(Solution Manual) Corporate Finance Middle East

Ross, Westerfield, Jaffe, Bley, 1

Business

Solution Manual

1st Edition

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Solution Manual for Corporate Finance Middle East, The downloadable file consists of 564 pages, and the total size of the file is 3.51 MB. Purchase now only for highly discounted price.

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

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1 © 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. Solutions Manual Corporate Finance Ross, Westerfield, and Jaffe Middle East edition Prepared by: 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/0ag374y2d bne97k/SM+Corporate+Finance,+1st+Middl e+East+Edition+1e+Ross,+Weste rfield,+Jaffe +Bley.zip/file Solutions Manual 2 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner . This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Answers to Concept Questions 1. 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 agenc y 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. 2. Such organizations f requently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. A better approach mi ght 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. 3. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flow s, both short -term and long-term. If this is correct, then the statement is false. 4. 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 e xample, ethical and/or illegal behavior, and the framework of stock valuation explicitly 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 re levant) 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?” 5. 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. 6. The goal of manag ement 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 manage ment 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 p rice, 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 C 3 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this. 7. 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 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 impleme nt effective monitoring mechanisms on managers than can individual owners, based on the institutions’ deeper resources and experiences with their own management. 8. 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. However, th is may not always be the case. If the managers of the mutual fund or pension plan are not concerned with the interests of the investors, the agency problem could potentially remain the same, or even increase since there is the possibility of agency problem s between the fund and its investors. 9. How much is too much? Who is worth more, Larry Ellsion 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 sim ply 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. 10. Maximizin g the current share price is the same as maximizing the future share price at any future period. The value of a share of stock depends on all of the future cash flows of company. Another way to look at this is that, barring large cash payments to sharehold ers, the expected price of the stock must be higher in the future than it is today. Who would buy a stock for $100 today when the share price in one year is expected to be $80? Solutions Manual 4 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner . This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. CHAPTER 2 FINANCIAL STATEMENTS AND CASH FLOW Answers to Concepts Review and Critical Thinking Questions 1. True. Every asset can be converted to cash at some price. However, when we are referring to a liquid asset, the added assumption that the asset can be quickly converted to cash at or near market value is important. 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 cas h 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. The bottom line number shows the change in the cash balance on the balance sheet. As such, it is not a useful number for ana lyzing 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 cash flows treat interest as a financing cash flow. The logic of the acc ounting statement 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 results from the company’s choice of debt an d equity. We will have more to say about this in a later chapter. When comparing the two cash flow statements, the financial statement of cash flows is a more appropriate measure of the company’s performance because of its treatment of interest. 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 corp orate 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 l arge, 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 to have negativ e cash flow from operations, but it would be fairly ordinary for a start -up, so it depends. Solutions Manual 5 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 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 the com pany 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 and principal, its cash flow to creditors will be nega tive. 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. 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 $ 5,700 CL $ 4,400 NFA 27,000 LTD 12,900 OE ?? TA $32,700 TL & OE $32,700 We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $32,700. We also know that TL & OE is equal to current liabilities plus long -term debt plus owners’ equity, so owners’ equity is: OE = $32,700 –12,900 – 4,400 = $15,400 NWC = CA – CL = $5,700 – 4,400 = $1,300 2. The income statement for the company is: Income Statement Sales $387,000 Costs 175,000 Depreciation 40,000 EBIT $172,000 Interest 21,000 EBT $151,000 Taxe s 52,850 Net income $ 98,150 Solutions Manual 6 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 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 = $98,150 – 30,000 Addition to retained earnings = $68,150 3. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current assets , we get: CA = NWC + CL = $800,000 + 2,400,000 = $3,200,000 The market value of current assets and net fixed assets is given, so: Book value CA = $3,200,000 Market value CA = $2,600,000 Book value NFA = $5,200,000 Market value NFA = $6,500,000 Book value assets = $8,400,000 Market value assets = $9,100,000 4. Taxes = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($273,000 – 100,000) Taxes = $89,720 The average tax rate is the total tax paid divided by taxable income, so: Average tax rate = $89,720 / $273,000 Average tax rate = 32.86% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39%. 5. To calculate OCF, we first need the income statement: Income Statement Sales $18,700 Costs 10,300 Depreciation 1,900 EBIT $6,500 Interest 1,250 Taxable income $5,250 Taxes 2,100 Net income $3,150 OCF = EBIT + Depreciation – Taxes OCF = $6,500 + 1,900 – 2,100 OCF = $6,300 6. Net capital spending = NFA end– NFA beg + Depreciation Net capital spending = $1,690,000 – 1,420,000 + 145,000 Net capital spending = $415,000 Solutions Manual 7 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 7. The long -term debt account will increase by $35 million, the amount of the new long -term debt issue. Since the company sold 10 million new shares of stock with a $1 par value, the common stock account will increase by $10 million. The capital surplus account will increase by $48 million, the value of the new stock sold above its par value. Since the company had a n et income of $9 million, and paid $2 million in dividends, the addition to retained earnings was $7 million, which will increase the accumulated retained earnings account. So, the new long -term debt and stockholders’ equity portion of the balance sheet wil l be: Long -term debt $ 100,000,000 Total long -term debt $ 100,000,000 Shareholders ’ equity Preferred stock $ 4,000,000 Common stock ($1 par value) 25,000,000 Accumulated retained earnings 142,000,000 Capital surplus 93,000,000 Total equity $ 264,000,000 Total Liabilities & Equity $ 364,000,000 8. Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = $127,000 – (LTD end – LTD beg) Cash flow to creditors = $127,000 – ($1,520,000 – 1,450,000) Cash flow to creditors = $127,000 – 70,000 Cash flow to creditors = $57,000 9. Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = $275,000 – [(Common end + APIS end) – (Common beg + APIS beg)] Cash flow to stockholde rs = $275,000 – [($525,000 + 3,700,000) – ($490,000 + 3,400,000)] Cash flow to stockholders = $275,000 – ($4,225,000 – 3,890,000) Cash flow to stockholders = –$60,000 Note, APIS is the additional paid -in surplus. 10. Cash flow from assets = Cash flo w to creditors + Cash flow to stockholders = $57,000 – 60,000 = –$3,000 Cash flow from assets = OCF – Change in NWC – Net capital spending –$3,000 = OCF – (–$87,000) – 945,000 OCF = $855,000 Operating cash flow = –$3,000 – 87,000 + 945,000 Operating cash flow = $855,000 Solutions Manual 8 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 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 $95 Depreciation 90 Changes in other current assets (5) Change in a ccounts payable 10 Total cash flow from operations $190 Investing activities Acquisition of fixed assets $(110) Total cash flow from investing activities $(110) Financing activities Proceeds of long -term debt $5 Dividends (75) Total cash flow from financing activities ($70) Change in cash (on balance sheet) $10 b. Change in NWC = NWC end – NWC beg = (CA end – CL end) – (CA beg – CL beg) = [($65 + 170) – 125] – [($55 + 165) – 115) = $110 – 105 = $5 c. To find the cash flow generated by the firm’s assets, we need the operating cash flow, and the capital spending. So, calculating each of these, we find: Operating cash flow Net income $95 Depreciation 90 Operating cash flow $185 Note that we can calculate OCF in this manner since there are no taxes. Solutions Manual 9 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. Capital spending Ending fixed assets $390 Beginning fixed assets (370) Depreciation 90 Capital spending $110 Now we can calculate the cash flow generated by the firm’s assets, which is: Cash flow from assets Operating cash flow $185 Capital spending (110) Change in NWC (5) Cash flow from assets $ 70 12. With the information provided, the cash flows from the firm are the capital spending and the change in net working capital, so: Cash flows from the firm Capital spending $(21,000) Additions to NWC (1,900) Cash flows from the firm $(22,900) And the cash flows to the investors of the firm are: Cash flows to investors of the firm Sale of long -term debt (17,000) Sale of common stock (4,000) Dividends paid 14,500 Cash flows to investors of the firm $(6,500) Solutions Manual 10 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 13. 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 $1,060,000 Cost of goods sold 525,000 Selling costs 215,000 Depreciation 130,000 EBIT $190,000 Interest 56,000 Taxable income $134,000 Taxes 46,900 Net income $ 87,100 b. And the operating cash flow is: OCF = EBIT + Depreciation – Taxes OCF = $190,000 + 130,000 – 46,900 OCF = $273,100 14. To find the OCF, we first calculate net income. Income Statement Sales $185,000 Costs 98,000 Other expenses 6,700 Depreciation 16,500 EBIT $63,800 Interest 9,000 Taxable income $54,800 Taxes 19,180 Net income $35,620 Dividends $9,500 Additions to RE $26,120 a. OCF = EBIT + Depreciation – Taxes OCF = $63,800 + 16,500 – 19,180 OCF = $61,120 b. CFC = Interest – Net new LTD CFC = $9,000 – (–$7,100) CFC = $16,100 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 CFS = $9,500 – 7,550 CFS = $1,950 Solutions Manual 11 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. d. We know that CFA = CFC + CFS, so: CFA = $16,100 + 1,950 = $18, 050 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 = $26,100 + 16,500 Net capital spending = $4 2,600 Now we can use: CFA = OCF – Net capital spending – Change in NWC $18,050 = $61,120 – 42,600 – Change in NWC. Solving for the change in NWC gives $470, meaning the company increased its NWC by $470. 15. The solution to this question works the income statement backwards. Starting at the bottom: Net income = Dividends + Addition to ret ained earnings Net income = $1,570 + 4,900 Net income = $6,470 Now, looking at the income statement: EBT – (EBT × Tax rate) = Net inc ome Recognize that EBT × tax rate is simply the calculation for taxes. Solving this for EBT yields: EBT = NI / (1 – Tax rate) EBT = $6,470 / (1 – .35) EBT = $9,953.85 Now we can calculate: EBIT = EBT + Interest EBIT = $9,953.85 + 1,840 EBIT = $11,793.85 The last step is to use: EBIT = Sales – Costs – Depreciation $11,793.85 = $41,000 – 26,400 – Depreciation Depreciation = $2,806.15 Solutions Manual 12 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 16. 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 $12,400, equity is equal to $1,50 0, and if TA is $9,600, equity is equal to $0. We should note here that while the market value of equity cannot be negative, the book value of shareholders’ equity can be negative. 17. a. Taxes Growth = 0.15($50,000) + 0.25($25,000) + 0.34($86,000 – 75,000) = $17,490 Taxes Income = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($235,000) + 0.34($8,600,000 – 335,000) = $2,924,000 b. Each firm has a marginal tax rate of 34 percent 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. 18. Income Statement Sales $630,000 COGS 470,000 A&S expenses 95,000 Depreciation 140,000 EBIT ($75,000) Interest 70,000 Taxable income ($145,000) Taxes (35%) 0 a. Net income ($145,000 ) b. OCF = EBIT + Depreciation – Taxes OCF = ($75,000) + 140,000 – 0 OCF = $65,000 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. 19. A firm can still pay out d ividends 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 spendin g Cash flow from assets = $65,000 – 0 – 0 = $65,000 Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $34,000 – 0 = $34,000 Cash flow to creditors = Cash flow from assets – Cash flow to stockholders Cash flow to c reditors = $65,000 – 34,000 Cash flow to creditors = $31,000 Solutions Manual 13 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 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 = $70,000 – 31,000 Net new LTD = $39,000 20. a. The income statement is: Income Statement Sales $19,900 Cost of good s sold 14,200 Depreciation 2,700 EBIT $ 3,000 Interest 670 Taxable income $ 2,330 Taxes 932 Net income $1,398 b. OCF = EBIT + Depreciation – Taxes OCF = $3,000 + 2,700 – 932 OCF = $4,768 c. Change in NWC = NWC end – NWC beg = (CA end – CL end) – (CA beg – CL beg) = ($5,135 – 2,535) – ($4,420 – 2,470) = $2,600 – 1,950 = $650 Net capital spending = NFA end – NFA beg + Depreciation = $16,770 – 15,340 + 2,700 = $4,130 CFA = OCF – Change in NWC – Net capital spending = $4,768 – 650 – 4,130 = –$12 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 workin g capital; it had to raise a net $12 in funds from its stockholders and creditors to make these investments. d. Cash flow to creditors = Interest – Net new LTD = $670 – 0 = $670 Solutions Manual 14 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. Cash flow to stockholders = Cash flow from assets – Cash flow to creditors = –$12 – 670 = –$682 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 = $650 – (–682) = $1,332 The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $650 in new net working capital and $4,130 in new fixed assets. The firm had to raise $12 from its stakeholders to support this new investment. It accomplished this by raising $1,332 in the form of new equity. After paying out $650 of this in the form of dividends to shareholders and $670 in the form of interest to creditors, $12 was left to meet the firm’s cash flow needs for investment. 21. a. Total assets 2011 = $936 + 4,176 = $5,112 Total liabilities 2011 = $382 + 2,160 = $2,542 Owners’ equity 2011 = $5,112 – 2,542 = $2,570 Total assets 2012 = $1,015 + 4,896 = $5,911 Total liabilities 2012 = $416 + 2,477 = $2,893 Owners’ equity 2012 = $5,911 – 2,893 = $3,018 b. NWC 2011 = CA11 – CL11 = $936 – 382 = $554 NWC 2012 = CA12 – CL12 = $1,015 – 416 = $599 Change in NWC = NWC12 – NWC 11 = $599 – 554 = $45 c. We can calculate net capital spending as: Net capital spending = Net fixed assets 2012 – Net fixed assets 2011 + Depreciation Net capital spending = $4,896 – 4,176 + 1,150 Net capital spending = $1,870 So, the comp any had a net capital spending cash flow of $1,870. We also know that net capital spending is: Net capital spending = Fixed assets bought – Fixed assets sold $1,870 = $2,160 – Fixed assets sold Fixed assets sold = $2,160 – 1,870 Fixed assets sold = $290 Solutions Manual 15 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 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 = $12,380 – 5,776 – 1,150 EBIT = $5,454 EBT = EBIT – Interest EBT = $5,454 – 314 EBT = $5,140 Taxes = EBT  .40 Taxes = $5,140  .40 Taxes = $2,056 OCF = EBIT + Depreciation – Taxes OCF = $5,454 + 1,150 – 2,056 OCF = $4,548 Cash flow from assets = OCF – Change in NWC – Net capital spending. Cash flow from assets = $4,548 – 45 – 1,870 Cash flow from assets = $2,633 d. Net new borrowing = LTD12 – LTD11 Net new borrowing = $2,477 – 2,160 Net new borrowing = $317 Cash flow to creditors = Interest – Net new LTD Cash flow to creditors = $314 – 317 Cash flow to creditors = –$3 Net new borrowing = $317 = Debt issued – Debt retired Debt retired = $432 – 317 Debt retired = $115 Solutions Manual 16 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 22. Balance sheet as of Dec. 31, 2011 Cash $4,109 Accounts payable $4,316 Accounts receivable 5,439 Notes payable 794 Inventory 9,670 Current liabilities $5,110 Current assets $19,218 Long -term debt $13,460 Net fixed assets $34,455 Owners' equity 35,103 Total assets $53,673 Total liab. & equity $53,673 Balance sheet as of Dec. 31, 2012 Cash $5,203 Accounts payable $4,185 Accounts receivable 6,127 Notes payable 746 Inventory 9,938 Current liabilities $4,931 Current assets $21,268 Long -term debt $16,050 Net fixed assets $35,277 Owners' equity 35,564 Total assets $56,545 Total liab. & equity $56,545 2011 Income Statement 2012 Income Statement Sales $7,835.00 Sales $8,409.00 COGS 2,696.00 COGS 3,060.00 Other expenses 639.00 Other expenses 534.00 Depreciation 1,125.00 Depreciation 1,126.00 EBIT $3,375.00 EBIT $3,689.00 Interest 525.00 Interest 603.00 EBT $2,850.00 EBT $3,086.00 Taxes 969.00 Taxes 1,049.24 Net income $1,881.00 Net income $2,036.76 Dividends $956.00 Dividends $1,051.00 Additions to RE 925.00 Additions to RE 985.76 23. OCF = EBIT + Depreciation – Taxes OCF = $3,689 + 1,126 – 1,049.24 OCF = $3,765.76 Change in NWC = NWC end– NWC beg = (CA – CL) end– (CA – CL) beg Change in NWC = ($21,268 – 4,931) – ($19,218 – 5,110) Change in NWC = $2,229 Net capital spending = NFA end – NFA beg+ Depreciation Net capital spending = $35,277 – 34,455 + 1,126 Net capital spending = $1,948 Solutions Manual 17 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $3,765.76 – 2,229 – 1,948 Cash flow from assets = –$411.24 Cash flow to creditors = Interest – Net new LTD Net new LTD = LTD end – LTD beg Cash flow to creditors = $603 – ($16,050 – 13,460) Cash flow to creditors = –$1,987 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+ Addition s to RE  Net new equity = OE end– OE beg+ RE beg– (RE beg + Additions to RE) = OE end – OE beg – Additions to RE Net new equity = $35,564 – 35,103 – 985.76 = –$524.76 Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $1,051 – (–$524.76) Cash flow to stockholders = $1,575.76 As a check, cash flow from assets is –$411.24 Cash flow from assets = Cash flow from creditors + Cash fl ow to stockholders Cash flow from assets = –$1,987 + 1,575.76 Cash flow from assets = –$411.24 Challenge 24. 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 = $173 + 98 + 19 + 48 EBIT = $338 Now we can calculate the operating cash flow as: Operating cash flow Earnings before interest and taxes $338 Depreciation 94 Current taxes (98) Operating cash flow $334 Solutions Manual 18 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. The cash flow from assets is found in the investing activities portion of the accounting statement of cash flows, so: Cash flow from assets Acquisition of fixed assets $215 Sale of fixed assets (23) Capital spending $192 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 $14 Accounts receivable 18 Inventories (22) Accounts payable (17) Accrued expenses 9 Notes payable (6) Other (3) NWC cash flow ($7) 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 $48 Retirement of debt 162 Debt service $210 Proceeds from sale of long -term debt (116) Total $94 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 $ 86 Repurchase of stock 13 Cash to stockholders $ 99 Proceeds from new stock issue (44) Total $ 55 Solutions Manual 19 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 25. 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 26. a. The tax bubble causes average tax rates to catch up to ma rginal tax rates, thus eliminating the tax advantage of low marginal rates for high income corporations. b. Assuming a taxable income of $335,000, the taxes will be: Taxes = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($235K) = $113.9K Average tax rate = $113.9K / $335K = 34% The marginal tax rate on the next dollar of income is 34 percent. For corporate taxable income levels of $335K to $10M, average tax rates are equal to marginal tax rates. Taxes = 0.34($10M) + 0.35($5M) + 0.38($3.3 33M) = $6,416,667 Average tax rate = $6,416,667 / $18,333,334 = 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 = 0.34($200K) = $68K = 0.15($50K) + 0.25($25K) + 0.34($25K) + X($100K); X($100K) = $68K – 22.25K = $45.75K X = $45.75K / $100K X = 45.75% Solutions Manual 20 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner . This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. CHAPTER 3 FINANCIAL STATEMENTS ANALYSIS AND FINANCIAL MODELS Answers to Concepts Review and Critical Thinking 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 w hether some aspects of the firm’s operations, finances, or investment activities 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 l ine 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. 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. Simi lar arguments could be made for a peer group comparison. 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 rati o is good or bad, both simply 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 time 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 driving force behind a business. A firm’s assets, employees, and, in fact, just about ever y 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 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 changes its dividend policy by increasing the retention ratio, or its total asset turnover increases. Solutions Manual 21 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 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 financing 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 th e retention rate 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 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 calcu lated 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. ROE is a better measure of the company’s performance. 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 performance in achieving this goal ov er the period. 9. The EBITD/Assets ratio shows the company’s operating performance before interest, taxes, and depreciation. This ratio would show how a company has controlled costs. While taxes are a cost, and depreciation and amortization can be conside red costs, they are not as easily controlled by company management. Conversely, depreciation and amortization can be altered by accounting choices. This ratio only uses costs directly related to operations in the numerator. As such, it gives a better metri c to measure management performance over a period than does ROA. 10. Long -term liabilities and equity are investments made by investors in the company, either in the form of a loan or ownership. Return on investment is intended to measure the return the company earned from these investments. Return on investment will be higher than the return on assets for a company with current liabilities. To see this, realize that total assets must equal total debt and equity, and total debt and equity is equal to curr ent liabilities plus long -term liabilities plus equity. So, return on investment could be calculated as net income divided by total assets minus current liabilities. 11. Presumably not, but, of course, if the product had been much less popular, then a si milar fate would have awaited due to lack of sales. 12. Since customers did not pay until shipment, receivables rose. The firm’s NWC, but not its cash, increased. At the same time, costs were rising faster than cash revenues, so operating cash flow decli ned. The firm’s capital spending was also rising. Thus, all three components of cash flow from assets were negatively impacted. 13. Financing possibly could have been arranged if the company had taken quick enough action. Sometimes it becomes apparent th at help is needed only when it is too late, again emphasizing the need for planning. Solutions Manual 22 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 14. 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. 15. Demanding cash upfront, 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, pri ce increases may be especially beneficial. 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 step s 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. ROE = (PM)(TAT)(EM) ROE = (.043)(1.75)(1.55) = .1166 or 11.66% 2. The equity multiplier is: EM = 1 + D/E EM = 1 + 0.80 = 1.80 One formula to calculate return on equity is: ROE = (ROA)(EM) ROE = 0.097(1.80) = .1746 , or 17.46% ROE can also be calculated as: ROE = NI / TE So, net income is: NI = ROE(TE) NI = (.1746)($735,000) = $128,331 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 w e know the profit margin, we can find the net income since sales are given. So, we begin with the DuPont Identity: ROE = 0.15 = (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 = [(0.15)($1,310)] / [(1 + 1.20)( $2,700)] = .0331 Solutions Manual 23 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. Now that we have the profit margin, we can use this number and the given sales figure to solve for net income: PM = .0331 = NI / S NI = .0331($2,700) = $89.32 4. An increase of sales to $42,300 is an increase of: Sales increase = ($42,300 – 37,300) / $37,300 Sales increase = .134 0, or 13.40% Assuming costs and assets increase proportionally, the pro forma financial statements will look like this: Pro for ma income statement Pro forma balance sheet Sales $42,300.00 Assets $ 144,024.13 Debt $ 30,500.00 Costs 29,258.45 Equity 102,272.31 EBIT 13,041.55 Total $ 144,024.13 Total $132,772.31 Taxes (34%) 4,434.13 Net income $ 8,607.43 The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or: Dividends = ($2,500 / $7,590)($8,607.43) Dividends = $2,835.12 The addition to retained earnings is: Addition to retained earnings = $8,607.43 – 2,835.12 Addition to retained earnings = $5,772.31 And the new equity balance is: Equity = $96,500 + 5,772.31 Equity = $102,272.31 So the EFN is: EFN = Total assets – Total liabilities and equity EFN = $144,024.13 – 132,772.31 EFN = $11,251.82 Solutions Manual 24 © 2013 by McGraw -Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distri buted, or posted on a website, in whole or part. 5. The maximum percentage sales increase without issuing new equity is the sustainable growth rate. To calculate the sustainable growth rate, we first need to calculate the ROE, which is: ROE = NI / TE ROE = $9,702 / $81,000 ROE = .1198 The plowback ratio, b, is one minus the payout ratio, so: b = 1 – .30 b = .70 Now we can use the sustainable growth rate equation to get: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)] Sustainable grow th rate = [.1198(.70)] / [1 – .1198(.70)] Sustainable growth rate = .0915 , or 9.15% So, the maximum dollar increase in sales is: Maximum increase in sales = $54,000(.0915) Maximum increase in sales = $4,941.96 6. We need to calculate the retention ratio to calculate the sustainable growth rate. The retention ratio is: b = 1 – .20 b = .80 Now we can use the sustainable growth rate equation to get: Sustainable growth rate = (ROE × b) / [1 – (ROE × b)] Sustainable growth rate = [.13(.80)] / [1 – .13(.80)] Sustainable growth rate = .1161 or 11.61% 7. We must first calculate the ROE using the DuPont ratio to calculate the sustainable growth rate. The ROE is: ROE = (PM)(TAT)(EM) ROE = (.074)(2.20)(1. 40) ROE = .2279 or 22.79% The plowback ratio is one minus the dividend payout ratio, so: b = 1 – .40 b = .60