Long Term Investment Decisions

Question 1

Which factor is used in the capital asset pricing model (CAPM) but not the Gordon growth model to estimate the cost of common equity?

Answer 1

The company’s beta

CAPM uniquely requires the company’s beta, a measure of systematic risk, which is not used in the Gordon growth model.

Question 2

What is a primary advantage of using the Gordon growth model to estimate the cost of common equity?

Answer 2

It incorporates a company’s dividend growth rate

The Gordon growth model incorporates a company’s expected dividend growth rate, which is a key advantage.

Question 3

Which key factors are used to approximate the return required by shareholders in the Gordon growth model?

Answer 3

Dividend growth rate and current share price

The Gordon growth model uses the dividend growth rate and the current share price to approximate the return required by shareholders.

Question 4

Which method estimates the cost of common equity by considering the expected market returns and the risk-free rate?

Answer 4

Capital asset pricing model

The capital asset pricing model estimates the cost of common equity by considering the expected market returns, the risk-free rate, and the stock’s beta.

Question 5

What will be the projected accounts receivable for Rusty RoboTech at the beginning of 20X4?

Answer 5

$90,000

Projected Accounts Receivable = Projected Sales × Accounts Receivable to Sales Ratio. $600,000 × 15% = $90,000.

Question 6

What is the projected amount of cash Rusty RoboTech will have at the beginning of 20X4 based on the percent of sales method?

Answer 6

$30,000

Projected Cash = Projected Sales × Historical Cash to Sales Ratio. $600,000 × 5% = $30,000.

Question 7

What is a primary reason for a firm to consider slowing its sales growth?

Answer 7

To reduce its dependency on external financing

Slowing sales growth by increasing the price of its product can reduce the discretionary financing need (DFN) by both increasing net margin and decreasing forecasted assets.

Question 8

What is the sustainable growth rate for a company with net income of $50,000 and total equity of $350,000 that pays out 12% of its net income in dividends?

Answer 8

12.57%

The sustainable growth rate is calculated by multiplying the return on equity (ROE) by 1 minus the dividend payout ratio of 12%.

Question 9

What is the formula for calculating the sustainable growth rate?

Answer 9

ROE × (1 - Dividend payout ratio)

ROE is calculated as Net Income divided by Total Equity.

Question 10

What capital budgeting method is used by firms that wish to recover their invested capital as quickly as possible?

Answer 10

Payback

The payback method focuses on recovering investment as quickly as possible.

Question 11

What are the projected incremental net revenues for the second delivery vehicle in Year 1?

Answer 11

$15,000

This is the expected revenue for the first year of operation after the investment.

Question 12

What is the payback period for a delivery vehicle purchased for $80,000 with the following incremental net revenues: Year 1: $15,000, Year 2: $20,000, Year 3: $35,000, Year 4: $40,000, Year 5: $41,000?

Answer 12

4 years

Payback period is calculated by adding the revenues until the initial investment is recovered.