Essentials of Corporate Finance (Mcgraw-hill/Irwin Series in Finance, Insurance, and Real Estate) 9th Edition Solution Manual

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Solutions ManualEssentials of Corporate FinanceRoss, Westerfield, and Jordan9thedition01/03/2016Prepared byBrad JordanUniversity of KentuckyJoe SmoliraBelmont University

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CHAPTER 1INTRODUCTION TO CORPORATEFINANCEAnswers to Concepts Review and Critical Thinking Questions1.Capital budgeting (deciding on whether to expand a manufacturing plant),capital structure (decidingwhether to issue new equity and use the proceeds to retire outstanding debt), and working capitalmanagement (modifying the firm’s credit collection policy with its customers).2.Disadvantages: unlimited liability,limited life, difficulty in transferring ownership, hard to raisecapital funds. Some advantages: simpler, less regulation, the owners are also the managers, sometimespersonal tax rates are better than corporate tax rates.3.The primary disadvantage of the corporate form is the double taxation to shareholders of distributedearnings and dividends. Some advantages include: limited liability, ease of transferability, ability toraise capital, and unlimited life.4.The treasurer’s office and the controller’s office are the two primary organizational groups that reportdirectly to the chief financial officer. The controller’s office handles cost and financial accounting, taxmanagement, and management information systems. The treasurer’s office is responsible for cash andcredit management, capital budgeting, and financial planning. Therefore, the study of corporatefinance is concentrated within the functions of the treasurer’s office.5.To maximize the current market value (share price) of the equity of the firm (whether it’s publiclytraded or not).6.In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders electthe directors of the corporation, who in turn appoint the firm’s management. This separation ofownership from control in the corporate form of organization is what causes agency problems to exist.Management may act in its own or someone else’s best interests, rather than those of the shareholders.If such events occur, they may contradict the goal of maximizing the share price of the equity of thefirm.7.A primary market transaction.8.In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) tobuy and sell their assets. Dealer markets like NASDAQ represent dealers operating in dispersed localeswho buy and sell assets themselves, usually communicating with other dealers electronically orliterally over the counter.9.Since such organizations frequently pursue social or political missions, many different goals areconceivable. One goal that is often cited is revenue minimization; i.e., providing their goods and

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CHAPTER 1–2services to society at the lowest possible cost. Another approach might be to observe that even a not-for-profit business has equity. Thus, an appropriate goal would be to maximize the value of the equity.10.An argument can be made either way. At one extreme, we could argue that in a market economy, allof these things are priced. This implies an optimal level of ethical and/or illegal behavior and theframework of stock valuation explicitly includes these. At the other extreme, we could argue that theseare non-economic phenomena and are best handled through the political process. The following is aclassic (and highly relevant) thought question that illustrates this debate: “A firm has estimated thatthecost of improving the safety of one of its products is $30 million. However, the firm believes thatimproving the safety of the product will only save $20 million in product liability claims. What shouldthe firm do?”11.The goal will be the same, but the best course of action toward that goal may require adjustments duetodifferent social, political, and economic climates.12.The goal of management should be to maximize the share price for thecurrent shareholders. Ifmanagement believes that it can improve the profitability of the firm so that the share price will exceed$35, then they should fight the offer from the outside company. If management believes that this bidderor other unidentifiedbidders will actually pay more than $35 per share to acquire the company, thenthey should still fight the offer. However, if the current management cannot increase the value of thefirm beyond the bid price, and no other higher bids come in, then management is not acting in theinterests of the shareholders by fighting the offer. Since current managers often lose their jobs whenthe corporation is acquired, poorly monitored managers have an incentive to fight corporate takeoversin situations such as this.13.We would expect agency problems to be less severe in other countries, primarily due to the relativelysmall percentage of individual ownership. Fewer individual owners should reduce the number ofdiverse opinions concerning corporate goals. Thehigh percentage of institutional ownership mightlead to a higher degree of agreement between owners and managers on decisions concerning riskyprojects. In addition, institutions may be able to implement more effective monitoring mechanismsthan can individual owners, giveninstitutions’ deeper resources and experiences with their ownmanagement. The increase in institutional ownership of stock in the United States and the growingactivism of these large shareholder groups may lead to a reduction in agencyproblems for U.S.corporations and a more efficient market for corporate control.14.How much is too much? Who is worth more,Michael Fries or LeBron James? The simplest answer isthat there is a market for executives just as there is for all types of labor. Executive compensation isthe price that clears the market. The same is true for athletes and performers. Having said that, oneaspect of executive compensation deserves comment. A primary reason executive compensation hasgrown so dramatically is that companies have increasingly moved to stock-based compensation. Suchmovement is obviously consistent with the attempt to better align stockholder and managementinterests. In recent years, stock prices have soared, so management has cleaned up. It is sometimesargued that much of this reward is simply due to rising stock prices in general, not managerialperformance. Perhaps in the future, executive compensation will be designed to reward onlydifferential performance, i.e., stock price increases in excess of general market increases.

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3–SOLUTIONS MANUAL15.The biggest reason that a company would “go dark” is because of the increased audit costs associatedwith Sarbanes-Oxley compliance. A company should always do a cost-benefit analysis, and it may bethe case that the costs of complying with Sarbox outweighthe benefits. Of course, the company couldalways be trying to hide financial issues of the company! This is also one of the costs of going dark:Investors surely believe that some companies are going dark to avoid the increased scrutiny fromSarbox.This taints other companies that go dark just to avoid compliance costs. This is similar to thelemon problem with used automobiles: Buyers tend to underpay because they know a certainpercentage of used cars are lemons. So, investors will tend to pay lessfor the company stock than theyotherwise would. It is important to note that even if the company delists, its stock is still likely traded,but on the over-the-counter market pink sheets rather than on an organized exchange. This addsanother cost sincethe stock is likely to be less liquid now. All else the same, investors pay less for anasset with less liquidity. Overall, the cost to the company is likely a reduced market value. Whetherdelisting is good or bad for investors depends on the individual circumstances of the company. It isalso important to remember that there are already many small companies that file only limited financialinformation.

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CHAPTER 2WORKING WITH FINANCIALSTATEMENTSAnswers to Concepts Review and Critical Thinking Questions1.Liquidity measures how quickly and easily an asset can be converted to cash without significant lossin value. It’s desirable for firms to havehigh liquidity so that they can more safely meet short-termcreditor demands. However, liquidity also has an opportunity cost. Firms generally reap higher returnsby investing in illiquid, productive assets. It’s up to the firm’s financial management staffto find areasonable compromise between these opposing needs.2.The recognition and matching principles in financial accounting call for revenues, and the costsassociated with producing those revenues, to be “booked” when the revenue process is essentiallycomplete, not necessarily when the cash is collected or billsare paid. Note that this way is notnecessarily correct; it’s the way accountants have chosen to do it.3.Historical costs can be objectively and precisely measured, whereas market values can be difficult toestimate, and different analysts would come up with different numbers. Thus, there is a tradeoffbetween relevance (market values) and objectivity (bookvalues).4.Depreciation is a non-cash deduction that reflects adjustments made in asset book values in accordancewith the matching principle in financial accounting. Interest expense is a cash outlay, but it’s afinancing cost, not an operating cost.5.Market values can never be negative. Imagine a share of stock selling for–$20. This would mean thatif you placed an order for 100 shares, you would get the stock along with a check for $2,000. Howmany shares do you want to buy? More generally, becauseof corporate and individual bankruptcylaws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceedassets in market value.6.For a successful company that is rapidly expanding, capital outlays would typically be large, possiblyleading to negative cash flow from assets. In general, what matters is whether the money is spentwisely, not whether cash flow from assets is positiveor negative.7.It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-up, so it depends.8.For example, if acompany were to become more efficient in inventory management, the amount ofinventory needed would decline. The same might be true if it becomes better at collecting itsreceivables. In general, anything that leads to a decline in ending NWC relative to beginning NWCwould have this effect. Negative net capital spending would mean more long-lived assets wereliquidated than purchased.

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5–SOLUTIONS MANUAL9.If a company raises more money from selling stock than it pays in dividends in a particular period, itscash flow to stockholders will be negative. If a company borrows more than it pays in interest, its cashflow to creditors will be negative.10.The adjustments discussed were purely accounting changes; they had no cash flow or market valueconsequences unless thenew accounting information caused stockholders to revalue the company.Solutions to Questions and ProblemsNOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiplesteps. Due to space and readability constraints, when these intermediate steps are included in this solutionsmanual, rounding may appear to have occurred. However, the final answer for each problem is foundwithout rounding during any step in the problem.Basic1.The balance sheet for the company will look like this:Balance sheetCurrent assets$2,030Current liabilities$1,640Net fixed assets9,780Long-term debt4,490Owners’ equity5,680Total assets$11,810Total liabilities and owners’equity$11,810The owners’ equity is a plug variable. We know that total assets must equal total liabilities and owners’equity. Total liabilities and owners’ equity is the sum of all debt and equity, so if we subtract debtfrom totalliabilities and owners’ equity, the remainder must be the equity balance, so:Owners’ equity = Total liabilities and owners’ equity–Current liabilities–Long-term debtOwners’ equity = $11,810–1,640–4,490Owners’ equity = $5,680Net working capital is current assets minus current liabilities, so:NWC =Current assets–Current liabilitiesNWC = $2,030–1,640NWC = $390

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CHAPTER2–62.The income statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract outinterest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get:Income StatementSales$634,000Costs328,000Depreciation73,000EBIT$233,000Interest38,000Taxable income$195,000Taxes68,250Net income$126,7503.The dividends paid plus the addition to retained earnings must equal net income, so:Net income = Dividends + Addition to retained earningsAddition to retained earnings = $126,750–43,000Addition to retained earnings = $83,7504.Earnings per share is the net income divided by the shares outstanding, so:EPS = Net income / Shares outstandingEPS = $126,750/35,000EPS = $3.62per shareAnd dividends per share are the total dividends paid divided by the shares outstanding, so:DPS = Dividends / Shares outstandingDPS = $43,000 /35,000DPS = $1.23 pershare5.Using Table 2.3, we can see the marginal tax schedule. The first $50,000 of income is taxed at 15percent, the next$25,000 is taxed at 25 percent, the next $25,000 is taxed at 34 percent, and the next$143,000 is taxed at 39 percent. So, the total taxes for the company will be:Taxes =.15($50,000) +.25($25,000) +.34($25,000) +.39($243,000–100,000)Taxes = $78,0206.The average tax rate is the total taxes paid divided by taxable income, so:Average tax rate = Total tax /TaxableincomeAverage tax rate = $78,020/ $243,000Average tax rate = .3211, or 32.11%The marginal tax rate is the tax rate on the next dollar of income. The company has net income of$243,000 and the 39 percent tax bracket is applicable to a net income up to $335,000, so the marginaltax rate is 39 percent.

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7–SOLUTIONS MANUAL7.To calculate the OCF, we first need to construct an income statement. The income statement startswith revenues and subtracts costs to arrive at EBIT. We then subtract out interest to get taxable income,and then subtract taxes to arrive at net income. Doing so, we get:Income StatementSales$38,530Costs12,750Depreciation2,550EBIT$23,230Interest1,850Taxable income$21,380Taxes (35%)7,483Net income$13.897Now we can calculate the OCF, which is:OCF = EBIT + Depreciation–TaxesOCF = $23,230+ 2,550–7,483OCF = $18,2978.Net capital spending is the increase in fixed assets, plus depreciation. Using this relationship, we find:Net capital spending = NFAend–NFAbeg+ DepreciationNet capital spending = $2,134,000–1,975,000 + 325,000Net capital spending = $484,0009.The change in net working capital is the end of period net working capital minus the beginning ofperiod net working capital, so:Change in NWC = NWCend–NWCbegChange in NWC = (CAend–CLend)–(CAbeg–CLbeg)Change in NWC = ($1,685–1,305)–(1,530–1,270)Change in NWC = $12010.The cash flow to creditors is the interest paid, minus any net new borrowing, so:Cash flow to creditors = Interest paid–Net new borrowingCash flow to creditors = Interest paid–(LTDend–LTDbeg)Cash flow to creditors = $102,800–($1,551,000–1,410,000)Cash flow to creditors =–$38,20011.The cash flow to stockholders is the dividends paid minus any new equity raised. So, the cash flow tostockholders is: (Note that APIS is theadditional paid-in surplus.)Cash flow to stockholders = Dividends paid–Net new equityCash flow to stockholders = Dividends paid–[(Commonend+ APISend)–(Commonbeg+ APISbeg)]Cash flow to stockholders = $148,500–[($148,000 + 2,618,000)–($130,000 + 2,332,000)]Cash flow to stockholders =–$155,50012.We know that cash flow from assets is equal to cash flow to creditors plus cash flow to stockholders.So, cash flow from assets is:

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CHAPTER2–8Cash flow from assets = Cash flow to creditors + Cash flow to stockholdersCash flow from assets =–$38,200–155,500Cash flow from assets =–$193,700We also know that cash flow from assets is equal to the operating cash flow minus the change in networking capital and the net capital spending. We can use this relationship to find the operating cashflow. Doing so, we find:Cash flow from assets = OCF–Change in NWC–Net capital spending–$193,700= OCF–(–$115,000)–(705,000)OCF =–$193,700–115,000 +705,000OCF = $396,300Intermediate13.To find the book value of current assets, we use: NWC = CA–CL. Rearranging to solve for currentassets, we get:CA = NWC + CL = $220,000 + 850,000 = $1,070,000The market value of current assets and fixed assets is given, so:Book value CA= $1,070,000NWC= $1,050,000Book value NFA=$3,300,000Market value NFA=$4,800,000Book value assets=$4,370,000Total=$5,850,00014.a.To calculate the OCF, we first need to construct an income statement. The income statement startswith revenues and subtracts costs to arrive at EBIT. We thensubtract out interest to get taxableincome, and then subtract taxes to arrive at net income. Doing so, we get:Income StatementSales$173,000Costs91,400Other Expenses5,100Depreciation12,100EBIT$64,400Interest8,900Taxable income$55,500Taxes21,090Net income$34,410Dividends$9,700Addition to retained earnings24,710

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9–SOLUTIONS MANUALDividends paid plus addition to retained earnings must equal net income, so:Net income = Dividends + Addition to retained earningsAddition to retained earnings = $34,410–9,700Addition to retained earnings = $24,710So, the operating cash flow is:OCF = EBIT + Depreciation–TaxesOCF = $64,400 + 12,100–21,090OCF = $55,410b.The cash flow to creditors is the interest paid, minus any new borrowing. Since the companyredeemed long-term debt, the net new borrowing isnegative. So, the cash flow to creditors is:Cash flow to creditors = Interest paid–Net new borrowingCash flow to creditors = $8,900–(–$4,000)Cash flow to creditors = $12,900c.The cash flow to stockholders is the dividends paid minus any new equity. So, the cash flow tostockholders is:Cash flow to stockholders = Dividends paid–Net new equityCash flow to stockholders = $9,700–2,900Cash flow to stockholders = $6,800d.In this case, to find the addition to NWC, we need tofind the cash flow from assets. We can thenuse the cash flow from assets equation to find the change in NWC. We know that cash flow fromassets is equal to cash flow to creditors plus cash flow to stockholders. So, cash flow from assetsis:Cash flow from assets = Cash flow to creditors + Cash flow to stockholdersCash flow from assets = $12,900 + 6,800Cash flow from assets = $19,700Net capital spending is equal to depreciation plus the increase in fixed assets, so:Net capitalspending = Depreciation + Increase in fixed assetsNet capital spending = $12,100 + 23,140Net capital spending = $35,240Now we can use the cash flow from assets equation to find the change in NWC. Doing so, we find:Cash flow from assets = OCF–Change in NWC–Net capital spending$19,700 = $55,410–Change in NWC–$35,240Change in NWC = $470

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CHAPTER2–1015.Here we need to work the income statement backward. Starting with net income, we know that netincome is:Net income = Dividends + Addition to retained earningsNet income = $2,170+3,500Net income = $5,670Net income is also the taxable income, minus the taxable income times the tax rate, or:Net income = Taxable income–(Taxable income)(Tax rate)Net income = Taxable income(1–Tax rate)We can rearrange this equation and solve for the taxable income as:Taxable income = Net income / (1–Tax rate)Taxable income = $5,670/ (1–.40)Taxable income = $9,450EBIT minus interest equals taxableincome, so rearranging this relationship, we find:EBIT = Taxable income + InterestEBIT = $9,450+ 1,980EBIT = $11,430Now that we have the EBIT, we know that sales minus costs minus depreciation equals EBIT. Solvingthis equation for EBIT, we find:EBIT = Sales–Costs–Depreciation$11,430= $67,000–49,200–DepreciationDepreciation = $6,37016.We can fill in the balance sheet with the numbers we are given. The balance sheet will be:Balance SheetCash$197,000Accounts payable$288,000Accounts receivable265,000Notes payable194,000Inventory563,000Current liabilities$482,000Current assets$1,025,000Long-term debt1,490,000Total liabilities$2,072,000Tangible net fixed assets$5,150,000Intangible net fixed assets863,000Common stock??Accumulated retained earnings4,586,000Total assets$7,038,000Total liabilities & owners’ equity$7,038,000Total liabilities and owners’ equity is:TL & OE = CL + LTD + Common stock +Retained earnings

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11–SOLUTIONS MANUALSolving for this equation for common stock gives us:Common stock =$7,038,000–4,586,000–2,072,000Common stock=$380,00017.Owners’ equity is the maximum of total assets minus total liabilities, or zero. Although thebook valueof owners’ equity can be negative, the market value of owners’ equity cannot be negative, so:Owners’ equity = Max [(TA–TL), 0]a.If total assets are $9,300, the owners’ equity is:Owners’ equity = Max[($9,300–8,400), 0]Owners’ equity = $900b.If total assets are $6,900, the owners’ equity is:Owners’ equity = Max[($6,900–8,400), 0]Owners’ equity = $018.a.Using Table 2.3, we can see the marginal tax schedule. For Corporation Growth, the first $50,000of income istaxed at 15 percent, the next $25,000 is taxed at 25 percent, and the next $1,500 istaxed at 34 percent. So, the total taxes for the company will be:TaxesGrowth=.15($50,000) +.25($25,000) +.34($1,500)TaxesGrowth= $14,260ForCorporation Income, the first $50,000 of income is taxed at 15 percent, the next $25,000 istaxed at 25 percent, the next $25,000 is taxed at 34 percent, the next $235,000 is taxed at 39 percent,and the next $7,315,000 is taxed at 34 percent. So, the total taxes for the company will be:TaxesIncome=.15($50,000) +.25($25,000) +.34($25,000) +.39($235,000)+.34($7,315,000)TaxesIncome= $2,601,000b.The marginal tax rate is the tax rate on the next $1 of earnings. Each firm has a marginal tax rateof 34% on the next $10,000 of taxable income, despite their different average tax rates, so bothfirms will pay an additional $3,400 in taxes.

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CHAPTER2–1219.a.The income statement starts with revenues and subtracts costs to arrive at EBIT. We then subtractinterest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get:Income StatementSales$2,350,000Cost of goods sold1,925,000Adminexpenses530,000Depreciation420,000EBIT$105,000Interest245,000Taxable income–$140,000Taxes (35%)0Net income–$140,000The taxes are zero since we are ignoring any carryback or carryforward provisions.b.The operating cash flow for the year was:OCF = EBIT +Depreciation–TaxesOCF = $105,000 +420,000–0OCF = $525,000c.Net income was negative because of the tax deductibility of depreciation and interest expense.However, the actual cash flow from operations was positive because depreciation is a non-cashexpense and interest is a financing, not an operating, expense.20.A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficientcash flow to make the dividend payments. The assumptions made in the question are:Change in NWC = Net capital spending = Net new equity = 0To find the new long-term debt, we first need to find the cash flow from assets. The cash flow fromassets is:Cash flow from assets = OCF–Change in NWC–Net capital spendingCash flow from assets = $525,000–0–0Cash flow from assets = $525,000We can also find the cash flow to stockholders, which is:Cash flow to stockholders = Dividends–Net new equityCash flow to stockholders = $395,000–0Cash flow to stockholders = $395,000Now we can use the cash flow from assets equation to find the cash flow to creditors. Doing so, weget:Cash flow from assets = Cash flow to creditors + Cash flow to stockholders$525,000 = Cash flow to creditors + $395,000Cash flow to creditors = $130,000

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13–SOLUTIONS MANUALNow we can use the cash flow to creditors equation to find:Cash flow to creditors = Interest–Net new long-term debt$130,000 = $245,000–Net new long-term debtNet new long-term debt = $115,00021.a.To calculate the OCF, we first need to construct an income statement. The income statement startswith revenues and subtracts costs to arrive at EBIT. We then subtract out interest to get taxableincome, and then subtract taxes to arrive at net income. Doing so, we get:Income StatementSales$28,476Cost of goods sold20,136Depreciation3,408EBIT$ 4,932Interest497Taxable income$4,435Taxes (40%)1,774Net income$ 2,661b.Theoperating cash flow for the year was:OCF = EBIT + Depreciation–TaxesOCF = $4,932+3,408–1,774OCF= $6,566c.To calculate the cash flow from assets, we also need the change in net working capital and netcapital spending. The change in net working capital was:Change in NWC = NWCend–NWCbegChange in NWC = (CAend–CLend)–(CAbeg–CLbeg)Change in NWC = ($4,234–2,981)–($3,528–3,110)Change in NWC = $835And the net capital spending was:Net capital spending = NFAend–NFAbeg+ DepreciationNet capital spending = $22,608–19,872+3,408Net capital spending = $6,144So, the cash flow from assets was:Cash flow from assets = OCF–Change in NWC–Net capital spendingCash flow from assets = $6,566–835–6,144Cash flow from assets =–$413The cash flow from assets can be positive or negative, since it represents whether the firm raisedfunds or distributed funds on a net basis. In this problem, even though net income and OCF arepositive, the firm invested heavily in fixed assets and net working capital; it had to raise a net $413in funds from its stockholders and creditors to make these investments.

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CHAPTER2–14d.The cash flow to creditors was:Cash flow to creditors = Interest–Net new LTDCash flow to creditors = $497–0Cash flow to creditors = $497Rearranging the cash flow from assets equation, we can calculate the cash flow to stockholders as:Cash flow from assets = Cash flow to stockholders + Cash flow to creditors–$413= Cash flow to stockholders + $497Cash flow to stockholders =–$910Now we can use the cash flow to stockholders equation to find the net new equity as:Cash flow to stockholders = Dividends–Net new equity–$910= $739–Net new equityNet new equity = $1,649The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow fromoperations. The firm invested $835in new net working capital and $6,144in new fixed assets. Thefirm had to raise $413from its stakeholders to support this new investment. It accomplished thisby raising $1,649in the form of new equity. After paying out $739in the form of dividends toshareholders and $497in the form of interest to creditors, $413was left to just meet the firm’s cashflow needs for investment.22.a.To calculate owners’ equity, we first need total liabilities and owners’ equity. From the balancesheet relationship we know that this is equal to total assets. We are given the necessary informationto calculate total assets. Total assets are current assets plus fixed assets, so:Total assets = Current assets + Fixed assets = Total liabilities and owners’ equityFor 2015, we get:Total assets = $2,718+ 12,602Total assets = $15,320Now, we can solve for owners’ equity as:Total liabilities and owners’ equity = Current liabilities + Long-term debt + Owners’ equity$15,320= $1,174+6,873+ Owners’ equityOwners’ equity = $7,273For 2016, we get:Total assets = $2,881+13,175Total assets = $16,056

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15–SOLUTIONS MANUALNow we can solve for owners’ equity as:Total liabilities and owners’ equity = Current liabilities + Long-term debt + Owners’ equity$16,056= $1,726+8,019+ Owners’ equityOwners’ equity = $6,311b.The change in net working capital was:Change in NWC = NWCend–NWCbegChange in NWC = (CAend–CLend)–(CAbeg–CLbeg)Change in NWC = ($2,881–1,726)–($2,718–1,174)Change in NWC =–$389c.To find the amount of fixed assets thecompany sold, we need to find the net capital spending. Thenet capital spending was:Net capital spending = NFAend–NFAbeg+ DepreciationNet capital spending = $13,175–12,602+3,434Net capital spending = $4,007To find the fixed assets sold, we can also calculate net capital spending as:Net capital spending = Fixed assets bought–Fixed assets sold$4,007= $7,160–Fixed assets soldFixed assets sold = $3,153To calculate the cash flow from assets, we first need to calculate the operating cash flow. For theoperating cash flow, we need the income statement. So, the income statement for the year is:Income StatementSales$40,664Costs20,393Depreciation3,434EBIT$16,837Interest638Taxable income$16,199Taxes (40%)6,480Net income$9,719Now we can calculate the operating cashflow, whichis:OCF = EBIT + Depreciation–TaxesOCF = $16,837+3,434–6,480OCF= $13,791And the cash flow from assets is:Cash flow from assets = OCF–Change in NWC–Net capital spending.Cash flow from assets = $13,791–(–$389)–4,007Cash flow from assets = $10,173

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CHAPTER2–16d.To find the cash flow to creditors, we first need to find thenet new borrowing. The net newborrowing is the difference between the ending long-term debt and the beginning long-term debt,so:Net new borrowing = LTDEnding–LTDBeginnningNet new borrowing = $8,019–6,873Net new borrowing = $1,146So, the cash flow to creditors is:Cash flow to creditors = Interest–Net new borrowingCash flow to creditors = $638–1,146Cash flow to creditors=–$508The net new borrowing is also the difference between the debt issued and the debt retired. We knowthe amount the company issued during the year, so we can find the amount the company retired.The amount of debt retired was:Net new borrowing = Debt issued–Debt retired$1,146= $2,155–Debt retiredDebt retired = $1,00923.To construct the cash flow identity, we will beginwithcash flow from assets. Cash flow from assetsis:Cash flow from assets = OCF–Change in NWC–Net capital spendingSo, the operating cash flow is:OCF = EBIT + Depreciation–TaxesOCF = $103,562+69,038–27,703OCF = $144,897Next, we will calculate the change in net working capital,which is:Change in NWC = NWCend–NWCbegChange in NWC = (CAend–CLend)–(CAbeg–CLbeg)Change in NWC = ($73,571–34,127)–($58,325–30,352)Change in NWC = $11,471Now, we can calculate the capital spending. The capital spending is:Net capital spending = NFAend–NFAbeg+ DepreciationNet capital spending = $513,980–435,670+69,038Net capital spending = $147,348Now,we have the cash flow from assets, which is:Cash flow from assets = OCF–Change in NWC–Net capital spendingCash flow from assets = $144,897–11,471–147,348Cash flow from assets =–$13,922

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17–SOLUTIONS MANUALThe company’s assets generated an outflow of $13,922. The cash flow from operations was $144,897,and the company spent $11,471on net working capital and $147,348on fixed assets.The cash flow to creditors is:Cash flow to creditors = Interest paid–New long-term debtCash flow to creditors = Interest paid–(Long-term debtend–Long-term debtbeg)Cash flow to creditors = $24,410–($192,300–173,100)Cash flow to creditors = $5,210The cash flow to stockholders is a little trickier in this problem. First, we need to calculate the newequity sold. The equity balance increased during the year. The only way to increase the equity balanceis retained earnings or sell equity. To calculate the new equity sold, we can use the following equation:New equity = Ending equity–Beginning equity–Addition to retained earningsNew equity = $361,124–290,543–35,249New equity = $35,332What happened was the equity account increased by $70,581. Of this increase, $35,249came fromaddition to retained earnings, so the remainder must have been the sale of new equity. Now we cancalculate the cash flow to stockholders as:Cash flow to stockholders = Dividends paid–Net new equityCash flow to stockholders = $16,200–35,332Cash flow to stockholders =–$19,132The company paid $5,210to creditors and raised $19,132from stockholders.Finally, the cash flow identity is:Cash flow from assets = Cash flow to creditors+ Cash flow to stockholders–$13,922=$5,210+–$19,132The cash flow identity balances, which is what we expect.Challenge24.Net capital spending= NFAend–NFAbeg+ Depreciation= (NFAend–NFAbeg) +(Depreciation + ADbeg)–ADbeg= (NFAend–NFAbeg)+ ADend–ADbeg= (NFAend+ ADend)–(NFAbeg+ ADbeg)= FAend–FAbeg25.a.The tax bubble causes average tax rates to catch up to marginal tax rates, thus eliminating the taxadvantage of low marginal rates forhigh-incomecorporations.

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CHAPTER2–18b.Taxes =.15($50K) +.25($25K) +.34($25K) +.39($235K) = $113.9KAverage tax rate = $113.9K / $335K = 34%The marginal tax rate on the next dollar of income is 34 percent.For corporate taxable income levels of $335K to $10M, average tax rates are equal to marginal taxrates.Taxes =.34($10M) +.35($5M) +.38($3.333M) = $6,416,667Average tax rate = $6,416,667 / $18,333,334 = 35%The marginal tax rate on the next dollar of income is 35 percent. For corporate taxable incomelevels over $18,333,334, average tax rates are again equal to marginal tax rates.c.At the end of the “tax bubble”, the marginal tax rate on the next dollar should equal the average taxrate on all preceding dollars. Since the upper threshold of the bubble bracket is now $200,000, themarginal tax rate on dollar $200,001should be 34 percent, and the total tax paid on the first$200,000 should be $200,000(.34). So, we get:Taxes= .34($200K) = $68K = .15($50K) + .25($25K) + .34($25K) + X($100K)X($100K)= $68K–22.25K = $45.75KX= $45.75K / $100KX= 45.75%

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CHAPTER 3WORKING WITH FINANCIALSTATEMENTSAnswers to Concepts Review and Critical Thinking Questions1.a.If inventory is purchased with cash, then there is no change in thecurrent ratio. If inventory ispurchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.b.Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.c.Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0.d.As long-term debt approaches maturity, the principal repayment and the remaining interestexpense become current liabilities. Thus, if debt is paid off with cash, the current ratio increasesif it was initially greater than 1.0. If the debt has not yet become a current liability, then paying itoff will reduce the current ratio since current liabilities are not affected.e.Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged.f.Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.g.Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the currentratio increases.2.The firm has increased inventory relative to other current assets; therefore, assuming current liabilitylevels remain mostly unchanged, liquidity has potentially decreased.3.A current ratio of .50 means that the firm hastwice as much in current liabilities as it does in currentassets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers forimmediate payment, the firm might have a difficult time meeting its obligations. A currentratio of1.50 means the firm has 50% more current assets than it does current liabilities. This probablyrepresents an improvement in liquidity; short-term obligations can generally be met completely witha safety factor built in. A current ratio of 15.0,however, might be excessive. Any excess funds sittingin current assets generally earn little or no return. These excess funds might be put to better use byinvesting in productive long-term assets or distributing the funds to shareholders.4.a.Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effectsof inventory, generally the least liquid of the firm’s current assets.b.Cash ratio represents the ability of the firm to completely pay off its current liabilities balance withits most liquid asset (cash).c.The capital intensity ratio tells us the dollar amount investment in assets needed to generate onedollar in sales.

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20–SOLUTIONSd.Total asset turnover measures how much in sales is generated by each dollar of firm assets.e.Equity multiplier represents the degree of leverage for an equity investor of the firm; it measuresthe dollar worth of firm assets each equity dollar has a claim to.f.Times interest earned ratio provides a relative measure of howwell the firm’s operating earningscan cover current interest obligations.g.Profit margin is the accounting measure of bottom-line profit per dollar of sales.h.Return on assets is a measure of bottom-line profit per dollar of total assets.i.Return on equity is a measure of bottom-line profit per dollar of equity.j.Price–earnings ratio reflects how much value per share the market places on a dollar of accountingearnings for a firm.5.Common size financial statements express all balance sheet accounts as a percentage of total assetsand all income statement accounts as a percentage of total sales. Using these percentage values ratherthan nominal dollar values facilitates comparisons between firms of different size or business type.6.Peer group analysis involves comparing the financial ratios and operating performance of a particularfirm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peersallows the financial manager to evaluate whether some aspects of the firm’s operations, finances, orinvestment activities are out of line with the norm, thereby providing some guidance on appropriateactions to take to adjust these ratios, if appropriate. An aspirant group would be a set of firms whoseperformance the company in question would like to emulate. The financial manager often uses thefinancial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluatedby how well they match the performance of an identified aspirant group.7.Return on equity is probably the most important accounting ratio that measures the bottom-lineperformance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes therole of a firm’s profitability, asset utilization efficiency, and financial leverage in achieving a ROEfigure. For example, a firm with ROE of 20% would seem to be doing well, but this figure may bemisleading if it were a marginally profitable (low profit margin) and highly levered (high equitymultiplier). Ifthe firm’s margins were to erode slightly, the ROE would be heavily impacted.8.The book-to-bill ratio is intended to measure whether demand is growing or falling. It is closelyfollowed because it is a barometer for the entire high-tech industry where levels of revenues andearnings have been relatively volatile.9.If a company is growing by opening new stores, then presumably total revenues would be rising.Comparing total sales at two different points in time might be misleading. Same-store sales control forthis by only looking at revenues of stores open within aspecific period.

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CHAPTER3–2110.a.For an electric utility such as Con Ed, expressing costs on a perkilowatt-hourbasis would be away of comparing costs with other utilities of different sizes.b.For a retailer such as JC Penney, expressing sales on a per square foot basis would be useful incomparing revenue production against other retailers.c.For an airline such as Delta, expressing costs on a per passenger mile basis allows forcomparisons with other airlines by examining how much it costs to fly one passenger one mile.d.For an on-line service such as Google or Yahoo!, using a per web hit basis for costs would allowfor comparisons with similar services.e.For a hospital such as Holy Cross, revenues and costs expressed on a per bed basis would beuseful.f.For a college textbook publisher such as McGraw-HillHigher Education, the leadingpublisherof finance textbooks for the college market, the obvious standardization would be per book sold.11.As with any ratio analysis, the ratios themselves do not necessarily indicate a problem, but simplyindicate that something is different and it is up to us to determine if a problem exists. If the cost ofgoods sold as a percentage of sales is increasing,we would expect that EBIT as a percentage of saleswould decrease, all else constant. An increase in the cost of goods sold as a percentage of sales occursbecause the cost of raw materials or other inventory is increasing at a faster rate than the sales price.This may be a bad sign since the contribution of each sales dollar to net income and cash flow is lower.However, when a new product, for example, the HDTV, enters the market, the price of one unit willoften be high relative to the cost of goods sold perunit, and demand, therefore sales, initially small.As the product market becomes more developed, price of the product generally drops, and salesincrease as more competition enters the market. In this case, the increase in cost of goods sold as apercentage of sales is to be expected. The maker or seller expects to boost sales at a faster rate than itscost of goods sold increases. In this case, a good practice would be to examine the common-sizeincome statements to see if this is an industry-wide occurrence.12.If we assume that the cause is negative, the two reasons for the trend of increasing cost of goods soldas a percentage of sales are that costs are becoming too high or the sales price is not increasing fastenough. If the cause is an increase in the cost of goods sold, the manager should look at possibleactions to control costs. If costs can be lowered by seeking lower cost suppliers of similar or higherquality, the cost of goods sold as a percentage of sales should decrease. Another alternative istoincrease the sales price to cover the increase in the cost of goods sold. Depending on the industry, thismay be difficult or impossible. For example, if the company sells most of its products under a long-term contract that has a fixed price, it may not be able to increase the sales price and will be forced tolook for other cost-cutting possibilities. Additionally, if the market is competitive, the company mightalso be unable to increase the sales price.

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22–SOLUTIONSSolutions to Questions and ProblemsNOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiplesteps. Due to space andreadability constraints, when these intermediate steps are included in this solutionsmanual, rounding may appear to have occurred. However, the final answer for each problem is foundwithout rounding during any step in the problem.Basic1.To find the current assets, we must use the net working capital equation. Doing so, we find:NWC = Current assets–Current liabilities$1,965= Current assets–$5,460Current assets = $7,425Now, use this number to calculate the current ratio and the quick ratio. The current ratio is:Current ratio = Current assets / Current liabilitiesCurrent ratio = $7,425/ $5,460Current ratio = 1.36timesAnd the quick ratio is:Quick ratio = (Current assets–Inventory) / Current liabilitiesQuick ratio = ($7,425–2,170) / $5,460Quick ratio = .96times2.To find the return on assets and return on equity, we need net income. We can calculate the net incomeusing the profit margin. Doing so, we find the net income is:Profit margin = Net income / Sales.07 = Net income / $13,500,000Net income = $945,000Now we can calculate the return on assets as:ROA = Net income / Total assetsROA = $945,000 / $8,700,000ROA = .1086, or 10.86%We do not have the equity for the company, but we know that equity must be equal to total assetsminus total debt, so the ROE is:ROE = Net income / (Total assets–Total debt)ROE = $945,000 / ($8,700,000–4,100,000)ROE = .2054, or20.54%

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CHAPTER3–233.The receivables turnover for the company was:Receivables turnover = Credit sales / ReceivablesReceivables turnover = $6,787,626/ $583,174Receivables turnover = 11.64timesUsing the receivables turnover, we can calculate the days’ sales in receivables as:Days’ sales in receivables = 365 days / Receivables turnoverDays’ sales in receivables = 365 days / 11.64Days’ sales in receivables = 31.36daysThe average collection period, which is the same as the days’ sales in receivables, was31.36days.4.The inventory turnover for the company was:Inventory turnover = COGS / InventoryInventory turnover = $8,543,132/ $527,156Inventory turnover = 16.21timesUsing the inventory turnover, we can calculate the days’ sales in inventory as:Days’ sales in inventory = 365 days / Inventory turnoverDays’ sales in inventory = 365 days / 16.21Days’ sales in inventory = 22.52daysOn average, a unit of inventory sat on the shelf 22.52days before it was sold.5.To find the debt–equityratio using the total debt ratio, we need to rearrange the total debt ratioequation. We must realize that the total assets are equal to total debt plus total equity. Doing so, wefind:Total debt ratio = Total debt / Total assets.19= Total debt / (Total debt + Total equity).81(Total debt) = .19(Total equity)Total debt / Total equity = .19/ .81Debt–equity ratio = .23And the equity multiplier is one plus the debt–equity ratio, so:Equity multiplier = 1 + D/EEquity multiplier = 1 + .23Equity multiplier = 1.23

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24–SOLUTIONS6.We need to calculate the net income before we calculate the earnings per share. The sum of dividendsand addition to retained earnings must equal net income, so net income must have been:Net income = Addition to retained earnings + DividendsNet income = $534,000 + 185,000Net income = $719,000So, the earnings per share were:EPS = Net income / Shares outstandingEPS = $719,000 /365,000EPS = $1.97per shareThe dividends per share were:Dividends per share = Total dividends / Shares outstandingDividends per share = $185,000 /365,000Dividends per share = $.51per shareThe book value per share was:Book value per share = Total equity / Shares outstandingBook value per share = $7,450,000 /365,000Book value per share = $20.41per shareThe market-to-book ratio is:Market-to-book ratio = Share price / Book value per shareMarket-to-book ratio = $49/ $20.41Market-to-book ratio =2.40timesThe PE ratio is:PE ratio = Share price / EPSPE ratio = $49/ $1.97PE ratio =24.87timesSales per share are:Sales per share = Total sales / Shares outstandingSales per share = $15,400,000 /365,000Sales per share = $42.19The P/S ratio is:P/S ratio = Share price / Sales per shareP/S ratio = $49/ $42.19P/S ratio = 1.16times

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CHAPTER3–257.With the information given, we must use the Du Pont identity to calculate return on equity. Doing so,we find:ROE = (Profit margin)(Total asset turnover)(Equity multiplier)ROE = (.052)(1.65)(1.83)ROE = .1570, or 15.70%8.We can use the Du Pont identity and solve for the equity multiplier. With the equity multiplier we canfind the debt–equity ratio. Doing so we find:ROE = (Profit margin)(Total asset turnover)(Equity multiplier).1720= (.076)(1.73)(Equity multiplier)Equity multiplier = 1.31Now, using the equation for the equity multiplier, we get:Equity multiplier = 1 + Debt–equity ratio1.31= 1 + Debt–equity ratioDebt–equity ratio = .319.To find the days’ sales in payables, we first need to find the payables turnover. The payables turnoverwas:Payables turnover = Cost of goods sold / Payables balancePayables turnover = $87,386/ $19,472Payables turnover = 4.49timesNow, we can use the payables turnover to find the days’ sales in payables as:Days’ sales in payables = 365 days / Payables turnoverDays’ sales in payables = 365 days / 4.49Days’ sales in payables =81.33daysThe company left its bills to suppliers outstanding for81.33days on average. A large value for thisratio could imply that either (1) the company is having liquidity problems, making it difficult to payoff its short-term obligations, or (2) that the company has successfully negotiated lenient credit termsfrom its suppliers.10.With the information provided, we need to calculate the return on equity using an extended return onequity equation. We first need to find the equity multiplier,which is:Equity multiplier = 1 + Debt–equity ratioEquity multiplier = 1 + .75Equity multiplier = 1.75

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26–SOLUTIONSNow we can calculate the return on equity as:ROE = (ROA)(Equity multiplier)ROE = .069(1.75)ROE = .1208, or 12.08%The return on equity equation weused was an abbreviated version of the Du Pont identity. If wemultiply the profit margin and total asset turnover ratios from the Du Pont identity, we get:(Net income / Sales)(Sales / Total assets) = Net income / Total assets = ROAWith the return on equity, we can calculate the net income as:ROE = Net income / Total equity.1208= Net income / $815,000Net income = $98,41111.To find the internal growth rate, we need the plowback, or retention, ratio. The plowback ratio is:b= 1–.25b= .75Now, we can use the internal growth rate equation to find:Internal growth rate = [(ROA)(b)] / [1–(ROA)(b)]Internal growth rate = [.072(.75)] / [1–.072(.75)]Internal growth rate = .0571, or5.71%12.To find the sustainable growth ratewe need the plowback, or retention, ratio. The plowback ratio is:b= 1–.20b= .80Now, we can use the sustainable growth rate equation to find:Sustainable growth rate = [(ROE)(b)] / [1–(ROE)(b)]Sustainable growth rate = [.168(.80)] / [1–.168(.80)]Sustainable growth rate = .1553, or 15.53%13.We need the return on equity to calculate the sustainable growth rate. To calculate return on equity,we need to realize that the total asset turnover is the inverse of the capital intensity ratio and the equitymultiplier is one plus the debt–equity ratio. So, the return on equity is:ROE = (Profit margin)(Total asset turnover)(Equity multiplier)ROE = (.081)(1/.45)(1 + .55)ROE = .2790, or 27.90%

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CHAPTER3–27Next we need the plowback ratio. Theplowback ratio is one minus the payout ratio. We can calculatethe payout ratio as the dividends divided by net income, so the plowback ratio is:b= 1–($65,000 / $120,000)b= .46Now we can use the sustainable growth rate equation to find:Sustainable growth rate = [(ROE)(b)] / [1–(ROE)(b)]Sustainable growth rate = [.2790(.46)] / [1–.2790(.46)]Sustainable growth rate = .1466, or 14.66%14.We need the return on equity to calculate the sustainable growth rate. Using the Du Pont identity, thereturn on equity is:ROE = (Profit margin)(Total asset turnover)(Equity multiplier)ROE = (.057)(2.80)(1.47)ROE = .2346, or23.46%To find the sustainable growth rate, we need the plowback, or retention, ratio. The plowback ratio is:b= 1–.55b= .45Now, we can use the sustainable growth rate equation to find:Sustainable growth rate = [(ROE)(b)] / [1–(ROE)(b)]Sustainable growth rate = [.2346(.45)] / [1–.2346(.45)]Sustainable growth rate = .1180, or11.80%15.To calculate the common-size balance sheet, we divide each asset account by total assets, and eachliability and equity account by total liabilities and equity. For example, the common-size cashpercentage for2015is:Cash percentage = Cash / Total assetsCash percentage = $19,256/ $880,664Cash percentage =.0219, or 2.19%

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28–SOLUTIONSRepeating this procedure for each account, we get:20152016AssetsCurrent assetsCash$19,2562.19%$21,9462.21%Accounts receivable46,3965.27%54,4865.50%Inventory109,62612.45%129,25313.04%Total$175,27819.90%$205,68520.76%Fixed assetsNet plant and equipment$705,38680.10%$785,20579.24%Total assets$880,664100%$990,890100%Liabilities and owners' equityCurrent liabilitiesAccounts payable$171,53119.48%$153,98415.54%Notes payable79,2189.00%107,60610.86%Total$250,74928.47%$261,59026.40%Long-term debt$255,00028.96%$278,50028.11%Owners' equityCommon stock and paid-insurplus$160,00018.17%$170,00017.16%Accumulated retained earnings214,91524.40%280,80028.34%Total$374,91542.57%$450,80045.49%Total liabilities and owners' equity$880,664100%$990,890100%16.a.The current ratio is calculated as:Curent ratio =Current assets / Current liabilitiesCurrent ratio2015= $175,278/ $250,749Current ratio2015= .70timesCurrent ratio2016= $205,685/ $261,590Current ratio2016= .79 times

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CHAPTER3–29b.The quick ratio is calculated as:Quick ratio = (Current assets–Inventory) / Current liabilitiesQuick ratio2015= ($175,278–109,626) / $250,749Quick ratio2015= .26timesQuick ratio2016= ($205,685–129,253) / $261,590Quick ratio2016= .29timesc.The cash ratio is calculated as:Cash ratio = Cash / Current liabilitiesCash ratio2015= $19,256/ $250,749Cash ratio2015= .08timesCash ratio2016= $21,946/ $261,590Cash ratio2016= .08timesd.The debt–equity ratio is calculated as:Debt–equity ratio = Total debt / Total equityDebt–equity ratio = (Current liabilities + Long-term debt) / Total equityDebt–equity ratio2015= ($250,749+255,000) / $374,915Debt–equity ratio2015= 1.35timesDebt–equity ratio2016= ($261,590+278,500) / $450,800Debt–equity ratio2016= 1.20timesAnd the equity multiplier is:Equity multiplier = 1 + Debt–equity ratioEquity multiplier2015= 1 + 1.35Equity multiplier2015= 2.35timesEquity multiplier2016= 1 + 1.20Equity multiplier2016= 2.20timese.The total debt ratio is calculated as:Total debt ratio = Total debt / TotalassetsTotal debt ratio = (Current liabilities + Long-term debt) / Total assetsTotal debt ratio2015= ($250,749+255,000) / $880,664Total debt ratio2015= .57times

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