(Solution Manual) Corporate Finance: Principles and Applications

Ross, Westerfield, Jaffe, Jordan, 5

Business

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5th Edition

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Author(s): Ross, Westerfield, Jaffe, Jordan

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End of Chapter Solutions Corporate Finance: Principles and Applications 5th edition Ross, Westerfield, Jaffe, and Jordan 3-1-2018 Prepared by Brad Jordan University of Kentucky Joe Smolira Belmont University CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Answers to Concept Questions 1. The three basic forms are sole proprietorships, pa rtnerships, and corporations. Some disadvantages of sole proprietorships and partnershi ps are: unlimited liability, limited life, difficulty in transferring ownership, and hard to raise capital funds. Some a dvantages are: simpler, less regulation, the owners are also the managers, and sometimes personal tax rat es are better than corporate tax rates. The primary disadvantage of the corporate form is the double ta xation to shareholders on distributed earnings and dividends. Some advantages include : limited liability, ease of transferability, ability to raise capital, and unlimited life. When a business is started, most take the form of a sole proprietorship or partnership because of the relative simplicity of starting these forms of businesses. 2. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly traded or not). 3. 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 ap point the firm’s management. This separation of ownership from control in the corporate form of orga nization 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 c ontradict the goal of maximizing the share price of the equity of the firm. 4. Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is reve nue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to so ciety. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answ er is that the appropriate goal is to maximize the value of the equity. 5. Presumably, the current stock value reflects the ri sk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false. 6. 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 op timal level of, for example, unethical and/or illegal behavior, and the framework of stock valuation e xplicitly includes these. At the other extreme, we could argue that these are non-economic phenomena a nd 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?” 7. 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. CHAPTER 1 B-2 8. The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitabil ity 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 manage rs have an incentive to fight corporate takeovers in situations such as this. 9. We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individual ownership. Fewer individual owne rs should reduce the number of diverse opinions concerning corporate goals. The hi gh percentage of institu tional ownership might lead to a higher degree of agreement between ow ners 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 institu tional ownership of stock in the United States and the growing activism of these large shareholder gr oups may lead to a reduction in agency problems for U.S. corporations and a more effi cient market for corporate control. 10. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest answer is that there is a market for executiv es 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 that executive compensation has grown so dramatically is that companies ha ve increasingly moved to st ock-based compensation. Such movement is obviously consistent with the a ttempt to better align stockholder and management interests. When stock prices soar, management cleans up. It is sometimes argued that much of this reward is due to rising stock pr ices in general, not managerial pe rformance. Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases. CHAPTER 2 FINANCIAL STATEMENTS AND CASH FLOW Answers to Concept 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 liqui dity so that they have a large factor of safety in meeting short-term creditor demands. However, since liquidity also has an op portunity 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 fina ncial 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 account ants have chosen to do it. 3. The bottom-line number shows the change in the cash balance on the balance sheet. As such, it is not a useful number for analyzing a company. 4. The major difference is the treatment of interest expense. The accounting statement of cash flows treats interest as an operating cash flow, while the fi nancial statement of cash flows treats interest as a financing cash flow. The logic of the accounting statem ent of cash flows is that since interest appears on the income statement, which shows the operations for the period, it is an operating cash flow. In reality, interest is a financing expense, which r esults from the company’s choice of debt/equity. We will have more to say about this in a later chapte r. When comparing the two cash flow statements, the financial statement of cash flows is a more appropriate measure of the company’s operating performance because of its treatment of interest. 5. Market values can never be negative. Imagine a shar e of stock selling for –$20. This would mean that if you placed an order for 100 shares, you would ge t 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, fo r example, capital outlays will be large, possibly leading to negative cash flow from assets. In genera l, what matters is whether the money is spent productively, 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. CHAPTER 2 B-2 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 re lative to beginning would have this effect. Negative net capital spending wo uld 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 comp any borrows more than it pays in interest and principal, its cash flow to creditors will be negative. 10. The adjustments discussed were purely accounting ch anges; they had no cash flow or market value consequences. Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved us ing a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when th ese 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 $6,800 CL $5,400 NFA 29,400 LTD 13,100 OE ?? TA $36,200 TL & OE $36,200 We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $36,200. We also know that TL & OE is equal to current liabilit ies plus long-term debt plus owners’ equity, so owners’ equity is: Owners’ equity = $36,200 – 13,100 – 5,400 = $17,700 NWC = CA – CL = $6,800 – 5,400 = $1,400 2. The income statement for the company is: Income Statement Sales $528,600 Costs 264,400 Depreciation 41,700 EBIT $222,500 Interest 20,700 EBT $201,800 Taxes (35%) 70,630 Net income $131,170 CHAPTER 2 B - 3 One equation for net income is: Net income = Dividends + Addition to retained earnings Rearranging, we get: Addition to retained earnings = Net income – Dividends Addition to retained earnings = $131,170 – 27,000 Addition to retained earnings = $104,170 3. To find the book value of current assets, we use the NWC equation, that is: NWC = CA – CL Rearranging to solve for current assets, we get: CA = NWC + CL CA = $320,000 + 1,075,000 CA = $1,395,000 So, the book value balance sheet will be: Book Value Balance Sheet Current assets $1,395,000 Fixed assets 3,900,000 Total assets $5,295,000 The market value of current assets is give n, so the market value balance sheet is: Market Value Balance Sheet NWC $ 410,000 Fixed assets 5,300,000 Total assets $5,710,000 4. Taxes = .15($50,000) + .25($25,000) + .34($25,000) + .39($328,500 – 100,000) Taxes = $111,365 The average tax rate is the total tax paid divided by taxable income, so: Average tax rate = $111,365 / $328,500 Average tax rate = .3390, or 33.90% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate is 39 percent. CHAPTER 2 B-4 5. To calculate OCF, we first need the income statement: Income Statement Sales $30,700 Costs 11,100 Depreciation expense 2,100 EBIT $17,500 Interest expense 1,140 EBT $16,360 Taxes (40%) 6,544 Net income $ 9,816 Using the equation for OCF, we get: OCF = EBIT + Depreciation – Taxes OCF = $17,500 + 2,100 – 6,544 OCF = $13,056 6. The net capital spending is the increase in fixed assets, plus depreciation, so: Net capital spending = NFA end – NFA beg + Depreciation Net capital spending = $4,450,000 – 3,750,000 + 395,000 Net capital spending = $1,095,000 7. The long-term debt account will increase by $9.5 million, the amount of the new long-term debt issue. Since the company sold 4 million new shares of stoc k with a $1 par value, the common stock account will increase by $4 million. The capital surplus acc ount will increase by $22 million, the value of the new stock sold above its par value. Since the co mpany had a net income of $15.3 million, and paid $3.1 million in dividends, the addition to retained earnings was $12.2 million, which will increase the accumulated retained earnings account. So, the new l ong-term debt and stockholders’ equity portion of the balance sheet will be: Long-term debt $ 46,500,000 Total long-term debt $ 46,500,000 Shareholders’ equity Preferred stock $ 2,100,000 Common stock ($1 par value) 12,900,000 Capital surplus 63,000,000 Accumulated retained earnings 87,500,000 Total equity $ 165,500,000 CHAPTER 2 B - 5 8. The cash flow to creditors is the interest pa id minus the change in long-term debt, so: Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = $187,000 – (LTD end – LTD beg) Cash flow to creditors = $187,000 – ($2,530,000 – 2,400,000) Cash flow to creditors = $57,000 9. The cash flow to stockholders is the dividends paid minus any new equity purchased by shareholders, so: Cash flow to stockholders = Divi dends paid – Net new equity Cash flow to stockholders = $270,000 – [(Common end + APIS end) – (Common beg + APIS beg)] Cash flow to stockholders = $270,000 – [($595, 000 + 6,180,000) – ($540,000 + 5,600,000)] Cash flow to stockholders = –$365,000 Note: APIS is the additional paid-in surplus. 10. We know that the cash flow from assets must be equal to the cash flow to credito rs plus the cash flow to stockholders, so: Cash flow from assets = Cash flow to creditors + Cash flow to stockholders Cash flow from assets = $57,000 – 365,000 Cash flow from assets = –$308,000 Now, we can use the relationship between the cash flow from assets and the operating cash flow, change in net working capital, a nd capital spending to find the operating cash flow. Doing so, we find: Cash flow from assets = –$308,000 = OCF – Change in NWC – Net capital spending –$308,000 = OCF – (–$65,000) – 640,000 Operating cash flow = $267,000 CHAPTER 2 B-6 Intermediate 11. a. The accounting statement of cash flows explains the change in cash during the year. The accounting statement of cash flows will be: Statement of cash flows Operations Net income $148 Depreciation 77 Changes in other current assets –12 Change in accounts payable 6 Total cash flow from operations $219 Investing activities Acquisition of fixed assets –$211 Total cash flow from investing activities –$211 Financing activities Proceeds of long-term debt $44 Dividends –40 Total cash flow from financing activities $4 Change in cash (on balance sheet) $ 12 b. The change in net working capital is the e nding net working capital minus the beginning net working capital, so: Change in NWC = NWC end – NWC beg = ( C A end – CL end) – (CA beg – CL beg) = [($93 + 265) – 301] – [($81 + 253) – 295) = $57 – 39 = $18 c. To find the cash flow generated by the firm ’s assets, we need the operating cash flow, and the capital spending. Since there are no interest paym ents, EBIT is the same as EBT. Calculating each of these, we find: Operating cash flow EBT $246 Depreciation 77 –Taxes 98 Operating cash flow $225 CHAPTER 2 B - 7 Next, we will calculate the capital spending, which is: Capital spending Ending fixed assets $824 –Beginning fixed assets 690 Depreciation 77 Capital spending $211 Now we can calculate the cash flow generated by the firm’s assets, which is: Cash flow from assets Operating cash flow $225 –Capital spending 211 –Change in NWC 18 Cash flow from assets –$4 Notice that the accounting statement of cash flow s shows a positive cash flow, but the financial cash flows show a negative cash flow. The financial cash flow is a better number for analyzing the firm’s performance. 12. To construct the cash flow identity, we will begi n cash flow from assets. Cash flow from assets is: Cash flow from assets = OCF – Change in NWC – Net capital spending So, the operating cash flow is: OCF = EBIT + Depreciation – Taxes OCF = $153,769 + 66,513 – 45,671 OCF = $174,611 Next, we will calculate the change in net working capital which is: Change in NWC = NWC end – NWC beg Change in NWC = (CA end – CL end) – (CA beg – CL beg) Change in NWC = ($66,284 – 32,978) – ($57,026 – 29,342) Change in NWC = $5,622 Now, we can calculate the capital spending. The capital spending is: Net capital spending = NFA end – NFA beg + Depreciation Net capital spending = $498,312 – 415,289 + 66,513 Net capital spending = $149,536 Now, we have the cash flow from assets, which is: Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $174,611 – 5,622 – 149,536 Cash flow from assets = $19,453 CHAPTER 2 B-8 The company generated $19,453 from its assets. The cash flow from operations was $174,611, and the company spent $5,622 on net working capital and $149,536 in fixed assets. The cash flow to creditors is: Cash flow to creditors = Interest paid – New long-term debt Cash flow to creditors = Interest paid – (Long-term debt end – Long-term debt beg) Cash flow to creditors = $23,280 – ($179,400 – 165,300) Cash flow to creditors = $9,180 The cash flow to stockholders is a little trickier in this problem. First, we need to calculate the new equity sold. The equity balance increased during th e year. The only way to increase the equity balance is to add addition to retained earnings or sell equity . To calculate the new equi ty sold, we can use the following equation: New equity = Ending equity – Beginnin g equity – Addition to retained earnings New equity = $352,218 – 277,673 – 69,618 New equity = $4,927 What happened was the equity account increased by $74,545. Of this increase, $69,618 came from addition to retained earnings, so the remainder must have been the sale of new equity. Now we can calculate the cash flow to stockholders as: Cash flow to stockholders = Di vidends paid – Net new equity Cash flow to stockholders = $15,200 – 4,927 Cash flow to stockholders = $10,273 The company paid $9,180 to creditors and $10,273 to its stockholders. Finally, the cash flow identity is: Cash flow from assets = Cash flow to creditors + Cash flow to stockholders $19,453 = $4,927 + $10,273 The cash flow identity balances, which is what we expect. 13. With the information provided, the cash flows fro m the firm are the capital spending and the change in net working capital, so: Cash flows from the firm Capital spending –$19,200 Additions to NWC –2,700 Cash flows from the firm –$21,900 CHAPTER 2 B - 9 And the cash flows to the investors of the firm are: Cash flows to investors of the firm Sale of long-term debt –$16,500 Sale of common stock –2,700 Dividends paid 7,100 Cash flows to investors of the firm –$12,100 14. a. The interest expense for the company is the amount of debt times the interest rate on the debt. So, the income statement for the company is: Income Statement Sales $757,000 Cost of goods sold 249,800 Selling expenses 146,000 Depreciation expense 87,000 EBIT $274,200 Interest expense 40,500 EBT $233,700 Taxes 81,795 Net income $151,905 b. And the operating cash flow is: OCF = EBIT + Depreciation – Taxes OCF = $274,200 + 87,000 – 81,795 OCF = $279,405 15. To find the OCF, we first calculate net income. Income Statement Sales $225,000 Costs 103,200 Other expenses 6,100 Depreciation expense 15,300 EBIT $100,400 Interest expense 11,200 EBT $89,200 Taxes 31,227 Net income $57,973 Dividends $18,100 Addition to retained earnings $39,873 CHAPTER 2 B-10 a. The operating cash flow was: OCF = EBIT + Depreciation – Taxes OCF = $100,400 + 15,300 – 31,227 OCF = $84,473 b. The cash flow to creditors is the interest paid minus any net new long-term debt, so: CFC = Interest – Net new LTD CFC = $11,200 – (–$8,500) CFC = $19,700 Note that the net new long-term debt is nega tive because the company repaid part of its long- term debt. c. The cash flow to stockholders is the di vidends paid minus any net new equity, or: CFS = Dividends – Net new equity CFS = $18,100 – 6,000 CFS = $12,100 d. We know that CFA = CFC + CFS, so: CFA = $19,700 + 12,100 CFA = $31,800 CFA is also equal to (OCF – Net capital spe nding – Change in NWC). We already know OCF. Net capital spending is equal to: Net capital spending = Increase in NFA + Depreciation Net capital spending = $33,000 + 15,300 Net capital spending = $48,300 Now we can use: CFA = OCF – Net capital spending – Change in NWC $31,800 = $84,473 – 48,300 – Change in NWC Solving for the change in NWC yields $4,37 3, meaning the company increased its NWC by $4,373. 16. The solution to this question works the income statement back wards. Starting at the bottom: Net income = Dividends + Addition to retained earnings Net income = $5,200 + 8,100 Net income = $13,300 Now, looking at the income statement: EBT – (EBT × Tax rate) = Net income CHAPTER 2 B - 11 Recognize that EBT × Tax rate is the calcula tion for taxes. Solving this for EBT yields: EBT = NI / (1 – Tax rate) EBT = $13,300 / (1 – .35) EBT = $20,462 Now we can calculate: EBIT = EBT + Interest EBIT = $20,462 + 2,050 EBIT = $22,512 The last step is to use: EBIT = Sales – Costs – Depreciation $22,512 = $57,900 – 28,600 – Depreciation Depreciation = $6,788 17. The balance sheet for th e company looks like this: Balance Sheet Cash $168,000 Accounts payable $429,000 Accounts receivable 237,000 Notes payable 171,000 Inventory 385,000 Current liabilities $600,000 Current assets $790,000 Long-term debt 1,985,000 Total liabilities $2,585,000 Tangible net fixed assets 3,410,000 Intangible net fixed assets 827,000 Common stock ?? Accumulated ret. earnings 2,084,000 Total assets $5,027,000 Total liab. & owners’ equity $5,027,000 Total liabilities and owners’ equity is: TL & OE = CL + LTD + Common stock Solving this equation for equity gives us: Common stock = $5,027,000 – 2,084,000 – 2,585,000 Common stock = $358,000 18. 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 = Ma x [(TA – TL), 0]. So, if TA is $15,100, equity is equal to $3,500, and if TA is $9,900, equity is e qual to $0. We should note here that the book value of shareholders’ equity can be negative. 19. a. Taxes Growth = .15($50,000) + .25($25,000) + .34($4,500) = $15,280 Taxes Income = .15($50,000) + .25($25,000) + .34($25,000) + .39($235,000) + .34($7,950,000 – 335,000) = $2,703,000 CHAPTER 2 B-12 b. Each firm has a marginal tax rate of 34 percen t on the next $10,000 of taxable income, despite their different average tax rates, so both fi rms will pay an additi onal $3,400 in taxes. 20. a. The income statement for the company is: Income Statement Sales $809,000 Costs 549,000 Administrative and selling expenses 136,000 Depreciation expense 85,000 EBIT $ 39,000 Interest expense 67,000 EBT –$28,000 Taxes 0 Net income –$28,000 b. OCF = EBIT + Depreciation – Taxes OCF = $39,000 + 85,000 – 0 OCF = $124,000 c. Net income was negative because of the tax deduc tibility of depreciation a nd 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. 21. 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 = $124,000 – 0 – 0 = $124,000 Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $75,000 – 0 = $75,000 Cash flow to creditors = Cash flow from assets – Cash flow to stockholders Cash flow to creditors = $124,000 – 75,000 Cash flow to creditors = $49,000 Cash flow to creditors is also: Cash flow to creditors = Interest – Net new LTD So: Net new LTD = Interest – Cash flow to creditors Net new LTD = $67,000 – 49,000 Net new LTD = $18,000 CHAPTER 2 B - 13 22. a. The income statement is: Income Statement Sales $44,600 Cost of goods sold 27,500 Depreciation 4,630 EBIT $12,470 Interest 1,050 Taxable income $11,420 Taxes (40%) 4,568 Net income $ 6,852 b. OCF = EBIT + Depreciation – Taxes OCF = $12,470 + 4,630 – 4,568 OCF = $12,532 c. Change in NWC = NWC end – NWC beg = (CA end – CL end) – (CA beg – CL beg) = ($7,720 – 4,830) – ($6,840 – 4,580) = $630 Net capital spending = NFA end – NFA beg + Depreciation = $35,610 – 27,510 + 4,630 = $12,730 CFA = OCF – Change in NWC – Net capital spending = $12,532 – 630 – 12,730 = –$828 The cash flow from assets can be positive or nega tive, 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 fixe d assets and net working capital; it had to raise a net $828 in funds from its stockholders and creditors to make these investments. d. Cash flow to creditors = Interest – Net new LTD = $1,050 – 0 = $1,050 Cash flow to stockholders = Cash flow from assets – Cash flow to creditors = –$828 – 1,050 = –$1,878 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 = $2,275 – (–1,878) = $4,153 CHAPTER 2 B-14 The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $630 in new ne t working capital and $12,730 in new fixed assets. The firm had to raise $828 from its stakeholders to support this new investment. It accomplished this by raising $4,153 in the form of new equity. After paying out $2,275 of this in the form of dividends to shareholders and $1,050 in the form of interest to creditors, $828 was left to meet the firm’s cash flow needs for investment. 23. a. Total assets 2016 = $1,066 + 5,184 = $6,250 Total liabilities 2016 = $475 + 2,880 = $3,355 Owners’ equity 2016 = $6,250 – 3,355 = $2,895 Total assets 2017 = $1,145 + 5,472 = $6,617 Total liabilities 2017 = $518 + 3,090 = $3,608 Owners’ equity 2017 = $6,617 – 3,608 = $3,009 b. NWC 2016 = CA 2016 – CL 2016 = $1,066 – 475 = $591 NWC 2017 = CA 2017 – CL 2017 = $1,145 – 518 = $627 Change in NWC = NWC 2017 – NWC 2016 = $627 – 591 = $36 c. We can calculate net capital spending as: Net capital spending = Net fixed assets 2017 – Net fixed assets 2016 + Depreciation Net capital spending = $5,472 – 5,184 + 1,339 Net capital spending = $1,627 So, the company had a net capital spending cash flow of $1,627. We also know that net capital spending is: Net capital spending = Fixed assets bought – Fixed assets sold $1,627 = $2,740 – Fixed assets sold Fixed assets sold = $2,740 – 1,627 Fixed assets sold = $1,113 To calculate the cash flow from assets, we must first calculate the operating cash flow. The operating cash flow is calculated as follows (you can also prepare a traditional income statement): EBIT = Sales – Costs – Depreciation EBIT = $15,690 – 3,739 – 1,339 EBIT = $10,612 EBT = EBIT – Interest EBT = $10,612 – 562 EBT = $10,050 Taxes = EBT  .35 Taxes = $10,050  .35 Taxes = $3,518 CHAPTER 2 B - 15 OCF = EBIT + Depreciation – Taxes OCF = $10,612 + 1,339 – 3,518 OCF = $8,434 Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $8,434 – 36 – 1,627 Cash flow from assets = $6,771 d. Net new borrowing = LTD 2017 – LTD 2016 Net new borrowing = $3,090 – 2,880 Net new borrowing = $210 Net new borrowing = $210 = Debt issued – Debt retired Debt retired = $634 – 210 Debt retired = $424 Cash flow to creditors = Interest – Net new LTD Cash flow to creditors = $562 – 210 Cash flow to creditors = $352 24. Balance sheet as of Dec. 31, 2016 Cash $21,364 Accounts payable $27,349 Accounts receivable 28,283 Inventory 50,287 Long-term debt 71,550 Current assets $99,934 Net fixed assets $179,166 Owners' equity 180,201 Total assets $279,100 Total liab. & equity $279,100 Balance sheet as of Dec. 31, 2017 Cash $21,856 Accounts payable $25,639 Accounts receivable 31,864 Inventory 51,675 Long-term debt 83,476 Current assets $105,395 Net fixed assets $183,440 Owners' equity 179,720 Total assets $288,835 Total liab. & equity $288,835 CHAPTER 2 B-16 2016 Income Statement 2017 Income Statement Sales $40,743.00 Sales $43,277.00 COGS 14,020.00 COGS 15,912.00 Other expenses 3,322.00 Other expenses 2,776.00 Depreciation 5,853.00 Depreciation 5,858.00 EBIT $17,548.00 EBIT $18,731.00 Interest 2,098.00 Interest 3,142.00 EBT $15,450.00 EBT $15,589.00 Taxes (35%) 5,407.50 Taxes (35%) 5,456.15 Net income $10,042.50 Net income $10,132.85 Dividends $4,966.00 Dividends $5,468.00 Additions to RE $5,076.50 Additions to RE 4,664.85 25. OCF = EBIT + Depreciation – Taxes OCF = $18,731 + 5,858 – 5,456.15 OCF = $19,132.85 Change in NWC = NWC end – NWC beg = (CA – CL) end – (CA – CL) beg Change in NWC = ($105,395 – 25,639) – ($99,934 – 27,349) Change in NWC = $7,171 Net capital spending = NFA end – NFA beg + Depreciation Net capital spending = $183,440 – 179,166 + 5,858 Net capital spending = $10,132 Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $19,132.85 – 7,171 – 10,132 Cash flow from assets = $1,829.85 Cash flow to creditors = Interest – Net new LTD Net new LTD = LTD end – LTD beg Cash flow to creditors = $3,142 – ($83,476 – 71,550) Cash flow to creditors = –$8,784 Net new equity = Common stock end – Common stock beg Common stock + Retained earnings = Total owners’ equity Net new equity = (OE – RE) end – (OE – RE) beg Net new equity = OE end – OE beg + RE beg – RE end RE end = RE beg + Additions to RE Net new equity = OE end – OE beg + RE beg – (RE beg + Additions to RE 2014) Net new equity = OE end – OE beg – Additions to RE 2014 Net new equity = $179,720 – 180,201 – 4,664.85 Net new equity = –$5,145.85 Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $5,468 – (–$5,145.85) Cash flow to stockholders = $10,613.85 CHAPTER 2 B - 17 As a check, cash flow from assets is $1,829.85. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders Cash flow from assets = –$8,784 + 10,613.85 Cash flow from assets = $1,829.85 Challenge 26. We will begin by calculating the operating cash flow. Fi rst, we need the EBIT, which can be calculated as: EBIT = Net income + Current taxes + Deferred taxes + Interest EBIT = $321 + 185 + 34 + 96 EBIT = $636 Now we can calculate the operating cash flow as: Operating cash flow Earnings before interest and taxes $636 Depreciation 177 – Current taxes 185 Operating cash flow $628 The net capital spending is found in the investing activities portion of the accounting statement of cash flows, so: Net capital spending Acquisition of fixed assets $332 – Sale of fixed assets 42 Capital spending $290 The net working capital cash flows are all found in the operations cash flow section of the accounting statement of cash flows. However, instead of cal culating the net working capital cash flows as the change in net working capital, we must calcul ate each item individually. Doing so, we find: Net working capital cash flow Cash $27 Accounts receivable 52 Inventories –41 Accounts payable –33 Accrued expenses 17 Other –4 NWC cash flow $18 CHAPTER 2 B-18 Except for the interest expense and notes payable, the cash flow to cr editors is found in the financing activities of the accounting statement of cash flows. The interest expense from the income statement is given, so: Cash flow to creditors Interest $96 Retirement of debt 195 Debt service $291 – Proceeds from sale of long-term debt –105 Total $186 And we can find the cash flow to stockholders in the financing section of the accounting statement of cash flows. The cash flow to stockholders was: Cash flow to stockholders Dividends $158 Repurchase of stock 26 Cash to stockholders $184 – Proceeds from new stock issue –50 Total $134 27. Net capital spending = NFA end – NFA beg + Depreciation = (NFA end – NFA beg) + (Depreciation + AD beg) – AD beg = (NFA end – NFA beg)+ AD end – AD beg = (NFA end + AD end) – (NFA beg + AD beg) = FA end – FA beg 28. 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. Assuming a taxable income of $335,001, the taxes will be: Taxes = .15($50,000) + .25($25,000) + .34($25,000) + .39($235,000) Taxes = $113,900 Average tax rate = $113,900 / $335,000 Average tax rate = .34, or 34% The marginal tax rate on the next dollar of income is 34 percent. For corporate taxable income levels greater th an $18,333,334, average tax rates are equal to marginal tax rates. Taxes = .34($10,000,000) + .35($5,000,000) + .38($3,333,334) Taxes = $6,416,667 CHAPTER 2 B - 19 Average tax rate = $6,416,667 / $18,333,334 Average tax rate = .35, or 35% The marginal tax rate on the next dollar of inco me 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 = $45,750 X = $45,750 / $100,000 X = .4575, or 45.75% CHAPTER 3 FINANCIAL STATEMENTS ANALYSIS AND LONG-TERM PLANNING Answers to Concept Questions 1. Time trend analysis gives a picture of chang es in the company’s financial situation over time. Comparing a firm to itself over time allows the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment ac tivities have changed. 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. Comp aring a firm to its peers allows the financial manager to evaluate whether some aspects of the fi rm’s operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate acti ons to take to adjust these ratios if necessary. Both allo w an investigation into what is different about a company from a financial perspective, but neither method gives an indication of whether the difference is positive or negative. For example, suppose a company’s current ratio is increasing over time. It could mean that the company had been facing liquidity problems in th e past and is rectifying those problems, or it could mean the company has b ecome less efficient in managing its current accounts. Similar arguments could be made for a peer group comparis on. A company with a current ratio lower than its peers could be more efficient at managing its current accounts, or it could be facing liquidity problems. Neither analysis method tells us whether a ratio is g ood or bad, both show that something is different, and tells us where to look. 2. If a company is growing by opening new stores , then presumably total revenues would be rising. Comparing total sales at two different points in tim e might be misleading. Same-store sales control for this by only looking at revenues of stores open within a specific period. 3. The reason is that, ultimately, sales are the drivi ng force behind a business. A firm’s assets, employees, and, in fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees, inventory, and financing are determined by its future sales level. 4. Two assumptions of the sustainable growth formul a are that the company does not want to sell new equity, and that financial policy is fixed. If the company raises outside equity, or increases its debt- equity ratio, it can grow at a higher rate than the sustainable growth rate. Of course, the company could also grow faster than its profit margin increases, if it changes its dividend policy by increasing the retention ratio, or its total asset turnover increases. 5. The sustainable growth rate is greater than 20 percen t, because at a 20 percent growth rate the negative EFN indicates that there is excess financing still available. If the firm is 100 percent equity financed, then the sustainable and internal growth rates are e qual and the internal growth rate would be greater than 20 percent. However, when the firm has some debt, the internal growth rate is always less than the sustainable growth rate, so it is ambiguous whethe r the internal growth rate would be greater than or less than 20 percent. If the retention ratio is increased, the firm will have more internal funding sources available, and it will have to take on more debt to keep the debt-–equity ratio constant, so the EFN will decline. Conversely, if the retention ratio is decreased, the EFN will rise. If the retention rate CHAPTER 3 B - 21 is zero, both the internal and sustainable growth ra tes are zero, and the EFN will rise to the change in total assets. 6. Common-size financial statements provide the financia l manager with a ratio analysis of the company. The common-size income statement can show, for exampl e, that cost of goods sold as a percentage of sales is increasing. The common-size balance sheet can show a firm’s increasing reliance on debt as a form of financing. Common-size statements of cash flows are not calculated for a simple reason: There is no possible denominator. 7. It would reduce the external funds needed. If the company is not operating at full capacity, it would be able to increase sales without a commensurate increase in fixed assets. 8. Presumably not, but, of course, if the product had been much less popular, then a similar fate would have awaited due to lack of sales. 9. Since customers did not pay until shipment, rece ivables rose. The firm’s NWC, but not its cash, increased. At the same time, costs were rising fast er than cash revenues, so operating cash flow declined. The firm’s capital spending was also risi ng. Thus, all three components of cash flow from assets were negatively impacted. 10. Financing possibly could have been arranged if the company had taken quick enough action. Sometimes it becomes apparent that help is needed only when it is too late, again emphasizing the need for planning. 11. All three were important, but the lack of cash or, more generally, financial resources ultimately spelled doom. An inadequate cash resource is usually cited as the most common cause of small business failure. 12. Demanding cash upfront, increasing prices, subc ontracting production, and improving financial resources via new owners or new sources of credit are some of the options. When orders exceed capacity, price increases may be especially beneficial. 13. ROE is a better measure of the company’s performan ce. ROE shows the percentage return for the year earned on shareholder investment. Since the goal of a company is to maximize shareholder wealth, this ratio shows the company’s performan ce in achieving this goal over the period. 14. The EBITDA/Assets ratio shows the company’s opera ting performance before interest, depreciation, and taxes. This ratio would show how a company has controlled costs. While taxes are a cost, and interest and depreciation can be considered cost s, they are not as easily controlled by company management. Conversely, depreciation and amortizat ion can be altered by accounting choices. This ratio only uses revenue minus costs that are directly re lated to operations in the numerator. As such, it gives a better metric to measure management performance over a period than does ROA.