(Solution Manual) Corporate Finance

Ross, Westerfield, Jaffe, Jordan, 12

Business

Solution Manual

12th Edition

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Solution Manual for Corporate Finance, The downloadable file consists of 570 pages, and the total size of the file is 5.6 MB. Purchase now only for highly discounted price.

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

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Solutions Manual Corporate Finance Ross, Westerfield, Jaffe, and Jordan 12th edition 01/02/2019 Prepared by: Brad Jordan University of Kentucky Joe Smolira Belmont Universi ty 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 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. 2. 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., provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize the value of the equity. 3. 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. 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 example, ethical 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?‖ 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 management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder, or other unidentified bidders, will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this. 10 – SOLUTIONS MANUAL 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 conce rning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions‘ deeper resources and experiences with their own management . 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, this 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 increa se, since there is the possibility of agency problems between the fund and its investors. 9. 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. 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 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. Maximizing 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 shareholders, 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? CH1 1,4,6,7,9,10 CHAPTER 2 ACCOUNTING STATEMENTS, TAXES, 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 cash is collected or bills are paid. Note that this way is not necessarily correct; it‘s the way accountants have chosen to do it. 3. 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 cash flows treat interest as a financing cash flow. The logic of the accounting statement of cash flows is that since interest appears on the income statement, which shows the operations for the perio d, it is an operating cash flow. In reality, interest is a financing expense, which results from the company‘s choice of debt and 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 corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negativ e, implying that liabilities cannot exceed assets in market value. 6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative. 7. It‘s probably not a good sign for an established company to have negative cash flow from operations, but it would be fairly ordinary for a start-up, so it depends. 8 – SOLUTIONS MANUAL 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 company 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 negative. 10. The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the assets. 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 $ 4,300 CL $ 2,900 NFA 24,000 LTD 10,700 TA $28,300 OE TL & OE ?? $28,300 We know that total liabilities and owners‘ equity (TL & OE) must equal total assets of $28,300. We also know that TL & OE is equal to current liabilities plus long -term debt plus owners‘ equity, so owners‘ equity is: Owners‘ equity = $28,300 – 10,700 – 2,900 Owners‘ equity = $14,700 And net working capital is current assets minus current liabilities, s o: NWC = Current assets – Current liabilities NWC = $4,300 – 2,900 NWC = $1,400 CHAPTER 2 - 9 2. The income statement for the company is: Income Statement Sales $473,000 Costs 275,000 Depreciation 42,000 EBIT $156,000 Interest 23,000 EBT $133,000 Taxes 27,930 Net income $105,070 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 = $105,070 – 25,000 Addition to retained earnings = $80,070 3. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current assets, we get: Current assets = Net working capital + Current liabilities Current assets = $850,000 + 2,200,000 Current assets = $3,050,000 The market value of current assets and net fixed assets is given, so: Book value CA = $3,050,000 Market value CA = $2,700,000 Book value NFA = $4,900,000 Market value NFA = $6,400,000 Book value assets = $7,950,000 Market value assets = $9,100,000 4. Taxes = .10($9,525) + .12($38,700 – 9,525) + .22($82,500 – 38,700) + .24($157,500 – 82,500) + .32($189,000 – 157,500) Taxes = $42,169.50 The average tax rate is the total tax paid divided by taxable income, so: Average tax rate = $42,169.50/$189,000 Average tax rate = .2231, or 22.31% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate is 32 percent. 10 – SOLUTIONS MANUAL 5. To calculate OCF, we first need the income statement: Income Statement Sales $22,400 Costs 11,600 Depreciation 2,200 EBIT $8,600 Interest 1,370 Taxable income $7,230 Taxes 1,591 Net income $5,639 OCF = EBIT + Depreciation – Taxes OCF = $8,600 + 2,200 – 1,591 OCF = $9,209 6. Net capital spending = NFA end – NFA beg + Depreciation Net capital spending = $1,430,000 – 1,280,000 + 146,000 Net capital spending = $296,000 7. The long-term debt account will increase by $30 million, the amount of the new long-term debt issue. Since the company sold 4.5 million new shares of stock with a $1 par value, the common stock account will increase by $4.5 million. The capital surplus account will increase by $53.5 million, the value of the new stock sold above its par value. Since the company had a net income of $7.5 million, and paid $1.7 million in dividends, the addition to retained earnings was $5.8 million, which will increase the accumulated retained earnings account. So, the new long -term debt and stockholders‘ equity portion of the balance sheet will be: Long -term debt $ 75,000,000 Total long-term debt $ 75,000,000 Shareholders‘ equity Preferred stock $ 2,900,000 Common stock ($1 par value) 15,500,000 Accumulated retained earnings 112,800,000 Capital surplus 102,500,000 Total equity $ 233,700,000 Total liabilities & equity $ 308,700,000 8. Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = $170,000 – (LTD end – LTD beg) Cash flow to creditors = $170,000 – ($1,645,000 – 1,565,000) Cash flow to creditors = $170,000 – 80,000 Cash flow to creditors = $90,000 CHAPTER 2 - 11 9. Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = $335,000 – [(Common end + APIS end) – (Common beg + APIS beg)] Cash flow to stockholders = $335,000 – [($525,000 + 3,750,000) – ($490,000 + 3,400,000)] Cash flow to stockholders = $335,000 – ($4,275,000 – 3,890,000) Cash flow to stockholders = –$50,000 Note, APIS is the additional paid-in surplus. 10. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders = $90,000 – 50,000 = $40,000 Cash flow from assets = OCF – Change in NWC – Net capital spending $40,000 = OCF – (–$96,000) – 735,000 Operating cash flow = $40,000 – 96,000 + 735,000 Operating cash flow = $679,000 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 $129 Depreciation 92 Changes in other current assets (17) Change in accounts payable 17 Total cash flow from operations $221 Investing activities Acquisition of fixed assets $(111) Total cash flow from investing activities $(111) Financing activities Proceeds of long-term debt $8 Dividends (97) Total cash flow from financing activities ($89) Change in cash (on balance sheet) $21 12 – SOLUTIONS MANUAL b. Change in NWC = NWC end – NWC beg = (CA end – CL end) – (CA beg – CL beg) = [($84 + 192) – 146] – [($63 + 175) – 129) = $130 – 109 = $21 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 $129 Depreciation 92 Operating cash flow $221 Note that we can calculate OCF in this manner since there are no taxes. Capital spending Ending fixed assets $417 Beginning fixed assets –398 Depreciation 92 Capital spending $111 Now we can calculate the cash flow generated by the firm‘s assets, which is: Cash flow from assets Operating cash flow $221 Capital spending –111 Change in NWC –21 Cash flow from assets $ 89 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 –$29,000 Additions to NWC –2,400 Capital spending and NWC cash flow –$31,400 And the cash flows to the investors of the firm are: Cash flows to investors of the firm Sale of long-term debt –$16,400 Sale of common stock –4,000 Dividends paid 13,100 Cash flows to investors of the firm –$7,300 CHAPTER 2 - 13 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 $865,000 Cost of goods sold 455,000 Selling costs 210,000 Depreciation 105,000 EBIT $ 95,000 Interest 27,200 Taxable income $ 67,800 Taxes 14,238 Net income $ 53,562 b. And the operating cash flow is: OCF = EBIT + Depreciation – Taxes OCF = $95,000 + 105,000 – 14,238 OCF = $185,762 14. To find the OCF, we first calculate net income. Income Statement Sales $246,000 Costs 135,000 Other expenses 7,100 Depreciation 19,100 EBIT $84,800 Interest 10,000 Taxable income $74,800 Taxes 18,876 Net income $55,924 Dividends $9,800 Additions to RE $46,124 a. OCF = EBIT + Depreciation – Taxes OCF = $84,800 + 19,100 – 18,876 OCF = $85,024 b. CFC = Interest – Net new LTD CFC = $10,000 – (–$6,800) CFC = $16,800 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 = $9,800 – 7,900 CFS = $1,900 14 – SOLUTIONS MANUAL d. We know that CFA = CFC + CFS, so: CFA = $16,800 + 1,900 CFA = $18,700 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 = $41,900 + 19,100 Net capital spending = $61,000 Now we can use: CFA = OCF – Net capital spending – Change in NWC $18,700 = $85,024 – 61,000 – Change in NWC Change in NWC = $5,324 This means the company increased its NWC by $5,324. 15. The solution to this question works the income statement backwards. Star ting at the bottom: Net income = Dividends + Addition to retained earnings Net income = $1,720 + 5,300 Net income = $7,020 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 = Net income/(1 – Tax rate) EBT = $7,020/(1 – .21) EBT = $8,886.08 Now we can calculate: EBIT = EBT + Interest EBIT = $8,886.08 + 2,050 EBIT = $10,936.08 The last step is to use: EBIT = Sales – Costs – Depreciation $10,936.08 = $54,000 – 29,500 – Depreciation Depreciation = $13,563.92 CHAPTER 2 - 15 16. The market value of shareholders‘ equity cannot be negative. A negative market value in this case would imply t hat 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 $11,900, equity is equal to $1,200, and if TA is $9,400, 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. Income Statement Sales $630,000 COGS 465,000 A&S expenses 85,000 Depreciation 135,000 EBIT –$55,000 Interest 70,000 Taxable income –$125,000 Taxes (21%) 0 a. Net income –$125,000 b. OCF = EBIT + Depreciation – Taxes OCF = –$55,000 + 135,000 – 0 OCF = $80,000 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. 18. A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficient cash flow to make the dividend payments. Change in NWC = Net capital spending = Net new equity = 0. (Given) Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $80,000 – 0 – 0 = $80,000 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 creditors = $80,000 – 34,000 Cash flow to creditors = $46,000 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 = $70,000 – 46,000 Net new LTD = $24,000 16 – SOLUTIONS MANUAL 19. a. The income statement is: Income Statement Sales $24,360 Cost of goods sold 17,600 Depreciation 3,400 EBIT $ 3,360 Interest 860 Taxable income $ 2,500 Taxes 525 Net income $1,975 b. OCF = EBIT + Depreciation – Taxes OCF = $3,360 + 3,400 – 525 OCF = $6,235 c. Change in NWC = NWC end – NWC beg = (CA end – CL end) – (CA beg – CL beg) = ($6,410 – 3,445) – ($5,560 – 3,040) = $2,965 – 2,520 = $445 Net capital spending = NFA end – NFA beg + Depreciation = $21,180 – 18,650 + 3,400 = $5,930 CFA = OCF – Change in NWC – Net capital spending = $6,235 – 445 – 5,930 = –$140 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 n et working capital; it had to raise a net $140 in funds from its stockholders and creditors to make these investments. d. Cash flow to creditors = Interest – Net new LTD = $860 – 0 = $860 Cash flow to stockholders = Cash flow from assets – Cash flow to creditors = –$140 – 860 = –$1,000 We can also calculate the cash flow to stockholders as: Cash flow to stockholders = Dividends – Net new equity Solving for net new equity, we get: Net new equity = $1,000 – (–790) = $1,790 CHAPTER 2 - 17 The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $445 in new net working capital and $5,930 in new fixed assets. The firm had to raise $140 from its stakeholders to support this new investment. It accomplished this by raising $1,790 in the form of new equity. After paying out $790 of this in the form of dividends to shareholders and $860 in the form of interest to creditors, $140 was left to meet the firm‘s cash flow needs for inves tment. 20. a. Total assets 2018 Total liabilities 2018 Owners‘ equity 2018 = $1,157 + 5,261 = $6,418 = $481 + 2,856 = $3,337 = $6,418 – 3,337 = $3,081 Total assets 2019 Total liabilities 2019 Owners‘ equity 2019 = $1,411 + 6,125 = $7,536 = $534 + 3,256 = $3,790 = $7,536 – 3,790 = $3,746 b. NWC 2018 NWC 2019 Change in NWC = CA – CL = $1,157 – 481 = $676 = CA – CL = $1,411 – 534 = $877 = NWC end – NWC beg = $877 – 676 = $201 c. We can calculate net capital spending as: Net capital spending = Net fixed assets end – Net fixed assets beg + Depreciation Net capital spending = $6,125 – 5,261 + 1,478 Net capital spending = $2,342 So, the company had a net capital spending cash flow of $2,342. We also know that net capital spending is: Net capital spending = Fixed assets bought – Fixed assets sold $2,342 = $2,820 – Fixed assets sold Fixed assets sold = $2,820 – 2,342 Fixed assets sold = $478 To calculate the cash flow from assets, we must first calculate the operating cash flow. The operating cash flow is calculated as follows (we could also prepare a traditional income statement): EBIT = Sales – Costs – Depreciation EBIT = $17,688 – 7,118 – 1,478 EBIT = $9,092 EBT = EBIT – Interest EBT = $9,092 – 392 EBT = $8,700 Taxes = EBT  .22 Taxes = $8,700  .22 Taxes = $1,914 18 – SOLUTIONS MANUAL OCF = EBIT + Depreciation – Taxes OCF = $9,092 + 1,478 – 1,914 OCF = $8,656 Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $8,656 – 201 – 2,342 Cash flow from assets = $6,113 d. Net new borrowing = LTD end – LTD beg Net new borrowing = $3,256 – 2,856 Net new borrowing = $400 Net new borrowing = $400 = Debt issued – Debt retired Debt retired = $545 – 400 Debt retired = $145 Cash flow to creditors = Interest – Net new LTD Cash flow to creditors = $392 – 400 Cash flow to creditors = –$8 21. Balance sheet as of Dec. 31, 2018 Cash $4,438 Accounts payable $4,661 Accounts receivable 4,874 Notes payable 858 Inventory 10,444 Current liabilities $5,519 Current assets $19,756 Long -term debt $14,537 Net fixed assets $37,211 Owners' equity 36,911 Total assets $56,967 Total liab. & equity $56,967 Balance sheet as of Dec. 31, 2019 Cash $5,620 Accounts payable $4,520 Accounts receivable 6,617 Notes payable 806 Inventory 10,733 Current liabilities $5,326 Current assets $22,970 Long -term debt $17,334 Net fixed assets $39,049 Owners' equity 39,359 Total assets $62,019 Total liab. & equity $62,019 CHAPTER 2 - 19 2018 Income Statement 2019 Income Statement Sales $8,462.00 Sales $9,082.00 COGS 2,912.00 COGS 3,305.00 Other expenses 690.00 Other expenses 577.00 Depreciation 1,215.00 Depreciation 1,216.00 EBIT $3,645.00 EBIT $3,984.00 Interest 567.00 Interest 652.00 EBT $3,078.00 EBT $3,332.00 Taxes 646.38 Taxes 699.72 Net income $2,431.62 Net income $2,632.28 Dividends $1,032.00 Dividends $1,135.00 Additions to RE 1,399.62 Additions to RE 1,497.28 22. OCF = EBIT + Depreciation – Taxes OCF = $3,984 + 1,216 – 699.72 OCF = $4,500.28 Change in NWC = NWC end – NWC beg = (CA – CL) end – (CA – CL) beg Change in NWC = ($22,970 – 5,326) – ($19,756 – 5,519) Change in NWC = $3,407 Net capital spending = NFA end – NFA beg + Depreciation Net capital spending = $39,049 – 37,211 + 1,216 Net capital spending = $3,054 Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $4,500.28 – 3,407 – 3,054 Cash flow from assets = –$1,960.72 Cash flow to creditors = Interest – Net new LTD Net new LTD = LTD end – LTD beg Cash flow to creditors = $652 – ($17,334 – 14,537) Cash flow to creditors = –$2,145 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) = OE end – OE beg – Additions to RE Net new equity = $39,359 – 36,911 – 1,497.28 = $950.72 Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $1,135 – 950.72 Cash flow to stockholders = $184.28 20 – SOLUTIONS MANUAL As a check, cash flow from assets is –$1,960.72 Cash flow from assets = Cash flow from creditors + Cash flow to stockholders Cash flow from assets = –$2,145 + 184.28 Cash flow from assets = –$1,960.72 Challenge 23. 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 = $187 + 81 + 11 + 38 EBIT = $317 Now we can calculate the operating cash flow as: Operating cash flow Earnings before interest and taxes $317 Depreciation 74 Current taxes –81 Operating cash flow $310 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 $194 Sale of fixed assets –19 Capital spending $175 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 $12 Accounts receivable 12 Inventories –15 Accounts payable –11 Accrued expenses 6 Other –2 NWC cash flow $2 CHAPTER 2 - 21 Except for the interest expense, 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 $38 Retirement of debt 145 Debt service $183 Proceeds from sale of long-term debt –110 Total $73 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 $67 Repurchase of stock 32 Cash to stockholders $99 Proceeds from new stock issue –39 Total $60 24. 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 CH2 Concepts Questions 1 Questions and Problems 3,6,11,14,16,18,23,24 CHAPTER 3 LONG -TERM FINANCIAL PLANNING AND GROWTH 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 whether some aspects of the firm‘s operations, finances, or investment activities have changed. Peer group analysis involves comparing the financial ratios and operating performa nce of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm‘s operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate actions to take to adjust these ratios if appropriate. Both allow an investigation into what is different about a company from a financial perspective, but neither method gives an indic ation 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 ratio lower than its peers could be more efficient at managing its current accounts, or it could be facing liquidity problems. Neither analysis method tells us whether a ratio is 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 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 every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firm‘s future need for things like capital assets, employees, inventory, and financing are determined by its future sales level. 4. Two assumptions of the sustainable growth 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 at a faster rate if its profit margin increases, if it changes its dividend policy by increasing the retention ratio, or its total asset turnover increases. CHAPTER 3 - 23 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 percen t. 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 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 calculated for a simple reason: There is no possible denominator. 7. It would reduce the external funds needed. If the company is not operating at full capacity, it would be able to increase sales without a commensurate increase in fixed assets. 8. ROE is a better measure of the company‘s pe rformance. ROE shows the percentage return 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 over 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 considered 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 metric to measure manage ment 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 current 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 similar 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 declined. 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. 24 – SOLUTIONS MANUAL 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 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. 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. Ho wever, 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 = (Profit margin)(Total asset turnover)(Equity multiplier) ROE = (.061)(1.87)(1.35) ROE = .1540, or 15.40% 2. The equity multiplier is: Equity multiplier = 1 + D/E Equity multiplier = 1 + .85 Equity multiplier = 1.85 One formula to calculate return on equity is: ROE = (ROA)(Equity multiplier ) ROE = .073(1.85) ROE = .1351, or 13.51% ROE can also be calculated as: ROE = Net income/Total equity So, net income is: Net income = ROE(Total equity) Net income = .1351($910,000) Net income = $122,895.50 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 = .14 = (Profit margin)(Total asset turnover)(Equity multip lier) ROE = (Profit margin)(Sales/Total assets)(1 + D/E) CHAPTER 3 - 25 Solving the DuPont Identity for profit margin, we get: Profit margin = [(ROE)(Total assets)]/[(1 + D/E)(Sales)] Profit margin = [(.14)($1,520)]/[(1 + 1.35)($3,300)] Profit margin = .0274 Now that we have the profit margin, we can use this number and the given sales figure to solve for net income: Profit margin = .0274 = Net income/Sales Net income = .0274($3,300) Net income = $90.55 4. An increase of sales to $42,112 is an increase of: Sales increase = ($42,112 – 37,600)/$37,600 Sales increase = .1200, or 12.00% Assuming costs and assets increase proportionally, the pro forma financial statements will look like this: Pro forma income statement Pro forma balance sheet Sales $42,112.00 Assets $ 151,200.00 Debt $ 37,000.00 Costs 29,232.00 Equity 105,151.20 EBIT 12,880.00 Total $ 151,200.00 Total $142,151.20 Taxes (21%) 2,704.80 Net income $10,175.20 The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or: Dividends = ($2,700/$9,085)($10,175.20) Dividends = $3,024 The addition to retained earnings is: Addition to retained earnings = $10,175.20 – 3,024 Addition to retained earnings = $7,151.20 And the new equity balance is: Equity = $98,000 + 7,151.20 Equity = $105,151.20 So the EFN is: EFN = Total assets – Total liabilities and equity EFN = $151,200 – 142,151.20 EFN = $9,048.80 26 – SOLUTIONS MANUAL 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 = $20,066/$88,000 ROE = .2280, or 22.80% 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 growth rate = [.2280(.70)]/[1 – .2280(.70)] Sustainable growth rate = .1899, or 18.99% So, the maximum dollar increase in sales is: Maximum increase in sales = $49,000(.1899) Maximum increase in sales = $9,306.67 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 = [.11(.80)]/[1 – .11(.80)] Sustainable growth rate = .0965, or 9.65% 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 = (.057)(2.65)(1.60) ROE = .2417, or 24.17% The plowback ratio is one minus the dividend payout ratio, so: b = 1 – .70 b = .30 CHAPTER 3 - 27 Now, we can use the sustainable growth rate equation to get: Sustainable growth rate = (ROE × b)/[1 – (ROE × b)] Sustainable growth rate = [.2417(.30)]/[1 – .2417(.30)] Sustainable growth rate = .0782, or 7.82% 8. An increase of sales to $9,462 is an increase of: Sales increase = ($9,462 – 8,300)/$8,300 Sales increase = .14, or 14% Assuming costs and assets increase proportionally, the pro forma financial statements will look like this: Pro forma income statement Pro forma balance sheet Sales $ 9,462 Assets $ 21,774 Debt $ 8,400 Costs 7,399 Equity 12,763 Net income $ 2,063 Total $ 21,774 Total $ 21,163 If no dividends are paid, the equity account will increase by the net income, so: Equity = $10,700 + 2,063 Equity = $12,763 So the EFN is: EFN = Total assets – Total liabilities and equity EFN = $21,774 – 21,163 EFN = $611 9. a. First, we need to calculate the current sales and change in sales. The current sales are next year‘s sales divided by one plus the growth rate, so: Current sales = Next year‘s sales/(1 + g) Current sales = $320,000,000/(1 + .12) Current sales = $285,714,286 And the change in sales is: Change in sales = $320,000,000 – 285,714,286 Change in sales = $34,285,714