(Solution Manual) Corporate Finance

Besley, Brigham, 7

Business

Solution Manual

7th Edition

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Solution Manual for Corporate Finance, The downloadable file consists of 530 pages, and the total size of the file is 3.45 MB. Purchase now only for highly discounted price.

Author(s): Besley, Brigham

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Chapter 1 CFIN7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. INTEGRATIVE PROBLEM SOLUTIONS a. Finance deals with decisions about money —that is, how money is raised and used by companies and individuals. Because value is based on cash flows, finance is integral to the successful operations of a firm. To be successful, a firm must understand how to raise funds, how much it costs to use investors’ money, and how to appropriately invest funds. The principal reason many small businesses fail is because the decision makers do not have a basic understanding of finance. b. Everyone deals with financial decisions, both in business and in their personal lives. For this reason, and be cause there are financial impli cations in nearly every business -related decision , it is important that everyone has at least a general knowledge of financial concepts so they can make informed decisions about money. Marty should be especially knowledgeable in finance because he is a one -person operation —he is the person who makes the financial decisions for his firm. c. The three main forms of business organization are the proprietorship , the partnership , and the corporation . Although proprietorships and partnerships are easy to start, the major disadvantage to these forms of business is that the owners have unlimited personal liability for the debts of the businesses. On the other hand, a corporation is more difficult to start than the other forms of business, but owners have limited li ability. Most business is conducted by corporations because this organizational form maximizes firms’ values. d. Mr. Kimble probably should organize as a proprietorship because it is easy to start the business as a proprietorship . In addition, it generally is more advantageous from a tax standpoint for a small business to be organized as a proprietorship rather than as a corporation. e. If the company is so successful that it grows to be a large organization, then Mr. Kimble probably should change from a proprietorship to a corporation. A major reason for changing to a corporation is to protect personal wealth —the owners of a corporation are not personally liable for the debts of the business, whereas the owners of proprietorships and partnerships are personally fully liable for all business debts. When a company becomes very large, most Chapter 1 CFIN7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. owners believe that the limited liability offered by the corporate form of business is extremely important. In addition, changing to a corporation will provide Mr. Kimble more sources to raise funds to support growth, because corporations can issue stocks and bonds to raise funds in the financial markets wh ereas proprietorships cannot. f. Mr. Kimble should operate the business so that his best interests are met. Perhaps he would like to maximize the value of his company, or perhaps he would prefer to maximize his leisure time while making a good living with his business. Whatever goal(s) he chooses, as long as he is sole owner of the company, Mr. Kimble can operate the business as he pleases. However, if he sells a portion of the company to investors, then Mr. Kimble will have to pay more attention to the be st interests of the investors —that is, he will have to pursue the goal of maximizing the value of the firm. g. After converting to a corporation and selling stock to outsiders, PAR will have multiple owners, which means that Mr. Kimble and his management team will have to consider the best interests of the other owners when making decisions about the corporation. Mr. Kimble and his management team are “agents” of the stockholders, and they should operate the business to maximize the value of the firm. To e nsure management makes decisions that are in the best interests of the owners, the company can pay incentives that are based on the success of the firm, make management owners of the firm, or use other methods to encourage management to make the “correct” decisions. Such methods will help to lessen the chances of management making decisions in their own best interests rather than the stockholders’ best interests —that is, such actions help to mitigate the possibility of agency problems. h. U.S. and foreign companies “go international” for the following major reasons: 1. To seek new markets. After a company has saturated its home market, growth opportunities often are better in foreign markets. 2. To seek raw materials. Few countries have all the raw materi als they need within their own borders, which means generally they must seek some raw materials from other countries. 3. To seek new technology. No single nation holds a commanding advantage in all technologies, so companies scour the globe for leading sc ientific and design ideas. Chapter 1 CFIN7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4. To seek production efficiency. Companies in countries where production costs are high tend to shift production to low -cost countries. 5. To avoid political and regulatory hurdles. For example, companies move production to foreign countries in which they sell products to get around the countries’ import quotas. i. The following is a list of problems of which Mr. Kimble should be aware when conducting busines in foreign markets: 1. Different currency denominations. Cash flows in various parts of a multinational corporate system often are denominated in different currencies. Hence, an analysis of exchange rates and the effects of fluctuating currency values must be included in all financial analyses. Chapter 1 CFIN7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 2. Economic and legal ramifications. Each country in which the firm operates has its own unique political and economic institutions, and institutional differences among countries can cause significant problems when a firm tries to coordinate and control the worldwide operations of its subsidiaries. Such differences can restrict multinational corporations’ flexibility to deploy resources as they wish and can even make procedures illegal in one part of the company that are required in another part. These di fferences also make it difficult for executives trained in one country to operate effectively in another. 3. Language differences. The ability to communicate is critical in all business transactions. 4. Cultural differences. Even within geographic regi ons long considered fairly homogeneous, different countries have unique cultural heritages that shape values and influence the role of business in the society. Multinational corporations find that such matters as defining the appropriate goals of the firm, attitudes toward risk taking, dealing with employees, and the ability to curtail unprofitable operations can vary dramatically from one country to the next. 5. Role of governments. Most traditional models in finance assume the existence of a competitive marketplace in which the terms of trade are determined by the participants. However, in foreign countries, in some instances, the terms under which companies compete, the actions that must be taken or avoided, and the terms of trade on various transaction s are determined not in the marketplace but by direct negotiation between the host government and the multinational corporation. 6. Political risk. The distinguishing characteristic that differentiates a nation from a multinational corporation is that t he nation exercises sovereignty over the people and property in its territory. Hence, a nation is free to place constraints on the transfer of corporate resources and even to expropriate —that is, take for public use —the assets of a firm without compensatio n. Chapter 1 CFIN 7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 1 Solutions 1-1 Finance deals with decisions about money. Finance decisions deal with how money is raised and used by businesses, governments, and individuals. In business, decisions about cash inflows include for what price products should be sold, how funds should be raised when firms ha ve good investment opportunities, and so forth; decisions about cash outflows include what expenses must be incurred, which investments should be purchased, and so forth. 1-2 Simply stated, everyone should have a basic understanding of finance because everyone faces financial decisions daily, whether those decisions are as simple as determining how much money to c arry in one’s pocket or they require more sophisticated thought processes, such as the purchase of a house or planning for retirement . Persons who make business decisions must understand finance because their decisions generally include an element of finance in the sense that the results of their decisions generally require some type of funding to be operationalized. 1-3 The value of a firm can be measured by the market value of its stock. Thus, the firm maximizes value/wealth by maximizing the value of it s stock. 1-4 Value is measured as the present value of the cash flows that an investment is expected to generate during its life. The three factors that determine value are (1) the amount of the future cash flows, (2) the timing of the future cash flows, and (3) investors’ required rate of return. If the amount of the cash flows increases, the cash flows are received sooner, investors’ required rate of return decreases, or any combination of these events occur, the value of an investment will increase. 1-5 Profit maximization abstracts from (1) the timing of profits and (2) the riskiness of different operating plans. However, both factors are reflected in stock price maximization. Profit maximization is a short -sighted goal because it doesn’t consider the impact on future earnings or the firm’s future risk position. On the other hand, a firm’s value is determined by the cash flows it is expected to generate in the future, as well as the risk associated with those expected cash flows. Thus, profit maximization would not Chapter 1 CFIN 7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. necessarily lead to stock price maximization. A firm could maximize its current profit but go bankrupt in the near future by implementing “corner -cutting” measures that increase profits. Such measures might include not replacing equipment when i t is worn out, decreasing the quality of the product that is manufactured and sold, reducing the number of employees, and so forth. 1-6 Such factors as a compensation system that is based on management performance (bonuses tied to profits, stock option pl ans) as well as the possibility of being removed from office (voted out of office, an unfriendly tender offer by another firm) serve to keep management ’s focus on stockholders ’ interests. If a firm is taken over, or acquired, by another firm, generally top management is let go. To help ensure that they are no t in this position, management should take steps to ensure the firm is operated as efficient ly as possible. Efficient firms generally are priced correctly in the financial markets, thus are not takeover targets. 1-7 The answer to this question depends on which action satisfies you more as the sole owner of the business. But chance s are you would be inclined to maximize your personal satisfaction, which does not preclude you from maximizing the value of the business. No agency problem exists in a proprietorship because there is only one owner, and he or she is the person who makes the day -to-day business decisio ns. 1-8 Provided that the rate of return on assets exceeds the interest rate on debt, greater use of debt will raise the expected rate of return on stockholders ’ equity. Also, the interest on debt is tax deductible, which provides a further advantage. How ever, (1) greater use of debt will have a negative imp act on the stockholders if the c ompany ’s return on assets falls below the cost of debt, and (2) increased use of debt increases the chances of going bankrupt. The effects of the use of debt, called “financial leverage, ” are spelled out in detail in Chapter 1 6. 1-9 Corporate governance refers to the “set of rules” that a firm follows when conducting business. In general, corporate governance relates to how a firm is operated. Corporate governance affects the manner in which a firm approaches its decision -making tasks, Chapter 1 CFIN 7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. treats its employees and customers, constructs its financial statements, and so forth. Because its governance policy affects how a company does business, corporate governance is a major factor that determines whether a firm “acts” ethically. If a firm does not ha ve a good corporate governance policy —that is, a good set of rules to follow —then there is a chance that management might behave unethically —either intentionally or unintentionally —at some point. Firms that have good corporate governance policies generally have higher values than firms that don’t. 1-10 Firms “go international” for many reasons, including to seek new markets, to get access to raw materials, to avoid political hurdles, to name a few. Considering differential labor costs abroad, transportation, tax advantages, and so forth, U.S. corporations can maximize long -run profits. There are also nonprofit be havioral and strategic considerations, such as maximizing market share and enhancing the prestige of corporate officers. 1-11 Factors that make financial decision making more complicated for firms that operate in foreign countries include differences in c urrency, language, culture, governmental relations, political risk, legal structure, and economy. The general techniques and concepts applied by purely domestic firms are valid for multinational firms. These factors, however, increase the risks that multin ational firms face when making financial decisions. 1-12 The general areas of study in finance include (1) financial markets and institutions, which includes the study of the roles of banks, credit unions, and other financial organizations in the financial markets; (2) investments, which focuses on how investmen ts are valued and selected to be include d in portfolios; (3) financial services, which refers to the area of study that deals with the management of money, primarily for individuals; and (4) managerial finance, which deals with how firms make decisions abo ut their cash flows, both inflows and outflows. Simply stated, finance deals with how firms generate and use funds. To do a good job, people must understand how all four of the areas of finance are related. For example, publicly traded firms raise money in the financial markets, which means financial Chapter 1 CFIN 7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. managers must understand the financial markets. Likewise, persons who work in the financial markets must understand the needs of publicly traded firms and of investors to ensure they are offering the right fi nancial products. 1-13 Proprietorship, partnership, and corporation are the three principal forms of business organization. The advantages of the first two include the ease and low cost of formation. The advantages of the corporation include limited liabi lity, indefinite life, ease of ownership transfer, and access to capital markets. The disadvantages of proprietorship s and partnerships are (1) difficulty in obtaining large sums of capital; (2) unlimited personal liability for business debts; (3) limited life; and (4) difficulty of transferring ownership. The disadvantages of a corporation are (1) double taxation of earnings and (2) sett ing up a corporation and filing required state and federal reports that are complex and time -consuming. 1-14 Hybrid forms of business have been created over the years as the result of the needs of businesspeople and investors. The hybrid forms of business generally include the advantages of partnerships and corporations in one business. As business operations change in the future, so too will the structure of business organizations. 1-15 Ethics refers to the attitude and behavior that a firm applies when dealing with stakeholders. A firm must consider all its stakeholders —that is, investors, customers, employees, local community, environment, and so forth —when conducting business; otherwise , it will not stay in business for very long. For example, if a firm makes huge profits at the expense of its customers, then the customers will quit purchasing from the firm when they discover how they have been treated —the customers will either begin purchasing from competitors or find substitute products to purchase. As a result, although their satisfaction does not have to be maximized, the firm must find a way to keep all stakeholders happy. Likewise, if a firm focuses only on its common stockholders, o ther stakeholders will take appropriate actions, which could mean the death of the company. A firm that increases the value of its stock in the short run , risks going out of business because such a short -run decision is short -sighted and can be extremely h armful to the long-run success of the firm. Chapter 1 CFIN 7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-16 A firm must consider all its stakeholders —that is, investors, customers, employees, local community, environment, and so forth —when conducting business; otherwise , it will not stay in business for very long . For example, if a firm makes huge profits at the expense of its customers, then the customers will quit purchasing from the firm when they discover how they have been treated —the customers will either begin purchasing from competitors or find substitute products to purchase. As a result, although their satisfaction does not have to be maximized, the firm must find a way to keep all stakeholders happy. Likewise, if a firm focuses only on its common stockholders, other stakeholders will take appropriate act ions, which could mean the death of the company. 1-17 The corporate structure of foreign firms generally is characterized by greater concentration in ownership, which often means more involvement in ownership and operations by large lenders, such as banks and other financial institutions, and by large groups or families. In many instances, this means that banks, other financial institutions, and ownership groups can meet most or all of the financing needs of a firm. In the United States, on the other hand, banks and financial institutions are restricted in the amounts of corporate debt and stock they can own. Thus, most large U.S. firms have very dispersed ownership structures because they must raise needed funds from a large number of sources —it generally is not possible to get the large amount of funds needed from a single source or even from very few sources. “One -stop” financing outlets do not currently exist in the United States. It is argued that greater concentration in ownership breeds fewer agency -related problems, so that managers can better focus on maximizing the wealth of the firm, which are also their self -fulfilling goals. In addition, because creditors generally have a significant ownership position in the firm, it is in their best interests t o make sure the firm is successful. Therefore, when financial difficulties arise, such creditors are perhaps more likely to “bail out” the company than creditors in the United States. On the other hand, many argue that the foreign ownership structures crea te a corporate environment in which managers can easily become entrenched; thus, it is very difficult to get rid of inefficient management. In addition, creditors might be too eager to try and save failing firms, and hence turn “good money” into “bad money ” instead of walk ing away and not compound ing their existing losses. Chapter 1 CFIN 7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. It is difficult to say which form of business organization is better —the “open” company with disperse ownership that we have in the United States and Canada, or the more “closed” compan y with more concentrated ownership that we find in Japan, Germany, and many other countries. Government regulations, the sophistication of both the financial markets and the product markets, and the culture of the country impact greatly on which type of bu siness organization works better. 1-18 Stockholder wealth maximization is a long -run goal. Companies, and consequently the stockholders, prosper when management makes decisions that will produce long -term increases in earnings. Actions that are continuall y short -sighted often “catch up” with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that U.S. firms are too short - run profit oriented. A prime example was th e U.S. auto industry in the 1970s and early 1980s, which was accused of continuing to build large “gas guzzler” automobiles because they had higher profit margins rather than retooling for smaller, more fuel -efficient models. 1-19 (a) Agency problems should not exist in a proprietorship, because there is only one owner, who generally is the sole decision maker. The owner operates the business in a fashion that will improve his or her own welfare. Thus, the owner can do whatever makes hi m or her happy, even if such actions are harmful to the business. (b) As more owners are included in a business, the likelihood of agency problems increase s because the potential for conflicts as to what actions promote the best interest s of all owners i ncreases. As a result, the possibility of agency problems in a partnership is greater than in a proprietorship. And, businesses with greater numbers of partners have greater chances of experiencing agency problems. (c) As mentioned in part (b), the great er the number of owners in a business, the greater the possibility of agency problems. Consequently, we would expect the potential for agency problems to be much great er in a corporation with 100,000 stockholders than in a partnership with 100 partners. Si milarly, we would expect the possibility Chapter 1 CFIN 7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. of agency problems to be even great er in a corporation that is publicly traded with millions of stockholders. 1-20 The statement is not valid in every instance. Clearly, there are cases in which a firm’s stock price has declined as the result of managerial decisions that were not in the best interest s of shareholders. However, the stock prices of firms are also based on external factors, including economic conditions. In a poor economy, the stock prices of most compa nies decline even when management is making decisions that are considered in the best interests of their shareholders. 1-21 Generally small businesses start as proprietorships and partnerships because these forms of business are easy to set up. But, as a company becomes more successful and grows larger, it probably should change from a proprietorship to a corporation. A major reason for changing to a corporation is to protect personal wealth —the owners of a corporation are not personally liable for the debts of the business, whereas the owners of proprietorships and partnerships are personally fully liable for all business debts. When a company becomes very large, most owners believe that the limited liability offered by the corporate form of business is extremely important. In addition, a corporation has additional sources available to raise funds; that is, corporations can issue debt an d stock. 1-22 In an oligopolistic industry, a small number of companies dominate the competition. On the other hand, there generally are no dominant firms in a highly competitive industry with many participants; there is only fierce competition. As a resu lt, the management of an oligopolistic firm would be more likely to engage voluntarily in “socially conscious” practices. Competitive firms would be less able to engage in such practices unless they were cost -justified, because such actions generally come with a substantial negative effect on the “bottom line.” 1-23 U.S. companies build manufacturing plants overseas to take advantage of differential labor costs, transportation, tax advantages, and so forth, which can help them to maximize long -run profits and wealth. There are also nonprofit behavioral and strategic considerations, such as maximizing market share and enhancing the prestige of corporate officers. Chapter 1 CFIN 7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1-24 An agency problem exists when mangers make decisions concerning the operations of a company that are in their best interests and those interests conflict with the best interests of the owners (stockholders). Methods used to motivate managers to act in the shareholders’ best interests include: (1) linking managers’ compensation to the comp any’s stock performance; (2) requiring managers to purchase stock in the company, which makes them owners of the firm like other stockholders; (3) ensuring managers understand that below -average performance could lead to dismissal or a takeover from anothe r firm, in which case managers normally are dismissed. 1-25 As we will show in later chapters, the financial decisions corporations make relate to how to raise funds (sources) when they are needed and how to invest surplus funds when they exist. As an ind ividual, we make the same decisions —when we buy a car or a house, we search for the appropriate funding sources (in most cases the cheapest), and when we have excess funds, we decide what investments should be made (considering risk and return) . Although d iscussions in the book focus on corporations, the techniques/concepts we describe can also be applied by individuals to make personal financial decisions. SPREADSHEET PROBLEM SOLUTIONS a. Following are the data and the ratios for Cary: INPUT DATA: KEY OUTPUT: Cary Industry Cash $ 72,000 Quick 0.85 1.00 A/R 439,000 Current 2.33 2.70 Inventor y 894,000 Inv. turn. 4.00 5.80 Land and bldg 238,000 DSO (days) 36.84 32.00 Machinery 132,000 FA turnover 9.95 13.00 Other F.A. 61,000 TA turnover 2.34 2.60 ROA 5.90% 9.10% Accts & Notes Pay. $ 432,000 ROE 13.07% 18.20% Accruals 170,000 TD/TA 54.81% 50.00% Long -term debt 404,290 PM 2.53% 3.50% Common stock 575,000 EPS $4.71 n.a. Retained earnings 254,710 Stock Price $23.57 n.a. P/E rat io 5.00 6.00 Total assets $ 1,836,000 M/B 0.65 n.a. Total liabilities & equity $ 1,836,000 RE last year 146,302 Income statement Sales $ 4,290,000 Cost of G.S. 3,580,000 Adm. & sales exp. 236,320 Depreciation 159,000 Misc. expenses 134,000 Net income $ 108,408 P/E ratio 5.0 No. of shares 23,000 Cash dividend $ 0.95 Here are Cary’s base -case ratios and other data as compared to the industry: Cary Industry Comment Quick 0.85 1.0 Weak Current 2.33 2.7 Weak Inventory turnover 4.0 5.8 Poor Days sales outstanding 36.8 days 32.0 days Poor Fixed assets turnover 10.0 13.0 Poor Total assets turnover 2.3 2.6 Poor Return on assets (ROA) 5.9% 9.1% Bad Return on equity (ROE) 13.1% 18.2% Bad Debt r atio 54.8% 50.0% High Profit margin on sales 2.5% 3.5% Bad EPS $4.71 n.a. -- Stock Price $23.57 n.a. -- P/E ratio 5.0 6.0 Poor M/B ratio 0.65 n.a. -- Cary appears to be poorly managed —all its ratios are worse than the industry averages, and the result is low earnings, a low P/E, a low stock price, and a low M/B ratio. The company needs to do something to improve. b. The revised data and ratios are shown below: INPUT DATA: KEY OUTPUT: Cary Industry Cash $ 314,000 Quick 1.25 1.00 A/R 439,000 Current 2.41 2.70 Inventories 700,000 Inv. turn. 5.00 5.80 Land and bldg 238,000 DSO (days) 36.84 32.00 Machinery 132,000 FA turnover 9.95 13.00 Other F.A. 61,000 TA turnover 2.28 2.60 ROA 8.30% 9.10% Accts & Notes Pay. $ 432,000 ROE 17.82% 18.20% Accruals 170,000 TD/TA 53.41% 50.00% Long -term debt 404,290 PM 3.65% 3.50% Common stock 575,000 EPS $6.80 n.a. Retained earnings 302,710 Stock Price $34.00 n.a. P/E ratio 5.00 6.00 Total assets $ 1,884,000 M/B 0.89 n.a. Total liabilities & equity $ 1,884,000 RE last year 146,302 Income statement Sales $ 4,290,000 Cost of G.S. 3,500,000 Adm. & sales exp. 236,320 Depreciation 159,000 Misc. expenses 134,000 Net income $ 156,408 P/E ratio 5.0 No. of shares 23,000 Cash dividend $ 0.95 Cary’s liquid ity position has improved. In addition, ROA and ROE are better than in the previous scenario, and the profit margin now is higher than the industry average. Although the stock price has increased more than $10 per share, there is room for more improvements . c. The revised data and ratios are shown below: INPUT DATA: KEY OUTPUT: Cary Industry Cash $ 84,527 Quick 1.21 1.00 A/R 395,000 Current 2.99 2.70 Inventories 700,000 Inv. turn. 4.93 5.80 Land and bldg 238,000 DSO (days) 33.15 32.00 Machinery 132,000 FA turnover 8.25 13.00 Other F.A. 150,000 TA turnover 2.52 2.60 ROA 10.53% 9.10% Accts & Notes Pay. $ 275,000 ROE 19.88% 18.20% Accruals 120,000 TD/TA 47.03% 50.00% Long -term debt 404,290 PM 4.17% 3.50% Common stock 575,000 EPS $7.78 n.a. Retained earnings 325,237 Stock Price $46.68 n.a. P/E ratio 6.00 6.00 Total assets $ 1,699,527 M/B 1.19 n.a. Total liabilities & equity $ 1,699,527 RE last year 146,302 Income statement Sales $ 4,290,000 Cost of G.S. 3,450,000 Adm. & sales exp. 248,775 Depreciation 159,000 Misc. expenses 134,000 Net income $ 178,935 P/E ratio 6.0 No. of shares 23,000 Cash dividend $ 0.95 Under these new conditions, Cary Corporation l ooks much better. Its turnover ratios are still low, but its ROA and ROE are above the industry average, its estimated P/E ratio is better, and its stock price is anticipated to double. There still is room for improvement, but the company is in much better shape. d. The financial statements and ratios for the scenario in which the cost of goods sold decreases by an additional $125,000 are shown next. As you can see, the profit ratios are quite high and the stock price has risen to $66.24. INPUT DATA: KEY OUTPUT: Cary Industry Cash $ 159,527 Quick 1.40 1.00 A/R 395,000 Current 3.18 2.70 Inventories 700,000 Inv. turn. 4.75 5.80 Land and bldg 238,000 DSO (days) 33.15 32.00 Machinery 132,000 FA turnover 8.25 13.00 Other F.A. 150,000 TA turnover 2.42 2.60 ROA 14.31% 9.10% Accts & Notes Pay. $ 275,000 ROE 26.04% 18.20% Accruals 120,000 TD/TA 45.04% 50.00% Long -term debt 404,290 PM 5.92% 3.50% Common stock 575,000 EPS $11.04 n.a. Retained earnings 400,237 Stock Price $66.24 n.a. P/E ratio 6.00 6.00 Total assets $ 1,774,527 M/B 1.56 n.a. Total liabilities & equity $ 1,774,527 RE last year 146,302 Income statement Sales $ 4,290,000 Cost of G.S. 3,325,000 Adm. & sales exp. 248,775 Depreciation 159,000 Misc. expenses 134,000 Net income $ 253,935 P/E ratio 6.0 No. of shares 23,000 Cash dividend $ 0.95 e. The financial statements and ratios for the scenario in which the cost of goods sold increases by $125,000 over the revised estimate are shown next. As you can see, profits would decline sharply. The ROE would drop to 12.6 percent , EPS would fall to $4.52, the stock price would drop to $27.11, and the M/B ratio would be only 0.76. INPUT DATA: KEY OUTPUT: Cary Industry Cash $ 9,527 Quick 1.02 1.00 A/R 395,000 Current 2.80 2.70 Inventories 700,000 Inv. turn. 5.11 5.80 Land and bldg 238,000 DSO (days) 33.15 32.00 Machinery 132,000 FA turnover 8.25 13.00 Other F.A. 150,000 TA turnover 2.64 2.60 ROA 6.40% 9.10% Accts & Notes Pay. $ 275,000 ROE 12.59% 18.20% Accruals 120,000 TD/TA 49.20% 50.00% Long -term debt 404,290 PM 2.42% 3.50% Common stock 575,000 EPS $4.52 n.a. Retained earnings 250,237 Stock Price $27.11 n.a. P/E ratio 6.00 6.00 Total assets $ 1,624,527 M/B 0.76 n.a. Total liabilities & equity $ 1,624,527 RE last year 146,302 Income s tatement Sales $ 4,290,000 Cost of G.S. 3,575,000 Adm. & sales exp. 248,775 Depreciation 159,000 Misc. expenses 134,000 Net income $ 103,935 P/E ratio 6.0 No. of shares 23,000 Cash dividend $ 0.95 f. Computer models allow us to quickly analyze the impact of operating and financial decisions on the firm’s overall performance. A firm can analyze its financial ratios under different scenarios to see what might happen if a decision, such as the purchase of a new asset, did not produce the expected results. This gives the managers some idea about what might happen under the best and worst cases and helps them to make bet ter decisions. ETHICAL DILEMMA Hocus -Pocus—Look, An Increase in Sales! Ethical dilemma: Dynamic Energy Wares (DEW) has decided to change how it distributes its products to large companies. The change in the distribution system comes at a time when DEW’s profits are declining. The declining profits might not be the sole reason for the change, but it appears to be the primary impetus for the dec ision. It also appears the new policy requiring DEW’s distributors to increase inventory levels before the end of the fiscal year will artificially inflate DEW’s sales for the current year. However, DEW’s new policy does not require the distributors to pay for any increased inventory until next year (six months), and any unsold inventory can be returned after nine months. So, if the demand for DEW’s products actually is decreasing, the impact will appear on next year’s financial statements. If the financial manager actually intends to artificially inflate DEW’s profits this year, she must realize that such actions eventually will “catch up” with her. Discussion questions: • What is the ethical dilemma? Discussion about this question can be fueled by askin g some additional questions: Is it unethical for DEW to change its distribution system if the reason is to artificially inflate profits? Would it be unethical if the decision was made for the purposes of eliminating inefficiencies in the distribution proce ss? • Should DEW change its distribution system? Most would agree that DEW should not change its distribution system if the intent is simply to artificially inflate earnings in the current period. In fact, empirical studies indicate that such actions are useless if the purpose is to make the company look good to investors, because investors as a whole generally recognize such tactics for what they really are —“smoke screens.” On the other hand, if the purpose for the change is to increase inventory efficiency, then it probably is a wise decision. For examp le, the change should decrease the cost of holding (carrying) inventory because the levels of inventory held by DEW will decrease. If such actions do not adversely affect demand for its products, they should be carried out. • What should DEW do? It appear s that DEW needs some changes because profits have been declining during the past year. A quick, temporary “fix” is not an appropriate solution —it just delays the inevitable. DEW must come up with a solution that will stabilize or improve earnings in the l ong run. The fact that senior management has decided to form a task force to examine and recommend ways to improve its market share is a step in the right direction. Such action indicates that DEW wants to find a long -run solution to its declining profits. Discuss some additional steps (actions) DEW can take to improve its financial position and to remain competitive. • Would you go to the distributors’ meeting? What should you tell the distributors? If there is no penalty for declining to attend the distr ibutors’ meeting, most students would tell you they would prefer to stay home. But ask them what they would do if their boss, the financial manager, said they had to attend the meeting or lose their well -paying job. Now, you will find that some of the stud ents change their minds. Redirect the discussion by asking the students what strategy they would follow if they actually did attend the distributors’ meeting. Would they try to mislead the distributors if they believed DEW’s decision to change the distrib ution system was made solely for the purpose of artificially increasing profits? What tact would be taken if they believed the decision ultimately would improve inventory efficiency for both DEW and the distributors? How would distributors’ concerns be han dled? The answers to these questions will be varied. But you probably will find the discussion has an underlying theme —while many believe it is part of the business world, most students will express discomfort with the prospect of having to overtly mislead others. References: There have been many reports of firms that have followed a strategy similar to that described in this chapter’ s ethical dilemma. A couple of classic examples occurred in 1994 —one involved Bausch & Lomb, Inc., which is a well -known eyewear company; the other involved PerSeptiveBiosystems, which produces instruments used in biotechnology analysis. In the last quart er of 1993, Bausch & Lomb instituted a change in its distribution system that helped reduce inventories significantly and allowed the company to post a $10 million gain for the quarter. Midway through 1994, however, Bausch & Lomb estimated its distributors had excess inventory equal to $75 million. During the year, the company had to repurchase much of this excess inventory because it could not be sold by the distributors. Because of the poor performance of Bausch & Lomb in 1994, the CEO’s performance bonus was cut to zero. Additional information concerning Bausch & Lomb’s decision to change its distribution system can be found in the following articles: “Bausch & Lomb ’s Myopia,” Forbes , December 5, 1994, p. 14+. “Bad Math at Bausch & Lomb?,” Business Wee k, December 19, 1994, p. 108+. “Bausch & Lomb: Clouded Vision,” Financial World , May 23, 1995, p. 16+. It was reported that PerSeptive would offer its diagnostic equipment, some of which cost in excess of $50,000, to prospective customers on a trial bas is, requiring payment at some later date only if the equipment was found to be desirable. At the time, PerSeptive’s management stated the strategy was to increase renewable sales by allowing the market to experience its product firsthand before requiring a purchase commitment. Even though the trial offers were not technically considered sales, in some instances, PerSeptive recorded them as sales and corresponding receivables. For the quarter ending September 30, 1994, PerSeptive posted nearly a $21 million loss because it wrote off a large amount of inventory and had to reduce accounts receivable significantly. Its “free trial” offer did not generate the renewable sales that it hoped. For more information about PerSeptive and this situation, the following ar ticles might be helpful: “Enterprise: Tech Concerns Fudge Figures to Buoy Stocks,” The Wall Street Journal , May 19, 1994, p. B1+. “Biotech Company Is Questioned About ‘Try It Out’ Sales Strategy,” The Wall Street Journal , November 8, 1994, p. B1+. “PerS eptive Restates Its Results for Much of Past 2 Fiscal Years,” The Wall Street Journal , December 28, 1994. There are quite a few examples of “misjudgments” in the applications of accounting practices reported in the late 1990s, including the famous Enron s ituation. Articles that relate these misjudgments during that period include: “Accounting Abracadabra: Cooking the Books Proves Common Trick of the Trade,” USA Today , August 11, 1998, p. 1B. “More Second -Guessing: Markets Need Better Disclosure of Earnin gs Management,” Barron’s , August 24, 1998, p. 47. “SEC Probes Telxon’s Accounting Practices, Unusual Securities Trading,” Dow Jones Business News , February 22, 1999. “Rite Aid Restates Year Net Downward, Reversing Some Accounting Maneuvers,” The Wall Street Journal , June 2, 1999, p. A3. Following are articles that provide more recent examples of scenarios in which companies have restated earnings due to lapses in appl ication of accounting principles. “Tangoe Announces That It Will Restate Financial Statements,” Businesswire , March 7, 2016. ( http://www.businesswire.com ) Available online at https://www.businesswire.com/news/home/20160307006490/en/Tangoe -Announces -Restate - Financial -Statements . Venugopal, Aishwarya, “Kraft Heinz to restate nearly three years of financial reports after investigation,” Reuters , May 6, 2016. ( http://www.reuters.com ) Available online at https://www.reuters.com/article/us -kraft-heinz -restatement/kraft -heinz -to-restate -nearly - three -years -of-financial -reports -after-investigation -idUSKCN1SC0VF . Mohan, Nishant , “Companies Are Finding More Accounting Flubs,” The Wall Street Journal , September 20, 2018. ( http://www.wsj.com ) Available online at https://www.wsj.com/articles/companies -are-finding -more -accounting -flubs -1537474747 . Chapter 2 CFIN7 © 2022 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. INTEGRATIVE PROBLEM SOLUTIONS a. Begin by reviewing briefly what balance sheets and income statements are. Then give an overview of the statement of cash flows. Explain that some data (net income, depreciation, and dividends) come from the income statement, whereas the other items reflect differences between balance sheet accounts and thus show changes in those accounts between the two dates. The statement of cash flows highlights some important aspects of Computron’s financial condition. First, note that the firm’s net operating cash flow is –$73,780, so its operations are draining cash despite the positive net income reported on the income statement. Second, because of its negative cash flow from operations, Computron had to borrow a total of $1 26,180 in long - and short -term debt ($25,000 notes plus $101,180 long -term bonds) to cover its operating cash outlays, to pay for fixed asset additions, and to pay dividends. Even after all this borrowing, Computron’s cash account still fell by $5,600 duri ng 202 2. b. Financial ratios are used to get an idea about the future financial condition of a firm by determining how well the company is being operated and where it needs improving. The ratio categories and the questions they address are as follows: 1. Liquidity : Can the company make required payments in the short run (defined as the next year)? 2. Asset management : Are the investments in assets about right in view of sales levels? 3. Debt management (financing mix) : Does the company have about the righ t amount of debt, or is it over -leveraged? 4. Profitability : Are costs under good control as reflected in the profit margin, ROA, and ROE? 5. Market values : Do investors like what they see as reflected in the P/E and M/B ratios? c. Computron has $540,200 in obligations that must be satisfied during the coming year. Will it have trouble meeting its required payments? A full liquidity analysis requires a cash budget, but these two ratios provide quick, easy -to-use measures of liquidity: