(Solution Manual) Fundamentals of Corporate Finance

Ross,Westerfield,Jordan, 11

Business

Solution Manual

11th Edition

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Author(s): Ross, Westerfield, Jordan

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Solutions Manual Fundamentals of Corporate Finance 11th edition Ross, Westerfield, and Jordan 01-17-2015 Prepared by Brad Jordan University of Kentucky Joe Smolira Belmont UniversityCHAPTER 1 INTRODUCTION TO CORPORATE  FINANCE Answers to Concepts Review and Critical Thinking Questions 1.Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm’s credit collection policy with its customers). 2.Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, difficulty in raising capital funds. Some advantages: simpler, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates. 3.The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life. 4.In response to Sarbanes-Oxley, small firms have elected to go dark because of the costs of compliance. The costs to comply with Sarbox can be several million dollars, which can be a large percentage of a small firm’s profits. A major cost of going dark is less access to capital. Since the firm is no longer publicly traded, it can no longer raise money in the public market. Although the company will still have access to bank loans and the private equity market, the costs associated with raising funds in these markets are usually higher than the costs of raising funds in the public market. 5.The treasurer’s office and the controller’s office are the two primary organizational groups that report directly to the chief financial officer. The controller’s office handles cost and financial accounting, tax management, and management information systems, while the treasurer’s office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the treasury group’s functions. 6.To maximize the current market value (share price) of the equity of the firm (whether it’s publicly traded or not). 7.In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm. 8.A primary market transaction.CHAPTER 1 ­  2 9.In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to match buyers and sellers of assets. Dealer markets like NASDAQ consist of dealers operating at dispersed locales who buy and sell assets themselves, communicating with other dealers either electronically or literally over-the-counter. 10.Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; that is, provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize the value of the equity. 11.Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false. 12.An argument can be made either way. At the one extreme, we could argue that in a market economy, all of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are noneconomic phenomena and are best handled through the political process. A classic (and highly relevant) thought question that illustrates this debate goes something like this: “A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?” 13.The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions. 14.The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this. 15.We would expect agency problems to be less severe in countries with a relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more efficient market for corporate control.CHAPTER 1 ­  3 16.How much is too much? Who is worth more, Lawrence Ellison or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, that is, stock price increases in excess of general market increases.CHAPTER 2 FINANCIAL STATEMENTS, TAXES, AND  CASH FLOW Answers to Concepts Review and Critical Thinking Questions 1.Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in meeting short-term creditor demands. However, since liquidity also has an opportunity cost associated with it—namely that higher returns can generally be found by investing the cash into productive assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial management staff to find a reasonable compromise between these opposing needs. 2.The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to do it. 3.Historical costs can be objectively and precisely measured whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a trade-off between relevance (market values) and objectivity (book values). 4.Depreciation is a noncash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it’s a financing cost, not an operating cost. 5.Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value. 6.For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative. 7.It’s probably not a good sign for an established company, but it would be fairly ordinary for a start- up, so it depends. 8.For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would have this effect. Negative net capital spending would mean more long-lived assets were liquidated than purchased.9.If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest, its cash flow to creditors will be negative. 10.The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the derivatives. 11.Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have to take on the company's debt but would pocket its cash. Enterprise value differs significantly from simple market capitalization in several ways, and it may be a more accurate representation of a firm's value. In a takeover, the value of a firm's debt would need to be paid by the buyer. Thus, enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation. 12.In general, it appears that investors prefer companies that have a steady earnings stream. If true, this encourages companies to manage earnings. Under GAAP, there are numerous choices for the way a company reports its financial statements. Although not the reason for the choices under GAAP, one outcome is the ability of a company to manage earnings, which is not an ethical decision. Even though earnings and cash flow are often related, earnings management should have little effect on cash flow (except for tax implications). If the market is “fooled” and prefers steady earnings, shareholder wealth can be increased, at least temporarily. However, given the questionable ethics of this practice, the company (and shareholders) will lose value if the practice is discovered. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1.To find owners’ equity, we must construct a balance sheet as follows: Balance Sheet CA$ 5,300 CL$ 4,600 NFA 24,900 LTD10,300 OE ?? TA$30,200 TL & OE$30,200 We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $30,200. We also know that TL & OE is equal to current liabilities plus long-term debt plus owners’ equity, so owners’ equity is: Owner’s equity = $30,200 – 10,300 – 4,600 = $15,300 NWC = CA – CL = $5,300 – 4,600 = $700 CHAPTER 2 ­  6 2.The income statement for the company is: Income Statement Sales $817,000 Costs 343,000 Depreciation 51,000 EBIT $423,000 Interest 38,000 EBT $385,000 Taxes (35%) 134,750 Net income $250,250 3.One equation for net income is: Net income = Dividends + Addition to retained earnings Rearranging, we get: Addition to retained earnings = Net income – Dividends = $250,250 – 95,000 = $155,250 4.EPS= Net income / Shares = $250,250 / 90,000 = $2.78 per share DPS= Dividends / Shares = $95,000 / 90,000 = $1.06 per share 5.Taxes = .15($50,000) + .25($25,000) + .34($25,000) + .39($267,000 – 100,000) = $87,380 6.The average tax rate is the total tax paid divided by taxable income, so: Average tax rate = $87,380 / $267,000 = .3273, or 32.73% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39%. 7.To calculate OCF, we first need the income statement: Income Statement Sales $43,800 Costs 22,700 Depreciation 2,100 EBIT $19,000 Interest 1,600 Taxable income $17,400 Taxes (35%) 6,090 Net income $11,310 OCF = EBIT + Depreciation – Taxes = $19,000 + 2,100 – 6,090 = $15,010 8.Net capital spending = NFA end – NFAbeg + Depreciation Net capital spending = $3,500,000 – 2,700,000 + 328,000 Net capital spending = $1,128,0009.Change in NWC = NWC end – NWCbeg Change in NWC = (CA end – CLend) – (CAbeg – CLbeg) Change in NWC = ($5,180 – 2,830) – ($4,630 – 2,190) Change in NWC = $2,350 – 2,440 = –$90 10.Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = Interest paid – (LTD end – LTDbeg) Cash flow to creditors = $235,000 – ($2,280,000 – 1,950,000) Cash flow to creditors = –$95,000 11.Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = Dividends paid – [(Common end + APISend) – (Commonbeg + APISbeg)] Cash flow to stockholders = $565,000 – [($825,000 + 4,400,000) – ($670,000 + 4,100,000)] Cash flow to stockholders = $110,000 Note, APIS is the additional paid-in surplus. 12.Cash flow from assets = Cash flow to creditors + Cash flow to stockholders = –$95,000 + 110,000 = $15,000 Cash flow from assets = $15,000 = OCF – Change in NWC – Net capital spending = $15,000 = OCF – (–$45,000) – 1,250,000 Operating cash flow = $15,000 – 45,000 + 1,250,000 Operating cash flow = $1,220,000 Intermediate 13.To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current assets, we get: CA = NWC + CL = $220,000 + 850,000 = $1,070,000 The market value of current assets and fixed assets is given, so: Book value CA = $1,070,000 NWC = $1,050,000 Book value NFA= $3,300,000 Market value NFA = $4,800,000 Book value assets= $4,370,000 Total = $5,850,000CHAPTER 2 ­  8 14.To find the OCF, we first calculate net income. Income Statement Sales $267,000 Costs 148,000 Other expenses 8,200 Depreciation 17,600 EBIT $ 93,200 Interest 12,400 Taxable income $ 80,800 Taxes 32,620 Net income $ 48,180 Dividends $15,500 Additions to RE $32,680 a. OCF = EBIT + Depreciation – Taxes = $93,200 + 17,600 – 32,620 = $78,180 b. CFC = Interest – Net new LTD = $12,400 – (–4,900) = $17,300 Note that the net new long-term debt is negative because the company repaid part of its long- term debt. c. CFS = Dividends – Net new equity = $15,500 – 6,400 = $9,100 d. We know that CFA = CFC + CFS, so: CFA = $17,300 + 9,100 = $26,400 CFA is also equal to OCF – Net capital spending – Change in NWC. We already know OCF. Net capital spending is equal to: Net capital spending = Increase in NFA + Depreciation = $25,000 + 17,600 = $42,600 Now we can use: CFA = OCF – Net capital spending – Change in NWC $26,400 = $78,180 – 42,600 – Change in NWC Change in NWC = $9,180 This means that the company increased its NWC by $9,180.15.The solution to this question works the income statement backwards. Starting at the bottom: Net income = Dividends + Addition to retained earnings = $1,950 + 5,600 = $7,550 Now, looking at the income statement: EBT – EBT × Tax rate = Net income Recognize that EBT × Tax rate is simply the calculation for taxes. Solving this for EBT yields: EBT = NI / (1– Tax rate) = $7,550 / (1 – .35) = $11,615 Now you can calculate: EBIT = EBT + Interest = $11,615 + 4,300 = $15,915 The last step is to use: EBIT = Sales – Costs – Depreciation $15,915 = $61,000 – 29,600 – Depreciation Depreciation = $15,485 16.The balance sheet for the company looks like this: Balance Sheet Cash $ 134,000Accounts payable $ 210,000 Accounts receivable 105,000Notes payable 160,000 Inventory 293,000Current liabilities $ 370,000 Current assets $ 532,000Long-term debt 845,000 Total liabilities $1,215,000 Tangible net fixed assets 1,730,000 Intangible net fixed assets 670,000Common stock ?? Accumulated ret. earnings 1,453,000 Total assets $2,932,000Total liab. & owners’ equity $2,932,000 Total liabilities and owners’ equity is: TL & OE = CL + LTD + Common stock + Retained earnings Solving this equation for common stock gives us: Common stock = $2,932,000 – 1,215,000 – 1,453,000 = $264,000 17.The market value of shareholders’ equity cannot be negative. A negative market value in this case would imply that the company would pay you to own the stock. The market value of shareholders’ equity can be stated as: Shareholders’ equity = Max [(TA – TL), 0]. So, if TA are $8,7000, equity is equal to $1,900, and if TA are $5,900, equity is equal to $0. We should note here that the book value of shareholders’ equity can be negative.CHAPTER 2 ­  10 18.a. Taxes Growth = .15($50,000) + .25($25,000) + .34($14,500) = $18,680 Taxes Income = .15($50,000) + .25($25,000) + .34($25,000) + .39($235,000) + .34($8,950,000 – 335,000) = $3,043,000 b.Each firm has a marginal tax rate of 34% on the next $10,000 of taxable income, despite their different average tax rates, so both firms will pay an additional $3,400 in taxes. 19. Income Statement Sales $675,000 COGS 435,000 A&S expenses 85,000 Depreciation 125,000 EBIT $30,000 Interest 70,000 Taxable income –$40,000 Taxes (35%) 0 a.Net income –$40,000 b.OCF = EBIT + Depreciation – Taxes = $30,000 + 125,000 – 0 = $155,000 c.Net income was negative because of the tax deductibility of depreciation and interest expense. However, the actual cash flow from operations was positive because depreciation is a non-cash expense and interest is a financing expense, not an operating expense. 20.A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficient cash flow to make the dividend payments. Change in NWC = Net capital spending = Net new equity = 0. (Given) Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $155,000 – 0 – 0 = $155,000 Cash flow to stockholders = Dividends – Net new equity = $102,000 – 0 = $102,000 Cash flow to creditors = Cash flow from assets – Cash flow to stockholders Cash flow to creditors = $155,000 – 102,000 = $53,000 Cash flow to creditors = Interest – Net new LTD Net new LTD = Interest – Cash flow to creditors = $70,000 – 53,000 = $17,000 21.a. Income Statement Sales $30,096 Cost of goods sold 21,476 Depreciation 5,341 EBIT $ 3,279 Interest 2,409 Taxable income $ 870 Taxes (35%) 305 Net income $ 566 b.OCF = EBIT + Depreciation – Taxes = $3,279 + 5,341 – 305 = $8,316c.Change in NWC = NWCend – NWCbeg = (CAend – CLend) – (CAbeg – CLbeg) = ($7,829 – 4,159) – ($6,336 – 3,564) = $3,670 – 2,772 = $898 Net capital spending = NFAend – NFAbeg + Depreciation = $22,176 – 18,018 + 5,341 = $9,499 CFA = OCF – Change in NWC – Net capital spending = $8,316 – 898 – 9,499 = –$2,082 The cash flow from assets can be positive or negative, since it represents whether the firm raised funds or distributed funds on a net basis. In this problem, even though net income and OCF are positive, the firm invested heavily in both fixed assets and net working capital; it had to raise a net $2,082 in funds from its stockholders and creditors to make these investments. d.Cash flow to creditors = Interest – Net new LTD = $2,409 – 0 = $2,409 Cash flow to stockholders = Cash flow from assets – Cash flow to creditors = –$2,082 – 2,409 = –$4,491 We can also calculate the cash flow to stockholders as: Cash flow to stockholders = Dividends – Net new equity Solving for net new equity, we get: Net new equity = $1,716 – (–4,491) = $6,207 The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $898 in new net working capital and $9,499 in new fixed assets. The firm had to raise $2,082 from its stakeholders to support this new investment. It accomplished this by raising $6,207 in the form of new equity. After paying out $1,716 of this in the form of dividends to shareholders and $2,409 in the form of interest to creditors, $2,082 was left to meet the firm’s cash flow needs for investment. 22.a.Total assets 2014 = $1,005 + 4,144 = $5,149 Total liabilities 2014 = $402 + 2,190= $2,592 Owners’ equity 2014 = $5,149 – 2,592 = $2,557 Total assets 2015 = $1,089 + 4,990 = $6,079 Total liabilities 2015 = $451 + 2,329 = $2,780 Owners’ equity 2015 = $6,079 – 2,780 = $3,299 b.NWC 2014 = CA14 – CL14 = $1,005 – 402 = $603 NWC 2015 = CA15 – CL15 = $1,089 – 451 = $638 Change in NWC = NWC15 – NWC14 = $638 – 603 = $35 CHAPTER 2 ­  12 c.We can calculate net capital spending as: Net capital spending = Net fixed assets 2015 – Net fixed assets 2014 + Depreciation Net capital spending = $4,990 – 4,144 + 1,136 = $1,982 So, the company had a net capital spending cash flow of $1,982. We also know that net capital spending is: Net capital spending = Fixed assets bought – Fixed assets sold $1,982 = $2,080 – Fixed assets sold Fixed assets sold = $2,080 – 1,982 = $98 To calculate the cash flow from assets, we must first calculate the operating cash flow. The income statement is: Income Statement Sales $12,751 Costs 5,946 Depreciation expense 1,136 EBIT $ 5,669 Interest expense 323 EBT $ 5,346 Taxes (35%) 1,871 Net income $ 3,475 So, the operating cash flow is: OCF = EBIT + Depreciation – Taxes = $5,669 + 1,136 – 1,871 = $4,934 And the cash flow from assets is: Cash flow from assets = OCF – Change in NWC – Net capital spending. = $4,934 – 35 – 1,982 = $2,917 d.Net new borrowing = LTD15 – LTD14 = $2,329 – 2,190 = $139 Cash flow to creditors = Interest – Net new LTD = $323 – 139 = $184 Net new borrowing = $139 = Debt issued – Debt retired Debt retired = $420 – 139 = $281 Challenge 23.Net capital spending = NFAend – NFAbeg + Depreciation = (NFAend – NFAbeg) + (Depreciation + AD beg) – ADbeg = (NFAend – NFAbeg)+ ADend – ADbeg = (NFAend + ADend) – (NFAbeg + ADbeg) = FAend – FAbeg24.a.The tax bubble causes average tax rates to catch up to marginal tax rates, thus eliminating the tax advantage of low marginal rates for high income corporations. b.Taxes = .15($50,000) + .25($25,000) + .34($25,000) + .39($235,000) = $113,900 Average tax rate = $113,900 / $335,000 = .34, or 34% The marginal tax rate on the next dollar of income is 34 percent. For corporate taxable income levels of $335,000 to $10 million, average tax rates are equal to marginal tax rates. Taxes = .34($10,000,000) + .35($5,000,000) + .38($3,333,333) = $6,416,667 Average tax rate = $6,416,667 / $18,333,333 = .35, or 35% The marginal tax rate on the next dollar of income is 35 percent. For corporate taxable income levels over $18,333,334, average tax rates are again equal to marginal tax rates. c.Taxes = .34($200,000) = $68,000 $68,000= .15($50,000) + .25($25,000) + .34($25,000) + X($100,000); X($100,000) = $68,000 – 22,250 X = $45,750 / $100,000 X = 45.75% 25. Balance sheet as of Dec. 31, 2014 Cash $ 6,674 Accounts payable $ 4,822 Accounts receivable 8,837 Notes payable 1,288 Inventory 15,711 Current liabilities $ 6,110 Current assets $31,222 Long-term debt $22,352 Net fixed assets $55,977 Owners' equity $58,737 Total assets $87,199 Total liab. & equity $87,199 Balance sheet as of Dec. 31, 2015 Cash $ 7,113 Accounts payable $ 5,1008 Accounts receivable 10,371 Notes payable 1,262 Inventory 16,817 Current liabilities $ 6,370 Current assets $34,301 Long-term debt $27,099 Net fixed assets $59,700 Owners' equity $60,532 Total assets $94,001 Total liab. & equity $94,001CHAPTER 2 ­  14 2014 Income Statement 2015 Income Statement Sales $12,730.00 Sales $14,229.00 COGS 4,377.00 COGS 5,178.00 Other expenses 1,041.00 Other expenses 906.00 Depreciation 1,827.00 Depreciation 1,910.00 EBIT $5,485.00 EBIT $6,235.00 Interest 854.00 Interest 1,019.00 EBT $4,631.00 EBT $5,216.00 Taxes (34%) 1,574.54 Taxes (34%) 1,773.44 Net income $3,056.46 Net income $3,442.56 Dividends $1,522.00 Dividends $1,780.00 Additions to RE 1,534.46 Additions to RE 1,662.56 26.OCF = EBIT + Depreciation – Taxes = $6,235 + 1,910 – 1,773.44 = $6,371.56 Change in NWC = NWCend – NWCbeg = (CA – CL) end – (CA – CL) beg = ($34,301 – 6,370) – ($31,222 – 6,110) = $2,819 Net capital spending = NFAend – NFAbeg + Depreciation = $59,700 – 55,977 + 1,910 = $5,633 Cash flow from assets = OCF – Change in NWC – Net capital spending = $6,371.56 – 2,819 – 5,633 = –$2,080.44 Cash flow to creditors = Interest – Net new LTD Net new LTD = LTD end – LTDbeg Cash flow to creditors = $1,019 – ($27,099 – 22,352) = –$3,728 Net new equity = Common stock end – Common stockbeg Common stock + Retained earnings = Total owners’ equity Net new equity= (OE – RE) end – (OE – RE) beg = OEend – OEbeg + REbeg – REend REend = REbeg + Additions to RE15 Net new equity = OEend – OEbeg + REbeg – (REbeg + Additions to RE15) = OEend – OEbeg – Additions to RE Net new equity = $60,532 – 58,737 – 1,662.56 = $132.44 CFS = Dividends – Net new equity CFS = $1,780 – 132.44 = $1,647.56 As a check, cash flow from assets is –$2,080.44. CFA= Cash flow from creditors + Cash flow to stockholders CFA= –$3,278 + 1,647.56 = –$2,080.44CHAPTER 3 WORKING WITH FINANCIAL  STATEMENTS Answers to Concepts Review and Critical Thinking Questions 1.a.If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0. b.Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0. c.Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0. d.As long-term debt approaches maturity, the principal repayment and the remaining interest expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current ratio since current liabilities are not affected. e.Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged. f.Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged. g.Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases. 2.The firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain unchanged, liquidity has potentially decreased. 3.A current ratio of .50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50% more current assets than it does current liabilities. This probably represents an improvement in liquidity; short-term obligations can generally be met completely with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess funds sitting in current assets generally earn little or no return. These excess funds might be put to better use by investing in productive long-term assets or distributing the funds to shareholders. 4. a.Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm’s current assets. b.Cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid asset (cash). c.Total asset turnover measures how much in sales is generated by each dollar of firm assets. d.Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the dollar worth of firm assets each equity dollar has a claim to. e.Long-term debt ratio measures the percentage of total firm capitalization funded by long-term debt.CHAPTER 3 ­  16 f.Times interest earned ratio provides a relative measure of how well the firm’s operating earnings can cover current interest obligations. g.Profit margin is the accounting measure of bottom-line profit per dollar of sales. h.Return on assets is a measure of bottom-line profit per dollar of total assets. i.Return on equity is a measure of bottom-line profit per dollar of equity. j.Price-earnings ratio reflects how much value per share the market places on a dollar of accounting earnings for a firm. 5.Common-size financial statements express all balance sheet accounts as a percentage of total assets and all income statement accounts as a percentage of total sales. Using these percentage values rather than nominal dollar values facilitates comparisons between firms of different size or business type. Common-base year financial statements express each account as a ratio between their current year nominal dollar value and some reference year nominal dollar value. Using these ratios allows the total growth trend in the accounts to be measured. 6.Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate actions to take to adjust these ratios if appropriate. An aspirant group would be a set of firms whose performance the company in question would like to emulate. The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluated by how well they match the performance of an identified aspirant group. 7.Return on equity is probably the most important accounting ratio that measures the bottom-line performance of the firm with respect to the equity shareholders. The DuPont identity emphasizes the role of a firm’s profitability, asset utilization efficiency, and financial leverage in achieving an ROE figure. For example, a firm with ROE of 20% would seem to be doing well, but this figure may be misleading if it were marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm’s margins were to erode slightly, the ROE would be heavily impacted. 8.The book-to-bill ratio is intended to measure whether demand is growing or falling. It is closely followed because it is a barometer for the entire high-tech industry, where levels of revenues and earnings have been relatively volatile. 9.If a company is growing by opening new stores, then presumably total revenues would be rising. Comparing total sales at two different points in time might be misleading. Same-store sales control for this by only looking at revenues of stores open within a specific period. 10.a.For an electric utility such as Con Ed, expressing costs on a per-kilowatt-hour basis would be a way to compare costs with other utilities of different sizes. b.For a retailer such as Sears, expressing sales on a per-square-foot basis would be useful in comparing revenue production against other retailers. c.For an airline such as Southwest, expressing costs on a per-passenger-mile basis allows for comparisons with other airlines by examining how much it costs to fly one passenger one mile.d.For an online service provider such as Comcast, using a per internet session for costs would allow for comparisons with smaller services. A per subscriber basis would also make sense. e.For a hospital such as Holy Cross, revenues and costs expressed on a per-bed basis would be useful. f.For a college textbook publisher such as McGraw-Hill/Irwin, the leading publisher of finance textbooks for the college market, the obvious standardization would be per book sold. 11.Reporting the sale of Treasury securities as cash flow from operations is an accounting “trick,” and as such, should constitute a possible red flag about the companies accounting practices. For most companies, the gain from a sale of securities should be placed in the financing section. Including the sale of securities in the cash flow from operations would be acceptable for a financial company, such as an investment or commercial bank. 12.Increasing the payables period increases the cash flow from operations. This could be beneficial for the company as it may be a cheap form of financing, but it is basically a one-time change. The payables period cannot be increased indefinitely as it will negatively affect the company’s credit rating if the payables period becomes too long. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1.Using the formula for NWC, we get: NWC = CA – CL CA = CL + NWC CA = $4,380 + 1,920 CA = $6,300 So, the current ratio is: Current ratio = CA / CL Current ratio = $6,300 / $4,380 Current ratio = 1.44 times And the quick ratio is: Quick ratio = (CA – Inventory) / CL Quick ratio = ($6,300 – 3,750) / $4,380 Quick ratio = .58 timesCHAPTER 3 ­  18 2.We need to find net income first. So: Profit margin = Net income / Sales Net income = Profit margin(Sales) Net income = .06($17,500,000) Net income = $1,050,000 ROA = Net income / TA ROA = $1,050,000 / $13,100,000 ROA = .0802, or 8.02% To find ROE, we need to find total equity. Since TL & OE equals TA: TA = TD + TE TE = TA – TD TE = $13,100,000 – 5,700,000 TE = $7,400,000 ROE = Net income / TE ROE = $1,050,000 / $7,400,000 ROE = .1419, or 14.19% 3.Receivables turnover = Sales / Receivables Receivables turnover = $5,173,820 / $438,720 Receivables turnover = 11.79 times Days’ sales in receivables = 365 days / Receivables turnover Days’ sales in receivables = 365 / 11.79 Days’ sales in receivables = 30.95 days On average, the company’s customers paid off their accounts in 30.95 days. 4.Inventory turnover = COGS / Inventory Inventory turnover = $4,682,715 / $417,381 Inventory turnover = 11.22 times Days’ sales in inventory = 365 days / Inventory turnover Days’ sales in inventory = 365 / 11.22 Days’ sales in inventory = 32.53 days On average, a unit of inventory sat on the shelf 32.53 days before it was sold. 5.Total debt ratio = .53 = TD / TA Substituting total debt plus total equity for total assets, we get: .53 = TD / (TD + TE) Solving this equation yields: .53(TE) = .47(TD)Debt-equity ratio = TD / TE = .53 / .47 = 1.13 Equity multiplier = 1 + D/E = 2.13 6.Net income = Addition to RE + Dividends = $395,000 + 195,000 = $590,000 Earnings per share = NI / Shares = $590,000 / 170,000 = $3.47 per share Dividends per share = Dividends / Shares = $195,000 / 170,000 = $1.15 per share Book value per share = TE / Shares = $5,300,000 / 170,000 = $31.18 per share Market-to-book ratio = Share price / BVPS = $64 / $31.18 = 2.05 times P/E ratio = Share price / EPS = $64 / $3.47 = 18.44 times Sales per share = Sales / Shares = $5,150,000 / 170,000 = $30.29 P/S ratio = Share price / Sales per share = $64 / $30.29 = 2.11 times 7.ROE = (PM)(TAT)(EM) ROE = (.061)(2.10)(1.15) ROE = .1473, or 14.73% 8. This question gives all of the necessary ratios for the DuPont Identity except the equity multiplier, so, using the DuPont Identity: ROE = (PM)(TAT)(EM) ROE = .1615 = (.051)(1.95)(EM) EM = .1615 / (.051)(1.95) EM = 1.62 D/E = EM – 1 D/E = 1.62 – 1 D/E = .62 9. Decrease in inventory is a source of cash. Decrease in accounts payable is a use of cash. Increase in notes payable is a source of cash. Increase in accounts receivable is a use of cash. Change in cash = Sources – Uses Change in cash = $365 – 215 + 280 – 240 Change in cash = $190 Cash increased by $190CHAPTER 3 ­  20 10.The average time to pay suppliers is the days’ sales in payables, so: Payables turnover = COGS / Accounts payable Payables turnover = $57,382 / $10,432 Payables turnover = 5.50 times Days’ sales in payables = 365 days / Payables turnover Days’ sales in payables = 365 / 5.50 Days’ sales in payables = 66.36 days The company left its bills to suppliers outstanding for 66.36 days on average. A large value for this ratio could imply that either (1) the company is having liquidity problems, making it difficult to pay off its short-term obligations, or (2) that the company has successfully negotiated lenient credit terms from its suppliers. 11.First, we need the enterprise value, which is: Enterprise value = Market capitalization + Debt – Cash Enterprise value = $610,000 + 204,000 – 39,000 Enterprise value = $775,000 And EBITDA is: EBITDA = EBIT + Depreciation & Amortization EBITDA = $96,000 + 143,000 EBITDA = $239,000 So, the enterprise value-EBITDA multiple is: Enterprise value-EBITDA multiple = $775,000 / $239,000 Enterprise value-EBITDA multiple = 3.24 times 12.The equity multiplier is: EM = 1 + D/E EM = 1 + .65 EM = 1.65 One formula to calculate return on equity is: ROE = ROA(EM) ROE = .082(1.65) ROE = .1353, or 13.53% ROE can also be calculated as: ROE = NI / TESo, net income is: Net income = ROE(TE) Net income = .1353($515,000) Net income = $69,679.50 13. through 15: 2014#13 2015#13#14#15 Assets Current assets Cash $11,1352.67%$13,4072.93%1.20401.0963 Accounts receivable 28,4196.81%30,9156.75%1.0878.9905 Inventory 51,16312.26%56,29512.29%1.10031.0018 Total $90,71721.75%$100,61721.96%1.10911.0099 Fixed assets Net plant and equipment $326,45678.25%$357,56078.04%1.0953.9973 Total assets $417,173100%$458,177100%1.09831.0000 Liabilities and Owners’ Equity Current liabilities Accounts payable $45,16610.83%$48,18510.52%1.0668.9714 Notes payable 17,7734.26%18,2573.98%1.0272.9353 Total $62,93915.09%$66,44214.50%1.0557.9612 Long-term debt $44,00010.55%$39,0008.51%.8864.8070 Owners' equity Common stock and paid-in surplus $50,00011.99%$50,00010.91%1.0000.9105 Accumulated retained earnings 260,23462.38%302,73566.07%1.16331.0592 Total $310,23474.37%$352,73576.99%1.13701.0352 Total liabilities and owners' equity $417,173100%$458,177100%1.09831.0000 The common-size balance sheet answers are found by dividing each category by total assets. For example, the cash percentage for 2014 is: $11,135 / $417,173 = .0267, or 2.67% This means that cash is 2.67% of total assets. The common-base year answers for Question 14 are found by dividing each category value for 2015 by the same category value for 2014. For example, the cash common-base year number is found by: $13,407 / $11,135 = 1.2040 This means the cash balance in 2015 is 1.2040 times as large as the cash balance in 2014.CHAPTER 3 ­  22 The common-size, common-base year answers for Question 15 are found by dividing the common- size percentage for 2015 by the common-size percentage for 2014. For example, the cash calculation is found by: 2.93% / 2.67% = 1.0963 This tells us that cash, as a percentage of assets, increased by 9.63%. 16. 2014 Sources/Us es 2015 Assets Current assets Cash $11,135 $2,272U$13,407 Accounts receivable 28,419 2,496U30,915 Inventory 51,163 5,132U56,295 Total $90,717 $9,900U$100,617 Fixed assets Net plant and equipment $326,456 $31,104U$357,560 Total assets $417,173 $41,004U$458,177 Liabilities and Owners’ Equity Current liabilities Accounts payable $45,166 $3,019S$48,185 Notes payable 17,773 484S18,257 Total $62,939 $3,503S$66,442 Long-term debt $44,000 –$5,000U$39,000 Owners' equity Common stock and paid-in surplus $50,000 0$50,000 Accumulated retained earnings 260,234 42,501S302,735 Total $310,234 $42,501S$352,735 Total liabilities and owners' equity $417,173 $41,004S$458,177 The firm used $41,004 in cash to acquire new assets. It raised this amount of cash by increasing liabilities and owners’ equity by $41,004. In particular, the needed funds were raised by internal financing (on a net basis), out of the additions to retained earnings, and an increase in current liabilities. 17.a.Current ratio = Current assets / Current liabilities Current ratio 2014 = $90,717 / $62,939 = 1.44 times Current ratio 2015 = $100,617 / $66,442 = 1.51 times b.Quick ratio = (Current assets – Inventory) / Current liabilities Quick ratio 2014 = ($90,717 – 51,163) / $62,939 = .63 times Quick ratio 2015 = ($100,617 – 56,295) / $66,442 = .67 timesc.Cash ratio = Cash / Current liabilities Cash ratio 2014 = $11,135 / $62,939 = .18 times Cash ratio 2015 = $13,407 / $66,442 = .20 times d.NWC ratio = NWC / Total assets NWC ratio 2014 = ($90,717 – 62,939) / $417,173 = .0666, or 6.66% NWC ratio 2015 = ($100,617 – 66,442) / $458,177 = .0746, or 7.46% e.Debt-equity ratio = Total debt / Total equity Debt-equity ratio 2014 = ($62,939 + 44,000) / $310,234 = .34 times Debt-equity ratio 2015 = ($66,442 + 39,000) / $352,735 = .30 times Equity multiplier = 1 + D/E Equity multiplier 2014 = 1 + .34 = 1.34 Equity multiplier 2015 = 1 + .30 = 1.30 f.Total debt ratio = (Total assets – Total equity) / Total assets Total debt ratio 2014 = ($417,173 – 310,234) / $417,173 = .26 times Total debt ratio 2015 = ($458,177 – 352,735) / $458,177 = .23 times Long-term debt ratio = Long-term debt / (Long-term debt + Total equity) Long-term debt ratio 2014 = $44,000 / ($44,000 + 310,234) = .12 times Long-term debt ratio 2015 = $39,000 / ($39,000 + 352,735) = .10 times Intermediate 18.This is a multistep problem involving several ratios. The ratios given are all part of the DuPont Identity. The only DuPont Identity ratio not given is the profit margin. If we know the profit margin, we can find the net income since sales are given. So, we begin with the DuPont Identity: ROE = .11 = (PM)(TAT)(EM) = (PM)(S / TA)(1 + D/E) Solving the DuPont Identity for profit margin, we get: PM = [(ROE)(TA)] / [(1 + D/E)(S)] PM = [(.11)($2,604)] / [(1 + .75)($5,783)] PM = .0283 Now that we have the profit margin, we can use this number and the given sales figure to solve for net income: PM = .0283 = NI / S NI = .0283($5,783) Net income = $163.68CHAPTER 3 ­  24 19.This is a multistep problem involving several ratios. It is often easier to look backward to determine where to start. We need receivables turnover to find days’ sales in receivables. To calculate receivables turnover, we need credit sales, and to find credit sales, we need total sales. Since we are given the profit margin and net income, we can use these to calculate total sales as: PM = .079 = NI / Sales PM = $186,000 / Sales Sales = $2,354,430 Credit sales are 70 percent of total sales, so: Credit sales = .70($2,354,430) Credit sales = $1,648,101 Now we can find receivables turnover by: Receivables turnover = Credit sales / Accounts receivable Receivables turnover = $1,648,101 / $123,840 Receivables turnover = 13.31 times Days’ sales in receivables = 365 days / Receivables turnover Days’ sales in receivables = 365 / 13.31 Days’ sales in receivables = 27.43 days 20.The solution to this problem requires a number of steps. First, remember that Current assets + Net fixed assets = Total assets. So, if we find the CA and the TA, we can solve for NFA. Using the numbers given for the current ratio and the current liabilities, we solve for CA: Current ratio = Current assets / Current liabilities Current assets = Current ratio(Current liabilities) Current assets = 1.25($987) Current assets = $1,233.75 To find the total assets, we must first find the total debt and equity from the information given. So, we find the net income using the profit margin: Profit margin = Net income / Sales Net income = Profit margin(Sales) Net income = .086($6,860) Net income = $589.96 We now use the net income figure as an input into ROE to find the total equity: ROE = Net income / Total equity Total equity = Net income / ROE Total equity = $589.96 / .175 Total equity = $3,371.20