(Solution Manual) Fundamentals of Corporate Finance (Australia)

Ross, 8

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8th Edition

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Solutions Manual (All Chapters) Fundamentals of Corporate Finance (Australia) 8th edition Ross, Westerfield and Jordan Brad Jordan Joe Smolira © McGraw-Hill Australia Ross, Fundamentals of Corporate Finance, 8e © McGraw -Hill Australia Ross, Fundamentals of Corporate Finance, 8e CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Answers to Concepts review and critical thinking questions 1. Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt) and working capital management (modifying the firm’s credit collection policy with its customers). 2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, difficulty in raising capital funds. Some advantages: simpler, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates. 3. The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends for some shareholders . Some advantages include: limited liability, ease of transferability, ability to raise capital and unlimited life. 4. In response to stricter corporate governance legislations , some small firms have elected to go dark because of the costs of compliance. The costs to comply with some of the corporate governance legislations can be up to several million dollars, which can be a large percentage of a small firm ’s profits. A major cost of going dark is less access to capital. Since the firm is no longer publicly traded, it can no longer raise money in the public market. Although the company will still have access to bank loans and the private equity market, the costs associated with raising funds in these markets are usually higher than the costs of raising funds in the public market. 5. The treasurer’s office and the chief accountant’s office are the two primary organisational groups that report directly to the chief financial officer. The chief accountant’s office handles cost and financial accounting, tax management and management information systems . The treasurer’s office is responsible for cash and credit management, capital budgeting and financial planning. Therefore, the study of cor porate finance is concentrated within the treasury group’s functions. 6. The financial manager is the person responsible for making decisions in the interest of shareholders of a firm. The financial manager of a firm should be motivated to make good finan cial management decisions. The goal to maximise the current market value (share price) of the equity of the firm (whether it is publicly traded or not) always motivates the actions of the firm’s financial manager . 7. In the corporate form of ownership, th e shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. 2 SOLUTIONS MANUAL This separation of ownership from control in the corporate form of organisation 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 maximising the share price of the equity of the firm. 8. The Initial Public Offering (IPO) is a primary market transaction. The IPO is made to raise capital by the issue of new securities and the primary market is the place where the new securities are traded to raise capital. Hence, IPO is a primary market transaction. 9. In auction markets l ike the ASX, brokers buy and sell shares on the instructions of their clients, placing orders on the ASX’s automated trading system. Dealer markets such as NASDAQ in the US represent dealers operating in dispersed locales that buy and sell assets themselve s. They usually communicate with other dealers electronically or literally over the counter. 10. Since s uch organisations frequently pursue social or political missions, many different goals are conceivable. One goal that is often cited is revenue minimi sation; that is , 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 maximise the value of the equity. 11. Presumably, the current shares’ 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. 12. 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 implies an optimal level of, for example, ethical and/or illegal behaviour , and the framework of s hare valuation explicitly includes these. At the other extreme, we could argue that these are noneconomic phenomena and are best handled through the political process. A classic (and high ly relevant) thought question that illustrates this debate: ‘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? ’ 13. The goal of financial management is always to maximise the wealth of the shareholders. If the financial management is assumed in a foreign country, the goal remains the same. However, the best course of action towards that goal may require adjustments. This is due to different social, political and economic climates, which differ country to country. 14. The goal of management should be to maximise 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 bid der 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 CHAPTER 1 - 3 monitored managers have an incentive to fight corporate takeovers i n situations such as this one. 15. We would expect agency problems to be less severe in some other countries , primarily due to the relatively small percentage of individual shareholders . Fewer individual shareholders should reduce the number of diverse op inions concerning corporate goals. The high percentage of institutional shareholding might lead to a higher degree of agreement between shareholders and management on decisions concerning risky projects. In addition, institution al shareholders may be bette r able to implement effective monitoring mechanisms on management than can individual shareholders , based on the institution al shareholder s’ deeper resources and experiences with their own management. The increase in institutional shareholdings of companie s in Australia and the growing activism of these large shareholder groups may lead to a reduction in agency problems for Australian companies and a more efficient market for corporate control. 16. How much is too much? Who is worth more, Andrew Barkla or Chris Hemsworth ? The simplest answer is that there is a market for executives just as there is for all types of labour . Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect o f executive compensation deserves comment. A primary reason executive remuneration has grown so dramatically is that companies have increasingly moved to s hare-based remuneration . Such movement is obviously consistent with the attempt to better align shareholder and management interests. In recent years, s hare prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is due to rising share prices in general, not managerial performance. Perhaps in the future, executive remuneration will be designed to reward only differential performance, that is, share price increases in excess of general market increases. © McGraw -Hill Australia Ross, Fundamentals of Corporate Finance, 8e CHAPTER 2 FINANCIAL STATE MENTS, TAXES, AND CASH FLOW Answers to Concepts review and critical thinking questions 1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It is desirable for firms to have high liquidity so that they have a large factor of safety in meeting short -term creditor demands. However, since liquidity also has an opportunity cost associated with it —namely that higher returns can generally be found by inv esting the cash into productive assets —low liquidity levels are also desirable to the firm. It is up to the firm’s financial management staff to find a reasonable compromise between these opposing needs. 2. The recognition and matching principles in finan cial accounting call for revenues, and the expenses associated with producing those revenues, to be ‘booked ’ or recognised when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid so that profit for the period is appropriately computed . 3. Historical costs can be objectively and precisely measured , whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a trad e-off between relevance (market values) and objectivity (book values). 4. Depreciation is a non -cash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest is a cash outlay , but it is a financing cost, not an operating expense . 5. The market value of a company’s assets can be lower than the market value of its liabilities. Generally, market value of liabilities does not fluctuate much; however, market value of assets may re duce due to various impairment factors such as technological obsolescence . This would cause an excess of market value of liabilities over assets and would result in negative shareholders’ equity in accounting terms . However, the m arket values of shares can never be negative. Imagine a company’s share selling for –$20. This would mean that if you placed an order for 100 shares, you would get the share along with a receipt of $2000. How many shares do you want to buy? More generally, because of shareholders ’ limited liability at law in Australia and New Zealand , net worth for such a company ’s share can be zero but cannot be negative, implying that liabilities cannot exceed assets in market value of shareholders’ equity . 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 creating economic value -add, not whether cash flow fr om assets is positive or negative. CHAPTER 2 - 5 7. It is probably not a good sign for an established company, but it would be fairly ordinary for a start -up. In the case of persistent negative operating cash flows, the firm would not be able to pay its trade payables and other operating expenses and would have to depend upon non - current loans or shareholders’ contributed equity, which would not be economically sustainable. 8. For example, if a company were to become more efficient in inventory management, the amount of i nventory needed would decline. The same might be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would have this effect. Negative net capital spending would mean that more non- current assets were liquidated than purchased. 9. If a company raises more money from selling s hares than it pays in dividends in a particular period, its cash flow to shareholders will be negative. If a company borrows more than it pays in interest, its cash flow to creditors will be negative. 10. The adjustments discussed were purely accounting changes; they had no immediate cash flow or market value consequences unless the new accounting information caused shareholders to revise downwards their expectations on the company’s future economic state of affairs . 11. Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have to take on the company ’s debt but would pocket its cash. Enterprise value differs significantly from simple market capitali sation in several ways, and it may be a more accurate representation of a firm ’s value. In a takeover, the value of a firm ’s debt would need to be paid by the buyer . Thus, enterprise value provides a m uch more accurate takeover valuation because it includes debt in its value calculation. 12. In general, it appears that investors prefer companies that have a steady earnings stream. If true, this encourages companies to manage earnings. Under AAS , there are accounting choices for the way a company reports its financial statements. Although not the purpose of having accounting choices under AAS , one outcome is the ability of a company to manage earnings, which is not an ethical decision. Even though earnin gs and cash flow are often related, earnings management should have little effect on cash flow (except for certain tax implications). If the market is ‘fooled ’ and prefers steady earnings, shareholder wealth may be increased, at least temporarily. However, given the questionable ethics of this practice, the company ’s share price would correct downwards if the investors found out this practice is only to mislead them into overpricing the company’s shares . 6 SOLUTIONS MANUAL Solutions to Questions and problems Basic 1. To find shareholders’ equity , we must construct a statement of financial position as follows: Statement of finan cial position CA $ 4 900 CL $ 4 100 NNCA 27 300 NCD 10 200 SE ?? TA $32 200 TL & SE $32 200 We know that total liabilities and shareholders’ equity (TL & SE) must equal total assets of $3 2 200. We also know that TL & SE is equal to current liabilities plus non-current debt plus shareholders’ equity , so shareholders’ equity is: Shareholders’ equity = $32 200 – 10 200 – 4100 = $17 900 NWC = CA – CL = $ 4900 – 4100 = $800 2. The statement of profit or loss for the company is: Statement of profit or loss Revenue $796 000 Expenses 327 000 Depreciation 42 000 EBIT $427 000 Interest 34 000 PBT $393 000 Taxes ( 30%) 117 900 Profit for the year $275 100 3. One equation for profit for the year is: Profit for the year = Dividends + Addition to retained earnings Rearranging, we get: Addition to retained earnings = Profit for the year – Dividends = $ 275 100 – 95 000 = $180 100 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. CHAPTER 2 - 7 4. EPS = Profit for the year/Shares = $275 100/80 000 = $3.44 per share DPS = Dividends /Shares = $95 000/80 000 = $1.19 per share 5. To calculate OCF, we first need the statement of profit or loss : Statement of profit or loss Revenue $46 200 Expense s 23 100 Depreciation 2 200 EBIT $20 900 Interest 1 700 PBT $19 200 Taxes ( 30%) 5 760 Profit for the year $17 340 OCF = EBIT + Depreciation – Taxes = $ 20 900 + 2 200 – 5 760 = $17 340 6. Net capital spending = NNCA end – NNCA beg + Depreciation Net capital spending = $ 3 300 000 – 2 400 000 + 319 000 Net capital spending = $ 1 219 000 7. Change in NWC = NWC end – NWC beg Change in NWC = (CA end – CL end) – (CA beg – CL beg) Change in NWC = ($ 5360 – 2970 ) – ($4810 – 2230 ) Change i n NWC = $ 2390 – 2580 = –$190 8. Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = Interest paid – (NCDend – NCDbeg) Cash flow to creditors = $ 255 000 – ($2 210 000 – 1 870 000) Cash flow to creditors = –$85 000 9. Cash flow to shareholder s = Dividends paid – Net new equity Cash flow to shareholder s = Dividends paid – (SE end– SEbeg) Cash flow to shareholder s = $ 545 000 – ($5 005 000 – $4 630 000) Cash flow to shareholder s = $1 70 000 Note, APIS is the additional paid -in surplus. 8 SOLUTIONS MANUAL 10. Cash flow from assets = Cash flow to creditors + Cash flow to shareholder s = –$85 000 + 170 000 = $85 000 Cash flow from assets = $85 000 = OCF – Change in NWC – Net capital spending = $85 000 = OCF – (–$45 000) – 1 250 000 Operating cash flow = $85 000 – 45 000 + 1 250 000 Operating cash flow = $1 290 000 Intermediate 11. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current assets, we get: CA = NWC + CL = $2 35 000 + 895 000 = $1 130 000 The market value of current assets and non-current asset s is given, so: Book value CA = $1 130 000 Market value CA = $1 150 000 Book value NNCA = 3 400 000 Market value NNCA = 5 100 000 Book valu e assets = $4 530 000 Total = $6 250 000 12. To find the OCF, we first calculate profit for the year . Statement of profit or loss Revenue $305 000 Expense s 176 000 Other expenses 8 900 Depreciation 18 700 EBIT $101 400 Interest expense 12 900 Profit before tax $88 500 Taxes 23 345 Profit for the year $65 155 Dividends $19 500 Additions to RE $45 655 a. OCF = EBIT + Depreciation – Taxes = $ 101 400 + 18 700 – 23 345 = $96 755 b. CFC = Interest – Net new NCD = $12 900 – (–4 900) = $1 7 800 Note that the net new non-current debt is negative because the company repaid part of its non-current debt. CHAPTER 2 - 9 c. CFS = Dividends – Net new equity = $ 19 500 – 6400 = $13 100 d. We know that CFA = CFC + CFS, so: CFA = $1 7 800 + 13 100 = $30 900 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 NNCA + Depreciation = $ 46 000 + 18 700 = $64 700 Now we can use: CFA = OCF – Net capital spending – Change in NWC $30 900 = $96 755 – 64 700 – Change in NWC Change in NWC = $ 1155 This means that the company increased its NWC by $ 1155 . 13. The solution to this question works the statement of profit or loss backwards. Starting at the bottom: Profit for the year = Dividends + Addition to retained earnings = $ 1980 + 5700 = $7680 Now, looking at the statement of profit or loss : PBT – PBT × Tax rate = Profit for the year Recognise that PBT × Tax rate is the calculation for taxes. Solving this for PBT yields: PBT = PFY/(1 – Tax rate) = $ 7680 /(1 – 0.30) = $ 10 971 Now you can calculate: PBIT = PBT + Interest = $ 10 971 + 4400 = $15 371 The last step is to use: EBIT = Revenue – Expenses – Depreciation $15 371 = $64 000 – 30 700 – Depreciation Depreciation = $ 17 929 10 SOLUTIONS MANUAL 14. The statement of financial position for the company looks like this: Statement of financial position Cash $ 127 000 Accounts payable $ 21 0 000 Accounts receivable 115 000 Notes payable 155 000 Inventory 286 000 Current liabilities $ 365 000 Current assets $ 528 000 Non-current debt 830 000 Total liabilities $1 195 000 Tangible net non-current asset s $1 610 000 Intangible net non-current asset s 660 000 Ordinary share capital ?? Accumulated ret. earnings 1 368 000 Total assets $2 798 000 Total liab. & shareholders’ equity $2 798 000 Total liabilities and shareholders’ equity is: TL & SE = CL + NCD + Ordinary share capital + Retained earnings Solving this equation for ordinary share capital gives us: Ordinary share capital = $2 798 000 – 1 195 000 – 1 368 000 = $ 235 000 15. The market value of shareholders’ equity cannot be negative. A negative ma rket value in this case would imply that the company would pay you to own its shares . The market value of shareholders’ equity can be stated as: Shareholders’ equity = Max[(TA – TL), 0]. So, if TA are $9 400, equity is equal to $ 1 600, and if TA are $6 700, equity is equal to $0. We should note here that the book value of shareholders’ equity can be negative. 16. Statement of profit or loss Revenue $705 000 COS 445 000 A&D expenses 95 000 Depreciation 140 000 EBIT $25 000 Interest expense 70 000 Profit before tax –$45 000 Taxes ( 30%) 0 a. Profit for the year –$45 000 b. OCF = EBIT + Depreciation – Taxes = $ 25 000 + 140 000 – 0 = $1 65 000 c. Profit for the year was negative because the after -tax value of its earnings before interest and taxes less depreciation and interest is less than zero . However, the actual cash flow from operations was positive because depreciation is a non -cash expense and interest is a fi nancing expense, not an operating expense. CHAPTER 2 - 11 17. A firm can still pay out dividends even if profit for the year 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 = $ 165 000 – 0 – 0 = $ 165 000 Cash flow to shareholder s = Dividends – Net new equity = $ 102 000 – 0 = $ 102 000 Cash flow to creditors = Cash flow from assets – Cash flow to shareholder s Cash flow to creditors = $ 165 000 – 102 000 = $63 000 Cash flow to creditors = Interest – Net new NCD Net new NCD = Interest – Cash flow to creditors = $ 70 000 – 63 000 = $7 000 18. a. Statement of profit or loss Revenue $33 106 Cost of sales 23 624 Depreciation 5 877 EBIT $ 3 605 Interest 2 650 Profit before tax $ 955 Taxes ( 30%) 287 Profit for the year $ 669 b. OCF = EBIT + Depreciation – Taxes = $3605 + 5877 – 287 = $9196 c. Change in NWC = NWC end – NWC beg = (CA end – CL end) – (CA beg – CL beg) = ($8612 – 4575 ) – ($6970 – 3920 ) = $4037 – 3050 = $987 Net capital spending = NNCA end – NNCA beg + Depreciation = $24 394 – 19 820 + 5877 = $10 451 CFA = OCF – Change in NWC – Net capital spending = $9196 – 987 – 10 451 = –$2243 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 profit for the year and OCF are positive, the firm invested heavily in both non-current asset s and net working capital; it had to raise a net $ 2243 in funds from its shareholder s and creditors to make these investments. d. Cash flow to creditors = Interest – Net new LTD = $ 2650 – 0 = $ 2650 Cash flow to shareholder s = Cash fl ow from assets – Cash flow to creditors 12 SOLUTIONS MANUAL = –$2243 – 2650 = –$4893 We can also calculate the cash flow to shareholder s as: Cash flow to shareholder s = Dividends – Net new equity Solving for net new equity, we get: Net new equity = $1888 – (–4893 ) = $ 6781 The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $ 987 in new net working capital and $ 10 451 in new non-current asset s. The firm had to raise $ 2243 from its stakeholders to support this new investment. It accomplished this by raising $ 6 781 in the form of new equity. After paying out $ 1 888 of this in the form of dividends to shareholders and $ 2650 in the form of interest to creditors, $2243 was left to meet the firm’s cash flow needs for investment. 19. a. Total assets 2017 = $1206 + 4973 = $6179 Total liabilities 2017 = $482 + 2628 = $3110 Shareholders’ equity 2017 = $6179 – 3110 = $3069 Total assets 2018 = $1307 + 5988 = $7295 Total liabilities 2018 = $541 + 2795 = $3336 Shareholders’ equity 2018 = $7295 – 3336 = $3959 b. NWC 2017 = CA 2017 – CL 2017 = $1206 – 482 = $724 NWC 2018 = CA 2018 – CL 2018 = $1307 – 541 = $766 Change in NWC = NWC 2018 – NWC 2017 = $766 – 724 = $42 c. We can calculate net capital spending as: Net capital spending = Net non-current asset s2018 – Net non-current asset s2017 + Depreciation Net capital spending = $5988 – 4973 + 1363 = $2378 So, the company had a net capital spending cash flow of $ 2378 . We also know that net capital spending is: Net capital spending = Non-current asset s bought – Non-current asset s sold $2378 = $2496 – Non-current asset s sold Non-current asset s sold = $2496 – 2378 = $118 CHAPTER 2 - 13 To calculat e the cash flow from assets, we must first calculate the operating cash flow. The statement of profit or loss is: Statement of profit or loss Revenue $15 301 Costs 7 135 Depreciation expense 1 363 EBIT $ 6 803 Interest expense 388 PBT $ 6 415 Taxes ( 30%) 1 925 Profit for the year $ 4 491 So, the operating cash flow is: OCF = EBIT + Depreciation – Taxes = $ 6803 + 1363 – 1925 = $6242 And the cash flow from assets is: Cash flow from assets = OCF – Change in NWC – Net capital spending. = $6242 – 42 – 2378 = $3822 d. Net new borrowing = NCD20 – NCD D19 = $2795 – 2628 = $167 Cash flow to creditors = Interest – Net new NCD = $388 – 167 = $221 Net new borrowing = $167 = Debt issued – Debt retired Debt retired = $504 – 167 = $337 Challenge 20. Net capital spending = NNCA end – NNCA beg + Depreciation = (NNCA end – NNCA beg) + (Depreciation + AD beg) – AD beg = (NNCA end – NNCA beg)+ AD end – AD beg = (NNCA end + AD end) – (NNCA beg + AD beg) = NCAend – NCAbeg 14 SOLUTIONS MANUAL 21. Statement of financial position as at 31 Dec 2019 Cash $8 676 Accounts payable $6 269 Accounts receivable 11 488 Notes payable 1 674 Inventory 20 424 Current liabilities $7 943 Current assets $40 588 Non-current debt $29 060 Net non-current asset s $72 770 Shareholders’ equity $76 355 Total assets $113 358 Total liab. & equity $113 358 Statement of financial position as at 31 Dec 2020 Cash $9 247 Accounts payable $6 640 Accounts receivable 13 482 Notes payable 1 641 Inventory 21 862 Current liabilities $8 281 Current assets $44 591 Non-current debt $35 229 Net non-current asset s $77 610 Shareholders’ equity $78 691 Total assets $122 201 Total liab. & equity $122 201 2019 Statement of profit or loss 2020 Statement of profit or loss Revenue $16 549.00 Revenue $18 498.00 COS 5 690.00 COS 6 731.00 Other expenses 1 353.00 Other expenses 1 178.00 Depreciation 2 376.00 Depreciation 2 484.00 EBIT $7 130.00 EBIT $8 105.00 Interest expense 1 110.00 Interest expense 1 325.00 PBT $6 020.00 PBT $6 780.00 Taxes ( 30%) 1 806.00 Taxes ( 30%) 2 034.00 Profit for the year $4 214.00 Profit for the year $4 746.00 Dividends $1 979.00 Dividends $2 314.00 Additions to RE 2 235.00 Additions to RE 2 432.00 CHAPTER 2 - 15 22. OCF = EBIT + Depreciation – Taxes = $ 8105 + 2484 – 2034 = $8555 Change in NWC = NWC end – NWC beg = (CA – CL) end – (CA – CL) beg = ($44 591 – 8281 ) – ($40 588 – 7943 ) = $3665 Net capital spending = NNCA end – NNCA beg + Depreciation = $77 610 – 72 770 + 2484 = $7324 Cash flow from assets = OCF – Change in NWC – Net capital spending = $8555 – 3665 – 7324 = –$2434 Cash flow to creditors = Interest – Net new NCD Net new NCD = NCD end – NCD beg Cash flow to creditors = $ 1325 – ($35 229 – 29 060) = –$4844 Net new equity = Ordinary share capital end – Ordinary share capital beg Ordinary share capital + Retained earnings = Total shareholders’ equity Net new equity = (SE – RE) end – (SE – RE) beg = SEend – SEbeg + RE beg – RE end RE end = RE beg + Additions to RE 20  Net new equity = SEend – SEbeg + RE beg – (RE beg + Additions to RE 20) = SEend – SEbeg – Additions to RE 20 Net new equity = $78 691 – 76 355 – 2432 = –$96 CFS = Dividends – Net new equity CFS = $2314 – (–96) = $2410 As a check, cash flow from assets is –$2434 . CFA = Cash to from creditors + Cash flow to shareholder s CFA = –$4844 + 2410 = –$2434 © McGraw -Hill Australia Ross, Fundamentals of Corporate Finance, 8e CHAPTER 3 WORKING WITH FINANCIAL STATEMENTS Answers to Concepts review and critical thinking questions 1. a. If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1. 0. b. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0. c. Reducing short -term bank loan or current loan with cash increases the current ratio if it was initially greater than 1.0. d. As non-current de bt approaches maturity, the principal repayment and the remaining interest expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current ratio since current liabilities are not affected. e. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged. f. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged. g. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases. 2. An increase in current ratio and fall in liquid ratio states that the firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain mostly unchanged, liquidity has potentially decreased . 3. A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short -term or current creditors and suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50 per cent more current assets than it does current liabilities. This probably represents an improvement in liquidity; short -term obligations can generally be met completely with a safety factor built in. A current ratio of 15.0, however, might be excess ive. Any excess funds sitting in current assets generally earn little or no return. These excess funds might be put to better use by investing in productive long-term assets or distributing the funds to shareholders. 4. a. Quick ratio provides a measure of the short -term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm’s current assets. b. Cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid asset (cash). CHAPTER 3 - 17 c. Total asset turnover measures how much in revenue is generated by each dollar of firm assets. d. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the dollar worth of firm assets each equ ity dollar has a claim to. e. Non-current debt ratio measures the percentage of total firm capitali sation funded by non- current debt . f. Times interest earned ratio provides a relative measure of how well the firm’s operating earnings can cover current i nterest obligations. g. Profit margin is the accounting measure of bottom -line profit per dollar of revenue . h. Return on assets is a measure of bottom -line profit per dollar of total assets. i. Return on equity is a measure of bottom -line profit per do llar of equity. j. Price -earnings ratio reflects how much value per share the market places on a dollar of accounting profit for a firm. 5. Common -size financial statements express all statement of financial position accounts as a percentage of total ass ets and all statement of profit or loss accounts as a percentage of revenue . Using these percentage values rather than nominal dollar values facilitates comparisons between firms of different size or business type. Common -base year financial statements express each account as a ratio between their current year nominal dollar value and some reference year nominal dollar value. Using these ratios allows the total growth trend in the accounts to be measured. 6. Peer group analysis involves compa ring the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm’s operat ions, 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. An aspirant group would be a set of firms whose performance the company in question would like to emulate. The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluated by how well they match the performance of an identified aspirant group. 7. Return on equ ity is probably the most important accounting ratio that measures the bottom - line performance of the firm with respect to the equity shareholders. The DuPont identity emphasises the role of a firm’s profitability, asset utilisation efficiency and financial leverage in achieving an ROE figure. For example, a firm with ROE of 20 per cent would seem to be doing well, but this figure may be misleading if it were marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm’s margins were to erode slightly, the ROE would be heavily impacted. 8. The book -to-bill ratio is intended to measure whether demand is growing or falling. It is closely followed because it is a barometer for the entire high -tech industry , where levels of revenues and profits have been relatively volatile. 18 SOLUTIONS MANUAL 9. 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. 10. a. For an energy company such as AGL Ltd , expressing costs on a per -kilowatt -hour basis would be a way to compare costs with other utilities of different sizes. b. For a retailer such as Myer , expressing revenue on a per -square -metre basis would be useful in comparing revenue production against other retailers. c. For an airline such as Qantas , expressing costs on a per -passenger -kilometre basis allows for comparisons with other airlines by examining how much it costs to fly one passenger one kilometre . d. For an online service provider such as Singtel Optus , using a cost per internet session would allow for comparisons with smaller servi ces. A per subscriber basis would also make sense. e. For a hospital such as St Vincent’s Private , revenues and costs expressed on a per -bed basis would be useful. f. For a college textbook publisher such as McGraw -Hill Education , the leading publisher of finance textbooks for the tertiary education market, the obvious standardisation would be per book sold. 11. Reporting the sale of Treasury securities as cash flow from operations is an accounting ‘trick, ’ and as such, should constitute a possible red flag about the companies accounting practices. For most companies, the gain from a sale of securities should be placed in the financing section. Including the sale of securities in the cash flow from operation s would be acceptable for a financial company, such as an investment or commercial bank. 12. Increasing the payables period increases the cash flow from operations. This could be beneficial for the company as it may be a cheap form of financing, but it is basically a one - time change. The payables period cannot be increased indefinitely as it will negatively affect the company’s credit rating if the payables period becomes too long. 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 readabi lity 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. Using the formula f or NWC, we get: NWC = CA – CL CA = CL + NWC CA = $4590 + 2170 CHAPTER 3 - 19 CA = $6760 So, the current ratio is: Current ratio = CA /CL Current ratio = $6760 /$4590 Current ratio = 1.47 times And the quick ratio is: Quick ratio = (CA – Inventory) /CL Quick ratio = ($6760 – 3860 )/$4590 Quick ratio = 0.63 times 2. We need to find profit for the year first. So: Profit margin = Profit for the year /Revenue Profit for the year = Profit margin (Revenue ) Profit for the year = 0.05($16 700 000) Profit for the year = $835 000 ROA = Profit for the year /TA ROA = $835 000/$12 900 000 ROA = 0.0647, or 6.47% To find ROE, we need to find total equity. Since TL + TE equals TA: TA = TD + TE TE = TA – TD TE = $ 12 900 000 – 5 700 000 TE = $7 200 000 ROE = Profit for the year /TE ROE = $835 000/$7 200 000 ROE = 0.1160, or 1 1.60% 3. Receivables turnover = Revenue /Receivables Receivables turnover = $ 5 473 640/$537 810 Receivables turnover = 10.18 times Days’ sales in receivables = 365 days /Receivables turnover Days’ sales in receivables = 365 /10.18 Days’ sales in receivables = 35.86 days On average , the company’s customers paid off their accounts in 35.86 days. 20 SOLUTIONS MANUAL 4. Inventory turnover = COS /Inventory Inventory turnover = $ 4 981 315/$386 735 Inventory turnover = 12.88 times Days’ sales in inventory = 365 days /Inventory turnover Days’ sales in inventory = 365 /12.88 Days’ sales in inventory = 28.34 days On average, a unit of inventory sat on the shelf 28.34 days before it was sold. 5. Total debt ratio = 0.46 = TD /TA Substituting total debt plus total equity for total assets, we get: 0.46 = TD /(TD + TE) Solving this equation yields: 0.46(TE) = .54(TD) Debt -equity ratio = TD /TE = 0.46/0.54 = 0.85 Equity multiplier = 1 + D/E = 1.85 6. Profit for the year = Addition to RE + Dividends = $415 000 + 220 000 = $635 000 Earnings per share = PFY/Shares = $635 000/170 000 = $3.74 per share Dividends per share = Dividends /Shares = $220 000/170 000 = $1.29 per share Book value per share = TE /Shares = $5 600 000/170 000 = $32.94 per share Market -to-book ratio = Share price /BVPS = $65/$32.94 = 1.97 times PE ratio = Share price /EPS = $65/$3.74 = 17.40 times Revenue per share = Revenue /Shares = $7 450 000/170 000 = $43.82 P/S ratio = Share price /Revenue per share = $65/$43.82 = 1.48 times 7. ROE = (PM)(TAT)(EM) ROE = ( 0.061)(2.10)(1. 27) ROE = 0.1627, or 1 6.27% CHAPTER 3 - 21 8. This question gives all of the necessary ratios for the DuPont identity except the equity multiplier, so, using the DuPont identity: ROE = (PM)(TAT)(EM) ROE = 0.1584 = (0.064)(1.77)(EM) EM = 0.1584/(0.064)(1.77) EM = 1.40 D/E = EM – 1 D/E = 1.40 – 1 D/E = 0.40 9. Decrease in inventory is a source of cash . Decrease in accounts payable is a use of cash . Increase in notes payable is a source of cash . Increase in accounts receivable is a use of cash . Change in cash = Sources – Uses Change in cash = $375 – 220 + 290 – 270 Change in cash = $175 Cash increased by $ 175 10. The average time to pay suppliers is the days’ sales in payables, so: Payables turnover = COS /Accounts payable Payables turnover = $ 68 314/$15 486 Payables turnover = 4.41 times Days’ sales in payables = 365 days /Payables turnover Days’ sales in payables = 365 /4.41 Days’ sales in payables = 82.74 days The company left its bills to suppliers outstanding for 82.74 days on average. A large value for this ratio could imply that either (1) the company is having liquidity problems, making it difficult to pay off its short -term obligations, or (2) that the com pany has successfully negotiated lenient credit terms from its suppliers. 11. First, we need the enterprise value, which is: Enterprise value = Market capitali sation + Debt – Cash Enterprise value = $ 645 000 + 215 000 – 53 000 Enterprise value = $ 807 000 22 SOLUTIONS MANUAL And EBITDA is: EBITDA = EBIT + Depreciation & Amortisation EBITDA = $9 1 000 + 157 000 EBITDA = $2 48 000 So, the enterprise value -EBITDA multiple is: Enterprise value -EBITDA multiple = $ 807 000/$248 000 Enterprise value -EBITDA multiple = 3.2 5 times 12. The equity multiplier is: EM = 1 + D/E EM = 1 + 0.57 EM = 1. 57 One formula to calculate return on equity is: ROE = ROA(EM) ROE = 0.079(1.57) ROE = 0.1240, or 1 2.40% ROE can also be calculated as: ROE = PFY/TE So, profit for the year is: Profit for the year = ROE(TE) Profit for the year = 0.1240($620 000) Profit for the year = $76 898.60 CHAPTER 3 - 23 13. through 15: 2019 #13 2020 #13 #14 #15 Assets Current assets Cash $12 157 2.62% $14 105 2.94% 1.1602 1.1202 Accounts receivable 29 382 6.34% 32 815 6.84% 1.1168 1.0783 Inventory 54 632 11.79% 57 204 11.92% 1.0471 1.0110 Total $96 171 20.75% $104 124 21.69% 1.0827 1.0454 Non-current asset s Net plant and equipment $367 241 79.25% $375 830 78.31% 1.0234 0.9881 Total assets $463 412 100% $479 954 100% 1.0357 1.0000 Liabilities and equity Current liabilities Accounts payable $46 382 10.01% $49 276 10.27% 1.0624 1.0258 Notes payable 18 246 3.94% 19 784 4.12% 1.0843 1.0469 Total $64 628 13.95% $69 060 14.39% 1.0686 1.0317 Non-current debt $49 000 10.57% $45 000 9.38% 0.9184 0.8867 Equity Ordinary shares $50 000 10.79% $50 000 10.42% 1.0000 0.9655 Accumulated retained earnings 299 784 64.69% 315 894 65.82% 1.0537 1.0174 Total $349 784 75.48% $365 894 76.24% 1.0461 1.0100 Total liabilities and equity $463 412 100% $479 954 100% 1.0357 1.0000 The common -size statement of financial position answers are found by dividing each category by total assets. For example, the cash percentage for 2017 is: $12 157/$463 412 = 0.0262, or 2.6 2% This means that cash is 2.6 2 per cent of total assets. The common -base year answers for Question 14 are found by dividing each category value for 2020 by the same category value for 2019. For example, the cash common -base year number is found by: $14 105/$12 157 = 1.1602 24 SOLUTIONS MANUAL This means the c ash balance in 2020 is 1.1602 times as large as the cash balance in 2019. The common -size, common -base year answers for Question 15 are found by dividing the common -size percentage for 2020 by the common -size percentage for 2019. For example, the cash cal culation is found by: 0.0294 /0.0262 = 1.1202 This tells us that cash, as a percentage of assets, increased by 12.02 per cent. 16. 2019 Sources/Uses 2020 Assets Current assets Cash $12 157 $1 948 U $14 105 Accounts receivable 29 382 3 433 U 32 815 Inventory 54 632 2 572 U 57 204 Total $96 171 $7 953 U $104 124 Non-current asset s Net plant and equipment $367 241 $8 589 U $375 830 Total assets $463 412 $16 542 U $479 954 Liabilities and equity Current liabilities Accounts payable $46 382 $2 894 S $49 276 Notes payable 18 246 1 538 S 19 784 Total $64 628 $4 432 S $69 060 Non-current debt $49 000 –$4 000 U $45 000 Equity Ordinary shares $50 000 0 $50 000 Accumulated retained earnings 299 784 16 110 S 315 894 Total $349 784 $16 110 S $365 894 Total liabilities and equity $463 412 $16 542 S $479 954 The firm used $ 16 542 in cash to acquire new assets. It raised this amount of cash by increasing liabilities and equity by $ 16 542. In particular, the needed funds were raised by internal financing (on a net basis), out of the additions to retained earnings and an increase in current liabilities. 17. a. Current ratio = Current assets /Current liabilities