Question

Ericson Corporation’s total assets are projected to increase by $30 million next year. Ericson is also scheduled to repay $14 million in debt next year. Other than this repayment, no changes in liabilities are currently scheduled. Ericsons’s income is projected to be $4 million, half of which will be paid as a dividend. What is the amount of Ericson’s External Funds Needed (EFN) for next year?

(b) Ericson’s $4 million net income consists of $33 million in revenues, less $25 million in various cash-based costs, and $4 million in depreciation expense.   Also, of the $30 million increase in assets, $2 million is attributable to an increase in inventory and receivables.   No other changes in working capital are anticipated.   What is the amount of Ericson’s operating cash flow?

(c) Evaluate the following statement: In order to maximize shareholder value, it is important that the company always select those investments that provide the highest internal rate of return.

(d) Which of the following provides the highest effective annual interest rate?   Six percent per year with annual compounding, 5.75% with quarterly compounding, or 5.65% with daily compounding?

Answer 1

a) EFN = Change in Assets - Change in Spontaneous Liabilities - Net Income x Retention Ratio

= 30 - 0 - 4 x 50% = 28m

b) Operating Cash Flow = Net Income + Depreciation - Increase in NWC = 4 + 4 - 2 = 6m

c) The statement is incorrect because internal rate of return by itself doesn't increase the value to the shareholders. If the firm is taking much higher risk than the returns generated, the shareholder value may deteriorate.

d) EAR = (1 + APR/n)^n - 1

For annual, EAR = APR = 6%

For quarterly, EAR = (1 + 5.75%/4)^4 - 1 = 5.88%

For daily, EAR = e^(5.65%) - 1 = 5.81%

Hence, the annual rate offers higher effective rate.