You and two of your friends have decided to start up a new company that manufact
ID: 2751594 • Letter: Y
Question
You and two of your friends have decided to start up a new company that manufactures a “green” chemical (the product) starting with cellulose feedstock. You think you have a novel production route.
1) The three of you are in a conversation deciding how to finance your company. Which of your friends suggestions below make sense as a reasonable way to finance the company (there is more than one answer)
(A) Take out a loan by issuing bonds
(B) Each of you put in cash in exchange for equity
(C) Do a little bit of both of (A) and (B)
(D) None of (A)-(C) apply
2) Your product sells at a price that is very close to that of crude oil. If you wanted to hedge the price of your product what would you do?
(A) Go long crude oil futures
(B) Go short crude oil futures
(C) Go both long and short crude oil futures
(D) Take on more debt
3) You think you should sell your product to a company that makes fibers for clothing that is very close to your plant. Your friends think you should instead sell your product to pharmaceutical companies overseas. The debate you are having is about :
(A) How to finance the company
(B) What the breakeven value is of the company should it be sold
(C) What the strategy of the company should be
(D) The best way to optimize working capital
4) You and your friends have a second debate over whether you should be a “high technology” company or a more simple manufacturing company that focusses on product quality. Your friend says “high technology” companies ALWAYS have higher returns (ROIC) on invested capital because they are, afterall, high technology ! Does what you’ve learned in this class support this point?
Yes No
5) Your friends are concerned that there will be many other companies that enter the business and also make the same product and that the customers will use this fact to pressure you to reduce your selling price. Which statement below best describes this concern?
(A) He/she is concerned about the power of customers as in a Porter’s Five Forces analysis
(B) He/she is concerned about the threat of substitutes as in a Porter’s Five Forces analysis
(C) He/she is concerned about the cost of feedstock
(D) He/she is concerned about accounts payable
6) The profitability your industry can be expected to be higher if the industry evolves to a situation where the following are true (identify all that apply) :
(A) The power of suppliers is high
(B) The power of customers is low
(C) There are high barriers to entry
(D) There are no substitutes that are a threat
7) To get going with your business very quickly, you plan to buy an existing business. You expect the business you are buying to have an after tax cash flow $8 million per year for the next 5 years. Your WACC is 10% returns. What is the maximum amount you should you pay for this acquisition ?
8) Your friend tells you that she thinks the after tax cash flow in year 5 will only be $1 million in year 5 and not and not $8 million as originally projected in Problem 7. Given this new information, how much are you now willing to pay for the company ?
9) As indicated earlier, your company makes a chemical that has a price that is close to that of crude oil and the feedstock is cellulose. When you think about making this chemical from cellulose, what concept in the class describes this starting and ending point ?
(A)The value chain
(B) Accounts payable
(C) Accounts receivable
(D) ROIC
(E) ROE
10) The balance sheet of the company in year three is (in millions of $):
Cash 85 Short term debt 135
A/R 350 A/P 230
Inventories 300 Long term debt 175
Net Fixed Assets 565 Owner’s equity 760
total 1300 1300
The income statement is (in millions of $):
Sales 1600
Cost of goods sold -1240
Sales and general administration expense -200
Depreciation -55
Earnings before interest and taxes (EBIT) 105
Net interest expense -45
Earnings before tax (EBT) 60
Income tax expense -20
Earnings after tax (EAT) 40
Dividends 10
Retained earnings 30
Restructure the balance sheet into a managerial balance sheet.
(A) What is the working capital ?
(B) Looking at the managerial balance sheet you’ve constructed, what is the capital employed (which is equal to the invested capital) ?
(C) Looking at the combined debt (short and long term), what average interest rate is the firm paying on debt?
(D) Calculate the firms ROIC before taxes
(E) What is the firm’s ROE ?
(F) What is the firms operating profit margin ?
(G) What is the self-sustainable growth rate ?
11) Five years after you start up, you want to grow even more. From the list below, circle all those ways the firm can raise additional cash to finance the growth:
(A) Refinance its debt to reduce the interest rate
(B) Reduce the inventory the company carries without impacting operations
(C) Increase revenues by introducing a new product into the market
(D) Increase the companies operating costs
(E) Increase the companies tax rate
12) What are some advantages of financing by debt versus using equity ?
(A) There are none…you should always use equity
(B) The interest rate on the debt may be lower than your expected returns on investment meaning you can “lever” your investments and get an even bigger return
(C) By not issuing equity you don’t further dilute the ownership of the exiting equity owners
(D) Accounts payable are lower
13) What are some advantages of financing by equity versus using debt ?
(A) There are none…you should always use debt
(B) You don’t have to pay interest on equity that is issued
(C) Accounts payable are higher
(D)Working capital goes up
Explanation / Answer
6. (A) The power of suppliers is high
(B) The power of customers is low
(C) There are high barriers to entry
(D) There are no substitutes that are a threat
7. After tax cash flow =8m per year
WACC =10 %
Here ,we will make use of the concept of present value to arrive at the maximum amount of initial investment.
Present value of cash inflows =8000000/(1+.10)+ 800000/(1+.10)^2+8000000/(1+.10)^3+8000000/(1+.10)^4+8000000/(1+.10)^5
Present value of cash inflows = 30,326294 $
Maximum initial investment company should make is 30326294 if a return of 10% is required.
8.Here ,the present value calculation will need to be adjusted according for 5th year .Present value of cash inflows =8000000/(1+.10)+ 800000/(1+.10)^2+8000000/(1+.10)^3+8000000/(1+.10)^4+1000000/(1+.10)^5
=25979845
9.Value chain
10. a.Working capital =Current Assets-Current liabilities
Current Assets =Cash +AR+ Inventories=85+350+300=735
Current Liabilities =135+230=365
Working capital =735-365=370$
b. Capital Employed =Debt +Equity =175+760=935$
c. Average interest expense =Interest/Short term + Long term Debt=45/135+175=14 %
d. ROIC before taxes =Return on invested capital before taxes
ROIC = Earnings before interest and tax /Capital employed
ROIC=105/935=11.22 %
e.ROE=Return on equity
ROE=EBIT/Equity =105/175=60%
f. Operating profit margin =Operating profit/Sales *100=105/1600*100=6.5625%
g. Self-sustainable growth rate =ROE x (1 - dividend-payout ratio)
ROE=.60
Dividend payout ratio=Dividend/EAT=10/40=.25
Self-Sustainable growth rate =.60 * .75=45%
11. (A) Refinance its debt to reduce the interest rate
12. (B) The interest rate on the debt may be lower than your expected returns on investment meaning you can “lever” your investments and get an even bigger return
(C) By not issuing equity you don’t further dilute the ownership of the exiting equity owners
13. (B) You don’t have to pay interest on equity that is issued
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