PrinciplesofFinance-WEB-110

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a. costs the same as retaining earnings
b. will not impact a company’s WACC
c. is the most expensive source of capital because of flotation costs
d. is the cheapest source of capital because dividends do not have to be paid each year
13. If a bond with a face value of $1,000 has a conversion ratio of 10 shares, the conversion price is ________.
a. $0.01
b. $10
c. $100
d. $1,000
Review Questions
1. Why does a company’s capital have a cost?
2. Why is the rate that debt holders require to entice them to lend money to a company different from the
company’s effective cost of debt capital?
3. Assume that the corporate tax rate is 21%. Congress is discussing increasing the corporate tax rate to 32%.
How might this change the capital structures that companies choose?
4. Describe the order of claimants and how it impacts the returns that various providers of capital require to
entice them to provide funding to a company.
5. Explain what is meant by trade-off theory.
Problems
1. SodaFizz has debt outstanding that has a market value of $3 million. The company’s stock has a book
value of $2 million and a market value of $6 million. What are the weights in SodaFizz’s capital structure?
2. The yield to maturity on SodaFizz’s debt is 7.2%. If the company’s marginal tax rate is 21%, what is
SodaFizz’s effective cost of debt?
3. SodaFizz paid a dividend of $2 per share last year; its dividend has been growing at a rate of 2% per year,
and that growth rate is expected to continue into the future. The stock of SodaFizz is currently trading at
$19.50 per share. According to the constant dividend growth model, what is the cost of equity capital for
SodaFizz?
4. SodaFizz has a beta of 1.1. If the risk-free rate is 3% and the market risk premium is 11%, what is the cost
of equity capital for SodaFizz according to the capital asset pricing model?
5. Given the answers to Problems 1, 2, and 3, what is SodaFizz’s WACC when the constant dividend growth
model is used to calculate its equity cost of capital?
6. Given the answers to Problems 1, 2, and 4, what is SodaFizz’s WACC when the CAPM is used to calculate
SodaFizz’s equity cost of capital?
7. Shirley Manufacturing paid $1 million in interest payments last year. The company is in the 21% tax
bracket and has $15 million in debt outstanding. How much was the company’s interest tax shield last
year?
8. King Medical Supplies has issued preferred stock that pays a yearly dividend of $4 per share. This
preferred stock is trading at a price of $47 per share. What is King’s cost of preferred stock capital?
9. McPherson Pharmaceutical has common stock that is trading for $75 per share. The company paid a
532 17 • Review Questions
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dividend of $5.25 last year. This dividend is expected to increase at a rate of 3% per year. What is the cost
of equity capital for McPherson? If McPherson issues new shares with a flotation cost of $2 per share,
what is the company’s cost of new equity?
Video Activity
Calculating the Weighted Average Cost of Capital
Click to view content (https://openstax.org/r/WACC)
1. What is the formula for calculating WACC? What do each of the components of this formula represent?
2. In the video, the tax rate for Brick and Mortar Co. was 30%. What would your calculation of the company’s
WACC be if there was a change in the tax code and the tax rate for Brick and Mortar Co. fell to 15%? Why
does the tax rate impact a firm’s WACC? Do you think the managers of Brick and Mortar Co. should
consider making any changes to its capital structure if the tax rate falls to 15%? Why or why not?
Capital Structure for Real Estate Companies
Click to view video content (https://openstax.org/r/optimal-capital)
3. Why doesn’t one optimal capital structure exist for commercial real estate businesses?
4. How do you think a family that runs a multigenerational commercial real estate business will think about
risk compared to a young entrepreneur who is beginning to build a commercial real estate business? How
do you think the capital structures of these two entities are likely to compare? How would those capital
structures likely be linked to the risk profiles of the two companies?
17 • Video Activity 533
https://openstax.org/r/WACC
https://openstax.org/r/optimal-capital
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Figure 18.1 Forecasts are an important financial tool. (credit: modification of “Red Post-It Label, Calculator and Ballpen” by
photosteve101/flickr, CC BY 2.0)
Chapter Outline
18.1 The Importance of Forecasting
18.2 Forecasting Sales
18.3 Pro Forma Financials
18.4 Generating the Complete Forecast
18.5 Forecasting Cash Flow and Assessing the Value of Growth
18.6 Using Excel to Create the Long-Term Forecast
Why It Matters
Though no one in business has a crystal ball, managers must often do all they can to predict the future as
accurately as possible. This is called forecasting. Accounting and finance professionals use past performance
along with what they know about the business, its competitors, the economy, and the company’s plans for the
future to assemble detailed financial forecasts. Forecasts are useful to many individuals for different reasons.
A budget, a type of static forecast, helps accountants and managers see how their plans for the coming year
can be achieved. It outlines sales targets and how much can be spent on cost of goods sold and expenses to
achieve the company’s bottom-line (net income) targets. Investors use financial forecasts to help guide their
decisions to buy, sell or hold stocks or to estimate future potential income through dividends. Perhaps most
importantly, for our purposes in finance, forecasts are used to help predict and manage cash flows.
A business can have all the profit in the world at the end of the year, but if it doesn’t raise enough cash
(liquidity) to pay the bills and pay its employees halfway through the year, it could still go bankrupt despite
being profitable. Forecasting sales and expenses helps assemble a cash forecast—when sales will be collected
and when expenses will be paid—so that financial managers can look forward far enough to have enough time
to react accordingly and secure short- or long-term financing to meet gaps in cash flow.
Financial Forecasting
18
18 • Why It Matters 535
18.1 The Importance of Forecasting
Learning Outcomes
By the end of this section, you will be able to:
• Discuss how to use financial statements in forecasting firm financials.
• Explain why balance sheet items are important in forecasting a firm’s financial result.
• Explain why income statement items are important in forecasting a firm’s financial result.
In this section, we will briefly review some of the basic elements of financial statements and how we can
analyze historical statements to help assemble financial forecasts. Financial forecasting is important to short-
and long-term firm success. It helps a firm plan for the resources it will need, ensuring it will have enough cash
on hand at the right time to cover daily operations and capital expenditures. It helps the firm communicate its
future potential and manage its shareholders’ expectations. It also helps management assess future risk and
set plans in place to mitigate that risk.
Financial forecasting involves using historical data, analysis tools, and other information we can gather to
make an educated guess about the future financial performance of the firm. Historical figures provide a
reasonable starting point. We use tools such as ratios, common size, and trend analysis to fine-tune our
forecast. And finally, we assess what we know about the firm, its competitors, the economy, and anything else
that might impact performance and further fine-tune our forecast from there.
It’s important to take a moment to consider the role of ethics in forecasting. Ethics is a huge issue in the world
of accounting and finance in general, and forecasting is no different. There can be tremendous pressureon
management to perform, to deliver certain levels of profit, and to meet shareholder expectations.
Forecasting, as you will learn throughout this chapter, is not an exact science. There is a great deal of
subjectivity that can come into play when forecasting sales and expenses. Ethical behavior is crucial in this
area. Those who create forecasts must have a firm understanding of where their data comes from, how
reliable it is, and whether or not their assumptions and projections are reasonably justified.
Financial Statement Foundations
In Financial Statements, you were introduced to a firm called Clear Lake Sporting Goods. You learned about
the four key financial statements: the income statement, balance sheet, statement of stockholders’
equity, and statement of cash flows. Each one provides a different view of the firm’s financial health and
performance.
Clear Lake Sporting Goods is a small merchandising company (a company that buys finished goods and sells
them to consumers) that sells hunting and fishing gear. It uses financial statements to understand its
profitability and current financial position, to manage cash flow, and to communicate its finances to outside
parties such as investors, governing bodies, and lenders. We will use Clear Lake’s company information and
historical financial statements in this chapter as we explore its forecasting process. It’s important to note that
in this chapter, we are focusing on just one firm and the one method its managers have chosen to forecast
financial performance. There are a variety of types of firms in actual application, and they may choose to
forecast their financial performance differently. We are demonstrating just one approach here.
The balance sheet shows all the firm’s assets, liabilities, and equity at one point in time. It also supports the
accounting equation in a very clear and transparent way. We find one section of the balance sheet contains all
current and noncurrent assets that must total the other section of the balance sheet: total liabilities and
equity. In Figure 18.2, we see that Clear Lake Sporting Goods has total assets of $250,000 in the current year,
which balances with its total liabilities and equity of $250,000.
536 18 • Financial Forecasting
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	Chapter 17 How Firms Raise Capital
	Review Questions
	Problems
	Video Activity
	Chapter 18 Financial Forecasting
	Why It Matters
	18.1 The Importance of Forecasting