Question

24.

The sustainable growth rate of a firm is best described as the

		minimum growth rate achievable, assuming a 100 percent retention ratio.
		minimum growth rate achievable if the firm maintains a constant equity multiplier.
		maximum growth rate achievable, excluding external financing of any kind.
		maximum growth rate achievable, excluding any external equity financing while maintaining a constant debt-equity ratio.
		maximum growth rate achievable with unlimited debt financing.
		None of the options are correct.

25.

Which of the following statements are correct?

I. Going-concern value of a firm is equal to the present value of expected future cash flows to owners and creditors.
II. When an acquiring firm purchases a target firm’s equity, the acquirer need not assume the target’s liabilities.
III. The market value of a public company reflects the worth of the business to minority investors.
IV. The fair market value of a business is usually the lower of its liquidation value and its going-concern value.

		I and III only
		II and IV only
		II and III only
		I, II, and III only
		II, III, and IV only
		None of the options are correct.

26.

The following information is available about Chiantivino Corp. (CC):

Stock price per share	$	8.00
Common shares outstanding (millions)		10
Market value of interest-bearing debt (millions)	$	75
Weighted-average cost of capital		14%

An activist investor is confident that by terminating CC’s money-losing fortified wine division, she can increase free cash flow by $4 million annually for the next decade. In addition, she estimates that an immediate, special dividend of $10 million can be financed by the sale of the division.

		Assuming these actions do not affect CC’s cost of capital, what is the maximum price per share the investor would be justified in bidding for control of CC? What percentage premium does this represent?
		Show your answer if you conduct a sensitivity analysis by assuming the cost of capital is 15 percent and the increased cash flow is only $3.5 million per year. a. The maximum justifiable premium = the fair market value of CC under new management − the fair market value of CC under existing management. A plausible estimate of CC’s fair market value under existing management is its standalone value = current market value of firm = $8 × 10 million + 75 million = $155 million. Fair market value under new management = $155 million + present value of enhancements = $155 million + present value of a $4 million annuity for 10 years at 14% + $10 million from sale of the division. Input: 10 14 ? 4 0 n i PV PMT FV Output: −20.86 In Excel: =PV(0.14,10,4) =−20.86 Fair market value = 155 million + 20.86 million + 10 million = $185.86 million. Fair market value of equity = $185.86 −75 = $110.86 million. Fair market of equity per share = $110.86/10 = $11.09. This is a 38.6% premium over the existing $8 share price. b. The fair market value of the firm assuming a 15 percent discount rate and a $3.5 million annuity = 155 + 17.57 + 10 = $182.57 million. Value of equity = 182.57 − 75 = 107.57. Value per share = 107.57/10 = $10.76. This is a 34.5% premium over the existing price.

27.

Which of the following statements is/are correct?
I. Going-concern value of a firm is equal to the present value of expected net income.
II. When a buyer values a target firm, the appropriate discount rate is the buyer’s weighted-average cost of capital.
III. The liquidation value estimate of terminal value usually vastly understates a healthy company’s terminal value.
IV. The value of a firm’s equity equals the discounted cash flow value of the firm minus all liabilities.

		II only
		III only
		I and II only
		II and III only
		II, III, and IV only
		None of the options are correct.

28.

A recent annual income statement for Stone Creek Roofing is shown below.

Net sales	$5,000
Cost of sales		3,200
Gross profit		1,800
Operating expense		800
Depreciation expense		200
Operating income		800
Interest expense		100
Income before tax		700
Tax		175
Income after tax	$	525

Assume that during the year, Stone Creek spent $180 on new capital equipment and increased current assets net of non-interest-bearing current liabilities by $120. What was Stone Creek’s free cash flow in this year?

		$425
		$500
		$700
		$725
		$740
		None of the options are correct.

Answer 1

Ans 24: We have to chose one out of the following 6 choices:

(A) minimum growth rate achievable, assuming a 100 percent retention ratio.

(B) minimum growth rate achievable if the firm maintains a constant equity multiplier.

(C) maximum growth rate achievable, excluding external financing of any kind.

(D) maximum growth rate achievable, excluding any external equity financing while maintaining a constant debt-equity ratio.

(E) maximum growth rate achievable with unlimited debt financing.

(F) None of the options are correct.

Answer is choice D.

Let's understand why choice D is the correct answer.

The sustainable growth rate means the maximum growth rate using the financial resources which are internal to the firm without taking help of any external debt or equity.

Choice A and Choice B can be easily rejected as they define sustainable rate as "minimum" growth rate instead of "maximum" growth rate.

Option E can also be rejected easily as it includes "unlimited debt financing" instead of no external debt and equity financing.

Choice C is not correct answer as it excludes external financing of "any kind". It does not specifically mention debt and equity unlike choice D. Any other external financing excluding debt and equity (e.g. profit due to change in exchange rate etc.) are not excluded for sustainable growth rate.

Option D is the correct choice as it includes maximum growth rate and excludes external equity financing. With no additional equity financing, a constant debt equity ratio implies no additional debt raising. This option is correct as it includes maximum growth rate and excludes both external equity and external debt.

Dear Student, as per guidelines, only one question can be discussed in one query. Request you to put the other questions as new queries.