Fabozzi Frank, Peterson Pamela. Financial Management and Analysis Workbook

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430 SOLUTIONS

SHORT ANSWER QUESTIONS

Answers

1. Project ﬁnancing is attractive when the balance sheet remains unaf-

fected and does not inﬂuence the credit rating of the sponsoring party.

Project ﬁnancing allows for highly leveraged projects to take place

when they wouldn’t otherwise.

2. There are varying credit exposures that arise throughout a project

ﬁnancing in the engineering and construction phase, startup phase,

and operations phase.

A variety of guarantees and business partners can be utilized

though the life of the project ﬁnancing in order to maintain the

appropriate credit support.

3. Risks must be identiﬁed, evaluated, examined, and evaded during the

project in order to avoid project failures. Some common causes for

project failures include the following:

■

Delay in completion

■

Cost overrun

■

Technical failure

■

Financial failure

■

Uninsured losses

■

Increased price or material shortages

■

Technical obsolescence

■

Loss of competitive edge

■

Poor management

■

Actual value of security is too low

4. Nonrecourse borrowing by third parties is structured in ways so

that the third party’s (or sponsor’s) credit standing and balance

sheet are relatively unaffected. This is often done by using a third

party’s credit rating or using multiple parties’ credit ratings. When

multiple backers for a project all have good credit ratings, this

secures the lender’s conﬁdence that the project is viable and the risk

for default is minimized. For the backers, the project risk is likewise

minimized by sharing.

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Project Financing 431

5. Beneﬁts and incentives for project ﬁnancings are:

■

Availability of credit sources

■

Availability of guarantees

■

Better credit terms and interest costs

■

Achieve higher leverage

■

Meet legal requirements

■

Regulatory problems avoided

■

Segregated costs

■

Financial statements unaffected until completion

Disincentives for project ﬁnancing are:

■

Complexity

■

Complicated documentation

■

Higher cost of borrowing funds

■

Challenging negotiations with multiple parties

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CHAPTER

433

Strategy and Financial Planning

FILL IN THE BLANKS

Answers

1. economic, forecasting, accounting; Economic, marketing, production,

sales, costs; Accounting, summarize, project

2. comparative, producing, distributing; competitive; invest, more, return

3. strategy, maximizing; positive net present; objectives; strategic; ﬁnan-

cial, opportunities

4. Sales; Inaccurate, inventory, ﬁnancing; misses, understating, overstat-

ing, problems

5. cash, economic, industry, market; uncertainty; sales, regression, mar-

ket, opinions

6. familiarity, products, customers, competitors, future; expertise, evalu-

ate; problems; persuade, allocate

7. Forecasting, short, long; people; optimistic, rosier, future; past, weight;

responsible, rewarding, penalizing

8. budgeting, cash, income, balance; cash, most, income, balance; credit,

coincide

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434 SOLUTIONS

9. pro forma, projected, future; income, income, revenues, expenses;

investment, ﬁnancing

10. analysis, cash; pro forma, asset, liability, equity; percent-of-sales, sales,

income, sales, balance

SHORT ANSWER QUESTIONS

Answers

1. Financial planning is the allotment of resources to meet investment

goals. Financial planning is important as it gives insight into the man-

ager’s decisions as to their perception of market conditions and how

the dynamic market conditions will affect the investing and ﬁnancing

decisions of the company.

2. The ﬁrm’s investment plans and ﬁnancing plans mentioned in short

answer question 1 are the ﬁrm’s budgeting process. Operational bud-

geting refers to short-term budgeting and long-run planning is long-

term budgeting.

Budgeting determines feasible investments based on the current abil-

ity to ﬁnance them. Budgets gauge current and past performance of

departments, divisions, or individual managers.

3. Regression is a mathematical model ﬁtting technique that ﬁts a line

graphically expressing the relationship between two units. Regression

is used to forecast based on historical data. Forecasting errors are the

difference between the forecasted value and the actual value.

4. Analysis of cash ﬂows allows the tracking of cash inﬂows and outﬂows

as a result of operating, investing, and ﬁnancing activities. Cash inﬂows

should be greater than cash outﬂows. A cash budget, which is a

detailed statement of the cash ﬂows expected in future periods, can

help identify ﬁnancing and investment needs.

5. There are many analyses and forecasting techniques for cash ﬂows.

Each one is subject to its own prescribed assumptions concerning a

variety of factors such as the economic conditions, market conditions,

and other factors affecting cash ﬂows. Two methods mentioned in the

text that help gauge uncertainty of cash ﬂows are sensitivity analysis

SolCh29 Page 434 Tuesday, December 16, 2003 10:24 AM

Strategy and Financial Planning 435

and simulation analysis. Sensitivity analysis is the changing of one vari-

able at a time and examining its effect on all the other components.

When more than one variable is changed at a time, this involves simu-

lation analysis.

PROBLEMS

Answers

1. DoReMi Company:

Without adjustment:

With adjustments:

The cash account and, in turn, accounts payable, are the easiest and

quickest to adjust. The other accounts can be altered accordingly and

this should be taken into consideration for the long-term plan of the

company. However in the interim, for the pro forma balance sheet for

next month, the cash account can be easily reduced to adjust the cur-

rent ratio, by the following amount:

Using algebra to solve for X, $X = 333. If DoReMi reduces cash by

$333 (paying off $333 of short-term liabilities), the current ratio

requirement is satisﬁed.

Current ratio

$500 300 300++

$525

----------------------------------------------

2.10==

Debt-to-equity ratio

$525 575+

$525

-----------------------------

2.75==

With adjustment, current ratio

$500 x 300 300++–

$525 x–

-------------------------------------------------------

$1,100 x–

$525 x–

---------------------------

4.0==

SolCh29 Page 435 Tuesday, December 16, 2003 10:24 AM

436 SOLUTIONS

With adjustment to the cash account, the debt-to-equity ratio falls in

line below 2 to 1.92.

The cash balance may be less than what is needed for transaction

purposes, thus introducing the risk of not having sufﬁcient cash on

hand.

Other means of reducing the current ratio are to (1) reduce accounts

receivable (by not extending as much credit or being more aggressive in

collections), which risks hurting future sales; or (2) reduce levels of

inventory, which risks not having sufﬁcient inventory to meet demand.

In addition, the ﬁrm can borrow using long-term debt (increasing its

ﬁnancial leverage) to add to its current accounts, increasing its current

ratio. But this increases the ﬁnancial risk of the ﬁrm and may increase

the cost of debt and equity.

3. The predicted current, plant, and total assets are as follows:

Assets Liabilities and Equities

Cash $167 Accounts payable $192

Accounts receivable 300 Long-term debt 575

Inventory 300 Common equity 400

Plant and equipment 400 Total liabilities and equity $1,167

Total assets $1,167

Month Sales

Collection

Month’s

Sales

Collection

on Previous

Month’s

Sales

Collection

on Sales from

Two Months

Total

Collections

from July–

Sept. Sales

July $12,000 $2,400 from June from May $2,400

August $20,000 $4,000 $6,720 from June $8,720

September $15,000 $3,000 $11,200 $2,800 $17,000

Base

Year

As a % of

Base Year Sales Projected

Current assets $200,000 20% $280,000

Plant assets 500,000 50% 700,000

Total assets $700,000 70% $980,000

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