Question

Hi there, am prepping for a finance exam, but due to a sudden death in the family, I'm really behind. Here are the questions I'm having the hardest time with answering in doing my review. Any help would be sincerely appreciated. Thank you.

1. Using the following data, prepare a three-stage ROE decomposition (DuPont Analysis) for Home Depot.

Return on equity (ROE)    12%

Sales                $5,000

Current ratio            2.29

Dividend payout ratio        25%

Dividends paid            $100

Total liabilities            $4,000

Accounts payable        $600

2. Your task is to update your firm’s long-term financial model (that was originally prepared last year).  In financial modeling, a key assumption involves the firm’s dividend policy, as typically specified by the firm’s payout ratio.

You recognize many differences between today and last year.

Last year, the Treasury Yield Curve was upward sloping.  Today, the Treasury Yield Curve is inverted. Last year, the Fed was expected to raise interest rates.  Today, the Fed is expected to lower interest rates. We also know the following:

Today             Last year

Forward P/E             16                20

Equity Multiplier        2.50                      1.95

Based on the differences described above, would you expect the payout ratio in this year’s financial model to be higher or lower than it was last year?  Briefly explain.

3. Glencore will need to have $3,000 on June 20, 2023 (four years from now) to purchase new equipment.  To accumulate this money, it will make four equal investments, with the first of the equal investments beginning one year from now.  

a. If Glencore can earn an annual interest rate of 10%, how much must it invest per year?

b. After presenting your findings from the above calculation, Glencore’s CFO asks you to consider an alternative scenario. Both changes are to occur today and will continue throughout the four years. You are to consider both changes simultaneously.

1. The interest rate will increase today and remain at that higher level.

2. There will still be four equal investments, but the first investment will occur immediately.

Without doing any calculations, how would these changes (considered simultaneously) affect your answer in part a?  Using no more than 50 words, carefully justify your response.

4.  Your job involves financial modeling.  You gather the following information from pro forma financial statements for the upcoming year.

    Sales (all on credit)             $180,000

    Cost of goods sold                     $120,000           

    Accounts payable               $19,000

    Accounts receivable                $27,000

    Total assets                    $72,000

    Inventory                    $16,000

    Dividends                        $1,000

After building in many other assumptions, your preliminary analysis indicates that the external financing needed (EFN) for the coming year will be $7,000.

a. Calculate the average days payable (ADP) that was assumed when deriving the above results from the preliminary model.

b. You now want to make adjustments in your pro forma financial policies so that you will eliminate the need for external financing (that is, you want to have an EFN of $0). You remember from our discussions that changing the timing of payments to suppliers will affect the need for external financing.  Calculate what the average days payable period (ADP) must be so that the firm will have an EFN of $0.

5.  You are working as assistant to the CFO at Pepsico.  An investment banker is advising Pepsico to acquire Dr. Pepper Snapple Group (DPS).  To acquire DPS, the banker is recommending that Pepsi pay $1.5 billion above the current market value of DPS.  Pepsi will make the payment today. The banker notes that this higher price is justified based on the synergies from the acquisition.

a. Briefly explain what is meant by the “synergies from the acquisition”.  Provide an example of a synergy that may result from this specific transaction.

b. The banker later returns with a spreadsheet that estimates that the synergies will not begin immediately.  However, synergies of $125 million are expected at the end of year 3. Following year 3, you expect these synergies to grow at a constant rate throughout the foreseeable future.  If an appropriate interest rate for Pepsi is 10%, what must be the annual rate of growth of the synergies to justify the $1.5 billion premium in price that Pepsi must pay today? Provide brief calculations to support your position.

6a. Financial markets in most developed countries are said to be informationally efficient.  In 50 words or less, explain what is meant by the term “market efficiency”.

b. You notice a recent article in the Wall Street Journal that describes the enormous profits achieved by a person allegedly engaged in insider trading.  One of our colleagues comments, “The ability to achieve high profits from insider trading demonstrates that stock markets are not informationally efficient”.  In 50 words or less, explain why you agree or disagree.

7.  A mining company knows that eight years from now it will be required to pay $4,000,000 per year to restore the site of a major mine.  It is unsure as to how many of these annual payments will be required, but it knows that these payments are likely to be required for many years.  The first of the annual payments will occur at the end of year eight. To meet these obligations, the company invests $10,224,000 today. Assuming an annual interest rate of 12% for all years, for how many years will the firm be able to make the annual payments of $4,000,000?

8. You are interviewing for a job with a major airline.  The job description mentions that the position will involve a) doing short-term financial modeling and b) managing relationships with the firm’s banks and other lenders.  

To assess your understanding of corporate finance, the interviewer asks you, “How can short-term financial modeling be used as part of the process of managing relationships with banks and other lenders?”.  Using less than 50 words, provide a response to the interviewer’s question.

Answer 1

1. Dupont Analysis = Net Profit Margin×Asset Turnover× Equity Multiplier

where Net Profit Margin = Net Income/ Revenue

Asset Turnover = Sales/ Total Assets

Equity Multiplier= Total Assets/ Shareholders Equity

Working Note 1

Net Income= Dividend / Dividend Payout Ratio

= $100/25%

= $ 400

Therefore, Net Profit Margin = 400/5000 = 8%

Working Note 2

Asset Turnover = Sales/ Total Assets

= 5000/4000

= 1.25

Working Note 3

Equity Multiplier =  Total Assets/ Shareholders Equity   

= 5000 / (400/12%) ..............(Net Income / Return on Equity) = Shareholders Equity

= 1.5

Dupont Analysis = 1.5 * 1.25* 8%

= 15%

2. The Payout Ratio is a key financial metric used to determine the sustainability of a company’s dividend payments.  A lower payout ratio indicates that the company is using more of its earnings to reinvest in the company in order to grow further. A high payout ratio may mean that the company is sharing more of its earnings with its shareholders.