Professional Documents
Culture Documents
FINANCIAL
MANAGEMENT
Principles and Practice
Sixth Edition
Timothy J. Gallagher
Colorado State University
Solutions Manual
to accompany
This solutions manual provides the answers to all the review questions and end-of-chapter problems
in Financial Management: Principles and Practice, by Timothy Gallagher. The answers and the steps taken
to obtain the answers are shown.
Readers are reminded that in finance there is often more than one answer to a question or to a
problem, depending on ones viewpoint and assumptions. One answer is provided here to each question and
one approach is shown for solving each problem. Other answers and approaches may be equally valid, or
judged even better according to each individuals preference.
ii
TABLE OF CONTENTS
Chapter 1 Solutions ...................................................................................................................5
Chapter 2 Solutions ...................................................................................................................9
Chapter 3 Solutions .................................................................................................................13
Chapter 4 Solutions .................................................................................................................16
Chapter 5 Solutions .................................................................................................................24
Chapter 6 Solutions .................................................................................................................35
Chapter 7 Solutions .................................................................................................................42
Chapter 8 Solutions .................................................................................................................54
Chapter 9 Solutions .................................................................................................................62
Chapter 10 Solutions ...............................................................................................................68
Chapter 11 Solutions ...............................................................................................................80
Chapter 12 Solutions ...............................................................................................................94
Chapter 13 Solutions .............................................................................................................104
Chapter 14 Solutions .............................................................................................................114
Chapter 15 Solutions .............................................................................................................121
Chapter 16 Solutions .............................................................................................................125
Chapter 17 Solutions .............................................................................................................132
Chapter 18 Solutions .............................................................................................................139
Chapter 19 Solutions .............................................................................................................148
Chapter 20 Solutions .............................................................................................................164
Chapter 21 Solutions .............................................................................................................168
iii
iv
Chapter 1 Solutions
Answers to Review Questions
1.
2.
List and describe the three career opportunities in the field of finance.
Finance has three main career paths: financial management, financial markets and institutions, and
investments.
Financial management involves managing the finances of a business. Financial managerspeople
who manage a business firm's financesperform a number of tasks. They analyze and forecast a
firm's finances; assess risk, evaluate investment opportunities, decide when and where to find money
sources and how much money to raise, and decide how much money to return to the firm's investors.
Bankers, stockbrokers, and others who work in financial markets and institutions focus on the flow of
money through financial institutions and the markets in which financial assets are exchanged. They
track the impact of interest rates on the flow of that money.
People who work in the field of investments locate, select, and manage income-producing assets. For
instance, security analysts and mutual fund managers both operate in the investment field.
3.
4.
5.
List and explain the three financial factors that influence the value of a business.
The three factors that affect the value of a firm's stock price are cash flow, timing, and risk.
The Importance of Cash Flow: In business, cash is what pays the bills. It is also what the firm
receives in exchange for its products and services. Cash is therefore of ultimate importance, and the
expectation that the firm will generate cash in the future is one of the factors that gives the firm its
value.
The Effect of Timing on Cash Flows: Owners and potential investors look at when firms can expect
to receive cash and when they can expect to pay out cash. All other factors being equal, the sooner
companies expect to receive cash and the later they expect to pay out cash, the more valuable the
firm and the higher its stock price will be.
The Influence of Risk: Risk affects value because the less certain owners and investors are about a
firm's expected future cash flows, the lower they will value the company. The more certain owners
and investors are about a firm's expected future cash flows, the higher they will value the company.
In short, companies whose expected future cash flows are doubtful will have lower values than
companies whose expected future cash flows are virtually certain.
6.
Explain why accounting profits and cash flows are not the same thing.
Stock value depends on future cash flows, their timing, and their riskiness. Profit calculations do not
consider these three factors. Profit, as defined in accounting, is simply the difference between sales
revenue and expenses. It is true that more profits are generally better than less profits, but when the
pursuit of short-term profits adversely affects the size of future cash flows, their timing, or their
riskiness, then these profit maximization efforts are detrimental to the firm.
7.
8.
run media campaigns promoting the responsible use of alcohol, and contribute money to worthwhile
civic causes, the goodwill generated as a result of these activities causes long-term increases in the
firm's sales and cash flows, which translate into additional wealth for the firm's owners.
9.
10.
Compare and contrast the potential liability of owners of proprietorships, partnerships (general
partners), and corporations.
The sole proprietor has unlimited liability for matters relating to the business. This means that the
sole proprietor is responsible for all the obligations of the business, even if those obligations exceed
the amount the proprietor has invested in the business.
Each partner in a partnership is usually liable for the activities of the partnership as a whole. Even if
there are a hundred partners, each one is technically responsible for all the debts of the partnership.
If ninety-nine partners declare personal bankruptcy, the hundredth partner still is responsible for all
the partnership's debts.
A corporation is a legal entity that is liable for its own activities. Stockholders, the corporation's
owners, have limited liability for the corporation's activities. They cannot lose more than the amount
they paid to buy the corporations stock.
2.
3.
a. The value of the firm would go down due to the increase in the amount of time it takes to
receive the cash inflows.
b. The value of the firm would go up due to the increase in expected cash inflows.
c. If expected future cash flows do not change the value of the firm would go down due to the
increased riskiness of the firm.
4.
This practice obviously takes advantage of people who are in a difficult financial situation. This
transaction is voluntary, however, and high risk loans have high interest rates.
5.
LLCs have a small number of members like partnerships and each of these members is likely to
have an active voice in the company like a partnership. The LLC is taxed like a partnership.
Unlike a partnership, and more like a corporation, the owners generally enjoy limited liability.
Chapter 2 Solutions
2.
What is a security?
Securities are claims on financial assets. They can be described as claim checks that give their
owners the right to receive funds in the future. Securities are traded in both the money and capital
markets. Money market securities include Treasury bills, negotiable certificates of deposit,
commercial paper, and bankers acceptances. Capital market securities include bonds and stock.
3.
4.
5.
How are financial trades made in an over-the-counter market? Discuss the role of a dealer in the OTC
market.
In contrast to the organized exchanges, which have physical locations, the over-the-counter market
has no fixed location, or more correctly, it is everywhere. The over-the-counter market, or OTC, is
a network of dealers around the world who maintain inventories of securities for sale. If you wanted
to buy a security that is traded OTC, you would call your broker, who would then shop among
competing dealers who have the security in their inventory. After locating the dealer with the best
price, your broker would buy the security on your behalf.
The role of dealers: Dealers make their living buying securities and reselling them to others. They
operate just like car dealers who buy cars from manufacturers for resale to others. Dealers make
money by buying securities for one price (called the bid price) and selling them for a higher price,
(called the ask price). The difference, or spread, between the bid price and the ask price represents
the dealers fee.
6.
What is the role of a broker in security transactions? How are brokers compensated?
Brokers handle orders to buy or sell securities. Brokers are agents who work on behalf of an investor.
When investors call with an order, brokers work on their behalf to find someone to take the other side
of the proposed trade. If investors want to buy, brokers find sellers. If investors want to sell, brokers
find buyers. Brokers are compensated for their services when the person whom they represent, the
investor, pays them a commission on the sale or purchase of securities.
7.
8.
Would there be positive interest rates on bonds in a world with absolutely no risk (no default risk,
maturity risk, and so on)? Why would a lender demand, and a borrower be willing to pay, a positive
interest rate in such a no-risk world?
Yes, there would be a positive rate of interest in a risk-free world. This is because regardless of risk,
lenders of money must postpone spending during the time the money is loaned. Lenders, then, lose
the opportunity to invest their money for that period of time. To compensate for the cost of losing
investment opportunities while they postpone their spending, lenders demand, and borrowers pay, a
basic rate of return, the real rate of interest.
a. Surplus economic units have income that exceeds their expenditures. Wealthy families in the
household sector and most states (which have balanced budget requirements) are surplus economic
units.
b. Deficit economic units have expenditures that exceed their incomes. Home buyers and college
students are likely to be deficit economic units.
2.2.
a. false
b. false
c. false
d. false
10
2-3.
a. 2 3 4 1
b. The money market is dominated by large institutional traders and there is much competition. The
New York Stock Exchange tends to have larger more actively traded stocks. The over-the-counter
market tends to have smaller less actively traded securities. The real estate market has very high
transaction costs and trades take months.
2.4.
2-5.
2%
3%
1%
1%
1%
4.50%
4.75%
5.00%
5.25%
5.50%
5.75%
6.00%
6.50%
11
Implications:
a. For borrowers: Borrowers tend to look for the low point of the curve, which indicates the least
expensive loan maturity. In this case the low point is 3 months, leading the borrower to seek a shortterm loan. However, if a firm borrows long-term and obtains the higher interest rate, that rate is
locked in for the life of the loan (30 years in this case). If interest rates rise the borrower may be glad
he/she locked in the long-term rate.
b. Lenders face the opposite situation. Granting short-term-term loans at relatively low interest rates
may look unattractive now; but if short-term rates rise, the lenders will be able to roll over
investments at higher and higher rates.
12
Chapter 3 Solutions
Define intermediation.
The financial system makes it possible for surplus and deficit economic units to come together,
exchanging funds for securities, to their mutual benefit. When funds flow from surplus economic
units to a financial institution to a deficit economic unit, the process is known as intermediation. The
financial institution acts as an intermediary between the two economic units.
2.
What can a financial institution often do for a surplus economic unit that it would have difficulty
doing for itself if the surplus economic unit (SEU) were to deal directly with a deficit economic unit
(DEU)?
Surplus economic units do not usually have the expertise to determine whether deficit economic units
can and will make good on their obligations, so it is difficult for them to predict when a would-be
deficit economic unit will fail to pay what it owes. Such a failure is likely to be devastating to a
surplus economic unit that has lent a proportionately large amount of money. In contrast, a financial
institution is in a better position to predict who will pay and who won't. It is also in a better position,
having greater financial resources, to occasionally absorb a loss when someone fails to pay. (This is
just one example of the beneficial things financial institutions do for SEUs)
3.
What can a financial institution often do for a deficit economic unit (DEU)that it would have
difficulty doing for itself if the DEU were to deal directly with an SEU?
SEUs typically want to supply a small amount of funds, while DEUs typically want to obtain a large
amount of funds. Thus it is often difficult for surplus and deficit economic units to come together on
their own to arrange a mutually beneficial exchange of funds for securities. A financial institution
can step in and save the day. A bank, savings and loan, or insurance company can take in small
amounts of funds from many individuals, form a large pool of funds, and then use that large pool to
purchase securities from individual businesses and governments. (This is just one example of the
beneficial things financial institutions do for DEUs)
4.
What are a bank's primary reserves? When the Fed sets reserve requirements, what is its primary
goal?
Vault cash and deposits in the bank's account at the Fed are used to satisfy these reserve
requirements; they are called primary reserves. These primary reserves are non-interest-earning
assets held by financial institutions.
The Federal Reserve requires all commercial banks to keep a minimum amount of reserves on hand
to meet the withdrawal demands of its depositors and to pay other obligations as they come due.
13
Many would argue, however, that the reserve requirement is set more with monetary policy in mind
than to ensure that banks meet their depositors' withdrawal requests.
5.
Compare and contrast mutual and stockholder-owned savings and loan associations.
Some savings and loan associations are owned by stockholders, just as commercial banks and other
corporations are owned by their stockholders. Other S&Ls, called mutuals, are owned by their
depositors. When a person deposits money in an account at a mutual S&L, that person becomes a
part owner of the firm. The mutual S&L's profits (if any) are put into a special reserve account from
which dividends are paid from time to time to the owner/depositors.
6.
7.
Which type of insurance company generally takes on the greater risks: a life insurance company or a
property and casualty insurance company?
The risks protected against by property and casualty companies are much less predictable than are the
risks insured by life insurance companies. Hurricanes, fires, floods, and trial judgments are all much
more difficult to predict than the number of sixty-year-old females who will die this year among a
large number in this risk class. This means that property and casualty insurance companies must
keep more liquid assets than do life insurance companies.
8.
Compare and contrast a defined benefit and a defined contribution pension plan.
In a defined benefit plan, retirement benefits are determined by a formula that usually considers the
worker's age, salary, and years of service. The employee and/or the firm contribute the amounts
necessary to reach the goal. In a defined contribution plan, the contributions to be made by the
employee and/or employer are spelled out, but retirement benefits depend on the total accumulation
in the individual's account at the retirement date.
9.
Special security software is used such that customers who enter their identification and password
information can keep sensitive information out of the hands of hackers.
14
a) If there were no financial institutions the SEUs and the DEUs would find that the amount of
money needed by a given DEU did not match the amount of money available by a given SEU. The
money available would not be put to work and the economic activity that would have otherwise taken
place would not.
b) If financial institutions were available in this society they could position themselves between the
SEUs and DEUs. The financial institution could pool the $1,000 available (100 SEUs times $10
each) and pass that money along in $100 increments to the DEUs. This could be done via either a
debt or equity claim that the financial institution would accept from the DEU in return for the money.
3-2.
a) .10 rate on loans made - .05 rate paid to depositors = .05 = 5% interest rate spread
b) (.5 x .10) + (.5 x .12) = .11 = 11% weighted average loan rate
(.5 x .05) + (.5 x .07) = .06 = 6% weighted average deposit rate
11% - 6% = 5% interest rate spread
3-3.
3-4.
a) The FOMC should buy government securities in the open market. This would increase the
reserves of the banking system and would put downward pressure on the federal funds rate.
b) The Feds trader at the New York Federal Reserve Bank would contact various government
securities dealers and would buy the Treasury securities from them. Payment would be made by
crediting the accounts at the Fed of these dealers. This would make more funds available and would
tend to put downward pressure on the cost of these funds, the federal funds rate.
3-5.
15
Chapter 4 Solutions
Why do total assets equal the sum of total liabilities and equity? Explain.
Assets = Liabilities + Equity
Assets are the items of value a business owns. Liabilities are claims on the business by non-owners,
and equity is the owners' claim on the business. The sum of the liabilities and equity is the total
capital contributed to the business, which, by definition, equals the total value of the assets.
2.
What are the time dimensions of the income statement, the balance sheet, and the statement of cash
flows? Hint: Are they videos or still pictures? Explain.
The income statement is like a video: It measures a firm's profitability over a period of time (which
can be a week, a month, a year, or any other time period).
The balance sheet is like a still photograph. The balance sheet shows the firm's assets, liabilities, and
equity at a given point in time.
This cash flow statement like the income statement, can be compared to a video: It shows how cash
flows into and out of a company over a given period of time.
3.
Define depreciation expense as it appears on the income statement. How does depreciation affect
cash flow?
Accounting depreciation is the allocation of an asset's initial cost over time. Depreciation expense on
an income statement is the amount of the asset=s initial cost allocated to the period covered by the
income statement.
Depreciation expense is not a cash flow. Depreciation as an expense category affects cash flow,
however, because it is tax-deductible. Depreciation expense lowers a companys taxable income
and, therefore its income tax liability. In this way depreciation reduces cash outflows..
4.
16
5.
Explain how earnings available to common stockholders and common stock dividends paid from the
current income statement affect the balance sheet item retained earnings.
The change in the retained earnings account from one balance sheet to the next equals net income
less preferred stock dividends (which is the amount of earnings available to common stockholders)
less common stock dividends.
6.
7.
What are the three major sections of the statement of cash flows?
Cash flows from Operations
Cash flows from investing activities
Cash flows from financing activities
Net change in cash balance
Cash balance at beginning of period
Cash balance at end of period
8.
9.
10.
Identify whether the following items belong on the income statement or the balance sheet.
a. Interest Expense IS
b. Preferred Stock Dividends Paid IS
c. Plant and Equipment BS
d. Sales IS
e. Notes Payable BS
f. Common Stock BS
g. Accounts Receivable BS
h. Accrued Expenses BS
i. Cost of Goods Sold IS
j. Preferred Stock BS
k. Long-Term Debt BS
l. Cash BS
m. Capital in Excess of Par BS
n. Operating Income IS
o. Depreciation Expense IS
p. Marketable Securities BS
q. Accounts Payable BS
r. Prepaid Expenses BS
s. Inventory BS
t. Net Income IS
u. Retained Earnings BS
17
11.
Indicate in which section the following balance items belong (current assets, fixed assets, current
liabilities, long-term liabilities, or equity).
a. Cash CA
b. Notes Payable CL
c. Common Stock EQ
d. Accounts Receivable CA
e. Accrued Expenses CL
f. Preferred Stock EQ
g. Plant and Equipment FA
CASE A
200,000
160,000
40,000
300,000
70,000
270,000
80,000
850,000
930,000
40,000
100,000
140,000
520,000
790,000
CASE B
110,000
70,000
40,000
100,000
30,000
110,000
230,000
180,000
410,000
60,000
140,000
200,000
100,000
210,000
Sales
COGS
Gross Profit
Operating Expenses
Operating Income (EBIT)
Interest Expense
Earnings Before Taxes (EBT)
Tax Expense (40%)
Net Income
CASE A
500,000
200,000
300,000
60,000
240,000
10,000
230,000
92,000
138,000
CASE B
250,000
100,000
150,000
60,000
90,000
10,000
80,000
32,000
48,000
4-2.
4-3.
18
4-4.
4-5.
The marginal tax rate is the tax rate applied to the next dollar of income. Therefore, the marginal tax
rate is 34%.
The average tax rate is 34%
50,000 X .15 = 7,500
25,000 X .25 = 6,250
25,000 X .34 = 8,500
235,000 X .39 = 91,650
2,865,000 X .34 = 974,100
= $1,088,000
$1,088,000/$3,200,000 = 34%
4-6.
4-7.
Sales
$10,000,000
- Operating Costs
5,200,000
- Interest Expense
200,000
= EBT
$4,600,000
- Taxes (40%)
1,840,000
Net after-tax income
$2,760,000
Simons net after-tax income was $2,760,000 for the year.
4-8.
4-9
a) Cash + Marketable Securities + Inventory + Accounts Receivable + Prepaid expenses.
(11,000,000 + 9,000,000 + 11,000,000 + 3,000,000 + 1,000,000) = 35,000,000
Current Assets = $35,000,000
b) Fixed assets depreciation
30,000,000 8,000,000 = 22,000,000
Net Fixed Assets = $22,000,000
c) Notes Payable + Accrued Expenses
4,000,000 + 2,000,000 = 6,000,000
Current Liabilities = $6,000,000
19
a)
b)
c)
d)
e)
Gross Profit
$440,000 - $200,000 = $240,000
Operating Income (EBIT) $240,000 - $40,000 - 85,000 = $115,000
Earning Before Taxes (EBT)
$ 115,000 - $40,000 = $75,000
Income Taxes
$ 75,000 X 0.4 = $30,000
Net Income
$75,000 - $30,000 = $45,000
4-11
4-12
4-13.
4-14
$374,000
4-15.
20
4-16.
a ) Current Assets:
b ) Total Assets:
c ) Current Liabilities:
d ) Total Liabilities:
e ) Total Stockholders' Equity:
4-17.
4-18.
a ) Accumulated Depreciation
b ) Accounts Receivable (net)
c ) Inventories
d ) Prepaid Expenses
e ) Accounts Payable
f ) Accrued Expenses
g ) Plant and Equipment (gross)
h ) Marketable Securities
i ) Land
j ) Long Term Investments
k ) Common Stock
l ) Bonds Payable
4-19.
Operations:
Add:
(Dollars)
Inflow
Outflow
Outflow
Inflow
Outflow
Inflow
Outflow
Outflow
Inflow
Outflow
Inflow
Outflow
3,398
1,198
841
877
803
509
3,034
849
3
2,240
2,330
277
Net Income
Depreciation Exp.
Decrease in Prepaid Expenses
Increase in Accrued Expenses
Less: Increase in A/C Receivable
Increase in Marketable Securities
Increase in Inventories
Decrease in A/C Payable
Total Cash Flow from Operations
Investments:
Add: Decrease in Land
Less: Increase in Plant and Equipment
Increase in Long Term Investment
Total Cash Flow from Investments
10,628
3,398
877
509
(1,198)
( 849)
( 841)
( 803)
$11,721
3
(3,034)
(2,240)
($5,271)
21
Financing:
Add:
Less:
2,330
(5,000)
( 277)
($2,947)
$3,503
4-20. $3,503 = $9,037 end of 09 cash - $5,534 end of 08 cash Yes, the net cash flow figure from
problem #16 gives the same answer as calculating the change in the cash figures from the end of 2011 to the
end of 2012 balance sheets.
4-21.
Sales
COGS
Gross Profit
Operating Expenses
Operating Income (EBIT)
Interest Expense
Income before taxes (EBT)
Tax Expense (30%)
Net Income
900,000
300,000
600,000
200,000
400,000
100,000
300,000
90,000
$210,000
4-22.
4-23.
Year
1
2
3
4
5
6
7
8
9
10
11
22
4-24.
4-25.
23
Chapter 5 Solutions
2.
3.
Which ratios would a banker be most interested in when considering whether to approve an
application for a short-term business loan? Explain.
Bankers and other lenders use liquidity ratios to see whether to extend short-term credit to a firm.
Liquidity ratios measure the ability of a firm to meet its short-term obligations. These ratios are
important because failure to pay such obligations can lead to bankruptcy. Generally, the higher the
liquidity ratio, the more able a firm is to pay its short-term obligations.
4.
Which ratios would a potential long-term bond investor be most interested in? Explain.
Current and potential lenders of long-term funds, such as banks and bondholders, are interested in
debt ratios. When a business's debt ratios increase significantly, bondholder and lender risk increases
because more creditors compete for that firm's resources if the company runs into financial trouble.
5.
Under what circumstances would market to book value ratios be misleading? Explain.
The Market to Book ratio is useful, but it is only a rough approximation of how liquidation and going
concern values compare. This is because the Market to Book ratio uses accounting-based book
values. The actual liquidation value of a firm is likely to be different than the book value. For
instance, the assets of a firm may be worth more or less than the value at which they are currently
carried on the company's balance sheet. In addition, the current market price of the company's bonds
and preferred stock may also differ from the accounting value of these claims.
24
6.
Why would an analyst use the Modified Du Pont system to calculate ROE when ROE may be
calculated more simply? Explain.
Actually, an analyst would not use the Modified Du Pont equation to calculate ROE for precisely the
reason stated above. What an analyst would use the Modified Du Pont equation for is to help analyze
the factors that contribute to a firm's ROE. In other words, analysts use the Modified Du Pont system
to take apart ROE to see what factors are influencing it.
7.
Why are trend analysis and industry comparison important to financial ratio analysis?
Trend analysis helps financial managers and analysts see whether a company's current financial
situation is improving or deteriorating.
Cross-sectional analysis, or industry comparison, allows analysts to put the value of a firm's ratios in
the context of its industry.
5-2.
5-3.
5-4.
5-5.
5-6.
a)
b)
c)
d)
e)
$47,378/$94,001
$12,941/$94,001
$8,620/$94,001
$8,620/$66,971
$8,620/$54,508
=
=
=
=
=
50.40%
13.77%
9.17%
12.87%
15.81%
While the Net Profit Margin is higher than the industry average, the Return on Assets is lower.
may consider increasing its debt to leverage profits.
5-7.
5-8.
Pinewood
Yes. The Pinewood has very low debt and its earnings are extremely high compared to its interest
expense.
5-9.
We would need to know the industry averages for these figures, and also know about Pinewoods
credit and inventory management practices to comment meaningfully on the above figures.
26
5-10. Modified Du Pont: ROE = Net Profit Margin X Total Asset Turnover X Assets over Equity
= 0.0917 X 1.404 X $66,971/$54,508 = 15.82%
5-11.
a) EVA = EBIT (1- tax rate) (invested capital X investors required rate of return)
EVA = $12,941,000 X (1 - 0.35) ($77,389,000 X 0.10) = $672,750
b) Pinewood has a true economic profit of $672,750. This is the amount by which its
earnings exceed the returned expected by the firms investors.
c) MVA = Total market value invested capital
MVA = ($75,000,000 + $2,389,000) ($54,508,000 + $2,389,000) = $20,492,000
d) Pinewood has a total market value that is $20,492,000 greater that the amount of capital
invested in the firm.
5-12.
a) EVA = EBIT (1 Tax Rate) (invested capital X investors required rate of return)
EVA = $8,000 (.65) ($33,000 X .12)
= $5,200 $3,960
EVA = $1,240
b) The economic value is positive; therefore, Eversharp earned a sufficient amount during the
year to provide more than the expected rate of return from the investors and lenders who
contributed to the capital of the company.
c) MVA = Total market value invested capital
MVA = $33,000 - $21,000 = $12,000
d) Eversharps total market value exceeds its invested capital by $12,000.
5-13.
EVA & MVA Calculation:
Income tax rate
Cost of Capital
Stock Price (ref)
Number of shares outstanding (ref)
Market Value of Common Equity (ref)
Book Value of Common Equity
Debt Capital (ref)
Total Invested Capital (ref)
EVA
MVA
a. EVA
35%
12% Ka
$9
3,000
$27,000
$15,210
$6,630 (Notes payable + Long-Term Debt )
$33,630 (Debt + Common)
$189
b. Comment on EVA: This year T & J earned enough to exceed the return expected by the
contributors of the firm's capital by $189.
27
5-14.
a. Du Pont:
ROA
Modified Du Pont:
ROE
$6,000
15,068
6,667
282
28,017
34,483
$62,500
Liabilities + Equity
Accounts Payable
Notes Payable
Accrued Expenses
Total Current Liabilities
Bonds Payable
Common Stock
Retained Earnings
Total Liabilities + Equity
$6,000
2,739
600
9,339
15,661
16,000
21,500
$62,500
NI/$5,000 = 0.10
NI = $500
TE = TA - TL = $10,000 - $6,000 = $4,000
ROE = $500/$4,000 = .125 = 12.5%
5-17.
5-18.
28
5-19.
5-20.
5-21.
5-22.
5-23.
5-24.
5-25.
5-26.
5-27.
5-28.
5-29. a) Du Pont:
ROA
b)
c)
5-30.
Notoriously Niagara
Niagaras Notions
a)
b)
c)
29
d)
Notoriously Niagara must have a higher net profit margin because their asset turnover is low
compared to that of Niagaras Notions even though they have the same ROA. Niagras Notions has a high
asset turnover but a low net profit margin.
5-31.
a)
b)
c)
d)
e)
$2,250,000/1,750,000=$1.29
$40/$1.29 = 31
$15,000,000/1,750,000 = $8.57
$40/$8.57 = 4.67
Yes, the market seems to believe that the company has going-concern value as evidenced by
the market to book ratio greater than 1.
5-32.
Year
2010
2011
2012
Golden Products
Industry averages:
10.00%
9.44%
9.36%
.94
1.02
1.08
1.05
1.15
1.18
9.42%
1.13
2.00
The NPM is about average, although it is deteriorating. The liquidity, as measured by the current
ratio, is below average but improving. Asset utilization, as measured by the total asset turnover is way below
average.
5-33.
Return on Assets
11.00%
PM
10.00%
9.44%
9.36%
CR
0.94
1.02
1.08
Return on equity
0.60
TATO
1.05
1.15
1.18
FATO
1.21
1.33
1.36
26%
ROA
10.53%
10.90%
11.00%
D/A
0.68
0.64
0.60
ROE
33.33%
30.36%
27.50%
Golden Products has an improving ROA that now equals that of the industry norm. The ROE has
slipped a little, but is still above the industry norm in spite of the fact that Golden has a little less debt
in its capital structure in 2012. Overall, Johnny should be pleased.
5-34. ( Figures in $ '000)
NPM
ROA
30
Whole Company
9.7%
13.4%
5-35.
National Glass Company
Income Statement (in $ 000's)
2012
Sales
Cost of Goods Sold
Gross Profit
Selling and Admin Expenses
Depreciation
Operating Income
Interest Expense
Earnings Before Tax
Income Taxes
Net Income
Ratios:
$45,000
23,000
22,000
13,000
3,000
6,000
200
5,800
2,320
$3,480
$2,000
6,000
5,000
13,000
16,000
1,000
$30,000
$2,000
3,000
3,000
8,000
4,000
12,000
4,000
14,000
18,000
$30,000
31
ACP
Inventory Turnover
Debt to Assets
Current Ratio
Total Asset turnover
Fixed Asset Turnover
Return on Equity
Return on Assets
Operating Profit Margin
Gross Profit Margin
48.7 days
9X
40%
1.6250
1.50
2.6471
19.33%
11.6%
13.33%
48.89%
5-36.
a.)
(Industry)
i.
ii.
iii.
iv.
v.
vi.
vii.
viii.
ix.
x.
xi.
xii.
Kingston, 2012
Kingston, 2013
48.9%
15.1%
8.5%
11.56%
19.3%
1.63
1.00
.4
15.5X
53.5days
8.18X
1.4X
48.9%
13.3%
7.5%
9.97%
16.3%
1.62
1.04
.39
14.6X
61.6days
8.62X
1.3X
b.) Kingston has about the same net profit margin and return on equity as the industry norm. The return on
assets ratio for Kingston is about the same as than the industry norm.
c.) Determine the sources and uses of funds and prepare a statement of cash flows for 2013.
(1) Sources and Uses of Funds:
Change,
2012 to 2013
Balance SheetSources
Net Income
Dividends paid
Depreciation
Cash
Accounts Receivable, Net
Inventory
Property, Plant & Equipment, Gross
Land
Accounts Payable
Notes Payable
Accrued expenses
Bonds Payable
Common Stock
Totals
Uses
$3,353
$733
$3,000
($200) $200
$1,600
$1,600
$220
$220
$5,000
$5,000
$0
$600 $600
$300 $300
$100 $100
$0
$0
$7,553 $7,553
32
$5,533
New Property, Plant, & Equipment($5,000)
($5,000)
Dividends Paid ($733)
(733)
($200)
$2,000
$1,800
d.) Profit margins are eroding and generally a little below the industry norm. Liquidity is about average.
Debt is low, but interest coverage is below the industry norm in spite of the low debt load. Inventory
turnover is way below average. The negative cash flow of $200,000 came mainly from the buildup of
accounts receivable and plant & equipment.
e.) The current ratio, quick ratio, and times interest earned would get the most scrutiny from loan officers.
5-36b. EVA = EBIT X (1 tax rate) (invested capital X investors required rate of return)
EVA = ($4,000 X 0.60) ($60,000 X 0.10) = -$3,600
EVA = -$3,600
MVA = Total market value invested capital
MVA = $50,000 - $60,000 = -$10,000
MVA = -$10,000
5.37.
2012_________
$1,115,000/$3,814,000
29.23%
$519,000/$2,859,000
Return on Assets
18.15%
$1,115,000/$5,316,000
20.97%
33
c) Super Dot Com was less liquid at the end of 2012 than it was at the end of 2011.
Current Ratio
2010
$981,000/$245,000
4.00
2012_________
$1,720,000/$623,000
2.76
Quick Ratio
($981,000 - $307,000)/$245,000
2.75
34
($1,720,000 - $960,000)/$623,000
1.22
Chapter 6 Solutions
Why do businesses spend time, effort, and money to produce forecasts? Explain.
Businesses succeed or fail depending on how well prepared they are to deal with the situations they
confront in the future. Therefore they expend considerable sums making estimates (forecasts) of
what the future situation is likely to be. Businesses develop new products, set production quotas, and
select financing sources based on forecasts about the future economic environment and the firm's
condition. If economists predict interest rates will be relatively high, for example, firms may plan to
limit borrowing and defer expansion plans.
2.
3.
4.
Explain how the cash budget and the capital budget relate to pro forma financial statements.
The cash budget shows the projected flow of cash in and out of the firm for specified time periods.
The capital budget shows planned expenditures for major asset acquisitions. Forecasters incorporate
data from these budgets into pro forma financial statements under the assumption that the budget
figures will, in fact, occur.
5.
Explain how management goals are incorporated into pro forma financial statements.
Management sets a target goal, and forecasters produce pro forma financial statements under the
assumption that the goal will be reached. For example, if managements goal is to pay off all shortterm notes during the coming year, forecasters would incorporate this into the pro forma balance
sheet by setting Notes Payable to zero.
35
6.
7.
What do financial managers look for when they analyze pro forma financial statements?
After the pro forma financial statements are complete, financial managers analyze the forecast to
determine (1) what current trends suggest what will happen to the firm in the future, (2) what effect
management's current plans and budgets will have on the firm, and (3) what actions to take to avoid
problems revealed in the pro forma statements
8.
What action(s) should be taken if analysis of pro forma financial statements reveals positive trends?
Negative trends?
When analyzing the pro forma statements, managers often see signs of emerging positive or negative
conditions. If forecasters discover positive indicators, they will recommend that current plans be
continued. If forecasters see negative indicators, they will recommend corrective action.
$200,000
$150,000
$100,000
$50,000
$0
2007
2008
2009
2010
36
2011
2012
2013
6-2.
This year
Next Year
Forecasting Assumption
100
50
40
10
120
60
40
20
10
Current Assets
Fixed Assets
Total Assets
60
100
160
72
100
172
Current Liabs.
Long-term Debt
Common Stock
Retained Earns.
Tot Liabs & Eq
20
20
20
100
160
24
20
20
110
174
Sales
- Variable Costs
- Fixed Costs
= Net Income
Dividends
6-3.
$10,000
4,000
6,000
3,000
3,000
1,000
$2,000
20,000
8,000
12,000
3,000
9,000
3,000
6,000
$0
Current Assets
Net Fixed Assets
Total Assets
$25,000
15,000
$40,000
50,000
15,000
65,000
Current Liabilities
Long-term debt
Common Stock
Retained Earnings
Total Liabs & Eq
$17,000
3,000
7,000
13,000
$40,000
34,000
3,000
7,000
19,000
63,000
Sales
COGS
Gross Profit
Fixed Expenses
Before-Tax Profit
Tax @ 33.33%
Net Profit
Dividends
37
6-4.
22,000
28,444
800
27,644
8,293
19,351
Dividends
10,000
Addition to RE
9,351
6-5.
a)
Cash
.111111 X $110,000 = $12,222
Accounts Receivable .024667 X $110,000 = $2,713
Inventory
.088889 X $110,000 = $9,778
b)
c)
Accounts Payable
d)
e)
f)
g)
38
6-6.
Assets
2012
2013
Liabilities
Cash
$10,000 $12,500
Acct Rec.
25,000 31,250
Inventory
20,000 25,000
Prepaid Exp
2,000
2,500
Total Current
Assets
57,000 71,250
Fixed Assets 32,000 32,000
Depreciation
4,000
4,000
Total Assets
85,000 $99,250
Accounts Payable
Notes Payable
Accrued Expenses
Long Term Debt
Common Equity
Total Liabilities
Equity
2012
2013
$10,500
10,000
11,000
15,000
38,500
$13,125
12,500
13,750
15,000
38,500
85,000
$92,875
6-8.
2013
1,250
562.50
160
527.50
290.13
1,000
500
160
340
136
$38,400 $41,140
Liabilities + Equity
2012
2013
Accounts Payable
$4,400
4,840
Notes Payable
4,000
4,400
Accrued Expenses
5,000
5,500
Tot.Current Liabilities13,400
14,740
Bonds Payable
6,000
6,000
Common Equity
19,000 21,468
Tot.Liab. + Equity
$38,400 $42,208
In 2013 there would be $1,068 ($42,208-$41,140) in excess funds. This assumes, as the problem states, that
notes payable would increase by 10% along with other current liabilities. Notes payable usually does not
increase with sales.
Year
2013
Total Sales
$85,000 X 1.1
= $93,500
PBT
NI
Addition to RE
$93,500 X .11 $10,285 X .6 $6,171 X .40
= $10,285
= $6,171
= $2,468
39
6-9.
Compute the following ratios for 2012 and 2013:
2012
2013
Current Ratio
3
3
Debt to Assets Ratio 25%
25.3%
Sales to Assets Ratio 62.5%
66.27%
Net Profit Margin
10%
13.64%
Return on Assets
6.25%
9.04%
Return on Equity
8.33%
12.10%
Liquidity seems strong and stable. Debt is modest and stable. Asset utilization is improving slightly while
all the profit margins calculated show marked improvement.
6-10.
BRIGHT FUTURE CORPORATION
Historical and Projected Income Statements
Historical
2012
Sales
Cost of goods Sold
Gross Profit
Selling & Admin. Expenses
Depreciation Expense
Operating Income (EBIT)
Interest Expenses
Earnings Before Tax (EBT)
Income Tax (40%)
Net Income (NI)
Projected
2013
$10,000,000 $12,000,000
$4,000,000 $4,800,000
$6,000,000 $7,200,000
$800,000
$960,000
$2,000,000 $2,000,000
$3,200,000 $4,240,000
$1,350,000 $1,350,000
$1,850,000 $2,890,000
$740,000 $1,156,000
$1,110,000 $1,734,000
$400,000
$710,000
$1.11
$400,000
$1,334,000
$1.73
$9,000,000
$8,000,000
$1,000,000
$20,000,000
$1,000,000
$39,000,000
$20,000,000
$9,000,000
$11,000,000
$50,000,000
$10,800,000
$9,600,000
$1,200,000
$24,000,000
$1,200,000
$46,800,000
$20,000,000
$11,000,000
$9,000,000
$55,800,000
$10,800,000
$9,600,000
$1,200,000
$24,000,000
$1,200,000
$46,800,000
$20,000,000
$11,000,000
$9,000,000
$55,800,000
$12,000,000 $14,400,000
$5,000,000 $5,000,000
$3,000,000 $3,600,000
$20,000,000 $23,000,000
$14,400,000
$5,000,000
$3,600,000
$23,000,000
40
$20,000,000
$40,000,000
$1,000,000
$4,000,000
$5,000,000
$10,000,000
$50,000,000
$20,000,000
$43,000,000
$1,000,000
$4,000,000
$6,334,000
$11,334,000
$54,334,000
$1,466,000
$21,466,000
$44,466,000
$1,000,000
$4,000,000
$6,334,000
$11,334,000
$55,800,000
AFN is incorporated in L-T debt. If $1,466,000 of new L-T debt is issued the financing need will be met.
Other financing sources could be used but we chose new L-T debt in this illustration.
Question 2, Ratios:
2012
2013
b. Current Ratio
1.95
2.03
0.20
0.50
0.22
0.50
0.80
0.77
11.10% 14.45%
2.22% 3.11%
11.10% 15.30%
41
Chapter 7 Solutions
What is risk aversion? If common stockholders are risk averse, how do you explain the fact that they
often invest in very risky companies?
Risk aversion is the tendency to avoid additional risk. Risk-averse people will avoid risk if they can,
unless they receive additional compensation for assuming that risk. In finance, the added
compensation is a higher expected rate of return.
People are not all are equally risk averse. For example, some people are willing to buy risky stocks,
while others are not. The ones that do, however, almost always demand an appropriately high
expected rate of return for taking on the additional risk.
2.
3.
Why is the coefficient of variation often a better risk measure when comparing different projects than
the standard deviation?
Whenever we want to compare the risk of investments that have different means, we use the
coefficient of variation (CV). The CV represents the standard deviation's percentage of the mean.
Because the CV is a ratio, it adjusts for differences in means, while the standard deviation does not.
therefore the CV provides a standardized measure of the degree of risk that can be used to compare
alternatives.
4.
42
5.
Why does the riskiness of portfolios have to be looked at differently than the riskiness of individual
assets?
The riskiness of portfolios has to be looked at differently than the riskiness of individual assets
because the weighted average of the standard deviations of returns of individual assets does not result
in the standard deviation of a portfolio containing the assets. There is a reduction in the fluctuations
of the returns of portfolios which is called the diversification effect.
6.
What happens to the riskiness of a portfolio if assets with very low correlations (even negative
correlations) are combined?
How successfully diversification reduces risk depends on the degree of correlation between the two
variables in question. When assets with very low or negative correlations are combined in portfolios,
the riskiness of the portfolios (as measured by the coefficient of variation) is greatly reduced.
7.
What does it mean when we say that the correlation coefficient for two variables is -1? What does it
mean if this value were zero? What does it mean if it were +1?
Correlation is measured by the correlation coefficient, represented by the letter r. The correlation
coefficient can take on values between +1.0 (perfect positive correlation) to -1.0 (perfect negative
correlation). The closer r is to +1.0, the more the two variables will tend to move with each other at
the same time. The closer r is to -1.0, the more the two variables will tend to move opposite each
other at the same time. An r value of zero indicates that the variables values aren't related at all.
This is known as statistical independence.
8.
9.
Compare diversifiable and nondiversifiable risk. Which do you think is more important to financial
managers in business firms?
Diversifiable risk can be dealt with by, of course, diversifying. Nondiversifiable risk is generally
compensated for by raising ones required rate of return. Both types of risk are important to financial
managers.
43
10.
How do risk-averse investors compensate for risk when they take on investment projects?
Because of risk aversion, people demand higher rates of return for taking on higher-risk projects.
11.
Given that risk-averse investors demand more return for taking on more risk when they invest, how
much more return is appropriate for, say, a share of common stock, than is appropriate for a Treasury
bill?
Although we know that the riskreturn relationship is positive, the question of much return is
appropriate for a given degree of risk is especially difficult. Unfortunately, no one knows the answer
for sure. One well-known model used to calculate the required rate of return of an investment, given
its degree of risk, is the Capital Asset Pricing Model (CAPM).
12.
Discuss risk from the perspective of the Capital Asset Pricing Model (CAPM).
The Capital Asset Pricing Model, or CAPM, can be used to calculate the appropriate required rate of
return for an investment project given its degree of risk as measured by beta (). A project's beta
represents its degree of risk relative to the overall stock market. In the CAPM, when the beta term is
multiplied by the market risk premium term, the result is the additional return over the risk-free rate
that investors demand from that individual project. High-risk (high-beta) projects have high required
rates of return, and low-risk (low-beta) projects have low required rates of return.
Probability
Estimate
of Occurrence
CF
CF x P
CF - mean
$10,000
5.00%
$500
$13,000
10.00%
$16,000
20.00%
$19,000
30.00%
$5,700
$0
$0
$0
$22,000
20.00%
$4,400
$3,000
$9,000,000
$1,800,000
$25,000
10.00%
$2,500
$6,000
$36,000,000
$3,600,000
$28,000
5.00%
$1,400
$9,000
$81,000,000
$4,050,000
Sum of (R x P) = mean:
$19,000
$18,900,000
$4,347
($9,000)
$81,000,000
$4,050,000
$1,300
($6,000)
$36,000,000
$3,600,000
$3,200
($3,000)
$9,000,000
$1,800,000
44
22.88%
7-2.
EXPECTED VALUE, STANDARD DEVIATION AND COEFFICIENT OF VARIATION OF OPERATING INCOME
Operating
Sales Variable
Fixed
Income
Prob.
Estimate
of Occurrence
CF
$500
$250
$250
$0
P CF x P
2.00%
CF - mean
(CF - mean)
Px(CF - mean
$0
($350)
$122,500
$2,450
$700
$350
$250
$100
8.00%
$8
($250)
$62,500
$5,000
$1,200
$600
$250
$350
80.00%
$280
$0
$0
$0
$1,700
$850
$250
$600
8.00%
$48
$250
$62,500
$5,000
$1,900
$950
$250
$700
2.00%
$14
$350
$350
$122,500
$2,450
b.
$14,900
$122
c.
34.88%
a.
Sum of (R x P) = mean:
d. New expected value, standard deviation, and coefficient of variation based on revised sales forecast:
Operating
Sales Variable
Fixed
Income
Probability
Estimate
of Occurrence
CF
P CF x P
CF - mean
(CF - mean)
Px(CF - mean)
$500
$250
$250
$0
10.00%
$0
($350)
$122,500
$12,250
$700
$350
$250
$100
15.00%
$15
($250)
$62,500
$9,375
$1,200
$600
$250
$350
50.00%
$175
$0
$0
$0
$1,700
$850
$250
$600
15.00%
$90
$250
$62,500
$9,375
$1,900
$950
$250
$700
10.00%
$70
$350
$350
Sum of (R x P) = mean:
2
Sum of P x (CF - mean) = variance:
$122,500
$12,250
a.
7-3.
$43,250
$208
59.43%
Note how the increased possibilities that sales will be other than $1,200 caused the standard deviation
and coefficient of variation of operating income to nearly double.
Mean:
.10(1,000) + .2(5,000) + .45(10,000) + .15(15,000) + .10(20,000) =
100 + 1,000 + 4,500 + 2,250 + 2,000
Mean = $9,850
Standard Deviation:
2 = .1(1,000 9,850)2 + .2(5,000 9,850)2 + .45(10,000 9,850)2 + .15(15,000 9,850)2 +
.1(20,000 9,850)2
2 = 7,832,250 + 4,704,500 + 10,125 + 3,978,375 + 10,302,250
2 = 26,827,500
= 26,827,500
= 5,179.53
Standard deviation = 5,179.53
45
7-4.
I. EQUITY EDDIE'S COMPANY:
Operating
Income
Interest
Before-Tax
Estimate Expense
Income
Net
Taxes
Probability
Income of Occurrence
2
($216)
$46,656
$2,333
CF
CF x P
CF - mean
$28
$72
5.00%
$4
$100
$0
$100
$200
$0
$200
$56
$144
10.00%
$14
($144)
$20,736
$2,074
$400
$0
$400
$112
$288
70.00%
$202
$0
$0
$0
$600
$0
$600
$168
$432
10.00%
$43
$144
$20,736
$2,074
$700
$0
$700
$196
$504
5.00%
$25
$216
$46,656
$2,333
Sum of (R x P) = mean:
$288
a.
$8,813
$94
32.60%
Interest
Before-Tax
Estimate Expense
Income
Net
Taxes
Probability
Income of Occurrence
CF
CF x P
CF - mean
$110
$40
$70
$19.6
$50.4
5.00%
$2.52
($237.60)
$56,453.76
$2,822.69
$220
$40
$180
$50.4
$129.6
10.00%
$12.96
($158.40)
$25,090.56
$2,509.06
$440
$40
$400 $112.0
$288.0
70.00%
$201.60
$0.00
$0.00
$0.00
$660
$40
$620 $173.6
$446.4
10.00%
$44.64
$158.40
$25,090.56
$2,509.06
$770
$40
$730 $204.4
$525.6
5.00%
$26.28
$288.00
$237.60
$56,453.76
$2,822.69
a.
Sum of (R x P) = mean:
2
$10,663.49
$103.26
35.86%
Note how Barry Borrower's use of debt financing causes his company to have a higher
standard deviation and coefficient of variation of net income than Equity Eddie's.
7-5.
STANDARD DEVIATION AND COEFFICIENT OF VARIATION OF CASH FLOWS FOR THE GO-RILLA PROJECT
Cash Flow
Probability
Estimate
of Occurrence
CF
CF x P
CF - mean
(CF - mean)
P x (CF - mean)
$20,000
1.00%
$200
($6,000)
$36,000,000
$360,000
$22,000
12.00%
$2,640
($4,000)
$16,000,000
$1,920,000
$24,000
23.00%
$5,520
($2,000)
$4,000,000
$920,000
$26,000
28.00%
$7,280
$0
$0
$0
$28,000
23.00%
$6,440
$2,000
$4,000,000
$920,000
46
$30,000
12.00%
$3,600
$4,000
$16,000,000
$1,920,000
$32,000
1.00%
$320
$26,000
$6,000
$36,000,000
$360,000
Sum of (R x P) = mean:
2
variance:
$6,400,000
$2,530
9.73%
c. Comment:
Given that the average coefficient of variation of George's other product lines is 12%, we would
say that the Go-Rilla project is LESS risky than average
7-6.
Effect of Adding Asset B to Existing Portfolio A
Correlation coefficient r between existing portfolio A and new asset B:
$700,000
$200,000
$900,000
77.8%
22.2%
9.00%
3.00%
33.33%
12.00%
4.00%
33.33%
9.67%
2.50%
25.83%
a. Comparison of standard deviations of existing portfolio A and the new combined portfolio:
Standard deviation of existing portfolio A:
3.00%
2.50%
a. Comparison of coefficients of variation of existing portfolio A and the new combined portfolio:
Coefficient of variation of existing portfolio A:
33.33%
25.83%
47
7-7.
7-8.
7-9.
7-10.
Effect of Adding PROJ1 to Existing Portfolio
Expected Return of existing portfolio:
11.00%
4.00%
36.36%
13.00%
5.00%
38.46%
$820,000
$194,000
$1,014,000
c.
80.9%
d.
19.1%
3.37%
11.38%
29.63%
a.
b.
e.
:
48
7-11.
Required Rate of Return per the CAPM
Risk free rate (kRF)
Expected rate of return on the market (km)
5.0%
15.0%
Beta
Required rate of return on stock per the CAPM:
1.2
17.0%
(equation 7-6)
7-12.
7-13.
Effect on CAPM Required Rate of Return of Adding a New Project
Risk free rate (kRF)
5.0%
15.0%
1.5
0.8
20.0%
13.0%
c.
20.0%
80.0%
1.36
7-14.
STANDARD DEVIATION AND COEFFICIENT OF VARIATION OF PSC SALES REVENUE
Sales
Probability
Estimate
of Occurrence
CF
CF x P
CF - mean
$800
2.00%
$16
($1,200)
$1,440,000
$28,800
$1,000
8.00%
$80
($1,000)
$1,000,000
$80,000
$1,400
20.00%
$280
($600)
$360,000
$72,000
$2,000
40.00%
$800
$0
$0
$0
$2,600
20.00%
$520
$600
$360,000
$72,000
$3,000
8.00%
$240
$1,000
$1,000,000
$80,000
$3,200
2.00%
Sum of (R x P) = exp val:
$64
$2,000
$1,200
$1,440,000
$28,800
49
$361,600
$601
30.07%
7-15.
COEFFICIENT OF VARIATION OF PSC'S OPERATING INCOME
Operating
Sales Variable
Estimate
Fixed
Expenses
Expenses
Income
Probability
Estimate
of Occurrence
CF
CF x P
$800
$480
$0
$320
2.00%
$6
($480)
$230,400
$4,608
$1,000
$600
$0
$400
8.00%
$32
($400)
$160,000
$12,800
$1,400
$840
$0
$560
20.00%
$112
($240)
$57,600
$11,520
$2,000
$1,200
$0
$800
40.00%
$320
$0
$0
$0
$2,600
$1,560
$0
$1,040
20.00%
$208
$240
$57,600
$11,520
$3,000
$1,800
$0
$1,200
8.00%
$96
$400
$160,000
$12,800
$3,200
$1,920
$0
$1,280
2.00%
$26
$800
$480
$230,400
$4,608
Sum of (R x P) = mean:
2
$57,856
$241
30.07%
7-16.
COEFFICIENT OF VARIATION OF PSC'S OPERATING INCOME
Operating
Sales Variable
Estimate
Fixed
Expenses Expenses
Income
Probability
Estimate
of Occurrence
CF
CF x P
CF - mean
(CF - mean)
Px(CF - mean)
$800
$480
$400
($80)
2.00%
($2)
($480)
$230,400
$4,608
$1,000
$600
$400
$0
8.00%
$0
($400)
$160,000
$12,800
$1,400
$840
$400
$160
20.00%
$32
($240)
$57,600
$11,520
$2,000
$1,200
$400
$400
40.00%
$160
$0
$0
$0
$2,600
$1,560
$400
$640
20.00%
$128
$240
$57,600
$11,520
$3,000
$1,800
$400
$800
8.00%
$64
$400
$160,000
$12,800
$3,200
$1,920
$400
$880
2.00%
$18
$480
$230,400
$4,608
Sum of (R x P) = mean:
$400
50
$57,856
$241
60.13%
Note how the addition of fixed costs caused the coefficient of variation of PSC's operating income to
double from what it was in problem 7-10
Comment:
7-17.
MEASURING PSC'S FINANCIAL RISK
I. Expected value, standard deviation, and coefficient of variation of PSC's net income when no interest expense is
present
Sales
$800
$1,000
$1,400
$2,000
$2,600
$3,000
$3,200
Variable
$480
$600
$840
$1,200
$1,560
$1,800
$1,920
Fixed
$400
$400
$400
$400
$400
$400
$400
-$80
$0
$160
$400
$640
$800
$880
$0
$0
$0
$0
$0
$0
$0
Probability of
Net
Occurrence
Income
NI
P
NI X P NI - mean (NI 2
mean)
($80) ($24)
($56) 2%
$0
$0
$0 8%
$160 $48
$112 20%
$400 $120
$280 40%
$640 $192
$448 20%
$800 $240
$560 8%
$880 $264
$616 2%
Sum of (NI X P) = mean
-$1
$0
$22
$112
$90
$45
$12
$ 280
($336) $112,896
($280) $78,400
($168) $28,224
$0
$0
$168 $28,224
$280 $78,400
$336 $112,896
2
P X (NI 2
mean)
$2,258
$6,272
$5,645
$0
$5,645
$6,272
$2,258
$28,349
$168
60.1%
II. Expected value, standard deviation, and coefficient of variation of PSC's net income when interest expense is
present
Sales Variable
$800
$1,000
$1,400
$2,000
$2,600
$3,000
$3,200
$480
$600
$840
$1,200
$1,560
$1,800
$1,920
Fixed
$400
$400
$400
$400
$400
$400
$400
($80)
$0
$160
$400
$640
$800
$880
$60
$60
$60
$60
$60
$60
$60
Probability of
Taxes Net
Income
NI
Occurrence
P
($140) ($42)
($98) 2%
($60) ($18)
($42) 8%
$100 $30
$70 20%
$340 $102
$238 40%
$580 $174
$406 20%
$740 $222
$518 8%
$820 $246
$574 2%
Sum of (R X P) = mean =
NI X P NI - mean (NI 2
mean)
($2)
($3)
$14
$95
$81
$41
$11
$ 238
($336) $112,896
($280) $78,400
($168) $28,224
$0
$0
$168 $28,224
$280 $78,400
$336 $112,896
2
51
P X (NI 2
mean)
$2,258
$6,272
$5,645
$0
$5,645
$6,272
$2,258
$28,349
$168
70.7%
7-18.
I. New coefficient of variation of PSC's operating income:
Operating
Sales
Variable
Fixed
Income Probability of
Estimate Expenses Expenses Estimate Occurrence
EBIT
P
EBIT X EBIT - (EBIT 2
P
mean mean)
$800
$1,000
$1,400
$2,000
$2,600
$3,000
$3,200
$480
$600
$840
$1,200
$1,560
$1,800
$1,920
$250
$70
1%
$250
$150
6%
$250
$310
13%
$250
$550
60%
$250
$790
13%
$250
$950
6%
$250
$1,030
1%
Sum of (EBIT X P) = mean =
P X (EBIT - mean)
$2,304
$9,600
$7,488
$0
$7,488
$9,600
$2,304
$38,784
$197
35.8%
II. New coefficient of variation of PSC's net income when no interest expense is present
Sales
Variable
Fixed
Operating
$800
$1,000
$1,400
$2,000
$2,600
$3,000
$3,200
$480
$600
$840
$1,200
$1,560
$1,800
$1,920
$250
$250
$250
$250
$250
$250
$250
$70
$150
$310
$550
$790
$950
$1,030
Interest
BeforeTax
Expense Income Taxes
$0
$70
$0
$150
$0
$310
$0
$550
$0
$790
$0
$950
$0 $1,030
$21
$45
$93
$165
$237
$285
$309
Net
Probability of
Income Occurrence
NI
P
$49
1%
$105
6%
$217
13%
$385
60%
$553
13%
$665
6%
$721
1%
Sum of (NI X P) = mean =
NI X (NI 2
P mean)
P X (NI
2
mean)
$0 $112,896 $1,129
$6 $78,400 $4,704
$28 $28,224 $3,669
$231
$0
$0
$72 $28,224 $3,669
$40 $78,400 $4,704
$7 $112,896 $1,129
$385
2
$800
$1,000
$1,400
$2,000
$2,600
$3,000
$3,200
$480
$600
$840
$1,200
$1,560
$1,800
$1,920
$250
$250
$250
$250
$250
$250
$250
$70
$150
$310
$550
$790
$950
$1,030
$40
$40
$40
$40
$40
$40
$40
B-T
Income Taxes
$30
$110
$270
$510
$750
$910
$990
52
$9
$33
$81
$153
$225
$273
$297
Net
Probability of
Income Occurrence
NI
P
$21
1%
$77
6%
$189
13%
$357
60%
$525
13%
$637
6%
$693
1%
Sum of (NI X P) = mean =
NI X (NI 2
P mean)
P X (NI
2
mean)
$0 $112,896 $1,129
$5 $78,400 $4,704
$25 $28,224 $3,669
$214
$0
$0
$68 $28,224 $3,669
$38 $78,400 $4,704
$7 $112,896 $1,129
$357
-10.6%
-2.8%
Comments: The effect of PSC's risk reduction measures was to lower business risk substantially, but
financial risk increased slightly. Managers must evaluate this trade-off and proceed accordingly.
53
Chapter 8 Solutions
Answers to Review Questions
1.
2.
3.
4.
5.
What is an annuity?
An annuity is a series of equal cash flows, spaced evenly over time.
6.
Suppose you are planning to make regular contributions in equal payments to an investment fund for
your retirement. Which formula would you use to figure out how much your investments will be
worth at retirement time, given an assumed rate of return on your investments?
To figure out how much your investments will be worth at retirement time, given an assumed rate of
return on your investments, you would use the future value of an annuity formula:
54
(1 + k ) n 1
FVA = PMT
where:
7.
8.
If you are doing PVA and FVA problems, what difference does it make if the annuities are "ordinary
annuities" or "annuities due"?
In FVA or a PVA of annuity due problems, annuity payments earning interest one period sooner than
in ordinary annuity problems. So, higher FVA and PVA values result with an annuity due. The first
payment occurs sooner in the case of a future value of an annuity due. In present value of annuity due
problems, each annuity payment occurs one period sooner, so the payments are discounted less
severely.
9.
Which formula would you use to solve for the payment required for a car loan if you know the
interest rate, length of the loan, and the borrowed amount? Explain.
To solve for k when the known values are PVA, n, and PMT, start with the present value of an
annuity formula, Equation 8-3b, as follows:
Present Value of an Annuity Formula, Table Method
PVA = PMT X (PVIFAk,n)
Next, rearrange terms and solve for (PVIFAk, n) as follows
PVA / PMT = (PVIFAk,n)
Now refer to the PVIFA values in the text, Table IV. You know n, so find the n row corresponding
to the number of periods in your problem on the left hand side of the table. You have also determined
the PVIFA, so move across the n row until you find (or come close to) the value of PVIFA that you
have solved for. The percent column in which the value is located is the interest rate.
55
8-2.
a) 0%
b) 5%
c) 10%
d) 20%
8-3.
8-4.
a) 3%
b) 6%
c) 9%
d) 12%
8-5
a) 50,000
b) 75,000
c) 100,000
d) 125,000
8-6
a) 5 years
b) 10 years
c) 15 years
d) 20 years
8-7.
8-8.
a) 0%
b) 5%
c) 10%
d) 20%
8-9
8-10
a) 3%
b) 6%
c) 9%
d) 12%
56
8-11.
a)$50,000
b)$75,000
c)$100,000
d)$125,000
8-12.
a) 5 years
b) 10 years
c) 15 years
d) 20 years
8-13.
8-14.
a) 0% $15,000 X 30 = $450,000
b) 10% $15,000 X [(1-1/1.1030)/0.10] = $141,403.72
c) 20% $15,000 X [(1-1/1.2030)/0.20] = $74,684.05
d) 50% $15,000 X [(1-1/1.5030)/0.50] = $29,999.84
8-15.
8-16.
a)
b)
c)
d)
8-17.
8-18.
a) 0%
b) 2%
c) 10%
d) 20%
8-19.
8-20.
8-21.
a) $1,000
b) $10,000
c) $75,000
d) $125,000
9%
13%
15%
21%
$8,000 X 12 = $96,000.00
$8,000 X [(1.0212-1)/0.02] = $107,296.72
$8,000 X [(1.1012-1)/0.10] = $171,074.27
$8,000 X [(1.2012-1)/0.20] = $316,644.02
$5,523.63
$1,000 X [(1.055 1)/0.05] =
5
$10,000 X [(1.05 1)/0.05] = $55,256.31
$75,000 X [(1.055 1)/0.05] = $414,422.34
$125,000 X [(1.055 1)/0.05] = $690,703.91
57
8-22.
8-23.
8-24.
8-25.
8-26.
8-27.
8-28.
8-29.
8-30.
8-31.
8-32.
$70/0.09 = $777.78
8-33.
$65/0.085 = $764.71
8-34.
58
8-35
8-36.
a ) 5 years?
b ) 10 years?
c ) 20 years?
8-37.
PV = $16,850.58 X [1/(1+.06)5]
PV = $12,591.30
8-38.
8-39.
8-40.
8-41.
8-42.
8-43.
8-44.
8-45.
$10,000/(1+.03)5 = $8,626.09
$10,000/(1+.03)10 = $7,440.94
$10,000/(1+.03)20 = $5,536.76
59
8-47.
8-48.
$10,000/.05 = $200,000.00
8-49.
8-50.
8-51.
8-52.
$16,936.06 = $5,000 X [PVIFAk%,4 years], assuming payments start one year from the date of
borrowing
[PVIFAk%,4 years] = 3.3872; k = 7%
8-53.
8-54.
Option 1)
PV = $5,650
Option 2)
PV = $6,750 X [1/1.0158] = $5,992.05
Option 3)
PV = $800 X [(1-(1/(1+.015)8)/.015] = $5,988.74
Option 4)
PV = $1,000 + $5,250 X (1/(1+.015)8) = $5,660.48
Option 1 is the one with lowest cost to Jack.
8-55.
n = 30 X 12 = 360
k = .06/12 =0 .005 or 0.5%
$250,000 = PMT X [(1-1/1.005360)/0.005]
PMT = $250,000/166.7916144 = $1,498.88
8-56.
8-57.
a) n = 4 X 12 = 48
k = .06/12 =0 .005 or 0.5%
60
1
2
3
4
$90.9091
$123.9669
$100
$68.3013
a) n = 5X12 = 60
k = .06/12 = .005
$22,000 = PMT X [1-1/1.00560)/0.005]
$22,000 = PMT X 51.72556075
PMT = $22,000/51.72556075 = $425.32
61
$100
$150
Total Present Value of all Cash Flows, including the missing cash flow
Total present value of known cash flows only
Difference (Present Value of missing cash flow)
8-59.
$471.01
$471.01 (given)
$283.1774
$187.8326
$250
Chapter 9 Solutions
Which is lower for a given company: the cost of debt or the cost of equity? Explain. Ignore taxes in
your answer.
The cost of debt is always less than the cost of equity for a given firm. This is because the debt
investor is taking a lower risk than the equity investor and therefore the required rate of return is
lower.
2.
When a company issues new securities, how do flotation costs affect the cost of raising that capital?
When a company issues new securities flotation costs increase the cost of raising the capital. The
company receives a smaller amount of the proceeds from the new issues, the greater the flotation
costs.
3.
What does the weight refer to in the weighted average cost of capital?
The weight referred to in weighted average cost of capital refers to the portion of the total capital
raised by the firm that comes from a given source such as debt, preferred stock or equity.
4.
How do tax considerations affect the cost of debt and the cost of equity?
Because interest on debt is tax deductible to the issuing firm, the higher the tax rate the lower the
after tax cost of debt financing. Tax considerations do not enter into the cost of equity calculation
since dividends paid to stockholders are not tax deductible to the firm.
5.
If dividends paid to common stockholders are not legal obligations of a corporation, is the cost of
equity zero? Explain your answer.
Although common stockholders do not have a contractual claim on dividends the funds supplied by
stockholders definitely have a cost. Equity investors are paid last and so they are taking the greatest
risk among all the suppliers of capital. If the company does not earn a higher rate of return on equity
funds to compensate for the higher risk taken by equity investors, the price of the stock will fall and
therefore the value of the firm.
6.
What is the investment opportunity schedule (IOS)? How does it help financial managers make
business decisions?
62
The investment opportunity schedule shows graphically proposed capital budgeting projects
depicting the IRR and dollar amount of investment for each project. This helps the financial manager
make business decisions since the investment opportunity schedule and the marginal cost of capital
schedule can be plotted together, with those projects on the IOS schedule above the MCC being
acceptable.
7.
What is a marginal cost of capital schedule (MCC)? Is the schedule always a horizontal line?
Explain.
The marginal cost of capital schedule is a graphic depiction of the weighted average cost of capital at
different levels of financing. The MCC schedule is not always a horizontal line. For many firms the
MCC schedule increases, usually at discreet intervals, as the amount of funds to be raised increases.
8.
For a given IOS and MCC, how do financial managers decide which proposed capital budgeting
projects to accept, and which to reject?
For a given IOS and MCC, all independent projects that plot on the IOS above the MCC are
accepted. Those projects on the IOS below the MCC are rejected.
9-2.
9-3.
a)
(i) YTM = 7%
(ii) YTM = 11%
(iii) YTM = 13%
AT kd = .07(1-.40) = 4.2%
AT kd = .11(1-.40) = 6.6%
AT kd = .13(1-.40) = 7.8%
b)
(i) YTM = 7%
(ii) YTM = 11%
(iii) YTM = 13%
AT kd = .07(1-.34) = 4.62%
AT kd = .11(1-.34) = 7.26%
AT kd = .13(1-.34) = 8.58%
a)
AT kd = .10(1-.00) = 10.0%
b)
AT kd = .10(1-.22) = 7.8%
c)
AT kd = .10(1-.34) = 6.6%
Company
A
B
C
YTM
8%
11%
14%
Tax Rate(%)
34%
40%
30%
AT kd
0.8(1-.34) = 5.28%
0.11(1-.40) = 6.60%
0.14(1-.30) = 9.80%
63
9-4.
YTM
AT kd
T=40%
0.08(1-.40) = 4.80%
0.14(1-.40) = 8.40%
0.16(1-.40) = 9.60%
8%
14%
16%
9-5.
a)
kd = 13%
b)
AT kd = .13(1-.40) = 7.8%
9-6.
9-7.
9-8.
9-9.
9-10.
9-11.
9-12.
a)
b)
AT kd
T=34%
0.08(1-.34) = 5.28%
0.14(1-.34) = 9.24%
0.16(1-.34) = 10.56%
ks = ($7/$143) + 0. 13 = 17.90%
kn = ($7/($143 - $4) + 0. 13 = 18.04%
9-15.
a)
64
b)
Yes. Floatation costs make cost of capital from new common stock higher.
9-16.
9-17. a )
9-18.
b)
c)
AT kd = 0.10(1-0.4) = 6%
kp = $2/($31 - $1) = 6.67%
kn = $4/($100 -$4) + .06 = 10.17%
ka = (0.3)(6) + (0.15)(6.67) + (0.55)(10.17) = 8.394%
9-22.
9-23.
65
b)
c)
9-26.
OPTIMAL CAPITAL STRUCTURE: DEBT
35.00%
TAX RATE
40.00%
NET INCOME NEXT YEAR:
$1,200,000
ADDITION TO RETAINED EARNINGS $1,000,000
LOAN INTEREST RATE
10.00%
12.00%
COMMON STOCK PRICE PER SHARE
$50
DIVIDEND PER SHARE
$5
GROWTH RATE
9.00%
FLOATATION COST
8.00%
a. COST OF NEW EQUITY
COST OF RETAINED EARNINGS
AT COST OF DEBT
b. EQUITY BREAK POINT
DEBT
DEBT BREAK POINT
DEBT
TOTAL EQUITY
INVESTMENT OPPORTUNITIES
PROJECT INVESTMENT
RETURN
EQUITY 65.00%
A
$500,000
0.16
B
$1,600,000
0.12
C
$600,000
0.15
D
$1,500,000
0.18
FOR LOAN UPTO $750,000
$4,200,000
FOR LOAN ABOVE $750,000
19.87%
19.00%
6.00% FOR LOAN UPTO $750,000
7.20% FOR LOAN ABOVE $750,000
$1,538,462
$538,462
$2,142,857
$750,000
$1,392,857
14.45%
d.
15.44%
66
PROJECT
D
A
C
INVESTMENT
$1,500,000
$500,000
$600,000
RETURN
0.18
0.16
0.15
B $1,600,000
0.12
e.
MCC/IOS Schedule
Project D
18.00%
17.00%
A
C
16.00%
15.00%
14.00%
13.00%
12.00%
11.00%
$0
$500
IOS
f. Only Projects D and A would be chosen. They are the ones with IRR values on the IOS schedule that
plot above the MCC schedule.
67
Chapter 10 Solutions
How do we calculate the payback period for a proposed capital budgeting project? What are the
main criticisms of the payback method?
We calculate the payback period for a proposed project by adding a projects positive cash flows, one
period at a time, until the sum equals the initial investment. The number of time periods it takes to
cover this investment is the payback period. The main criticisms of the payback method are that cash
flows after the payback period are ignored and the time value of money is not considered.
2.
How does the net present value relate to the value of the firm?
The net present value is the dollar amount of the change to the value of the firm if the project under
consideration is accepted.
3.
What are the advantages and disadvantages of the internal rate of return method?
The internal rate of return method is a discounted cash flow method and a number expressed as a
percentage. These are typically seen as advantages. The main disadvantage of the internal rate of
return is that it is somewhat more difficult to calculate, although this is less true with the ready
availability of financial calculators.
4.
5.
What is the decision rule for accepting or rejecting proposed projects when using net present value?
When using the net present value decision rule any project with a net present value greater than or
equal to zero would be acceptable. Any project with a negative net present value would be rejected.
6.
What is the decision rule for accepting or rejecting proposed projects when using internal rate of
return?
Whenever the internal rate of return is greater than or equal to the required rate of return, the hurdle
rate, the project is accepted. When the internal rate of return is less than this required rate of return,
the project is rejected.
68
7.
8.
Explain how to resolve a ranking conflict between the net present value and the internal rate of
return. Why should the conflict be resolved as you explained?
Whenever there is a ranking conflict between net present value and internal rate of return we
generally suggest that the project with the highest net present value be chosen. This is because the
net present value method ties more directly with the primary financial goal of the firm, to maximize
firm value.
9.
10.
Why is the coefficient of variation a better risk measure to use than the standard deviation when
evaluating the risk of capital budgeting projects?
The coefficient of variation is a better risk measure than the standard deviation alone because the CV
adjusts for the size of the project. The CV measures the standard deviation divided by the mean and
therefore puts the standard deviation into context. For example, a standard deviation of .05 may be
considered large relative to a mean of .02 but would be considered a small value relative to a mean
value of 8.
11.
12.
Explain how using a risk-adjusted discount rate improves capital budgeting decision making
compared to using a single discount rate for all projects?
The risk-adjusted discount rate improves capital budgeting decision making compared to the single
discount rate approach because the RADR allows us to set a higher hurdle for the high risk project
and a lower hurdle for the low risk project thus aligning our capital budgeting decision making
process more closely with the goal of maximizing the value of the firm.
69
10-2.
CF0 = -80,000,000
CF1 = 0
CF2 = 0
CF3 = 0
CF4-23 = 5,000,000
I = 10%
NPV = -$48,018,167.84
IRR = 1.70%
10-3.
a)
b)
10-4.
CF0 = -20,000,000
CF1-25 = $2,000,000
I = 8%
NPV = $1,349,552
10-5.
IRR = 8.78%
10-6.
CF0 = -20,000,000
CF25 = 146, 211,879.90
MIRR = 8.28%
10-7.
Waters
Cum. CF
-$300,000
(300,000)
70
1
2
3
4
100,000
75,000
50,000
100,000
(100,000)
(25,000)
25,000
125,000
200,000
150,000
150,000
150,000
(100,000)
50,000
200,000
350,000
10-8.
Year
0
1
2
3
4
k= 8%
NPVweights (k = 8%) = $70,087.60
NPVwaters (k= 8%) = $243,115.32
10-9.
a)
b)
c)
10-10. a )
b)
10-11. a )
b)
Rifle Stock: NPV = -9,000 + 2,000 X .8850 + 5,000 X .7831 + 1,000 X .6931 + 4,000 X
.6133 = -168.20
Fork Lift: NPV = -12,000 +5,000 X .8850 + 4,000 X .7831 +6,000 X .6931 + 2,000 X .6133
= +942.60
Packaging Equip. NPV = -18,200 + 5,000 X .7831 + 10,000 X .6931 + 12,000 X .6133 =
+6.10
Fork Lift and Packaging; both have positive NPVs.
Cal's Project: NPV = -100,000 + 22,611 X (5.2064) = $17,721.23
Aron's Project:NPV = -300,000 + 63,655 X (5.2064) = $31,411.49
Cal's Project: 100,000/22,611 = PVIFAk,7 year; k = 13% = IRR
Aron's Project:300,000/63,655 = PVIFAk,7 year; k = 11% = IRR
71
c)
Arons Project; The NPV is positive and greater than the NPV for Cals Project..
d)
No.
10-12.
Time
Cash Flow
($10,000)
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$4,000
$9,432
$8,574
$7,795
$7,086
$6,442
$5,856
$5,324
$4,840
$4,400
$4,000
Terminal Value
$63,749
a.) IRR
38.5%
b.) MIRR
20.35%
Initial investment
T- 1
T- 2
T- 3
T- 4
T- 5
T- 6
T- 7
T- 8
T- 9
T- 10
10-13. a )
b)
9
8
7
6
5
4
3
2
1
0
c)
d)
e)
Printer #1: NPV = -2,000 + 900 X .8621 + 1,100 X .7432 + 1,300 X .6407 = +426.32
Printer #2: NPV = -2,500 + 1,500 X .8621 + 1,300 X .7,432 + 800 X .6407 = +271.87
No. NPV of Printer #1 is still higher.
72
Program
-20,000,000
1,000,000
2,000,000
5,000,000
6,000,000
6,000,000
6,000,000
6,000,000
6,000,000
6,000,000
6,000,000
I = 15%
NPV = $2,082,694.77
IRR = 17.14%
MIRR = 16.14%
TV = $89,336,820
10-15. a )
Project A:
Project B:
Project A.
b)
c)
Project A:
Project B:
d)
Mutually exclusive:
Independent:
e)
Project C:
Project C.
f)
Project C:
g)
Selections based on NPV and IRR method contradict each other. Since NPV method is
generally preferred, select Project C.
73
Display
[CF]
[2nd][CLR Work]
CF0 = 0.00
5000000[+/-][ENTER]
CF0 = -5,000,000.00
1850000[ENTER]
4 [ENTER]
C01 = 1,850,000.00
F01 = 4.00
250000[+/-][ENTER]
[ENTER]
C02 = -250,000.00
F02 = 1.00
[IRR]
IRR = 0.00
[CPT]
IRR = 16.59
c ) The IRR of 16.59% is greater than the required rate of return of 10%, so the project would get a
positive recommendation.
10-17. a) Hydroelectric Project
CF0 = ($100,000)
CF1 = $20,000
CF2 = $30,000
CF3 = $40,000
CF4 = $90,000
Geothermal Project
CF0 = ($100,000)
CF1 = $80,000
CF2 = $40,000
CF3 = $30,000
CF4 = $10,000
74
10-18. The Chalk Line Machine, Gel Padded Glove, Insect Repellant, and Recycled Base Cover projects
collectively have initial cash outlays of $90,000 (under the budget limit) and have NPVs that sum to
$12,950. No other combination of projects gives a higher total NPV and stays under the budget
limit.
10-19.
Given Information:
Initial investment
$5,669.62
Year 1
Year 2
Year 3
Required rate of return
$2,200
$2,200
$2,200
12%
Year:
Annual cash flows
PV of cash flows
NPV
b. Comment on the acceptability of the investment:
0
($5,670)
($5,670)
($386)
2
$2,200
$1,754
5%
322
10%
(199)
Comment: The project is unacceptable because it has a negative NPV. You would not
accept it even if you had cash available.
c. NPV Profile:
Discount rate
NPV
0%
930
NPV
NPV PROFILE
930
$900
$700
$500
$300
$100
($100)
($300)
($500)
322
(199)
0%
5%
10%
DISCOUNT RATE
Comment:
Comment: According to the NPV profile, the discount rate would have to be less than about
8% in order for the project's NPV to be positive.
d. Comment:
Comment: The IRR is that discount rate which produces an NPV of zero. Therefore, the IRR
could be calculated to determine the "hurdle rate" below which the project's NPV would be
positive (8% in this case).
75
3
$2,200
$1,566
10-22. a)
1. CVA = 2%/10% = .2
2. E(IRR) of new combined portfolio = (700,000/900,000 x 10%) + (200,000/900,000 x 11%
= 10.22%
3. STD. Of new combined portfolio = [(.7782x.022)+(.2222x.03)+(2x.222x.778x.9x.02x.03)].5
= .0218 = 2.18%
4. CV of new combined portfolio = .0218/.1022 = .2133
b)
c)
average risk
d)
76
10-24.
Proj. A
Proj. B
Proj.C
Proj. D
4.00%
9.00%
3.71%
4.00%
5.00%
3.63%
4.00%
3.00%
3.61%
4.00%
1.00%
3.60%
18.00%
12.00%
12.60%
15.00%
12.00%
12.30%
11.00%
12.00%
11.90%
8.00%
12.00%
11.60%
33.33%
29.45%
29.55%
30.36%
31.05%
d.
A IS THE
LOWEST
RISK
PROJECT
D IS THE
HIGHEST
RISK
PROJECT
77
10-26.
1
1 - (1.08 )10
a) NPV = $298,500 x
- $2,000,000
.08
1 - (1.10 )10
- $2,000,000
b) NPV = $298,500 x
.10
1 - (1.10 )10
- $2,000,000
NPV = $0 = CF x
.10
Project 1
Project 2
($200,000)
$0
$0
$20,000
$30,000
$40,000
$60,000
$90,000
($200,000)
$90,000
$70,000
$50,000
$30,000
$10,000
$10,000
$10,000
78
Year 8
$100,000
$10,000
7.2%
a. NPVs of the
projects:
NPV
Project 1
Project 2
$19,398
$33,705
Project 1
Project 2
8.8%
14.4%
2%
99,769
65,526
4%
65,182
52,380
b. IRRs of the
projects:
IRR
c. NPV Profiles:
Discount rate
NPV Project 1
NPV Project 2
6%
35,340
40,396
8%
9,502
29,435
10%
(12,943)
19,376
12%
(32,504)
10,118
14%
(49,605)
1,573
16%
(64,600)
(6,337)
NPV PROFILES
$120,000
$100,000
$80,000
$60,000
NPV
$40,000
Project 1
$20,000
Project 2
$0
($20,000)
2%
4%
6%
8%
10%
12%
14%
16%
($40,000)
($60,000)
($80,000)
DISCOUNT RATE
Comment:
Both projects have the same NPV at a discount rate of approximately 5.5%. At that discount rate the NPV
of both projects is about $45,000.
Reason
Project 2's NPV is higher
Project 1's NPV is negative
The NPV for both projects is negative
e) Look at the NPV profile. If the discount rate is 5%, this is to the left of the crossover point. Project 1
would have a higher NPV than Project 2. This would create a ranking conflict if the projects were mutually
exclusive. Project 2 has a higher IRR (14.3% for Project 2 versus 8.81 percent for Project 1).
At a discount rate below 5.4%, NPV and IRR give conflicting ranking signals. At a discount rate of
5.4% or more, the ranking of the two projects is the same.
f)
79
Chapter 11 Solutions
Why do we focus on cash flows instead of profits when evaluating proposed capital budgeting
projects?
We focus on cash flows instead of profits when evaluating proposed capital budgeting projects
because it is cash flow that changes the value of a firm. You can spend cash but you can not spend
profit.
2.
What is a sunk cost? Is it relevant when evaluating a proposed capital budgeting project? Explain.
A sunk cost is a cash flow that has already occurred, or that will occur, whether a project is accepted
or rejected. It is irrelevant when evaluating a proposed project.
3.
How do we estimate expected incremental cash flows for a proposed capital budgeting project?
We estimate expected incremental cash flows for a proposed project by estimating the changes in
sales and expenses that are incremental to the project, adding back the incremental depreciation
expense since depreciation expense is a non-cash expense.
4.
5.
How and why does working capital affect the incremental cash flow estimation for a proposed large
capital budgeting project? Explain.
Many large projects require additional working capital. This investment in additional working
capital becomes part of the initial investment. This investment is recovered at the end of the
projects life. There may be some spontaneous increase in current liabilities associated with a
project, but the change in net working capital, if any, is likely to be a positive value requiring an
increase in the initial investment of that amount.
6.
7.
How are financing costs generally incorporated into the capital budgeting analysis process?
Financing costs are usually captured in the discount or hurdle rate when doing NPV or IRR analysis.
The operating cash flows usually do not include financing costs because this would be double
counting.
$6,000
5,000
300
12,000
$23,300
$200,000
$60,000
3
5 years
40%
20% + 32% + 19.2% = 71.2% or,
0.712 X $200,000 = $142,400
$200,000 - $142,400 = $57,600
$60,000 - $57,600 = $2,400
$2,400 X 0.40 = $960
$60,000 - $960 = $59,040
$200,000
$80,000
3
5 years
40%
20% + 32% + 19.2% = 71.2% or,
0.712 X $200,000 = $142,400
$200,000 - $142,400 = $57,600
$80,000 - $57,600 = $22,400
$22,400 X 0.40 = $8,960
$80,000 - $8,960 = $71,040
81
11-3.
11-4.
Mower
Annual Revenues (increase)
Operating Costs (increase)
Depreciation (20%)
EBIT
Taxes (35%)
Depreciation
Net operating CF
$20,000
100,000
30,000
Year 1
$100,000
- 30,000
70,000
- 4,000
66,000
- 23,100
42,900
+ 4,000
$46,900
11-6.
Initial Cost of new Equipment $375,000
End of year:
13%
40%
1
20.00%
6
5.80%
Calculations:
Incremental Cash Flows:
Year
82
26,875
(10,750)
16,125
43,125
48,250
(19,300)
28,950
21,750
Net incremental
operating cash flows $102,000 $102,000 $70,800 $59,250 $59,250 $50,700
Present value of cash flows
$375,000
1
$120,000
Discount rate
Tax rate
13%
40%
Year
MACRS depreciation
percentages for five-year class
life equipment
Resale value of equipment
1
20.00%
2
32.00%
3
19.20%
4
11.50%
5
11.50%
6
5.80%
Calculations:
Incremental Cash Flows:
Year
EBDT
New depreciation expense
Change in Operating Income
Income tax on new income
Change in earnings after tax
Add back depreciation
Net incremental
operating cash flows
83
$125,000 X .10 =
Oper. Exp.
Depr. Exp.
$12,500
-20,000
-10,500
-18,000
7,200
-10,800
10,500
-300
Tax Saving@40%
Add back Depr.
Net Incremental Oper. Cash flow
c)
11-9.
GHOST SQUADRON HISTORICAL AIRCRAFT, INC.
ASSUMPTIONS:
MACRS Depreciation
Yr 1
14.3%
Tax rate
Cost of capital
35%
12%
Yr 2
24.5%
Yr 3
17.5%
Yr 4
12.5%
Yr 5
8.9%
Yr 6
8.9%
Yr 7
8.9%
($100,000)
($35,000)
($600,000)
($735,000)
Year:
New Revenues
Additional operating expenses
Depreciation on plane
Change in Operating Income
Tax on new income
Change in Earnings after tax
Add back depreciation
($40,000)
($105,105)
($145,105)
$50,787
($94,318)
$105,105
($40,000)
($180,075)
($220,075)
$77,026
($143,049)
$180,075
$70,000
($40,000)
($128,625)
($98,625)
$34,519
($64,106)
$128,625
$70,000
($40,000)
($91,875)
($61,875)
$21,656
($40,219)
$91,875
$70,000
($40,000)
($65,415)
($35,415)
$12,395
($23,020)
$65,415
$70,000
($40,000)
($65,415)
($35,415)
$12,395
($23,020)
$65,415
$70,000
($40,000)
($65,415)
($35,415)
$12,395
($23,020)
$65,415
$10,787
$37,026
84
$42,395 $42,395
Yr 8
4.5%
($735,000)
$10,787
11-10. a )
-2.7%
b)
Outflow
c)
Beginning of year 1
11-11.
Given:
Initial Cost of new Equipment
End of year:
New revenues
Discount rate
Tax rate
Year
MACRS depreciation percentages for
three-year class life equipment
Resale value of equipment
$90,000
1
$50,000
11%
30%
1
33.30%
$10,000
2
$30,000
3
$20,000
4
$20,000
44.50%
14.80%
7.40%
at the end of the fourth year
Calculations:
Incremental Cash Flows:
Year
Revenues
New depreciation expense
Change in Operating Income
Income tax on new income
Change in earnings after tax
Add back depreciation
Net incremental operating cash flows
85
1
$50,000
(29,970)
20,030
(6,009)
14,021
29,970
2
$30,000
(40,050)
(10,050)
3,015
(7,035)
40,050
3
$20,000
(13,320)
6,680
(2,004)
4,676
13,320
4
$20,000
(6,660)
13,340
(4,002)
9,338
6,660
$43,991
$33,015
$17,996
Resale value of equipment
Less income tax on sale
Net cash flow from equipment sale
$43,991
$33,015
$17,996
$39,632
$26,796
$13,159
$94,735
$15,998
10,000
(3,000)
7,000
$22,998
$15,149
($90,000)
$4,735
Comments: Yes, since the project has a positive NPV at the company's cost of capital, Flower
Belle should recommend that it be accepted.
11-12.
MACRS 3 YEARS
PRICE OF NEW EQUIPMENT:
YEARS USED
40.00%
COST OF CAPITAL 10.00%
SALVAGE VALUE OF NEW EQPT. 10,000
MACRS CLASSIFICATION:
3 YEARS
DEPRECIATION RATE
ACCUM. DEP. %)
1
2
3
4
33.30% 44.50% 14.80% 7.40%
100%
6,000
10,000
20,000
(10,000)
(4,000)
14,000
REVENUE STREAM
DEPRECIATION EXPENSE
CHANGE IN EARNINGS
ADD BACK DEPRECIATION
0
(90,000)
14,000
OPERATING CF
SALVAGE VALUE
DISCOUNT RATE
NPV
10.00%
$17,419.18
86
11-13.
Initial Cost of new equipment
End of year:
New revenues
Discount rate
Tax rate
$90,000
1
$50,000
10%
40%
Year
MACRS depreciation percentages for
three-year classlife equipment
1
33.30%
2
$30,000
2
44.50%
3
4
$20,000 $20,000
3
14.80%
4
7.40%
$20,000
$10,000
$10,000 at the end of the fourth year
$10,000
$5,000
($10,000)
$4,000
$14,000
($90,000)
($76,000)
($5,000)
($81,000)
Year
Revenues
New depreciation expense
Change in Operating Income
Income tax on new income
Change in earnings after tax
Add back depreciation
1
$50,000
(29,970)
20,030
(8,012)
12,018
29,970
2
$30,000
(40,050)
(10,050)
4,020
(6,030)
40,050
3
4
$20,000 $20,000
(13,320) (6,660)
6,680 13,340
(2,672) (5,336)
4,008
8,004
13,320
6,660
$41,988
$34,020
$17,328 $14,664
11-14. a )
$41,988
$38,171
$96,834
($81,000)
= NPV
$15,834
b)
c)
d)
87
$34,020
$28,116
$17,328 $25,664
$13,019 $17,529
e)
f)
11-15.
MACRS 3 YEARS 33.30% 44.50% 14.80% 7.40%
PRICE OF NEW EQUIPMENT:
PRICE OF OLD EQUIPMENT:
RESALE VALUE OF OLD EQPT:
YEARS USED
$22,000
0
0
4
40.00%
COST OF CAPITAL 14.00%
SALVAGE VALUE OF NEW EQUIP.
$0
MACRS CLASSIFICATION:
YEARS
100%
5000
3000
2000
1
2
3
4
20,000 20,000 10,000 10,000
(4,000) (4,000) (2,000) (2,000)
16,000 16,000 8,000 8,000
7,326 9,790 3,256 1,628
8,674
3,470
6,210
2,484
4,744 6,372
1,898 2,549
CHANGE IN EARNINGS
5,204
3,726
2,846 3,823
7,326 9,790
12,530 13,516
3,256 1,628
6,102 5,451
NEW EQUIPMENT
b.
OPERATING CF
c.
0
(22,000)
(2,000)
NWC
DISCOUNT RATE
88
12,530 13,516
2,000
6,102 5,451
6,102 7,451
14.00%
$5,922.36
27.24%
NPV
IRR
11-16.
Given:
Initial Cost of new Equipment
$150,000
$7,500
$50,000
Discount rate
10%
Tax rate
35%
Year
annually
MACRS depreciation
percentages for three-year class
33.30%
44.50%
14.80%
7.40%
life equipment
Calculations:
Incremental Cash Flows at T-0:
Cost of New Equipment
($150,000)
($7,500)
($157,500)
$50,000
$50,000
$50,000
$50,000
$50,000
(52,448)
(70,088)
(23,310)
(11,655)
(2,448)
(20,088)
26,690
38,345
50,000
857
7,031
(9,342)
(13,421)
(17,500)
(1,591)
(13,057)
17,349
24,924
32,500
52,448
70,088
23,310
11,655
$50,857
$57,031
$40,659
$36,579
$32,500
Net incremental
operating cash flows
89
$46,233
$169,077
($157,500)
$47,133
$30,547
$24,984
$20,180
a.
NPV =
$11,577
b. Yes, since the NPV of the investment is positive at RHPS's cost of capital, Weiss and Majors
should go forward with the project.
90
11-17.
Chemical Company of Baytown
Given:
Original cost of old equipment
Resale value of old equipment
Discount rate
Tax rate
Year
MACRS depreciation
percentages for three-year class
life equipment
6%
40%
1
33.30%
44.50%
3
14.80%
4
7.40%
Calculations:
a. Cash flows from sale of old equipment:
Year 2011
Depreciation expense on old equipment
Total accumulated depreciation
Book value of old equipment
Resale value of old equipment
Gain(loss) on sale of old equipment
(Tax)refund on transaction
Net cash received for old equipment
Year 2012
$13,320
$17,800
$31,120
$8,880 on Dec 31, 2012
$4,000 on Dec 31, 2012
($4,880)
$1,952
$5,952
$1,000
$5,000
$10,000
$16,000
$6,000
$3,000
$9,000
$7,000
c. Net cash outflow at the end of 2012 if new process line is installed:
Cost of New Equipment
Additional net working capital
Less proceeds from sale of old equipment
Net cash outflow at the end of 2012
$180,000
$7,000
($5,952)
$181,048
2010
$60,000
6,000
(59,940)
6,060
(2,424)
3,636
59,940
91
2011
$60,000
6,000
(80,100)
(14,100)
5,640
(8,460)
80,100
2012
$60,000
6,000
(26,640)
39,360
(15,744)
23,616
26,640
2013
$60,000
6,000
(13,320)
52,680
(21,072)
31,608
13,320
$63,576
$71,640
$50,256 $44,928
7,000
$63,576
$71,640
$59,977
$63,759
$42,196 $50,637
$216,570
($181,048)
= NPV
$35,522
Year
Net Cash Flow
0
($181,048)
1
$63,576
2
3
4
$71,640 $50,256 $63,928
IRR
14.4%
Year
$50,256 $63,928
3
f. NPV Profile
Year
0%
1%
2%
3%
4%
5%
6%
7%
8%
9%
10%
$68,352 $62,338 $56,556 $50,994 $45,641 $40,487 $35,522 $30,736 $26,122 $21,672 $17,377
$68,352
$62,338
$56,556
$50,994
$45,641
$40,487
$35,522
$30,736
$26,122
$21,672
$17,377
NPV
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
$0
0%
1%
2%
3%
4%
5%
6%
Cost of Capital
92
7%
8%
9%
10%
11-18.
PROBLEM 11-18
Real Options Decision Tree NPV Analysis
J & T's Double Diamond Brewhouse
Time
t0
Time
1
25%
($300,000)
50%
25%
$200,000
$100,000
Time
2
100%
Time
3
$100,000
Time
4
Time
5
|- Part c.
-|
JP x NPV
50%
$400,000
$400,000
$400,000
12.5%
$666,954
$83,369
30%
$200,000
$200,000
$200,000
7.5%
$309,669
$23,225
20%
$90,000
$90,000
$90,000
5.0%
$113,163
$5,658
100%
$100,000
100%
$100,000
$100,000
$100,000
50.0%
$43,308
$21,654
0%
($40,000)
100%
($40,000)
($40,000)
($40,000)
0.0%
($437,323)
$0
100%
$0
100%
$0
$0
$0
25.0%
($335,088)
($83,772)
Total NPV
of the
Deal:
$50,135
($40,000)
Cost of Capital:
14%
93
Chapter 12 Solutions
Describe the general pattern of cash flows from a bond with a positive coupon rate.
Cash flows from a bond with a positive coupon rate consist of periodic interest payments and the face
value payment at maturity. Coupon interest payments occur at regular intervals throughout the life of
the bond. The face value payment occurs on the maturity date.
2.
3.
What is the relationship between a bond's market price and its promised yield to maturity? Explain.
A bond's market price depends on its yield to maturity (YTM). When a bond has a YTM greater than
its coupon rate, it sells at a discount from its face value. When the YTM is equal to the coupon rate,
the market price equals the face value. When the YTM is less than the coupon rate, the bond sells at
a premium over face value.
4.
All other things held constant, how would the market price of a bond be affected if coupon interest
payments were made semiannually instead of annually?
Most bonds issued in the United States pay interest semiannually (twice per year). With semiannual
interest payments, we must adjust the bond valuation model (Equation 9-1 in the text) by multiplying
n, the number of years to maturity, by two, and dividing k, the annual interest rate, by two.
5.
What is the usual pattern of cash flows for a share of preferred stock? How does the market
determine the value of a share of preferred stock, given these promised cash flows?
Preferred stock has no maturity date, so it has no maturity value. Its future cash payments are
dividend payments that are paid to preferred stockholders at regular time intervals for as long as they
(or their heirs) own the stock. Cash payments from preferred stock dividends are scheduled to
continue forever. To value preferred stock, we adapt the discounted cash flow model to reflect that
preferred stock dividends are a perpetuity. See Equation 9-4 in the text.
6.
Name two patterns of cash flows for a share of common stock. How does the market determine the
value of the most common cash flow pattern for common stock?
94
Cash flows for a share of common stock consist of dividend payments and the price received for the
eventual sale of the share. Common stock valuation is complicated by the fact that common stock
dividends are difficult to predict compared to the interest and principal payments on a bond, or
dividends on preferred stock. Indeed, corporations may pay common stock dividends irregularly, or
not pay dividends at all.
As with bonds and preferred stock, the market values common stock by estimating the present value
of the expected future cash flows from the common stock. See Equation 9-6 in the text.
7.
Define the P/E valuation method. Under what circumstances should a stock be valued using this
method?
The P/E ratio indicates how much investors are willing to pay for each dollar of a stock's earnings. A
high P/E ratio indicates that investors believe the stock's earnings will increase, or that the risk of the
stock is low, or both.
Financial analysts often use a P/E model to estimate common stock value for businesses that are not
public. First, analysts compare the P/E ratios of similar companies within an industry to determine
an appropriate P/E ratio for companies in that industry. Second, analysts calculate an appropriate
stock price for firms in the industry by multiplying each firm's earnings per share (EPS) by the
industry average P/E ratio. See Equation 9-9 in the text.
8.
Compare and contrast the book value and liquidation value per share for common stock. Is one
method more reliable? Explain.
The Book Value of a firm's common stock is found by subtracting the value of the firm's liabilities,
and preferred stock, if any, as recorded on the balance sheet, from the value of its assets. The result
is the book value or net worth of the company's common stock. To find the book value per share of
common stock, divide the company's book value by the number of outstanding common stock shares.
See Equation 9-10 in the text.
The liquidation value and book value valuation methods are similar, except that the liquidation
method uses the market values of the assets and liabilities, not book values. The market values of the
assets are the amounts the assets would earn on the open market if they were sold (or liquidated).
The market values of the liabilities are the amounts of money it would take to pay off the liabilities.
Since it is based on market values, the liquidation value method is more reliable than the book value
method. However, liquidation value is a worst-case valuation assessment. A company's common
stock should be worth at least the amount generated per share at liquidation.
95
9. Answer the following questions about the discounted free cash flow model illustrated in Figure 12-4:
a. What are free cash flows?
Free cash flows represent the total cash flows from business operations that are available to be
distributed to the suppliers of a firms capital each year either in the form of interest to the debt
holders, or dividends to the stockholders.
b. Explain the terminal value calculation at the end of the forecast period. Why is it necessary?
The firm whose business operation is being valued is not expected to suddenly cease operating at the
end of the discrete forecasting period, but to continue operating indefinitely into the future as a going
concern. The terminal value calculation estimates the values of the cash flows that occur in the year
following the discrete forecasting period and beyond.
c. Explain the term present value of the firms operations (also known as Enterprise Value). What
does this number represent?
The present value of the companys free cash flows represents the market value of the firms core
income producing operations. In the world of finance and investing this is sometimes called the
firms Enterprise Value. It is not the total market value of the entire company, however, or the total
market value of the companys assets, because the current, or non-operating assets of the company
have not yet been accounted for.
d. Explain the adjustments necessary to translate enterprise value to the total present value of common
equity.
To obtain the value of the companys common stock, add the value of the firms current assets to the
enterprise value (this produces the value of the firms total assets). Next, subtract the values of
current liabilities, long-term debt, and preferred stock. The result is the present value of common
equity.
10. Explain the difference between the discounted free cash flow model as it is applied to the valuation of
common equity and as it is applied to the valuation of complete businesses.
The Free Cash Flow Model values the complete business as a part of the procedure to value common
equity. The value of a complete business is the sum of the values of the operating, or incomeproducing assets, plus the value of the non-operating, or current assets. All that is necessary to use
the Free Cash Flow Model to value a complete business, then, is to add the value of the companys
operations to the value of the companys current assets.
11. Why is the replacement value of assets method not generally used to value complete businesses?
The replacement value of assets method is not often applied to complete business valuations because
it is frequently very difficult to locate similar assets for sale on the open market, and because some
of a businesss assets are difficult to define and quantify.
96
a)
b)
c)
12-2.
a)
b)
c)
12-3.
3 X $2,000 = $6,000
12-4.
12-5.
Since $1,100 > $1,000, YTM < Coupon Rate; YTM < 9%
$90 X [1-1/ (1 + k)10/k] + $1,000 X (1/1 + k10) = $1,100
k = 7.54%
12-6.
a)
b)
c)
12-7.
12-8.
12-9.
Since, $1,125 > $1,000, YTM < Coupon Rate YTM < 12%
$120 X [(1-1/1.1010)/.10] + $1,000 X [1/1.1010] = $1,122.89; YTM 10%
YTM = 12%; YTM = Coupon Rate if Market Price = Par
12-10. a )
b)
12-11. a )
b)
$4/(.16-.01) = $26.67
$4/$26.67 = 15%
97
12-13. a )
b)
98
12-24. a )
b)
12-25. a )
b)
c)
d)
e)
f)
12-26. a)
Corporate Bond
Let YTM = k
$130 X [(1-1/(1+k)16)/k] + $1,000 X [1/(1+k)16] = 1,147.58
Solving, kd = 11%
b)
Preferred Stock
k = $14/$140
kp = 10%
c)
Common Stock
99
12-27.
The Nonconstant, or Supernormal Dividend Growth Model
Flash in the Pan Corporation
Given:
Year
1
Dividend growth rates
Dividend expected in 1 year
Assumed required rate of return
Year
2
20%
Year
3
30%
Year
4
20%
Year Year
5
6 and on
10% 5%
$3.00
15%
Calculations:
a. Present value of Dividends during the supernormal growth period:
Expected future dividends during
the supernormal growth period
$3.00
$3.60
$4.68
$5.62
$6.18
$2.61
$2.72
$3.08
$3.21
$3.07
Total
$14.69
b. Present value of dividends during the normal growth period (year 6 and on)
Terminal value at end of year 5
per Equation 12-7
Present value of terminal value
c. Total present value per share
of Flash in the Pan Corp. stock
$64.86
$32.25
$46.94
100
12-28. The Discounted Free Cash Flow Model for Total Common Equity
Hardi-Pets Corporation
Forecasting Variables:
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
10% 15% 20% 25% 30% 25% 20% 15% 10%
5%
50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
20% 20% 20% 20% 20% 20% 20% 20% 20% 20%
10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
10% 10% 10% 10% -10% -10% -10% -10% -10% -10%
10% 10% 10% 10% 10% 10% 10% 10% 10% 10%
40%
5% per year after 2022
20%
FORECAST:
Total revenue
Actual
2012
$1,000,000
$1,100,000 $1,265,000 $1,518,000 $1,897,500 $2,466,750 $3,083,438 $3,700,125 $4,255,144 $4,680,658 $4,914,691
500,000
500,000
550,000
550,000
632,500
632,500
759,000
759,000
948,750
948,750
1,233,375
1,233,375
1,541,719
1,541,719
1,850,063
1,850,062
2,127,572
2,127,572
2,340,329
2,340,329
2,457,346
2,457,345
200,000
300,000
220,000
330,000
253,000
379,500
303,600
455,400
379,500
569,250
493,350
740,025
616,688
925,031
740,025
1,110,037
851,029
1,276,543
936,132
1,404,197
982,938
1,474,407
100,000
200,000
110,000
220,000
126,500
253,000
151,800
303,600
189,750
379,500
246,675
493,350
308,344
616,687
370,013
740,024
425,514
851,029
468,066
936,131
491,469
982,938
80,000
120,000
88,000
132,000
101,200
151,800
121,440
182,160
151,800
227,700
197,340
296,010
246,675
370,012
296,010
444,014
340,412
510,617
374,452
561,679
393,175
589,763
100,000
(15,000)
110,000
(16,500)
(10,000)
$215,500
126,500
(18,150)
(16,500)
$243,650
151,800
(19,965)
(25,300)
$288,695
189,750
(21,962)
(37,950)
$357,538
246,675
(19,766)
(56,925)
$465,994
308,344
(17,789)
(61,669)
$598,898
370,013
(16,010)
(61,669)
$736,348
425,514
(14,409)
(55,502)
$866,220
$205,000
468,066
491,469
(12,968)
(11,671)
(42,551)
(23,403)
$974,226 $1,046,158
$7,323,106
179,583
169,201
101
167,069
172,424
187,273
200,570
205,501
201,455
188,812
1,351,683
$3,023,571
100,000
(80,000)
(500,000)
0
$2,543,571
12-29. The Discounted Free Cash Flow Model for a Complete Business
Great Expectations Company
Forecasting Variables:
2013 2014 2015 2016 2017 2018 2019 2020 2021 2022
Revenue growth factor
Expected gross profit margin
S, G, & A expense % of revenue
Depr. & Amort. % of revenue
Capital expenditure growth factor
Net working capital to sales ratio
Income tax rate
Assumed long-term sustainable growth rate
Discount rate
20%
50%
50%
10%
40%
19%
30%
51%
40%
10%
35%
18%
40%
52%
30%
10%
30%
17%
50%
53%
29%
10%
25%
16%
60%
54%
28%
10%
20%
15%
50%
55%
27%
10%
-10%
14%
40%
56%
26%
10%
-15%
13%
30%
57%
25%
10%
-20%
12%
20%
58%
24%
10%
-25%
11%
10%
59%
23%
10%
-30%
10%
40%
5% per year after 2022
20%
FORECAST:
Actual
2012
2013
2014
2015
$2,000,000
$2,400,000
$3,120,000
$4,368,000
1,200,000
800,000
1,200,000
1,200,000
1,528,800
1,591,200
2,096,640
2,271,360
3,079,440
3,472,560
4,822,272
5,660,928
7,076,160
9,686,477 12,306,228 14,424,045 15,488,676
8,648,640 12,328,243 16,312,908 19,918,918 22,288,584
1,200,000
(400,000)
1,200,000
0
1,248,000
343,200
1,310,400
960,960
1,900,080
1,572,480
2,935,296
2,725,632
4,245,696
4,402,944
5,723,827
6,604,416
7,154,784
8,242,311
8,688,770
9,158,124 11,676,607 13,599,814
200,000
(600,000)
0
0
240,000
(240,000)
(600,000)
0
312,000
31,200
(840,000)
0
436,800
524,160
(808,800)
0
655,200
917,280
(284,640)
632,640
1,048,320
1,677,312
0
1,677,312
1,572,480
2,830,464
0
2,830,464
2,201,472
4,402,944
0
4,402,944
2,861,914
6,296,210
0
6,296,210
3,434,296
8,242,311
0
8,242,311
3,777,726
9,822,088
0
9,822,088
0
(600,000)
0
(240,000)
0
31,200
0
524,160
253,056
664,224
670,925
1,006,387
1,132,186
1,698,278
1,761,178
2,641,766
2,518,484
3,777,726
3,296,924
4,945,387
3,928,835
5,893,253
Total revenue
102
2016
2017
2018
2019
2020
2021
2022
200,000
(1,000,000)
240,000
312,000
436,800
655,200
1,048,320
1,572,480
2,201,472
2,861,914
3,434,296
3,777,726
(1,400,000) (1,890,000) (2,457,000) (3,071,250) (3,685,500) (3,316,950) (2,819,408) (2,255,526) (1,691,645) (1,184,151)
76,000
129,600
212,160
349,440
589,680
733,824
817,690
792,530
629,621
343,430
($1,400,000) ($1,324,000) ($1,417,200) ($1,283,880) ($1,402,386) ($1,041,113)
$687,632 $2,841,521 $5,176,644 $7,317,659 $8,830,257
$61,811,799
(1,103,333)
(984,167)
(742,986)
(676,305)
(418,400)
$11,629,331
103
230,287
793,016
1,203,922
1,418,211 11,409,086
Chapter 13 Solutions
What is the operating leverage effect and what causes it? What are the potential benefits and
negative consequences of high operating leverage?
The operating leverage effect is the phenomenon whereby a small change in sales triggers a relatively
large change in operating income. It is caused by the presence of fixed operating costs. The
potential benefits are that if sales are rising operating income will rise more quickly. The negative
consequences are that falling sales will cause operating income to fall more quickly, including
negative values.
2.
Does high operating leverage always mean high business risk? Explain.
High operating leverage does not always mean high business risk. If the companies sales are quite
stable then the variation in operating income would be small even if the degree of operating leverage
were large.
3.
What is the financial leverage effect and what causes it? What are the potential benefits and negative
consequences of high financial leverage?
Financial leverage is the additional volatility of net income caused by the presence of fixed-cost
funds. The potential benefits are that if operating income is rising net income will rise more quickly.
The negative side is that if operating income is falling net income will fall more quickly, including
possibly negative values.
4.
Give two examples of types of companies likely to have high operating leverage. Find examples
other than those cited in the chapter.
Long distance telephone companies and electricity generating companies are likely to have operating
leverage. These two types of companies have very high fixed costs, because they are capital
intensive, and have relatively low variable costs.
5.
Give two examples of types of companies that would be best able to handle high debt levels.
Companies that handle local telephone service and those that handle natural gas delivery to
consumers would be expected to comfortably be able to handle high debt levels. This is because the
sales of these two types of companies tend not to react very much to the business cycle. Their sales
tend to grow with the population. They are often regulated and protected from competition, although
this is not so much true as it was a few years ago.
104
6.
What is an LBO? What are the risks for the equity investors and what are the potential rewards?
A leveraged buyout is a purchase of a publicly owned corporation by a small group of investors using
a large amount of borrowed money. The risks for the equity investors are those that exist whenever a
high degree of financial leverage exists. So too are the rewards, where small returns become large
returns because of leverage.
7.
If an optimal capital structure exists, what are the reasons why too little debt is as undesirable as is
too much debt?
Too little debt may be as undesirable as too much debt because if a firm has a very conservative
capital structure it may be losing the opportunity to reap the positive benefits of financial leverage.
A company with a bright future is probably not maximizing shareholder wealth if it has a very small
amount of debt in its capital structure. A more aggressive capital structure may create more value for
the owners.
13-2.
13-3.
13-4.
13-5.
a)
b)
Unit Sales b.e. = $20,000/($28 - $16) = 1,666.67 units; 1,667 units rounded up
DOLLARS b.e = $28 x 1,667 units = $46,676
c)
105
d)
$180,000
$160,000
$140,000
$120,000
$100,000
$80,000
$60,000
$40,000
$20,000
FIXED COST
13-6. a)
VAR. COST
TOT. COST
6,
00
0
50
0
5,
5,
00
0
50
0
4,
00
0
4,
50
0
3,
00
0
3,
50
0
2,
00
0
2,
50
0
1,
00
0
0
50
1,
$0
REVENUE
b)
c)
d)
$180,000
$160,000
$140,000
$120,000
$100,000
$80,000
$60,000
$40,000
$20,000
$0
0
500
1,000 1,500 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 6,000
FIXED COST
VAR. COST
106
TOT. COST
REVENUE
e)
Howard Beal Co., having higher fixed costs, and a lower variable cost per unit, has a higher profit
potential once they break-even. However, they have a greater loss potential, and need to achieve a higher
sales level to break even, because of the high fixed costs.
13-7.
YEAR
2012
2013
SALES IN UNITS
3000
3300
SALES IN DOLLARS
$84,000
$92,400
VAR.COST, $16/unit
$48,000
$52,800
FIXED COST
$20,000
$20,000
$16,000
$19,600
$2,000
$2,000
$14,000
$17,600
INTEREST EXP.
EBT
TAX @30%
$4,200
$5,280
NET INCOME
$9,800
$12,320
%CHANGE IN SALES
10.00%
%CHANGE IN EBIT
22.50%
%CHANGE IN NI
25.71%
a)
b)
Due to presence of fixed costs a given percentage change in sales gives a higher percentage change in
operating income (EBIT) (10% and 22.5% respectively). This is the operating leverage effect.
c)
(i)
DOL = % EBIT/% SALES = [($19,600 - $16,000)/$16,000]/[($92,400 $84,000)/$84,000] = 22.5%/10% = 2.25
(ii)
DOL = (SALES-VC)/(SALES-VC-FC) = ($84,000 - $48,000)/($84,000 - $48,000$20,000) = $36,000/$16,000 = 2.25
d)
(i) shows the effect of operating leverage -- EBIT varies at a larger percentage than sales.
(ii) pinpoints the source of operating leverage -- fixed operating costs.
13-8.
a)
Percentage change in NI = ($12,320 - $9,800)/$9,800= 25.71%
Percentage change in operating income = ($19,600 - $16,000)/$16,000 = 22.5%
b)
Due to presence of fixed interest expense a given percentage change in EBIT gives a higher
percentage change in net income (22.5% and 25.71% respectively). This is the financial leverage
effect.
c)
(i)
DFL = % NI/% EBIT = [($12,300 - $9,800)/$9,800]/[($19,600 - $16,000)/$16,000] =
25.71%/22.5% = 1.14
(ii)
DFL = EBIT/(EBIT - I) = $16,000/($16,000 - $2,000) = 1.14
d)
(i) shows the effect of financial leverage -- NI varies by a larger percentage than operating income
(EBIT).
107
13-9.
a)
b)
c)
d)
e)
SALES IN UNITS
14,000 sq.yards
$252,000
$21,000
FIXED COST
$9,000
$222,000
INTEREST EXP.
$3,000
EBT
$219,000
TAX @40%
$87,600
NET INCOME
$131,400
c)
d)
e)
13-11.
COMPANY A
COMPANY B
COMPANY C
12,000
12,000
12,000
$120,000
$120,000
$120,000
$60,000
$48,000
$12,000
$0
$10,000
$40,000
$60,000
$62,000
$68,000
SALES IN UNITS
SALES IN DOLLARS, units x $10 each
VARIABLE COST, $5, $4, and $1 per unit
respectively
FIXED COST
OPERATING INCOME (EBIT)
108
b)
C, B, A.
13-12. a )
b)
c)
YEAR 1
UNITS
SALES, units x $29 each
METHOD 2
YEAR 2
YEAR 1
YEAR 2
50,000
60,000
50,000
60,000
1,500,000
1,800,000
1,500,000
1,800,000
FC
700,000
700,000
100,000
100,000
300,000
360,000
825,000
990,000
$500,000
$740,000
$575,000
$710,000
EBIT
d)
e)
f)
g)
METHOD 1
h)
i)
YEAR 1
UNITS
SALES, units x $30 each
METHOD 2
YEAR 2
YEAR 1
YEAR 2
50,000
53,000
50,000
53,000
1,500,000
1,590,000
1,500,000
1,590,000
FC
700,000
700,000
100,000
100,000
300,000
318,000
825,000
874,500
$500,000
$572,000
$575,000
$615,500
EBIT
109
13-13. a )
b)
C, B, A.
COMPANY A:DFL = $100,000/($100,000 - $0) = 1.0
COMPANY B: DFL = $100,000/($100,000 - $2,000) = 1.02
COMPANY C: DFL = $100,000/($100,000 - $40,000) = 1.67
Answer to part a) was correct.
c)
CAPITAL STRUCTURE
COMPANY A
COMPANY B
COMPANY C
ALL EQUITY
90% EQUITY
10% EQUITY
$100,000
$100,000
$100,000
EBIT
INTEREST EXP.
$0
$2,000
$40,000
$100,000
$98,000
$60,000
TAXES @40%
$40,000
$39,200
$24,000
NET INCOME
$60,000
$58,800
$36,000
MICHAEL DORSEY
DOROTHY MICHAELS
EBT
13-14.
a.
EBIT
INTEREST EXPENSE
EBT
TAXES @40%
NET INCOME
YEAR 1 YEAR 2
YEAR 1
$50,000
$9,100
$40,900
$16,360
$24,540
$50,000
$900
$49,100
$19,640
$29,460
$60,000
$9,100
$50,900
$20,360
$30,540
b. %CHANGE in NI
24.45%
20.37%
c. %CHANGE in EBIT
20.00%
20.00%
d. DFL
1.22
1.02
e. DFL
1.22
1.02
YEAR 2
$60,000
$900
$59,100
$23,640
$35,460
h.
YEAR 1
EBIT
INTEREST EXPENSE
EBT
TAXES @40%
NET INCOME
$50,000
$9,100
$40,900
$16,360
$24,540
$50,000
$900
$49,100
$19,640
$29,460
DFL
1.22
110
$53,000
$9,100
$43,900
$17,560
$26,340
1.02
YEAR 2
$53,000
$900
$52,100
$20,840
$31,260
YEAR 2
SALES
$200,000
$225,000
EBIT
$95,000
NET INCOME
$30,000
DOL
1.35
DFL
1.09
a. %CHANGE in SALES =
12.50%
16.8750%
$111,031.25
18.3938%
$35,518.13
1.4715
f. %CHANGE in SALES =
20.00%
29.43%
$38,829.00
Also,
c)
111
13.19.
Soccer International, Inc.
Given:
2012
2013
Sales
Variable Costs
Fixed Costs
$560,000
$240,000
$160,000
$616,000
$264,000
$160,000
Interest Expense
$40,000
$40,000
$16
2013
$560,000
$240,000
$160,000
$160,000
$40,000
$120,000
$36,000
$84,000
$616,000
$264,000
$160,000
$192,000
$40,000
$152,000
$45,600
$106,400
2012
2013
35,000
$6.86
$9.14
38,500
$6.86
$9.14
17,500
17,500
2009
2010
$280,000
$280,000
Sales
Variable Costs
Fixed Costs
EBIT
Interest Expense
EBT
Income Taxes (30%)
Net Income
b. Breakeven point in units:
$160,000
$200,000
$360,000
$9
39,375
24,000
$164,571
$160,000
$4,571
$219,429
$160,000
$59,429
2012
2013
2.0
1.83
DOL
112
DFL
2012
2013
1.33
1.26
2008
2009
2.67
2.32
2012
2013
DCL
k. Effect of a price increase that produces higher sales:
Sales
$560,000
$84,000
113
$120,000
Chapter 14 Solutions
2.
How does a sinking fund function in the retirement of an outstanding bond issue?
A sinking fund is where a company puts payments that are then used to buy back outstanding bonds.
3.
What are some examples of restrictive covenants that might be specified in a bonds indenture?
An indenture might include limitations on future borrowings, restrictions on dividend payments,
and/or requirements that working capital be maintained at least at some minimum level.
4.
Define the following terms that relate to a convertible bond: conversion ratio, conversion value, and
straight bond value.
The conversion ratio is the number of shares of common stock that would be obtained if a convertible
bond were converted. The conversion value is the total value of the common stock that would be
obtained. The straight bond is the value a convertible bond would have without the conversion
feature.
5.
If a convertible bond has a conversion ratio of 20, a face value of $1,000, a coupon rate of 8 percent,
and the market price for the companys stock is $15 per share, what is the convertible bonds
conversion value?
The conversion value would equal the conversion ratio of 20 times the $15 market price of the stock
or $300.
6.
What is a callable bond? What is a putable bond? How do each of these features affect their
respective market interest rates?
A callable bond can be retired early at the discretion of the issuer. A putable can be retired early at
the discretion of the investor. A call provision increases the market interest rate and a put provision
decreases it.
114
14-2.
14-3.
14-4.
14-5.
14-6.
$85 X 30 = $2,550
14-7.
14-8.
Funds required to buy 1,000 bonds from the open market = $800 X 1,000 = $800,000. Therefore
savings from buying the bonds back instead of depositing $1 million in the sinking fund =
$1,000,000 - $800,000 = $200,000.
14-9.
YEARS
7 8 9
10 11 12 13 14 15 16 17 18 19 20
-950 100 100 100 100 100 100 100 100 100 100
1050
-950 100 100 100 100 100 100 100 100 100 1150
11.15% IRR
115
14-12. a)
b)
80 80 80 80 80 80 80 80 80
10 11 12 13 14 15 16 17 18 19
80
1000
80 80 80 80 80 80 80 80 80 1080
IRR
100 100 100 100 100 100 100 100 100 100 80 80 80 80 80 80 80 80 80
1050
-950
-950
10.52%
20
80
1000
100 100 100 100 100 100 100 100 100 200 80 80 80 80 80 80 80 80 80 1080
IRR
PROB 14-12b
-950
100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100
-950
10.61%
1000
100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 100 1100
IRR
116
-1000
90
90
90
90
90
130
130
130
130
10
900
-900
130
1000
CF
-1000
90
90
90
90
90
130
130
130
0.1051 = 10.51%IRR
Claim
$5 million
5 million
10 million
4 million
10 million
34 million
Received
5 million
5 million
10 million
0
0
20 million
14-20.
a) Call Premium paid
New Bond Underwriting Costs
Total incremental Cash Outflow
$60,000,000 X .04 =
$60,000,000 X .03 =
$2,400,000
$1,800,000
$4,200,000
117
130
1130
118
14-21.
Aurora Glass Fibers Lease-Buy Analysis
Part a, the buy option:
Assumptions:
Cost of new computers
Expected Life
Salvage value
Amount to be borrowed
Interest rate on loan
$800,000
4 years
$100,000
$800,000
10%
MACRS Depreciation:
(3-year asset class)
Yr 1
33.3%
Cost of capital
Tax rate
Yr 2
44.5%
Yr 3
14.8%
Yr 4
7.4%
0
($800,000)
800,000
($266,400)
106,560
(80,000)
32,000
($356,000)
142,400
(80,000)
32,000
($118,400)
47,360
(80,000)
32,000
$58,560
$55,245
$94,400
$84,016
($640)
($537)
($59,200)
23,680
(80,000)
32,000
(800,000)
100,000
(40,000)
($764,320)
($605,413)
($466,689)
$0
$0
3
($200,000)
$80,000
($120,000)
($100,754)
4
($200,000)
$80,000
($120,000)
($95,051)
($415,813)
$0
$0
119
1
($200,000)
$80,000
($120,000)
($113,208)
2
($200,000)
$80,000
($120,000)
($106,800)
($466,689)
($415,813)
$50,877
Decision:
120
Lease
Chapter 15 Solutions
What are some of the government requirements imposed on a public corporation that are not imposed
on a private, closely held corporation?
Public corporations must submit audited financial statements to the government for release to the
public. Private corporations can keep their financial information confidential.
2.
How are the members of the board of directors of a corporation chosen and to whom do these board
members owe their primary allegiance?
Members of a corporations board of directors are elected by the common stockholders and owe their
allegiance to these stockholders
3.
What are the advantages and the disadvantages of a new stock issue?
A new stock issue raises funds and decreases the riskiness of the firm. It also tends to send a
negative signal to the market since many investors believe a company would only sell new stock if
future financial prospects were dim.
4.
What does an investment banker do when underwriting a new security issue for a corporation?
When underwriting a new security issue an investment banker buys it and then resells it to investors.
5.
6.
Explain why warrants are rarely exercised unless the time to maturity is small?
Warrants are rarely exercised until the time to expiration is small because the market price of the
warrant is greater than the exercise value. The holder of the warrant would therefore sell it in the
secondary market instead of exercising it if he or she wanted to cash in.
7.
121
A warrants value would be high when the stock price, time to expiration, and/or expected stock
price volatility are high.
15-2.
Ms. Phinlay should buy the stock as the share is selling at a price ($20) which is lower than what she is
prepared to pay ($40) to get her required rate of return.
15-3.
a) .45(2,500,000) = 1,125,000
[(1,125,000 - 1) X (5 + 1)] / 2,500,000 = 2.669
2 directors
b) .55(2,500,000) = 1,375,000
[(1,375,000 1) X (5 + 1)] / 2,500,000 = 3.299
3 directors
15-4.
15-5.
15-6.
15-7.
122
15-8.
NUM VOTING SHARES NEEDED = [(1 X 200,000)/(7 + 1)] + 1 = 25,001. Since Ms. O'Niel holds
more shares than required, she can elect herself to the board.
15-9.
15-11. N = 2,000,000/500,000 = 4
Approx. Market Value of a Right = R = (65 - 55)/(4 + 1) = $2
15-12. Market Price of stocks selling ex-rights = 65 - 2 = $63
Approx. Market Value of a Right = R = (63 - 55)/(4) = $2
15-13. N = 7
Approx. Market Value of a Right = R = (77 - 65)/(7 + 1) = $1.50
Market Price of stocks selling ex-rights = 77 - 1.5 = $75.50
15-14. a) Approx. Market Value of a Right = R = (72 - 60)/(4 + 1) = $2.40
b) Maximum number of new shares that Johnny can buy = 700/4 = 175
c) Amount Johnny would spend = 175 X 60 = $10,500
d) Selling price of all of Johnny's rights = 700 X 2.40= $1,680
123
= $2.40 X 60 = $144.00
= 60 X $47.68 = $2,860.80
= $750.00
15-19.
Issue of new common stock by Wilkerson Corporation:
Current Market Price per share of Common Stock
Number of Common Shares outstanding
Amount of additional funds needed
Net Income for the year
Number of shares owned by Guy Hamilton
$40
600,000
$2,000,000
$1,000,000
10,000
$36
a.
b.
c.
124
$33
$29
$26
$1.67
$1.51
$1.67
$1.49
$1.67
$1.48
Chapter 16 Solutions
Explain the role of cash and of earnings when a corporation is deciding how much, if any, cash
dividends to pay to common stockholders.
In the long-run earnings are necessary to maintain dividend payments, but at the time an actual
dividend payment is made, adequate cash is necessary.
2.
Are there any legal factors that could restrict a corporation in its attempt to pay cash dividends to
common stockholders? Explain.
A firm may be legally restricted as to the dividends it can pay by existing bond indentures or loan
agreements. It may also be restricted as to the payment of common stock dividends is scheduled
preferred stock dividends have not been paid.
3.
What are some of the factors that common stockholders consider when deciding how much, if any,
cash dividends they desire from the corporation in which they have invested?
Common stockholders would consider the companys investment opportunity, their need for income,
and their tax bracket when deciding on their desire for dividends.
4.
5.
Do you believe an increased common stock cash dividend can send a signal to the common
stockholders? If so, what signal might it send?
An increase in cash dividends is often seen as a positive signal. A company would be unlikely to
increase its dividend if it did not believe its future prospects were good enough to sustain the higher
level of dividends. This is because the market usually frowns upon a cut in dividends.
6.
125
7.
What is the effect of stock (not cash) dividends and stock splits on the market price of common
stock? Why do corporations declare stock splits and stock dividends?
Stock splits and stock dividends decrease the price per share of the common stock but should not
increase the total market value of all common stock outstanding unless other positive things are
perceived to occur. Many companies believe that a stock split or stock dividend makes their stock
more affordable and therefore more attractive to a wider range of potential investors.
16-2.
16-3.
$1,000,000
750,000
$250,000
$800,000
250,000
$550,000
16-4.
Net income
Dividend Payout (35%)
Addition to retained earnings
$4,000,000
1,400,000
$2,600,000
$1,200,000
2,600,000
$3,800,000
16-5.
(Figures in $ millions) Year 1 Year 2 Year 3
Net Income
30
20
25
Dividend Payout ratio 0.3
0.3
0.3
Dividend Paid
9
6
7.5
Addition to RE
21
14
17.5
Total Addition to RE = 21 + 14 + 17.5 = 52.5
126
16-6.
(Figures in $ millions) Year 1 Year 2
Net Income
30
20
Dividend Paid
10
10
Dividend Payout ratio 0.33
0.5
Addition to RE
20
10
Total Addition to RE = 20 + 10 + 15 = 45
16-7.
Year 3
25
10
0.4
15
16-9.
= 400 thousand
= $400
= 400 X $30 = $12,000
This increase is greater than the Retained Earnings of $10,000. Hence it is not possible to pay a 20%
stock dividend.
10% Stock Dividend($000s)
Increase in number of shares = 0.1 X $2 million = 200 thousand
Increase in common stock account = 200 X $1 = $200
Increase in capital in excess of par account = 200 X $30 = $6,000
Total increase = $6,000 + $200 = $6,200
This increase can be covered by a matching decrease in the retained earning account keeping the total
equity capital unchanged. The new retained earning will be 10,000 - 6,200 = $3,800. Hence it is
possible to pay a 10% stock dividend.
127
16-11.
($000s)
2,000
8,000
10,000
20,000
($000s)
2,200
14,000
3,800
20,000
New Market Price of the Stock = $31 X 2,000/2,200 = $28.18 per share.
16-12. a) 800,000 X (1 + 0.30) = 1,040,000 new total shares
1,040,000 800,000 = 240,000 new shares
b) CIEP = Capital in Excess of Par
CIEPbefore = $13,600,000
CIEPafter = $13,600,000 + (240,000 new shares X ($40 - $3))
CIEPafter = $22,480,000
c) CS = Common Stock
CSbefore = 800,000 X $3 = $2,400,000
CSafter = 1,040,000 X $3 = $3,120,000
RE = Retained Earnings
REbefore = $60,000,000
REafter = $60,000,000 ($3,120,000 - $2,400,000) ($22,480,000 - 13,600,000)
REafter = $50,400,000
16-13. 800,000 X $40 = $32,000,000
x = new stock price
1,040,000 x = $32,000,000
New stock price = $30.77
16-14. Before the stock split
Common Stock ( 3 million shares, $1.00 par)
Capital in excess of par
Retained Earnings
Total Common Equity
128
3,000
7,000
10,000
20,000
3,000
7,000
10,000
20,000
16-18.
Spring Field Manufacturing Company's Dividend Payments:
NUMBER OF SHARES OF COMMON STOCK OUTSTANDING =
NUMBER OF SHARES OF COMMON STOCK OWNED BY YOU =
YEAR
NET
INCOME
2013
2014
2015
2016
2017
$1,000,000
$1,100,000
$1,200,000
$1,300,000
$1,400,000
CAPITAL
INVESTMENTS
$800,000
$480,000
$1,000,000
$600,000
$2,000,000 $1,200,000
$800,000
$480,000
$1,000,000
$600,000
129
500,000
500
$520,000
$500,000
$0
$820,000
$800,000
$1.04
$1.00
$0.00
$1.64
$1.60
$520
$500
$0
$820
$800
16-19.
Spring Field
Payments:
Manufacturing
Company's
Dividend
YEAR
NET
INCOME
2013 $1,000,000
2014 $1,100,000
2015 $1,200,000
2016 $1,300,000
2017 $1,400,000
CAPITAL
INVESTMENTS
$800,000
$1,000,000
$2,000,000
$800,000
$1,000,000
EQUITY
FINANCING
$480,000
$600,000
$1,200,000
$480,000
$600,000
AMOUNT
FROM
NEW
SHARES
500
NO. OF
SHARES
DIVIDEND DIVIDEND DIVIDEND
OUTSTANDING PAYMENT
PER
RECEIVED
SHARE
500,000
500,000
600,000
600,000
600,000
$600,000
$520,000
$500,000
$600,000
$820,000
$800,000
$1.04
$1.00
$1.00
$1.37
$1.33
$520
$500
$500
$683
$667
b)
c)
= $3,000,000/$50 = 60,000
($ 000s)
1,500
3,500
5,000
10,000
($ 000s)
1,320
3,080
5,600
10,000
d) If net income next year is expected to be $4 million, what would be the EPS next year with and
without the repurchase?
EPS (without repurchase) = $4,000,000/500,000 = $8
EPS (with repurchase) = $4,000,000/440,000 = $9.09
e) If you own 50 shares of common stock of the company, would you like the company's decision of
buying back the stocks instead of paying a dividend?
Without Repurchase:
Dividend Earning Last Year = $3/Share X 50 shares = $ 150
Value of stock = $47/share X 50 shares
= $2,350
Total
= $2,500
130
With Repurchase:
Price of stock = $50/share X 500/440 = $56.82 per share
Value of stock = $56.82 X 50 = $2,841.00
The decision to buy back instead of paying a dividend would be preferred if the stock price were to
increase to $56.82 per share with the repurchase. The taxes that may be owed on the $150 in dividends
under the no repurchase scenario would decrease further the attractiveness of this alternative.
300,000
$1,200,000
$4
$1,500,000
$10,000,000
$12,700,000
1,200,000
$1,200,000
$1
$1,500,000
$10,000,000
$12,700,000
131
Chapter 17 Solutions
2.
What is the primary advantage to a corporation of investing some of its funds in working capital?
By investing in working capital a firm gets the liquidity it needs helping it to pay its bills. The risk of
the firm is therefore reduced.
3.
4.
5.
What are the risks associated with using a large amount of short-term financing for working capital?
Using a large amount of short-term financing generally allows funds to be raised at a lower cost but
increases the firms risk.
6.
What is the matching principle of working capital financing? What are the benefits of following this
principle?
The matching principle is when short-term financing is used for temporary current assets while longterm financing is used for permanent current assets and fixed assets. The main benefit of this
approach is that as temporary current assets are sold off the proceeds can be used to pay off the shortterm debt.
7.
What are the advantages and disadvantages of the aggressive working capital financing approach?
An aggressive working capital financing approach usually results in a lower cost of funds for a firm
but a higher level of risk.
132
8.
What is the most conservative type of working capital financing plan a company could implement?
Explain.
An all equity capital structure would be the most conservative type of working capital financing plan
approach. The more long-term financing used the more conservative the financing plan, and equity
is permanent financing.
17-2.
Firm 1:
$10,000 + $3,000 + $2,500 = $15,500 (working capital)
$15,500 - $7,500 - $4,000 = $4,000 (net working capital)
Current ratio = $15,500 / ($7,500 + $4,000) = 1.35
Quick ratio = ($15,500 - $3,000) / $11,500 = 1.09
Firm 2:
$8,000 + $6,000 + $3,500 = $17,500 (working capital)
$17,500 - $3,500 - $11,000 = $3,000 (net working capital)
Current ratio = $17,500 / ($3,500 + $11,000) = 1.21
Quick ratio = ($17,500 - $6,000) / $14,500 = 0.79
Firm 1 is more liquid due to its higher liquidity ratios.
17-3.
17-4.
a)
b)
c)
d)
160/(175 X .5) or 183.86% of TCA is financed by CL. This is an aggressive approach since
all TCA and most of PCA are being financed with riskier short-term funds.
133
17-5.
17-6.
a)
b)
c)
d)
a)
b)
c)
All of LuLu Belles current assets, and some of the fixed assets, are financed with short-term
funds (current liabilities). This is an aggressive approach.
d)
Reduce short-term debt, increase long-term debt and equity and invest in marketable
securities. This will increase net working capital and the current ratio.
17-7.
Cash
$100,000
Inventory
$200,000
Accounts Receivable
$150,000
Net Fixed Assets
$550,000
Total Assets
$1,000,000
Accounts Payable
$35,000
Notes Payable
$60,000
Long-term Debt
$505,000
Common Equity
$ 400,000
Total Liabilities and Equity $1,000,000
Permanent assets, net fixed assets and a small portion of temporary assets are financed with long-term debt
and equity. This is using a very conservative approach. Your exact numbers are likely to be different, but
the point is that long-term debt and equity financing are emphasized.
17-8.
$50,000
25,000
150,000
475,000
$700,000
Accounts Payable__$40,000_
Notes Payable ___50,000_
Long-term Debt __410,000_
Common Equity __ 200,000_
134
b)
Cash
Accounts Receivable
Inventory
Fixed Assets
17-9.
$50,000
25,000
150,000
475,000
$700,000
Accounts Payable__$30,000_
Notes Payable ___60,000_
Long-term Debt __185,000_
Common Equity __425,000_
17-10.
17-11.
NWC = CA - CL
$25,000 = ($30,000 + $15,000 + $130,000) - ($20,000 + Short-Term Debt)
Short-Term Debt = $175,000 - $25,000 - $20,000 = $130,000
Long-Term Debt = $675,000 - $450,000 - $130,000 - $20,000 = $75,000
17-12.
AGG.(A)(HIGH
RISK)
MOD.(M)(MOD.
RISK)
CON.(C)(LOW
RISK)
Temporary CA
75
75
75
Permanent CA
100
100
100
Fixed Assets
500
500
500
Total Assets
675
675
675
Current Liabilities
160
75
50
90
150
150
Stockholders' Equity
425
450
475
COMMENTS
Net Income
70
70
70
NWC
15
100
125
Current Ratio
1.09
2.33
3.50
Debt to Asset
0.37
0.33
0.30
ROE
16.47%
15.56%
14.74%
135
$45
$46
$34
$48
$40
$30
$28
$39
$45
$39
$52
$50
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$14
$17
$18
$6
$20
$12
$2
$0
$11
$17
$11
$24
$22
$17
$18
$6
$20
$12
$2
$0
$11
$17
$11
$24
$22
$20
$10
Fixed Assets
$0
31Jan
30Apr
31May
30Jun
31Jul
136
31Oct
17-15.
Working Capital Trends
$60
Temporary Current Assets
$55
$50
$45
$40
Fixed Assets
$35
$30
Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct
MONTH/ YEAR
b) Sep. of year 4:
TA= $52.04
TCA= $4.00
PCA= $9.04
FA= $39.00
Aug. of year 5:
TA= $54.80
TCA= $5.00
PCA= $10.80
FA= $39.00
c) Sep. of year 4:
(i) aggressive approach
CL = over $4.00
LT Financing = the remainder of $52.04
(ii) moderate approach
CL = $4.00
LT Financing = $48.04
(iii) conservative approach
CL = less than $4.00
LT Financing = the remainder of $52.04
Aug. of year 5:
(i) aggressive approach
CL = over $5.00
LT Financing = the remainder of $54.80
(ii) moderate approach
CL = $5.00
LT Financing = $49.80
(iii) conservative approach
CL = less than $5.00
LT Financing = the remainder of $54.80
137
17-16.
Working Capital Trends
$120
$110
$100
$90
$80
$70
$60
$50
$40
May
Sep
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
Jan
May
Sep
MONTH/ YEAR
17-16.
b) Sep. of year 2:
TA = $89.00
TCA = $18.00
PCA = $16.00
FA = $55.00
Oct. of year 4:
TA = $101.00
TCA = $22.50
PCA = $23.50
FA = $55.00
138
Chapter 18 Solutions
2.
Explain the factors affecting the choice of a minimum cash balance amount.
The minimum cash balance amount is determined by how easy it is to raise funds when needed, how
predictable the cash flows are, and how risk averse managers are.
3.
What are the negative consequences of a company holding too much cash?
A company holding too much cash would be giving up the opportunity to invest more in income
producing assets
4.
Explain the factors affecting the choice of a maximum cash balance amount.
The maximum cash balance amount is determined by available investment opportunities, the
expected return on investments, and the transaction cost of making investments.
5.
What is the difference between pro forma financial statements and a cash budget? Explain why pro
forma financial statements are not used to forecast cash needs.
Pro forma income statements deal with revenues and expenses that are not always cash flows while
cash budgets deal only with projected cash inflows and outflows.
6.
What are the benefits of collecting early and how do companies attempt to do this?
Money has time value. The sooner cash is collected, the better. Companies use regional collection
centers and lock boxes to facilitate this.
7.
What are the benefits of paying late (but not too late) and how do companies attempt to do this?
Because money has time value, the later cash is paid, but not too late, the better. Companies use
remote disbursement banks to facilitate holding onto funds longer.
139
8.
Refer to the Bulldog battery companys cash budget in Table 18-7. Explain why the company would
probably not issue $1 million worth of new common stock in January to avoid all short-term
borrowing during the year.
Common stock financing is long-term financing so it would probably not be used to meet this shortterm financing need.
Z=3
3 X TC X V
+L
4r
OR
Z=3
3 X $40 X $39,000
+ $2,200
4 X .03/365
Z=3
3 X TC X V
+L
4r
OR
Z=3
3 X $40 X $52,000
+ $3,900
4 X .03/365
18-4.
Z = 8,976,265,866 + $15,000
Z = $2,078.25 + $15,000
Z = $17,078.25
18-5.
H = (3 X $17,078.25) (2 X $15,000)
H = $51,234.75 $30,000
H = $21,234.75
141
18-6.
Lifelong Appliances Cash Collections
Given:
20% of customers pay off their accounts in month of sale
70% of customers pay off their accounts in first month following sale
10% of customers pay off their accounts in second month following sale
2012 --->
Nov
Sales ($000s)
2013 --->
Jan
Dec
$131
$129
20011 --->
Jan
Feb
$133 $139 $143 $191 $226 $242 $224 $184 $173 $166 $143
$136 $139
Feb
$126
Mar
Jul
Dec
2013 --->
Jan
Cash collections:
in month of sale
first month after sale
second month after sale
Total monthly cash collections
Feb
$25
90
13
$129
Mar
Jul
2011 --->
Jan
Feb
$27
$28 $29 $38 $45 $48 $45 $37 $35 $33 $29
88
93
97 100 134 158 169 157 129 121 116
13
13
13 14 14 19 23 24 22 18 17
$128 $134 $139 $152 $193 $226 $237 $218 $186 $173 $162
18-7.
Lifelong Appliances Cash Collections with Stricter Credit Terms
Given:
40% of customers pay off their accounts in month of sale
55% of customers pay off their accounts in first month following sale
5% of customers pay off their accounts in second month following sale
2012 --->
Nov
Sales ($000s)
$131
Dec
$129
2013 --->
Jan
$126
Feb
$133
2011 --->
Jan
Feb
$139 $143 $191 $226 $242 $224 $184 $173 $166 $143
$136 $139
Mar
Jul
2013 --->
Dec
Jan
$50
71
7
$128
Feb
$53
69
6
$129
Mar
Jul
$56 $57 $76 $90 $97 $90 $74 $69 $66 $57
73
76 79 105 124 133 123 101 95 91
6
7
7
7 10 11 12 11
9
9
$135 $140 $162 $203 $231 $234 $209 $182 $171 $157
142
2011 --->
Jan
Feb
18-8.
18-9.
18-10.
Lifelong Appliances Cash Expenditures
Given:
2012 --->
Nov
Sales ($000s)
2013 --->
Dec
$131
Jan
$129
Dec
Materials purchasing Schedule: Order materials
Feb
$126
Jul
2011 --->
Aug Sep Oct Nov Dec Jan Feb
$133 $139 $143 $191 $226 $242 $224 $184 $173 $166 $143 $136 $139
Jan
Feb
Mar
Manufacture Appliances Sell appliances Repeat each month
Cost of materials =
30% of sales
Payment for materials one month after purchase
Production costs other than purchases =
Selling and marketing Expenses =
General and Administrative Expenses =
Interest Payments =
Tax payments =
Dividend payments =
80%
19%
$11
$31
$100
$50
of purchases
of sales
thousand each month
thousand, paid in December
thousand, paid in 4 installments in April, June, September, and December
thousand each, paid in June and December
143
2013 --->
Dec
Materials Purchases
(reference only; not a cash flow)
Payments for materials purchases:
Other cash payments:
Production costs other than purchases
Selling and marketing Expenses
General and Administrative Expenses
Interest Payments
Tax payments
Dividend payments
Total Cash Outflows
Jan
$40
Feb
Jul
2011 --->
Aug Sep Oct Nov Dec Jan Feb
$42
$43 $57 $68 $73 $67 $55 $52 $50 $43 $41 $42
$40
$42 $43 $57 $68 $73 $67 $55 $52 $50 $43 $41
$33
$24
$11
$34 $46 $54 $58 $54 $44 $42 $40 $34 $33 $33
$25 $26 $27 $36 $43 $46 $43 $35 $33 $32 $27
$11 $11 $11 $11 $11 $11 $11 $11 $11 $11 $11
$31
$25
$25
$25
$25
$50
$50
$112 $126 $175 $173 $255 $168 $150 $163 $128 $118 $218
$108
18-11.
Lifelong Appliances Cash Expenditures, Revised
Given:
2012 --->
Nov
Sales ($000s)
2013 --->
Dec
$131
Jan
$129
Dec
Materials purchasing Schedule: Order materials
Cost of materials =
Feb
$126
Jul
2011 --->
Aug Sep Oct Nov Dec Jan Feb
$133 $139 $143 $191 $226 $242 $224 $184 $173 $166 $143 $136 $139
Jan
Feb
Mar
Manufacture Appliances Sell appliances Repeat each month
30% of sales
80%
19%
$11
$31
$100
$50
of purchases
of sales
thousand each month
thousand, paid in December
thousand, paid in 4 installments in April, June, September, and December
thousand each, paid in June and December
144
2013 --->
Dec
Materials Purchases
(reference only; not a cash flow)
Payments for materials purchases:
in month of purchase
in month following month of purchase
Other cash payments:
Production costs other than purchases
Selling and marketing Expenses
General and Administrative Expenses
Interest Payments
Tax payments
Dividend payments
Total Cash Outflows
Jan
$40
Feb
Jul
2011 --->
Aug Sep Oct Nov Dec Jan Feb
$42
$43 $57 $68 $73 $67 $55 $52 $50 $43 $41 $42
$13
$28
$13 $17 $20 $22 $20 $17 $16 $15 $13 $12 $13
$29 $30 $40 $47 $51 $47 $39 $36 $35 $30 $29
$33
$24
$11
$34 $46 $54 $58 $54 $44 $42 $40 $34 $33 $33
$25 $26 $27 $36 $43 $46 $43 $35 $33 $32 $27
$11 $11 $11 $11 $11 $11 $11 $11 $11 $11 $11
$31
$25
$25
$25
$25
$50
$50
$113 $130 $178 $175 $254 $165 $149 $162 $126 $117 $219
$109
18-12.
Fit-and-Forget Fittings Cash Budget
Given:
Sales:
2012 --->
Nov
Sales ($000s)
$2,266
Dec
$2,230
2013 --->
Jan
Feb
$2,116
$2,300
Mar
$2,402
Apr
Feb
Sell
Products
Jun
Jul
Aug
Sep
Oct
Nov
Dec
Jan
2011 --->
Feb
$2,420 $3,390 $3,909 $4,164 $3,933 $3,163 $2,912 $2,886 $2,424 $2,353 $2,442
Collections:
Dec
Materials purchasing Order
Schedule: materials
May
Mar
Repeat each
month
Cost of materials
20% of sales
=
Payment schedule for materials:
20% paid in cash in month of purchase
80% paid in cash in month following month of purchase
145
14%
16%
$180
$500
$1,600
$855
(in $000s)
2012 ---> 2013 --->
Nov Dec
Jan
Feb
Mar
Cash collections:
in month of sale
first month after sale
second month after sale
Total monthly cash collections
Cash Outflows:
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
2011 --->
Jan Feb
Materials Purchases
(reference only; not a cash flow)
Payments for materials purchases:
in month of purchase
in month following month of purchase
Other cash payments:
Production costs other than purchases
Selling and marketing Expenses
General and Administrative Expenses
Interest Payments
Tax payments
Dividend payments
Total Cash Outflows
$460
of purchases
of sales
thousand each month
thousand, paid in December
thousand, paid in 4 installments in April, June, September, and December
thousand each, paid in June and December
Apr
May
Jun
Jul
Aug
Sep
Oct
Nov
Dec
$480
$484
$678
$782
$833
$787
$633
$582
$577
$485
$471
$488
$96
$368
$97
$384
$136
$387
$156
$542
$167
$625
$157
$666
$127
$629
$116
$506
$115
$466
$97
$462
$94
$388
$98
$376
$67
$339
$180
$68
$368
$180
$95
$384
$180
$109
$387
$180
$117
$542
$180
$110
$625
$180
$89
$666
$180
$82
$629
$180
$81
$506
$180
$68
$466
$180
$66
$462
$180
$68
$388
$180
$500
$400
$400
$400
$400
$855
$855
$1,050 $1,097 $1,182 $1,775 $1,631 $2,994 $1,691 $1,513 $1,748 $1,273 $1,190 $2,865
$1,148 $1,080 $1,139
$627 $1,079
($117)
Apr
Jun
Dec
(in $000s)
Jan
Feb
Mar
May
Jul
Aug
Sep
Oct
Nov
$1,133 $2,281 $3,361 $4,500 $5,127 $6,206 $6,709 $8,978 $11,547 $13,512 $15,366 $17,093
1,148 1,080 1,139
627 1,079
503 2,269 2,569 1,965 1,854 1,727
(117)
2,281 3,361 4,500 5,127 6,206 6,709 8,978 11,547 13,512 15,366 17,093 16,976
1,110 1,110 1,110 1,110 1,110 1,110 1,110 1,110 1,110 1,110 1,110 1,110
$1,171 $2,251 $3,390 $4,017 $5,096 $5,599 $7,868 $10,437 $12,402 $14,256 $15,983 $15,866
146
2011 --->
Jan Feb
(in $000s)
$0
0
$0
0
$0
0
$0
0
$0
0
$0
0
$0
0
$0
0
$0
0
$0
0
$0
0
$0
0
10. Cash balance at end of month after financing $2,281 $3,361 $4,500 $5,127 $6,206 $6,709 $8,978 $11,547 $13,512 $15,366 $17,093 $16,976
147
Chapter 19 Solutions
Accounts receivable are sometimes not collected. Why do companies extend trade credit when they
could insist on cash for all sales?
Extending trade credit almost always leads to more sales. If the incremental cashflows, including the
investment in accounts receivable give a positive NPV, the decision to extend trade credit would
increase the value of the firm.
2.
3.
What are the primary variables being balanced in the EOQ inventory model? Explain
The primary variables being balanced in the EOQ model are carrying costs and ordering costs. The
more frequent orders are placed the lower the firms carrying costs and the higher its ordering costs.
4.
5.
What are the primary requirements for a successful JIT inventory control system?
For a JIT system to be successful the supplier must be willing and able to deliver materials
immediately and the quality of delivered materials must be high.
6.
Can a company have a default rate on its accounts receivable that is too low? Explain.
A company could have a default rate on AR that would be considered too low if by liberalizing credit
terms a significant increase in sales revenue and cash inflows were to result. If the increase in the
default rate is more than offset by the increase in sales revenue, after all incremental cash flows are
considered a positive NPV could result.
7.
How does accounts receivable factoring work? What are the benefits to the two parties involved?
What are the risks?
148
Factoring is when one firm sells accounts receivable (AR) to another. The purchasing firm is called
a factor. The factor makes a profit by purchasing the AR at a discount. Its risk is that some of the
AR may default. The selling firm gets the cash it needs.
19-5.
19-6.
149
2/15, n40
2/15, n60
$350,000
20%
increase
2%
3%
of sales
of sales
7%
10%
40%
11%
80% of sales
$10,000 under old credit policy
Question a:
Average collection period under old policy
Average collection period under new policy
Accounts Receivable under old policy
Accounts Receivable under new policy
Question b:
East-West Trading Company Financial Statements
INCOME STATEMENT
With old
With new
credit
credit
terms:
terms:
2/15, n40 2/15, n60
(given) (pro forma)
Sales (all on credit)
Cost of Goods Sold
Gross Profit
Bad debt expenses
Other operating expenses
Operating Income
Interest Expense
Before-Tax Income
Income Taxes
Net Income
$350,000
280,000
70,000
7,000
10,000
53,000
5,450
47,550
19,020
$28,530
$420,000
$336,000
84,000
12,600
$12,000
59,400
5,940
53,460
21,384
$32,076
20% increase
increase in proportion with sales
from assumptions
increase in proportion with sales
(ST Debt X ST Cost of Debt) + (LT Debt X LT Cost of Debt)
150
$15,000
29,918
50,000
94,918
120,000
$214,918
$18,000
49,710
60,000
127,710
120,000
$247,710
$14,918
35,000
49,918
30,000
79,918
25,000
60,000
50,000
135,000
$214,918
$17,902
$42,000
59,902
30,000
89,902
25,000
60,000
50,000
135,000
$224,902
AFN to balance:
same
same
same
same
same
Question c:
Incremental cash flows associated with the credit policy change
Initial investment at T-0
$70,000
$56,000
$5,600
$2,000
$490
$2,364
$66,454
per year
151
11%
19-8.
Given:
All sales on credit
Old credit terms
New credit terms
2/15, n40
2/15, n60
$350,000
20%
increase
2%
4%
of sales
of sales
7%
10%
40%
11%
80% of sales
$10,000 under old credit policy
Question a:
Average collection period under old policy
Average collection period under new policy
Accounts Receivable under old policy
Accounts Receivable under new policy
Question b:
East-West Company Financial Statements
INCOME STATEMENT
With old
With new
credit
credit
terms:
terms:
2/15, n40 2/15, n60
(given) (pro forma)
Sales (all on credit)
Cost of Goods Sold
Gross Profit
Bad debt expenses
Other operating expenses
Operating Income
Interest Expense
Before-Tax Income
Income Taxes
$350,000
280,000
70,000
7,000
10,000
53,000
5,450
$420,000
$336,000
84,000
16,800
$12,000
55,200
5,940
47,550
19,020
49,260
19,704
152
20% increase
increase in proportion with sales
from assumptions
increase in proportion with sales
(ST Debt X ST Cost of Debt) +
(LT Debt X LT Cost of Debt)
Net Income
$28,530
$29,556
$15,000
29,918
50,000
94,918
120,000
$214,918
$14,918
35,000
49,918
30,000
79,918
25,000
60,000
50,000
135,000
$214,918
$17,902
$42,000
59,902
30,000
89,902
25,000
60,000
50,000
135,000
$224,902
AFN to balance:
Question c:
Incremental cash flows associated with the credit policy change
Initial investment at T-0
($31,208) AFN
$70,000
$56,000
$9,800
$2,000
$490
$684
$68,974
$1,026
per year
153
3/10, n40
3/15, n30
$2,000,000
-10%
decrease
10 days
40 days
100 days
15 days
30 days
100 days
3%
1%
of sales
of sales
8%
11%
40%
13%
80% of sales
$60,000 under old credit policy
Question a:
Average collection period under old policy
Average collection period under new policy
Accounts Receivable under old policy
Accounts Receivable under new policy
Question b:
A-Z Trading Company Financial Statements
INCOME STATEMENT
With old
With new
credit
credit
terms:
terms:
3/10, n40 3/15, n30
(given) (pro forma)
Sales (all on credit)
Cost of Goods Sold
Gross Profit
Bad debt expenses
Other operating expenses
Operating Income
Interest Expense
Before-Tax Income
Income Taxes
Net Income
154
Question c:
Incremental cash flows associated with the credit policy change
Initial investment at T-0
$91,271
($200,000)
($160,000)
($42,000)
($6,000)
($1,600)
$3,840
($205,760)
$91,271
NPV =
155
= 12.91 units
Points
Score
156
4
3
2
1
0
___4____
_______
_______
_______
_______
4
3
2
1
0
___4____
_______
_______
_______
_______
Net Income
Greater $100,000
$75,000-$100,000
$50,000-$75,000
$25,000-$50,000
Less than $25,000
4
3
2
1
0
_______
_______
___2____
_______
_______
Total Score: 10
$1,200,000 X 0.30 = $360,000
Yes, they will be approved. TWI will be approved for $360,000.
19-16.
Sunrise Corporation Inventory Policy
Given:
Present inventory level
Proposed inventory level
60
100
350
450
15
23
$4,583
$36,000
$40,583
157
17
26
$5,196
$60,000
$65,196
Question b:
Sunrise Company Financial Statements
INCOME STATEMENT
Under old inventory
policy
60 units
(given)
$55,000
105,000
480,000
640,000
100,000
$740,000 $1,105,714
$100,000
95,000
195,000
65,000
260,000
60,000
220,000
200,000
480,000
$740,000
AFN to balance:
128,571
122,143
250,714
65,000
315,714
60,000
220,000
200,000
480,000
$795,714
$310,000
Question c:
Incremental cash flows associated with the credit policy change
Initial investment at T-0
($310,000) AFN
158
Increase in Sales
Outflows:
Increase in Cost of Goods Sold
Increase in Inventory Expense
Increase in Other Operating Exps
Increase in Interest Expense
Increase in Taxes
Total Outflows
$1,000,000
$800,000
$24,614
$28,571
$1,900
$57,966
$913,051
($310,000)
NPV =
$86,949
per year
11%
19-17.
Given:
Present inventory level
Proposed inventory level
60
90
350
390
Question a:
Under old inventory policy Under new inventory policy
60 units
90 units
E.O.Q
Number of orders per year
Ordering cost
Carrying cost
Total inventory cost
15
23
$4,583
$36,000
$40,583
159
16
24
$4,837
$54,000
$58,837
Question b:
Sunrise Company Financial Statements
INCOME STATEMENT
Under old inventory policy
60 units
(given)
Sales (all on credit)
Cost of Goods Sold
Gross Profit
Inventory costs
Other operating expenses
Operating Income
Interest Expense
Before-Tax Income
Income Taxes
Net Income
$3,500,000
2,800,000
700,000
40,583
100,000
559,417
13,150
$3,900,000
3,120,000
780,000
58,837
111,429
609,734
13,910
546,267
218,507
$327,760
595,824
238,330
$357,494
$236,000
Question c:
Incremental cash flows associated with the credit policy change
Initial investment at T-0
($236,000) AFN
$400,000
$320,000
160
$18,255
$11,429
$760
$19,823
$370,266
19-18.
Given:
Inventory Level in Units
Present inventory level
Proposed inventory level (1)
Proposed inventory level (2)
Proposed inventory level (3)
70
80
90
100
Expected Sales
340
375
390
400
Ordering cost
Carrying cost
$16,000
$12,800
7%
11%
40%
13%
80% of sales
$130,000 under current inventory policy
Question a:
Under old inventory
policy
70 units
E.O.Q
Number of orders per
year
Ordering cost
Carrying cost
Total inventory cost
16
21
17
22
18
22
18
22
$3,298
$28,000
$31,298
$3,464
$32,000
$35,464
$3,533
$36,000
$39,533
$3,578
$40,000
$43,578
161
Question b:
Windermere Corporation
INCOME STATEMENT
Under old inventory
policy
70 units
(given)
Sales (all on credit)
Cost of Goods Sold
Gross Profit
Inventory costs
Other operating
expenses
Operating Income
Interest Expense
Before-Tax Income
Income Taxes
Net Income
$5,440,000
4,352,000
1,088,000
31,298
130,000
$6,000,000
4,800,000
1,200,000
35,464
143,382
$6,240,000
4,992,000
1,248,000
39,533
149,118
$6,400,000
5,120,000
1,280,000
43,578
152,941
926,702
13,800
912,902
365,161
$547,741
1,021,154
14,485
1,006,669
402,668
$604,001
1,059,350
14,778
1,044,572
417,829
$626,743
1,083,481
14,974
1,068,508
427,403
$641,105
$125,324
$252,176
76,471
134,118
1,280,000
1,490,588
113,000
$1,603,588
129,412
111,765
241,176
65,000
306,176
80,000
320,000
518,000
918,000
$1,224,176
$379,412
Question c:
Incremental cash flows associated with the credit policy changes
Under new inventory policy Under new inventory policy
Under new inventory policy (3)
(1)
(2)
80 units
90 units
100 units
Initial investment at T-0
($125,324)
162
$560,000
$800,000 $960,000
$448,000
$640,000 $768,000
$4,166
$13,382
$8,234
$19,118
$685
$37,507
$503,740
$12,279
$22,941
$978
$1,174
$52,668
$62,242
$720,998 $866,636
$56,260
$79,002
($125,324)
($252,176)
($379,412)
$56,260
$79,002
$93,364
NPV
at a cost of capital of
13%
$307,449
$355,532
$338,770
Comments: All three proposed inventory policy changes have positive NPVs, and would therefore
be acceptable at the firm's cost of capital of 13%. Policy #2, inventory level of 90 units, has the
highest NPV, so it should be the alternative selected.
163
Chapter 20 Solutions
Companies with rapidly growing levels of sales do not need to worry about raising funds from
outside the firm. Do you agree or disagree with this statement? Explain.
Disagree. Rapidly growing firms need more assets to accommodate the increasing sales. Such firms
are more likely, not less, to seek outside financing. Internal funds are often insufficient.
2.
3.
What are compensating balances and why do banks require them from some customers? Under what
circumstances would banks be most likely to impose compensating balances?
Compensating balances are funds that a bank requires a customer to maintain in a non-interest
bearing account until the loan is retired. Banks sometimes impose compensating balance
requirements so as to increase the banks return on a loan. Compensating balances are most likely to
be used when the stated interest rate on a loan is below the banks required rate of return.
4.
5.
What is trustworthy collateral from the lenders perspective? Explain whether accounts receivable
and inventory are trustworthy collateral.
Assets that are readily marketable, of stable value, and not likely to disappear make for trustworthy
collateral. Accounts receivable and inventory could meet this test depending upon their particular
characteristics.
6.
Trade credit is free credit. Do you agree or disagree with this statement? Explain.
Trade credit is not free. It has a cost. Who bears that cost depends on the terms of the transaction
between the grantor and the recipient of the trade credit.
164
7.
What are the pros and cons of commercial paper relative to bank loans for a company seeking shortterm financing?
Commercial paper is usually a cheaper source of short-term financing for a firm, compared to bank
loans. Also, a larger amount of funds can often be raised by issuing commercial paper. Bank loans
are usually a more flexible source of short-term financing and establishing an on-going business
relationship with a bank may prove beneficial when money is tight.
20-2.
20-3.
9%
$1,600
8.70%
$1500
$2,000
8.33%
(i) Which alternative is best for Ralph from minimum effective interest rate point of view?
Alternative c
(ii)
20-4.
20-5.
165
20-6.
20-7.
20-8.
20-9.
a) 3/10, n 60
b) 2/15, n 30
Re-calculate the costs assuming payments were made on the 40th day in each of the above cases. Compare
your results.
a) 3/10, n 60
b) 2/15, n 30
20-14. a)
b)
c)
d)
166
167
Chapter 21 Solutions
What does it mean when the U.S. dollar weakens in the foreign exchange market?
When the U.S. dollar weakens in the foreign exchange market one U.S. dollar buys fewer units of
another countrys currency. It costs more U.S. dollars to buy a given quantity of another countrys
currency.
2.
What kinds of U.S. companies would benefit most from a stronger dollar in the foreign exchange
market? Explain.
U.S. companies that import goods from other countries would benefit from a stronger dollar. More
units of a foreign currency could be purchased for a given number of dollars. Other things equal, this
would lower the cost of foreign goods for the U.S. importer.
3.
Under what circumstance would the U.S. dollar and the Canadian dollar be said to have achieved
purchasing power parity?
The U.S. dollar and the Canadian dollar would be considered to have achieved purchasing power
parity when the exchange rate reflects the relative prices of a market basket of traded goods and
services at the current exchange rate. There would be no incentive to convert U.S. dollars to
Canadian dollars nor to convert Canadian dollars to U.S. dollars and purchase goods or services in
the other country.
4.
What are some of the primary advantages when a corporation has operations in countries other than
its home country? What are some of the risks?
Foreign operations may reduce a companys labor or material costs, and may increase its sales.
Risks include possible seizure of company assets by a foreign government, possible cultural blunders
that lead to lost sales, and exchange rate risks.
5.
168
a) British pound
b) Indian rupee
c) Japanese yen
d) Australian dollar
e) Mexican peso
f) Israeli shekel
1,000,000/1.5616
1/.017778
1/.012475
1/1.0054
1/.0721
1/.2570
=
=
=
=
=
=
640,369
Rs56.249 million
80.160 million
A$994.629 thousand
Peso 13.869 million
Shekel 3.891 million
21-2.
a) Chilean pesos
1/.001992
b) HK dollars
1/.1289
c) Singaporean dollars
1/.7833
d) euros
1,000,000/1.2558
e) Indian rupees
1/.017778
f) Mexican pesos
1/.0721
g)Thai baht
1/.0315
=
=
=
=
=
=
=
21-3.
2 X 1.0054
1.6 X 0.7833
5 X 1.2558
2.6 X 0.0721
2 X 0.012475
25 X 0.0135
=
=
=
=
=
=
$2,010,800
$1,253,280
$6,279,000
$187,460
$24,950
$337,500
21-4.
a) 1.2558
b) (1) $100,000 X 80.16032064 = 8,016,032
(2) $100,000 X 0.640368852 = 64,037
(3) $100,000 X 1.025956705 = 102,596
(4) $100,000 X 13.86962552 = 1,386,963
21-5.
21-6.
21-7.
21-8.
21-9.
If one British pound is equivalent to 1.5 euros, and one euro can purchase 60 baht, how many baht
can one purchase with 1 million British pounds?
1 British pound = 1.5 euros = 60 X 1.5 = 90 baht
1 million British pounds = 90 million baht
21-10. British pound = 1.5 euros; .8 X 1.5 euros = 1.2 dinars; 1.2 dinars X 160 yen
= 192 yen;
1 million British pounds = 192 million yen
$100,000
$100,000 X 119/100 = $119,000
($119,000 - $100,000)/$100,000 = 19%
170