(Solution Manual) Corporate Finance Core Principles and Applications

Ross, Westerfield, Jaffe, Jordan, 6

Business

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6th Edition

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Solution Manual for Corporate Finance Core Principles and Applications, The downloadable file consists of 471 pages, and the total size of the file is 2.66 MB. Purchase now only for highly discounted price.

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

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Corporate Finance: Principles and Applications 6th edition Ross, Westerfield, Jaffe, and Jordan Prepared by Brad Jordan Joe Smolira NOTE: (For Complete File, Download link at the end of this File)Get all chapters complete solutions manual files download link below https://www.mediafire.com/file/53zu5kdu g0zx93a/SM+Corporate+Finance+Core+Pri nciples+and+Applica tions,+6e+Ross,+West erfield,+Jaffe,+Jordan.zip/file CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Answers to Concept Questions 1. The three basic forms are sole proprietorships, partnerships, and corporations. Some disadvantages of sole proprietorships and partnerships are: unlimited liability, limited life, difficulty in transferring ownership, and hard to raise capital funds. Some advantages are: simpl icity, less regulation, the owners are also the managers, and so metimes personal tax rates are better than corporate tax rates. The primary disadvantage of the corporate form is the double taxation 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 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. 4. Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., provid e 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. 5. 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. 6. An argument can be made either way. At the one extreme, we could argue that in a market economy, all these things are priced. T hus, t here is an optimal level of, for example, unethical and/or illegal behavior, and the framework of stock valuation explicitl y includes these. At the other extreme, we could argue that these are non -economic 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?” 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 mana gement 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 mo re 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. 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 owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional o wnership 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. 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 executives just as there is for all types of labor. Executiv e 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 compan ies have increasingly moved to stock -based compensation. Such movement is obviously consistent with the attempt 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 prices in general, not managerial performance. 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 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 inv esting 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 financ ial 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 c orrect; it’s the way accountants 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 financial statement of cash flows treats interest as a financing cash flow. The logic of the accounting statement of cash flows is that since interest appe ars 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 results 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 share of sto ck 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 ass ets. In general, 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 relative to beginning NWC 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 and principal, its cash flow to creditors will be negative. 10. The adjustments were purely accounting changes; they had no cash flow or market valu e consequences. 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 solu tions 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 $6,400 CL $5,100 NFA 29,300 LTD 11,800 OE ?? TA $35,700 TL & OE $35,700 We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $3 5,700. We also know that TL & OE is equal to current liabilities plus long -term debt plus owners’ equity, so owners’ equity is: Owners’ equity = $35,700 – 11,800 – 5,100 = $1 8,800 NWC = CA – CL = $ 6,400 – 5,100 = $1, 300 2. The income statement for the company is: Income Statement Sales $517,400 Costs 296,300 Depreciation 42,300 EBIT $178,8 00 Interest 20,400 EBT $158,4 00 Taxes ( 21%) 33,264 Net income $125,136 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 = $ 125,136 – 27,000 Addition to retained earnings = $ 98,136 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 = $3 40,000 + 1, 125,000 CA = $1, 465,000 So, the book value balance sheet will be: Book Value Balance Sheet Current assets $1,465,000 Fixed assets 3,900,000 Total assets $5,365,000 The market value of current assets is given, so the market value balance sheet is: Market Value Balance Sheet NWC $ 380,000 Fixed assets 5,600,000 Total assets $5,980,000 4. Taxes = .1 0($9,700) + . 12($39,475 – 9,700 ) + .22($84,200 – 39,475 ) + .24($160,725 – 84,200) + .32($189,000 – 160,725) Taxes = $ 41,796.50 The average tax rate is the total tax paid divided by taxable income, so: Average tax rate = $ 41,796.50 /$189,0 00 Average tax rate = . 2211 , or 22.11 % The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate is 32 percent. CHAPTER 2 B -4 5. To calculate OCF, we first need the income statement: Income Statement Sales $32,400 Costs 14,300 Depreciation expense 2,200 EBIT $15,900 Interest expense 1,160 EBT $14,740 Taxes ( 23%) 3,390 Net income $11,350 Using the equation for OCF, we get: OCF = EBIT + Depreciation – Taxes OCF = $1 5,900 + 2,200 – 3,390 OCF = $1 4,709.80 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 ,630,000 – 3,820,000 + 405,000 Net capital spending = $1, 215,000 7. The long -term debt a ccount will increase by $ 7.6 million, the amount of the new long -term debt issue. Since the company sold 3.2 million new shares of stock with a $1 par value, the common stock account will increase by $ 3.2 million. The capital surplus account will increase by $17.6 million, the value of the new stock sold above its par value. Since the company had a net income of $ 12.24 million, and paid $ 2.48 million in dividends, the addition to retained earnings was $ 9.76 million, which will increase the accumulated retai ned earnings account. So, the new long -term debt and stockholders’ equity portion of the balance sheet will be: Long -term debt $ 37,2 00,000 Total long -term debt $ 37,2 00,000 Shareholders’ equity Preferred stock $ 1,680,000 Common stock ($1 par value) 10,320,000 Capital surplus 50,400,000 Accumulated retained earnings 69,96 0,000 Total equity $ 132,36 0,000 CHAPTER 2 B - 5 8. The cash flow to creditors is the interest paid minus the change in long -term debt, so: Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = $ 168,000 – (LTD end – LTD beg) Cash flow to creditors = $ 168,000 – ($2,280,000 – 2,160,000) Cash flow to creditors = $ 48,000 9. The cash flow to stockholders is the dividends paid minus any new equity purchased by shareholders, so: Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = $ 245,000 – [(Common end + APIS end) – (Common beg + APIS beg)] Cash flow to stockholders = $ 245,000 – [($536,000 + 5,560,000) – ($486,000 + 5, 040,000)] Cash flow to st ockholders = –$325,000 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 creditors plus the cash flow to stockholders, so: Cash flow from assets = Cash flow to creditors + Cash flow to stockholders Cash flow from assets = $ 48,000 – 325,000 Cash flow from assets = –$277,000 Now, we can use the relationship between the cash flow from assets and the operating cash flow, change in net working capital, and capital spending to find the operating cash flow. Doing so, we find: Cash flow from assets = OCF – Change in NWC – Net capital spending –$277,000 = OCF – (–$59,000) – 575,000 Operating cash flow = $239,000 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 $191 Depreciation 92 Changes in other current assets –14 Change in accounts payable 8 Total cash flow from operations $277 Investing activities Acquisition of fixed assets –$252 Total cash flow from investing activities –$252 Financing activities Proceeds of long -term debt $48 Dividends –58 Total cash flow from financing activities – $10 Change in cash (on balance sheet) $ 15 b. The change in net working capital is the ending net working capital minus the beginning net working capital, so: Change in NWC = NWC end – NWC beg = (CA end – CL end) – (CA beg – CL beg) = [($ 112 + 318) – 362] – [($97 + 304) – 354) = $68 – 47 = $21 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 payments, EBIT is the same as EBT. Calculating each of these, we find: Operating cash flow EBT $245 Depreciation 92 –Taxes 54 Operating cash flow $283 CHAPTER 2 B - 7 Next, we will calculate the capital spending, which is: Capital spending Ending fixed assets $988 –Beginning fixed assets 828 Depreciation 92 Capital spending $252 Now we can calculate the cash flow generated by the firm’s assets, which is: Cash flow from assets Operating cash flow $283 –Capital spending 252 –Change in NWC 21 Cash flow from assets $10 Notice that the accounting statement of cash flows 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 begin with 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 = $ 138,393 + 59,862 – 24,310 OCF = $ 173,945 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 = ($ 59,656 – 33,831 ) – ($51,323 – 26,408 ) Chan ge in NWC = $ 910 Now, we can calculate the capital spending. The capital spending is: Net capital spending = NFA end – NFA beg + Depreciation Net capital spending = $ 448,481 – 373,760 + 59,862 Net capital spending = $1 34,583 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 = $ 173,945 – 910 – 134,583 Cash flow from assets = $ 38,452 CHAPTER 2 B -8 The company generated $ 38,452 from its assets. The cash flow from operations was $ 173,945 , and the company spent $ 910 on net working capital and $ 134,583 on fixed assets. The cash flow to creditors is: Cash flow to creditors = Interest paid – New long -term debt Cash flow to credi tors = Interest paid – (Long -term debt end – Long -term debt beg) Cash flow to creditors = $ 20,952 – ($152,4 00 – 148,7 00) Cash flow to creditors = $ 17,252 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 the year. The only way to increase the equity balance is through addition to retained earnings or sell ing equity. To calculate the new equity sold, we can use the following equation: New equity = Endin g equity – Beginning equity – Addition to retained earnings New equity = $3 21,906 – 249,975 – 67,931 New equity = $ 4,000 What happened was the equity account increased by $ 71,931 . Of this increase, $ 67,931 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 = Dividends paid – Net new equity Cash flow to stockholders = $ 25,200 – 4,000 Cash flow to stockholders = $ 21,200 The company paid $ 17,252 to creditors and $ 21,200 to its stockholders. Finally, the cash flow identity is: Cash flow from assets = Cash flow to creditors + Cash flow to stockholders $38,452 = $ 17,252 + $ 21,200 The cash flow identity balances, which is what we expect. 13. With the information given, we have the capital spending, change in NWC, and cash flow to stockholders. The cash flow to cre ditors is: Cash flow to creditors = Interest paid – New long -term debt Cash flow to creditors = $2,460 – 19,800 Cash flow to creditors = –$17,340 Now we can use the cash flow identity to calculate the OCF: OCF – Change in NWC – Net capital spending = Cash flow to creditors + Cash flow to stockholders OCF – $3,380 – $23,100 = –$17,340 + $8,520 OCF = –$17,340 + 8,520 + 3,380 + 23,100 OCF = $17,660 CHAPTER 2 B - 9 14. a. The interest expe nse 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 $529,900 Cost of goods sold 174,800 Selling expenses 102,2 00 Depreciation expense 60,900 EBIT $192,000 Interest expense 28,800 EBT $163,2 00 Taxes 39,168 Net income $124,032 b. And the operating cash flow is: OCF = EBIT + Depreciation – Taxes OCF = $ 192,0 00 + 60,900 – 39,168 OCF = $ 213,732 15. To find the OCF, we first calculate net income. Income Statement Sales $315,000 Costs 208,600 Other expenses 8,600 Depreciation expense 21,400 EBIT $76,400 Interest expense 15,700 EBT $60,700 Taxes 12,747 Net income $47,953 Dividends $13,600 Addition to retained earnings 34,353 a. The operating cash flow was: OCF = EBIT + Depreciation – Taxes OCF = $ 76,400 + 21,400 – 12,74 7 OCF = $8 5,053 CHAPTER 2 B -10 b. The cash flow to creditors is the interest paid minus any net new long-term debt, so: CFC = Interest – Net new LTD CFC = $1 5,700 – (–$11,900) CFC = $ 27,600 Note that the net new long -term debt is negative because the company repaid part of its long - term debt. c. The cash flow to stockholders is the dividends paid minus any net new equity, or: CFS = Dividends – Net new equity CFS = $13,6 00 – 8,400 CFS = $ 5,200 d. We know that CFA = CFC + CFS, so: CFA = $ 27,600 + 5,200 CFA = $32,800 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 Net capital spending = $ 28,600 + 21,400 Net capital spending = $ 50,000 Now we can use: CFA = OCF – Net capital spending – Change in NWC $32,800 = $8 5,053 – 50,00 0 – Change in NWC Solving for the change in NWC yields $2,253 , meaning the company increased its NWC by $2,253 . 16. The solution to this question works the income statemen t backwards. Starting at the bottom: Net income = Dividends + Addition to retained earnings Net income = $ 6,240 + 9,420 Net income = $ 15,660 Now, looking at the income statement: EBT – (EBT × Tax rate) = Net income Recognize that EBT × Tax rate is the calculation for taxes. Solving this for EBT yields: EBT = NI /(1 – Tax rate) EBT = $1 5,660/ (1 – .21) EBT = $ 19,823 CHAPTER 2 B - 11 Now we can calculate: EBIT = EBT + Interest EBIT = $ 19,823 + 2,460 EBIT = $2 2,283 The last step is to use: EBIT = Sales – Costs – Depreciation $22,283 = $69,480 – 34,320 – Depreciation Depreciation = $ 12,877 17. The balance sheet for the company looks like this: Balance Sheet Cash $117,600 Accounts payable $300,3 00 Accounts receivable 165,9 00 Notes payable 118,000 Inventory 269,5 00 Current liabilities $418,3 00 Current assets $553,000 Long -term debt 1,389,5 00 Total liabilities $1,807,8 00 Tangible net fixed assets $2,387 ,000 Intangible net fixed assets 579,000 Common stock ?? Accumulated ret. earnings 1,458,8 00 Total assets $3,519 ,000 Total liab. & owners’ equity $3,519 ,000 Total liabilities and owners’ equity is: TL & OE = CL + LTD + Common stock Solving this equation for equity gives us: Common stock = $ 3,519,00 0 – 1,807,8 00 – 1,458,8 00 Common stock = $ 252,4 00 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 = Max[(TA – TL), 0]. So, if TA is $1 4,900, equity is equal to $ 1,400, and if TA is $ 10,700, equity is equal to $0. We should note here that the book value of shareholders’ equity can be negative. CHAPTER 2 B -12 19. a. The income statement for the company is: Income Statement Sales $890,000 Costs 604,000 Administrative and selling expenses 151,000 Depreciation expense 93,000 EBIT $ 42,000 Interest expense 74,000 EBT –$32,000 Taxes 0 Net income –$32,000 b. OCF = EBIT + Depreciation – Taxes OCF = $ 42,000 + 93,000 – 0 OCF = $ 135,000 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 mak e 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 = $ 135,000 – 0 – 0 = $ 135,000 Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $ 95,000 – 0 = $ 95,000 Cash flow to creditors = Cash flow from assets – Cash flow to stockholders Cash flow to creditors = $ 135,000 – 95,000 Cash flow to creditors = $40,000 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 = $ 74,000 – 40,000 Net new LTD = $ 34,000 CHAPTER 2 B - 13 21. a. The income statement is: Income Statement Sales $53,520 Cost of goods sold 36,800 Depreciation 5,560 EBIT $11,160 Interest 1,260 Taxable income $ 9,900 Taxes 2,475 Net income $ 7,425 b. OCF = EBIT + Depreciation – Taxes OCF = $11,160 + 5,560 – 2,475 OCF = $14,245 c. Change in NWC = NWC end – NWC beg = (CA end – CL end) – (CA beg – CL beg) = ($9,260 – 5,780 ) – ($8,210 – 5,490 ) = $760 Net capital spending = NFA end – NFA beg + Depreciation = $42,730 – 33,020 + 5,560 = $15,270 CFA = OCF – Change in NWC – Net capital spending = $14,245 – 760 – 15,270 = –$1,785 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 $ 1,785 in funds from its stockholders and creditors to make these investments. d. Cash flo w to creditors = Interest – Net new LTD = $1,260 – 0 = $1,260 Cash flow to stockholders = Cash flow from assets – Cash flow to creditors = –$1,785 – 1,260 = –$3,045 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 = $2,730 – (–3,045 ) = $5,775 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 $ 760 in new net working capital and $ 15,270 in new fixed assets. The firm had to raise $ 1,785 from its stakeholders to support this new investment. It accomplished this by raising $ 5,775 in the form of new equity. After paying out $ 2,730 of this in the form of dividends to shareholders and $ 1,260 in the form of interest to creditors, $ 1,785 was left to meet the firm’s cash flow needs for investment. 22. a. Total assets 2019 = $1,173 + 5,702 = $6,875 Total liabilities 2019 = $523 + 3,168 = $3,691 Owners’ equity 2019 = $6,875 – 3,691 = $3,184 Total assets 2020 = $1,260 + 6,019 = $7,279 Total liabilities 2020 = $570 + 3,399 = $3,969 Owners’ equity 2020 = $7,279 – 3,969 = $3,310 b. NWC 2019 = CA 2019 – CL 2019 = $1,173 – 523 = $650 NWC 2020 = CA 2020 – CL 2020 = $1,260 – 570 = $690 Change in NWC = NWC 2020 – NWC 2019 = $690 – 650 = $40 c. We can calculate net capital spending as: Net capital spending = Net fixed assets 2020 – Net fixed assets 2019 + Depreciation Net capital spending = $ 6,019 – 5,702 + 1,472 Net capital spending = $ 1,789 So, the company had a net capital spending cash flow of $ 1,789 . We also know that net capital spending is: Net capital spending = Fixed assets bought – Fixed assets sold $1,789 = $3,050 – Fixed assets sold Fixed assets sold = $3,050 – 1,789 Fixed assets sold = $1,261 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 = $1 7,259 – 5,113 – 1,472 EBIT = $ 10,674 EBT = EBIT – Interest EBT = $ 10,674 – 618 EBT = $ 10,674 Taxes = EBT  .25 Taxes = $ 10,674  .25 Taxes = $ 2,514 CHAPTER 2 B - 15 OCF = EBIT + Depreciation – Taxes OCF = $ 10,674 + 1,472 – 2,514 OCF = $ 9,632 Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $ 9,632 – 40 – 1,789 Cash flow from assets = $ 7,803 d. Net new borrowing = LTD 2020 – LTD 2019 Net new borrowing = $ 3,399 – 3,168 Net new borrowing = $ 231 Net new borrowing = $ 231 = Debt issued – Debt retired Debt retired = $ 618 – 231 Debt retired = $ 466 Cash flow to creditors = Interest – Net new LTD Cash flow to creditors = $ 618 – 231 Cash flow to creditors = $ 387 23. Balance sheet as of Dec. 31, 2019 Cash $25,636 Accounts payable $32,819 Accounts receivable 33,940 Inventory 60,344 Long -term debt 85,860 Current assets $119,920 Net fixed assets $215,940 Owners' equity 217,181 Total assets $335,860 Total liab. & equity $335,860 Balance sheet as of Dec. 31, 2020 Cash $26,227 Accounts payable $30,767 Accounts receivable 38,327 Inventory 62,015 Long -term debt 100,171 Current assets $126,479 Net fixed assets $220,130 Owners' equity 215,671 Total assets $346,609 Total liab. & equity $346,609 CHAPTER 2 B -16 2019 Income Statement 2020 Income Statement Sales $48,892 Sales $51,932 COGS 20,628 COGS 23,277 Other expenses 3,986 Other expenses 3,331 Depreciation 7,024 Depreciation 7,030 EBIT $17,254 EBIT $18,294 Interest 2,518 Interest 3,770 EBT $14,736 EBT $14,524 Taxes 3,684 Taxes 3,631 Net income $11,052 Net income $10,893 Dividends $5,900 Dividends $8,600 Additions to RE 5,152 Additions to RE 2,293 24. OCF = EBIT + Depreciation – Taxes OCF = $1 8,294 + 7,030 – 3,631 OCF = $ 21,693 Change in NWC = NWC end – NWC beg = (CA – CL) end – (CA – CL) beg Change in NWC = ($126,479 – 30,767 ) – (119,920 – 32,819 ) Change in NWC = $ 8,611 Net capital spending = NFA end – NFA beg + Depreciation Net capital spending = $ 220,130 – 215,940 + 7,030 Net capital spending = $ 11,220 Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $ 21,693 – 8,611 – 11,220 Cash flow from assets = $1, 862 Cash flow to creditors = Interest – Net new LTD Net new LTD = LTD end – LTD beg Cash flow to creditors = $ 3,770 – ($100,171 – 85,860) Cash flow to creditors = –$10,541 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 2020) Net new equity = OE end – OE beg – Additions to RE 2020 Net new equity = $ 215,671 – 217,181 – 2,293 Net new equity = –$3,803 Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $ 8,600 – (–$3,803 ) Cash flow to stockholders = $ 12,403 CHAPTER 2 B - 17 As a check, cash flow from assets is $1, 862. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders Cash flow from assets = –$10,541 + 12,403 Cash flow from assets = $1, 862 Challenge 25. We will begin by calculating the operating cash flow. First, 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 calculating the net working capital cash flows as the change in net working capital, we must calculate 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 creditors 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 26. 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 CHAPTER 3 FINANCIAL STATEMENTS ANALYSIS AND LONG -TERM PLANNING Answers to Concept Questions 1. Time trend analysis gives a picture of changes 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 activities h ave 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. Comparing a firm to its peers allows the financial manager to eva luate 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 necessary. Both allow 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 the past and is rectifying those problems, or it could mean the company has become less efficient in managing its current accounts. Similar arguments could be made for a peer group comparison. A company with a current rat io 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 good or bad, both show that something is different, and tell 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 time might be misleading. Same -store sales control for this by only looking at revenues of stores open with in a specific period. 3. The reason is that, ultimately, sales are the driving 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 d ifferently, 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 formula 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 c hanges its dividend policy by increasing the retention ratio or if its total asset turnover increases. 5. The sustainable growth rate is greater than 20 percent, because at a 20 percent growth rate , the negative EFN indicates that there is excess financi ng still available. If the firm is 100 percent equity financed, then the sustainable and internal growth rates are equal 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 whether 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 -20 is zero, both the internal and sustainable growth rates are zero, and the EFN will rise to the change in total assets. 6. Common -size financial statements provide the financial manager with a ratio analysis of the company. The common -size income statement can show, for example, that cost of goods sold as a percentage of sales is increa sing. 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 fund s 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, receivables rose. The firm’s NWC, but not its cash, increased. At the s ame time, costs were rising faster than cash revenues, so operating cash flow declined. The firm’s capital spending was also rising. Thus, all three components of cash flow from assets were negatively impacted. 10. Financing possibly could have been arra nged 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 resou rces ultimately spelled doom. An inadequate cash resource is usually cited as the most common cause of small business failure. 12. Demanding cash up front, increasing prices, subcontracting 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 performance. ROE shows the percentage return for the year earned on shareholder investm ent. Since the goal of a company is to maximize shareholder wealth, this ratio shows the company’s performance in achieving this goal over the period. 14. The EBITDA/Assets ratio shows the company’s operating 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 costs, they are not as easily controlled by company management. Conversely, depreciation and amortization can be alter ed by accounting choices. This ratio only uses revenue minus costs that are directly related to operations in the numerator. As such, it gives a better metric to measure management performance over a period than does ROA. CHAPTER 3 B - 21 Solutions to Questions and Prob lems 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 occurr ed. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. Using the DuPont identity, the ROE is: ROE = (PM)(TAT)(EM) ROE = (.0 597)(2.10)(.85) ROE = .1 066, or 1 0.66% 2. The equity multiplier is: EM = 1 + D/E EM = 1 + . 90 EM = 1. 90 One formula to calculate return on equity is: ROE = (ROA)(EM) ROE = .0 77(1.90) ROE = .1 463, or 1 4.63% ROE can also be calculated as: ROE = NI/TE So, net income is: NI = ROE(TE) NI = (.1 463)($880,000) NI = $1 28,744 3. This is a multi -step 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 = .1 4 = (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 = [(.1 4)($3,020 )]/[(1 + .55)($5,930 )] PM = .0 460, or 4.60%