %.
Required
Calculate KK’s weighted average cost of capital (WACC) under the assumption that KK
would issue new common shares. Show all of your calculations.
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FN1 Exam Review
Solution: We have to determine the investors’ required returns, what this costs the
company (tax and flotation cost considerations), and current market values of all sources
of financing.
Debt:
The YTM on the bonds is given as 14%.
If we issue new 8 year bonds offering a 14%, semi-annual coupon, then these bonds
should sell at par.
Cost of Debt:
FV = -1,000
PMT = 0.14/2*1000*(1-0.45) = -38.5
N = 16
PV = 1,000*(1-0.03) = 970
CPT IY = 4.1095
Careful – what have we just determined? The semi-annual effective rate. We must
remember to convert this rate into the effective annual rate.
Cost of debt = (1.041095)2 – 1 = 8.39%
Market Value of Debt:
FV = 12,000,000
PMT = 0.10*12,000,000*0.5 = 600,000
I/Y = 7.00%
(effective 6 month rate, to coincide with payment interval
N = 16
PV = 9,732,804
Table Method:
Determine effective period rate, for the period between payments = 6 months.
Effective semi-annual rate =
r = 7%
PV = 12,000,000/(1.07)16 + 600,000a,7%,16
= 4,064,815.17 + 600,000*9.4466 = 9,732,775.17
Preferred Shares:
rp = 10%
Flotation costs = 5% before tax = (1-.45) *.05 = 2.75% AFTER tax
kp = __0.10__
(1-.0275)
= 10.28%
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FN1 Exam Review
Market value of preferred shares:
Given: 0.07*5 = Dividend = 0.35
If dividend of 0.35 provides a return of 10% to the investors, then the price must
be: $3.50 (0.10*P = 0.35)
There are 1 million shares outstanding, total market value = $3,500,000
Common Shares:
Cost of Common Shares: Using CAPM:
re = rf + beta*(rm – rf)
We are given the market price of risk, which = (rm – rf)
rm is referred to as the return on the market.
0.045 + 1.4*.075 = 15%
Flotation costs = 5% before tax = (1-.45)*.05 = 2.75% AFTER tax
ke = __0.15__
(1-.0275)
= 15.42%
Market Value of 5 million shares outstanding:
We are given D0 (last year’s dividend) = 0.25
Growth rate = 2 ½%
Using eqn: P0 = __D1__
r–g
= 0.25*1.025 =
(.15-.025)
2.05
There are 5 million common shares outstanding, total market value = $10,250,000
Calculate WACC:
Debt
Preferred Shares
Common Shares
Market Value
9,732,804
3,500,000
10,250,000
23,482,804
Weight
.4145
.1490
.4365
Cost
8.39%
10.28%
15.42%
Wt X Cost
0.03477
0.01532
0.06731
0.11740
KK’s WACC = 11.74%, assuming new shares are issued.
If the question states that new investment will be financed by retained earnings, there are
no flotation costs to consider for common shares, BUT flotation costs would apply for
preferred shares and debt.
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FN1 Exam Review
Note:
If the question states that new bonds will be sold at a specific rate (as in this example),
then use the new coupon rate to calculate the after-tax cost of debt. If not explicitly
stated, then follow Module 7.3-2 to calculate the cost of debt (i.e. use the existing coupon
rate, and existing PV). To illustrate, assume the given information for debt for KK
Corporation was given as follows:
KK currently has a $12 million face value long-term debt issue outstanding. The bonds
have 8 years remaining until maturity, carry a 10% coupon, payable semi-annually, and
have a YTM of 14%.
We would determine the cost of debt as follows:
Step 1: Determine the current market price of these bonds, given a YTM = 14%
FV = 1,000
PMT = 50
N = 16
I/Y = 7
CPT PV = -811.07
Step 2: Determine the cost to the firm, assuming existing debt coupon rate and current
price:
FV = -1,000
PMT = -50*(1-.45) = -27.50
N = 16
PV = 811.07*(1-.03) = 786.74
I/Y = 4.67%
Step 3: Convert this semi-annual rate to the effective annual rate
(1.0467)2 – 1 = 9.56%
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FN1 Exam Review
Module 8:
8-1. Which of the following statements regarding net working capital (NWC) is not true?
1) The size of accounts receivable is largely the result of the level of credit sales, and
the financial executive’s role is largely restricted to influencing the terms of trade
credit.
2) Bank and other short-term loans are largely the result of the firm’s
production schedule, and the financial executive’s role is to ensure that
payments are made on a timely basis.
3) Production and marketing departments largely set inventory levels, and the
financial executive’s role is to ensure that the cost of holding inventory is
properly considered.
4) The primary account on the liability side over which the financial executive
exercises control is the amount of bank and other short-term loans.
8-2. If a supplier offers terms of 3/10, net 30, what is the cost of foregoing the discount?
1)
2)
3)
4)
3.00%
3.09%
44.86%
74.35%
What are your alternatives? Pay $97 on day 10, or pay $100 on day 30.
What this means: if you don’t take the discount, you are borrowing $97 for 20 days at a
cost of $3.
[1/(1-d)]n – 1 =[1/(1-.03)]365/20 - 1 = 74.35%
d = discount rate
n = 365/#days between payment periods
This formula has not been provided on past exams.
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FN1 Exam Review
8-3. Identify the three objectives of cash management, and briefly explain why each is an
important objective.
Solution:
Three objectives:
• To reduce the opportunity cost of holding idle cash
• To ensure that all obligations are paid on time
• To collect money owed as soon as it becomes due
Importance of these objectives:
• Idle cash does not earn interest. At least Temporary Investments earn some return,
but this return still falls short of the total required return (WACC)
• If all obligations are paid on time, good working relationships with suppliers,
employees and government agencies are maintained.
• Delayed collection of money owed represents an opportunity cost – basically
represents an interest free loan to customers. Any shortfalls resulting may force the
company to borrow money to cover shortfalls.
8-4: Ferney Ltd. is faced with a choice between 2 suppliers. Supplier 1 is offering
credit terms of 1/10, net 30, while Supplier 2 is offering terms of 2/10, net 60. Which
supplier should Ferney choose if it can borrow from its bank at 11% annual interest?
1)
2)
3)
4)
Supplier 1
Supplier 2
Either supplier
Neither supplier
Solution:
Determine the cost of the missed discount, using equation:
= [1/(1-d)]n – 1
Where n = 365 / # of days between the two payment dates.
d = percentage discount
Note: This equation has not been provided on past exams.
Supplier 1: [1/(1-.01) 365/20 – 1 = 0.2014 > 0.11
Supplier 2: [1/(1-.02) 365/50 – 1 = 0.1589 > 0.11
Ferney could take the discount and pay within 10 days with either supplier,
however, it should choose Supplier 2 because it offers the bigger discount.
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FN1 Exam Review
8-5. For a company that pays its accounts on their due dates, which of the following,
all else being equal, can be expected to increase the cost of trade credit?
1)
2)
3)
4)
A decrease in the cash discount rate
A shortening of the discount period
A shortening of the credit period
A lowering of interest rates
Cost of trade credit = [1/(1-d)]n – 1
Where n = 365 / # of days between the two payment dates.
d = percentage discount
-If the cash discount rate (d) is decreased, then denominator is higher, so cost is lower
-If discount period is shortened, but net terms are not changed, then # of days between the
two payment dates will increase, and n will decrease. If n decreases, then the cost is
lower. Eg. Change from 1/15 net 30 to 1/10 net 30
-If the credit period is shortened, then the # of days between the two payment dates will
decrease, and n will increase. If n increases, then the cost is higher. Eg. Change from
1/10 net 45 to 1/10 net 30
-If interest rates are lowered, this would affect the alternative cost of borrowing from the
bank, but have no effect on the cost of trade credit.
8-6. Upon completing your firm’s monthly cash budget for the next year, you notice that
the cash balance is forecasted to exceed $200,000 at the end of each of the next 7 months.
If you decide to invest the excess cash balance for a 7-month period, you will incur
transactions costs of $5,000. What minimum rate of interest do you require to make the
investment worthwhile?
1)
2)
3)
4)
2.16%
2.50%
4.32%
5.06%
Rate of interest must generate a 7 month return that exceeds the transaction costs of
$5,000.
Soln: determine the effective annual rate:
200,000 *[ (1 + r)7/12 – 1 ] > 5,000
200,000 * ( 1 + r) 7/12 – 200,000 > 5,000
( 1 + r ) 7/12 > 205,000
200,000
r > (205,000 ) 12/7
200,000
r > 4.32%
–1
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FN1 Exam Review
8-7. Your company’s primary supplier has decided to change its credit terms from 1/10
net 60 to 2/10 net 30. Assuming that you can borrow from a bank at a stated interest rate
of 9½%, which of the following statements is true?
1) Your company should not take the discount under the new terms but likely did
under the old terms.
2) Your company should take the discount under the new terms but likely did
not take it under the old terms.
3) Your company took the discount under both sets of terms.
4) Your company should not take the discount under either set of terms.
Determine effective financing cost from supplier for each credit term:
1/10 net 60; formula: (1/.99) 365/50 - 1 = 7.61%
supplier is lending you $99 at a cost of $1 for 50 days
effective annual rate = (1 + 1/99)365/50 – 1 = 7.61% (Cheaper than bank)
2/10 net 30: formula (2/.98)365/20 - 1 = 44.59%
supplier is lending $98 at a cost of $2 for 20 days
effective annual rate = (1 + 2/98) 365/20 – 1 =44.59% (More expensive than bank)
Correct answer: (2)
8-8: What is the after-tax cost of holding a unit of inventory under the following
conditions: physical storage costs are $6 per unit, a unit stays in inventory for an
average of 2 months, the cost of goods sold for a unit of inventory is $30, the firm’s
weighted average cost of capital (WACC) is 15%, and its tax rate is 40%?
1)
2)
3)
4)
$ 4.31
$ 6.71
$ 8.10
$10.50
Using the equation:
Cost = SC*(1-T) + [(1+r)t – 1]*COGS
SC = 6 T = 40% r = 15% t = 2/12 COGS = 30
Cost = 6*(1-0.4) + [(1+0.15)2/12 – 1]*30 = 4.31
Note:: This equation has not been provided on past exams
31
FN1 Exam Review
Module 9:
9-1: Variability in a firm’s sales level over time typically leads to fluctuations in the
firm’s net working capital (NWC).
(2) i) Briefly explain why variability in sales will lead to fluctuations in net working
capital.
(2) ii) Briefly explain why it is important for the financial executive to be aware of this
relationship between sales and net working capital.
Solution:
(2) i) Variability in sales will lead to fluctuations in net working capital because a firm’s
production pattern will often not coincide with its sales patterns.
(2) ii) The financial executive must be aware of the relationship between sales and net
working capital in order to plan for a source of funds when there is a cash shortfall, and
to plan for investments when there is excess cash.
9-2: Briefly explain how the financial planning process can help management
achieve the objective of maximizing firm value.
Solution:
Anticipating the future, including an analysis of possible future scenarios, helps
achieve the objective of maximizing firm value through managing future
profitability and risk. Ultimately, actions are chosen that lead to what is perceived
to be the “most desirable” set of pro forma financial statements.
9-3: The final element of the financial planning model is the set of choice
variables that includes strategic decisions made by management.
i) Briefly explain why it is important for management to identify the
strategic choices.
ii) Identify three strategic decisions made by management.
Solution:
(2)
i) It is important for management to identify the strategic choices so that
pro forma financial statements can be constructed under different
choices. The strategic choices that lead to the “most attractive” pro
forma financial statements can then be identified and these choices then
become the long-term financial plan for the firm.
(3)
ii) Three strategic decisions are:
1.
New capital expenditures made in each year
32
FN1 Exam Review
2.
3.
Decisions regarding financing and capital structure, including the
amount of debt and equity outstanding each year
The dividend to be paid in each year
9-4: Explain why, when assessing the viability of a financial plan, it can be useful to
translate the plan into a cash flow statement.
Solution:
It can be useful for several reasons. First, the cash flow statement allows for an
evaluation of the relative reliance on internal versus external sources of finance.
Second, because the cash flow statement details the changes in various accounts, it
can provide insights into the changes that have taken place over a period and
thereby can help in assessing trends in the financial health of the organization.
Third, it allows for the assessment of the appropriateness of financing decisions by
matching the term of the debt to the term of the asset.
33
FN1 Exam Review
Module 10:
10-1 (6 marks) . Three categories of ratios typically used in financial analysis are i)
liquidity ratios, ii) profitability and activity ratios, and iii) leverage and
coverage ratios. Briefly explain the type of information provided by the
ratios in each of these three categories.
Solution:
The types of information provided by each category of ratio are as
follows:
1) Liquidity ratios — assess a company’s ability to pay its debts in the
short term
2) Profitability and activity ratios — assess the overall managerial
effectiveness and profitability of a company
3) Leverage and coverage ratios — examine the relationship of
borrowed funds to owner-contributed funds (leverage ratios) and the
ability of the company to service its existing debt (coverage ratios)
10-2: GL Ltd. is a manufacturer of small appliances. Following is a condensed
income statement for the most recently completed fiscal period.
Sales
Cost of goods sold
Gross profit
Interest expense
Amortization
Profit before income taxes
Income tax expense
Net profit
$ 1,500,000
(600,000)
900,000
(125,000)
(275,000)
500,000
(200,000)
$ 300,000
Based on this information, what is GL’s times -interest -earned ratio?
1)
2)
3)
4)
2.4
5.0
6.2
7.2
Times interest earned ratio = EBIT/Interest charges
(900,000 - 275,000) / 125,000=5.0
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FN1 Exam Review
10-3. When undertaking the financial planning process, the financial executive must try to
anticipate future environmental changes, such as (1) changes in the competitive position
of the firm within its industry; (2) changes in the regulatory environment; (3) changes in
the international environment; and (4) changes in domestic financial markets, including
regulation of financial institutions. For each of these four changes, provide an example
and briefly explain how your example could potentially affect the firm’s profit.
Solution :
Competitive position:
Examples include projected increases or decreases in competition over the next few
years, or changes in the form that the competition takes. If competition increases, the firm
can expect either to suffer reduced sales or to be forced to increase its advertising
expenditures in an attempt to retain market share. Reduced sales and/or increased
advertising expenditures will both serve to reduce the firm’s profits.
Regulatory environment:
Examples include environmental, safety, and/or product quality standards, or taxes and
royalties. A strengthening of environmental, safety, and/or product quality standard s
could potentially force the firm to undertake capital projects in order to alter its
production technology to meet the new standards. With the increased amortization
charges, profits would be lower.
International environment:
Examples include changes in international financial markets or international trading
conditions. A tightening of international trade barriers could adversely affect the firm’s
(export) sales and thereby lead to reduced profits.
Domestic financial markets:
Examples include regulator y changes in domestic securities markets that could make it
either easier or more difficult to raise funds. The ability to raise funds will affect the
firm’s ability to undertake investment opportunities and thereby its future profits.
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FN1 Exam Review
10-4: The financial planning process results in a set of pro forma financial statements.
One of the elements required to construct these statements is the input of forecasted
exogenous data.
i) Briefly explain what exogenous data are.
ii) One example of forecasted exogenous data is forecasted sales. Identify th ree
additional examples of forecasted exogenous data.
iii) Briefly explain why the sales fore cast is an important element of any financial
planning process.
Solution:
(2) i) Exogenous (external) data relate to variables that impact on the pro forma
statements but are outside the control of the financial executive.
(3) ii) Additional examples include forecasted interest rates, forecasted exchange rates,
and forecasted collection patterns from customers, including bad debt estimates.
(2) iii) The sales forecast is a critical element of the financial planning process because it
forms the basis of much of the remainder of the pro forma financial statements. For
example, it is only after the sales forecast has been made that a production plan can be
developed, given the desirable inventory policy. The development of the production plan
in turn leads to a projection of cash outflows and inflows (under an assumed credit
policy) and to an estimate of the required investment in net working capital.
10-5 (6 marks). The first step in creating any strategic plan is to describe the
current situation. Briefly explain why this step is important. Identify the
four types of information that need to be gathered during this step.
Solution:
Describing the current situation is important because managers with a
good understanding of the current situation have an edge when planning
future actions. By understanding current performance, managers can
relate it to various internal and external factors that help them to identify
the company’s strengths and weaknesses.
Four types of information that need to be gathered:




Current financial conditions
Current products and services
The customer base and market
Human resources available
GOOD LUCK ON YOUR EXAM!!!!
Ruth
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