9.10: Chapters Eight and Nine- Review Questions

1. 1Define each of the following terms: Incrementalism, Sunk Costs, and Cannibalization.
2. 2In words, explain what is meant by Free Cash Flow.
3. 3Why is FCF important? Give two reasons. How do we use this model – for individual projects, for the entire corporation, or both? Explain.
4. 4What options does the company have regarding how it may choose to utilize its Free Cash Flow?
5. 5Create a Free Cash Flow template and spread the forecasted numbers based on the following assumptions: Last year’s sales were $15.5 million and are expected to grow for the next two years at 15% per year, followed by three years of 8% growth.
6. 6Cost of Goods Sold last year were $12.6 million and are expected to grow at a 7% rate per year indefinitely.
7. 7Depreciation is $550,000 per year at a straight-line rate; in the fifth year, the building will have been fully depreciated. This company has no depreciable equipment.
8. 8There is no amortization.
9. 9Selling and General Administrative expenses last year were $200,000 and will grow modestly at an annual 2% rate.
10. 10This company is in the 30% tax bracket, including Federal and State. There are no local taxes.
11. 11The company expects to spend $2 million each year on “ CapEx , ” all of which will be necessary.
12. 12Last year’s Current Assets, excluding Cash, were $2.5 million, and is expected to grow at a 5% rate per year indefinitely.
13. 13Last year’s Current Liabilities were $2 million and are expected to grow at a 3% rate for at least five years.
14. 14How does the analyst handle depreciation in the FCF Model? Why does s/he handle it that way? Note that depreciation occurs twice in the formula.
15. 15Can you list all four capital items , which are included in the Balance Sheet?
16. 16Why don’t we include capital costs in the FCF Model?
17. 17An increase in Current Assets provides for/uses funds. Which is it? Why?
18. 18On what basis do we distinguish between “internal” and “external” funds?
19. 19List some internal and external funds.
20. 20Calculate the External Funds Needed formula for the LCM Company (below), based on the following assumptions. Last year’s sales were $5,000 million.
21. 21Next year’s objective is to increase sales by 30%.
22. 22Variable costs will be 70% of sales . (Variable costs change with sales volume.)
23. 23Fixed Costs are expected to run 30% of P, P, & E (Fixed costs do not change and are unrelated to sales volume.)
24. 24Interest Expense is 5% of Notes Payable and 7% of Long-term debt.

What is the company’s EFN if it is to meet its growth objective?

1. 1What do this year’s three Solvency ratios look like?
2. 2Why w ill the company’s financial ratios change next year ?

• You are ill-advised to do this by XL . Do it by hand. Place it in a Word table.
• One needs to figure EBIT by adding in the Income Statement data to the template in the chapter.
• “Last Year’s” numbers are not illustrated in this Spread Sheet .
• “Year 1’s” numbers follow “Last Year’s.” For example, Last Year’s Sales were $15.5 Million. “This Year’s” sales increased by 15%. Therefore: (15.5) (1. 15 ) = $17.825.
• Be careful about the Current Assets and Current Liabilities numbers. We first calculate increases or decreases, not the gross numbers. Which data add to FCF ?

• D/E = (900 + 475) / 1,415 = 0.97
• D / TA = (900 + 475) / (900 + 475 + 1,415) = 0.4828
• TIE = EBIT / I = 1.050 / 0.068 = 15.44x

• EFN = [(A 0 /S 0 ) Δ S ] – [ (AP 0 /S 0 ) Δ S ] – [ (M 0 ) (S 1 ) ( RR 0 )]
• We will assume “Static Analysis.”