Disclaimer: This study guide contains problems that you may use to practice for the midterm exam #1. This is not an exhaustive list by any means. Additional problems will also be included in the exam, as well as modifications to the problems’

structure/content/question may be introduced. In addition, the midterm exam #1 will include many conceptual questions, that are not listed in this guide. To prepare for them,   students need to read respective textbook chapters and review lecture slides and notes. In addition, I highly recommend students to review problems covered in class and in homework assignments. Cengage Adaptive Test Preparation is available for each Chapter in MindTap and is highly recommended for practice.

1.   Chapter #1

a.   Organizational forms of business, their main characteristics, advantages and disadvantages.

b.   Available forms of funding

c.    Intra-company conflicts:

i.   Stockholders – managers conflict

ii.   Stockholders – bondholders conflict

d.   Main definitions from the chapter

2.   Chapter #2

a.   Capital allocation process

i.   Classes of securities

ii.   Market participants

iii.   Types of capital transfer

iv.   Types of financial markets

v.   Financial institutions and intermediaries

vi.   IPO process

vii.   Stock markets and their transactions

b.   Know and understand main definitions from the chapter

c.    Be able to apply principals discussed in a chapter to a real world questions

3.   Chapter #3

a.   Main financial statements: their construction and structure, information they contain

b.   Calculations related to main financial statements covered in class and the textbook

4.   Chapter #4

a.   Ratio analysis: main types of financial ratios and their interpretation

b.   ROE decomposition (Dupont  equation)

c.

Practice problems

Chapter #3

Problem #1

Brown Office Supplies recently reported $155,500 of sales, $89,250 of operating costs other than depreciation, and $10,750 of depreciation. It had $150,000 of bonds outstanding that carry a 5.0% interest rate, and its federal-plus-state income tax rate was 26%. How much was the firm's earnings before taxes (EBT)?

Solution:

Simple Income Statement

Sales

-Cost of Goods Sold

=Gross Profit

-Operating Costs

-Depreciation & Amortization

=Operating Profit or Income (EBIT)

-Interest Expenses

=Earnings before taxes (EBT)

-Taxes

=Net Income

EBT=Sales – Cost of Goods Sold – Operating Costs – Depreciation & Amortization – Interest Expenses

It looks like in this problem cost of goods sold is included in operating costs, then EBT = $155,500 - $89,250 - $10,750 - $150,000*5%= $48,000

Answer: $48,000

Problem #2

AB Airlines began operating in 2018. The company’s taxable income (EBT) for its first five years is listed below. Each year the company’s corporate tax rate has been 26%. Assume   that the company has taken full advantage of the Tax Code’s carry-back, carry-forward       provisions and that the current provisions were applicable in 2018. How much did the company pay in taxes in 2021?

Solution:

Every year company will use a portion of it’s loss of $5,000,000 from 2018. In 2021, the  company completely exhausts carry-forward losses and have to pay taxes on $1,000,000 over it’s unused carry-forward losses.

Taxes in 2021 = $1,000,000 * 26% = $260,000

Answer: $260,000

Problem #3

The PROBiz INC reported the following information:

Net Income: $600,000

Tax Rate = 27%

Interest Expense = $150,000

What is the company’s EBT?

What is the company’s operating income (EBIT)?

What is the company’s after-tax operating income (NOPAT)?

Solution:

In this problem we will have to reverse our calculations and start not from Sales, but from Net income and consecutively add all line items to it.

Simple Income Statement

Sales

-Cost of Goods Sold

=Gross Profit

-Operating Expenses

-Depreciation & Amortization

=Operating Profit or Income (EBIT)

-Interest Expenses

=Earnings before taxes (EBT)

-Taxes

=Net Income

Net Income = EBT – Taxes = EBT – EBT * Tax rate = EBT (1- Tax rate)       EBT = Net Income / (1 – Tax rate) = $600,000 / (1 – 0.27) = $821,917.81

EBT = EBIT – Interest Expenses

EBIT = EBT + Interest Expenses = $821,917.81 + $150,000 = $971,917.81 NOPAT=EBIT(1-T) = $971,917.81(1-0.27)=$709,500

Problem #4

AutoMotors recently reported the following information:

Net income = $730,000.

Tax rate = 27%.

Interest expense = $200,000.

Total invested capital employed = $9 million.

After-tax cost of capital = 8%.

What is the company’s EVA?

Solution:

EVA = NOPAT – (Total invested capital * WACC)

NOPAT = EBIT (1-Tax Rate)

As in previous problem:

EBT = Net Income / (1 – Tax rate) = $730,000 / (1 - 0.27) = $1,000,000

EBIT = EBT + Interest Expenses = $1,000,000 + $200,000 = $1,200,000

EVA = $1,200,000*(1 - 0.27) - $9,000,000 * 8% = $876,000 - $720,000 = $156,000

Answer: $156,000

Problem #5

Bauer Software's current balance sheet shows total common equity of $10,550,000. The company has 780,000 shares of stock outstanding, and they sell at a price of $12.50 per share. What is company’s MVA? By how much do the firm's market and book values per share differ? (Round your intermediate and final answer to two decimal places.)

Solution:

MVA = (P0   x  Number of shares) – Book value = ($12.50 * 780,000 ) - $10,550,000= -$800,000

Answer: -$800,000

Problem #6

Lovell Co. purchased preferred stock in another company. The preferred stock’s before-tax yield was 7.50%. The corporate tax rate is 27%. What is the after-tax return on the preferred stock, assuming a 50% dividend exclusion? (Round your final answer to two        decimal places.)

Solution:

BT Yield = 7.50%

50% of 7.50% is excluded from taxation dur to the dividend exclusion rule. Thus, 50% of 7.50% = 3.75% is excluded

Therefore, the company will have to pay taxes only on 7.50%-3.75%=3.75%

After-tax Yield = 3.75% (which are excluded from taxation) + 3.75% * (1- 0.27) = 6.4875%

Answer: AT Yield = 6.4875%

Problem #7

During 2022, Bascom Bakery paid out $55,000 of common dividends. It ended the year   with $110,000 of retained earnings versus the prior year’s retained earnings of $86,600. How much net income did the firm earn during the year?

Solution:

Change in Retained Earnings = $110,000 - $86,600 = $23,400 – this means that in 2022 the Bascom Bakery retained $23,400. Since company paid $55,000 in dividends, then                  Net Income = $23,400 + $55,000 = $78,400

Answer: $78,400

Problem #8

Vasudevan Inc. recently reported operating income of $6.12 million, depreciation of $1.35 million, and had a tax rate of 27%. The firm's expenditures on fixed assets and net               operating working capital totaled $0.95 million. How much was its free cash flow, in           millions?

Solution:

FCF = [NOPAT + Depreciation & amortization] – [Capital expenditures + DNOWC] FCF = $6.12M*(1 - 0.27) + $1.35M – $0.95M = $4.8676M

Answer: $4,867,600

Problem #9

Assume that the corporate tax rate is 27% and the personal tax rate is 25%. The founders of a newly formed business are debating between setting up the firm as a partnership       versus a corporation. The firm will not need to retain any earnings, so all of its after-tax    income will be paid out to its investors, who will have to pay personal taxes on whatever  they receive. What is the difference in the percentage of the firm's pre-tax income that      investors actually receive and can spend under the corporate and partnership forms of     organization ?

Solution:

Let firm’s pre-tax income = X.

If founders organize the firm as a corporation:

1)  They corporation will have to pay income tax of 27% AT corporate income = X minus 27% = 0.73X

2)  When founders receive dividends from a corporation, they will also have to pay personal income tax of 25% on dividends. Thus

AT personal income = 0.73X minus 25% = 0.73X(1-0.25)=0.5475X

This means that founders will receive 54.75% of the pretax corporate income

If founders organize the firm as a partnership, then the partnership does not have to pay   any corporate income tax, so the entire pre-tax income (X) will be transferred to founders. Founders will only have to pay their personal income tax of 25% on X. Thus,

AT personal income = X minus 25% = 0.75X