Financial Management: Theory And Practice, 2nd Edition Solution Manual

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Answers and Solutions:1-1Chapter 1An Overview of Financial Managementand the Financial EnvironmentANSWERS TO END-OF-CHAPTER QUESTIONS1-1a.A proprietorship, or sole proprietorship, is a business owned by one individual.Apartnership exists when two or more persons associate to conduct a business.Incontrast, a corporation is a legal entity created by provincial and federal laws.Thecorporation is separate and distinct from its owners and managers.b.In a limited partnership, limited partners’ liabilities, investment returns and controlare limited, while general partners have unlimited liability and control.A limitedliability partnership’s (LLP), primary benefit is the protection it offers partners toliability exposure from their partner’s professional negligence.Individual partnersstill maintain unlimited liability to their own negligence or those they directlysupervise.A professional corporation (PC) has most of the benefits of incorporationbut the participants are not relieved of professional (malpractice) liability.c.Shareholder wealth maximization is the appropriate goal for management decisions.The risk and timing associated with expected earnings per share and cash flows areconsidered in order to maximize the price of the firm’s common stock.d.A money market is a financial market for debt securities with maturities of less thanone year (short-term).The New York money market is the world’s largest.Capitalmarkets are the financial markets for long-term debt and corporate stock.The NewYork Stock Exchange and Toronto Stock Exchange are examples of capital markets.Primary markets are the markets in which newly issued securities are sold for the firsttime.Secondary markets are where securities are resold after initial issue in theprimary market.The New York Stock Exchange and Toronto Stock Exchange aresecondary markets.

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Answers and Solutions:1-2e.In private markets, transactions are worked out directly between two parties andstructured in any manner that appeals to them. Bank loans and private placements ofdebt with insurance companies are examples of private market transactions. In publicmarkets, standardized contracts are traded on organized exchanges.Securities thatare issued in public markets, such as common stock and corporate bonds, areultimately held by a large number of individuals.Private market securities are moretailor-made but less liquid, whereas public market securities are more liquid butsubject to greater standardization.Derivatives are claims whose value depends onwhat happens to the value of some other asset. Futures and options are two importanttypes of derivatives, and their values depend on what happens to the prices of otherassets, say Tim Horton's shares, Japanese yen, or pork bellies. Therefore, the value ofa derivative security is derived from the value of an underlying real asset.f.An investment banker is a middleman between businesses and savers.Investmentbanks assist in the design of corporate securities and then sell them to savers(investors) in the primary markets.A financial intermediary buys securities withfunds that it obtains by issuing its own securities.An example is a common stockmutual fund that buys common shares with funds obtained by issuing shares in themutual fund.g.A mutual fund is a corporation that sells shares in a fund and uses the proceeds to buystocks, long-term bonds, or short-term debt instruments.The resulting dividends,interest,andcapitalgainsaredistributedtothefund’sshareholdersafterthededuction of operating expenses.Different funds are designed to meet differentobjectives.Money market funds are mutual funds that invest in short-term debtinstruments typically with maturity dates of less than one year.h.Production opportunities are the returns available within an economy from investmentin productive assets.The higher the production opportunities, the more producerswould be willing to pay for required capital.Consumption time preferences refer tothe preferred pattern of consumption.Consumer’s time preferences for consumptionestablish how much consumption they are willing to defer, and hence save, atdifferent levels of interest.i.A foreign trade deficit occurs when businesses and individuals in a country importmore goods from foreign countries than are exported.Trade deficits must befinanced, and the main source of financing is debt.Therefore, as the trade deficitincreases, the debt financing increases, driving up interest rates.Interest rates,however, must be competitive with foreign interest rates; if the central bank attemptsto set interest rates lower than foreign rates, foreigners will sell bonds, decreasingbond prices, resulting in higher rates. Thus, if the trade deficit is large relative to thesize of the overall economy, it may hinder the central bank’s ability to combat arecession by lowering interest rates.

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Answers and Solutions:1-31-2Sole proprietorship, partnership, and corporation are the three principal forms of businessorganization. The advantages of the first two include the ease and low cost of formation.The advantages of the corporation include limited liability, indefinite life, ease ofownership transfer, and access to capital markets.The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sumsof capital; (2) unlimited personal liability for business debts; and (3) limited life.Thedisadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty oftransferring ownership, and (4) difficulty of raising large amounts of capital.Thedisadvantages of a corporation are (1) double taxation of earnings and (2) requirements tofile federal reports for registration, which are expensive, complex and time-consuming.1-3A firm’s fundamental, or intrinsic, value is the present value of its free cash flows whendiscounted at the weighted average cost of capital.If the market price reflects allrelevantinformation, then the observed price is also the intrinsic price.If materialinformation is withheld from investors, the firm’s intrinsic value may differ from itsactual market value.1-4a.Corporate philanthropy is always a sticky issue, but it can be justified in terms ofhelping to create a more attractive community that will make it easier to hire aproductive workforce. This corporate philanthropy could be received by shareholdersnegatively,especiallythoseshareholdersnotlivinginitsheadquarterscity.Shareholders are interested in actions that maximize share price, and if competingfirms are not making similar contributions, the “cost” of this philanthropy has to beborne by someone—the shareholders. Thus, the stock price could decrease.b.Companies must make investments in the current period in order to generate futurecash flows. Shareholders should be aware of this, and assuming a correct analysis hasbeen performed, they should react positively to the decision. The Chinese plant is inthis category.Assuming that the correct capital budgeting analysis has been made,the stock price should increase in the future.1-5Earnings per share in the current year will decline due to the cost of the investment madein the current year and no significant performance impact in the short run. However, thecompany’s intrinsic value and its share price should increase due to the significant costsavings expected in the future.

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Answers and Solutions:1-41-6In a well-functioning economy, capital will flow efficiently from those who supplycapital to those who demand it.This transfer of capital can take place in three differentways:1.Direct transfers of money and securities occur when a business sells its shares orbonds directly to savers, without going through any type of financial institution. Thebusiness delivers its securities to savers, who in turn give the firm the money it needs.2.Transfers may also go through an investment banking house that underwrites theissue. An underwriter serves as a middleman and facilitates the issuance of securities.The company sells its stocks or bonds to the investment bank, which in turn sellsthese same securities to savers.The businesses’ securities and the savers’ moneymerely “pass through” the investment banking house.3.Transfers can also be made through a financial intermediary.Here the intermediaryobtains funds from savers in exchange for its own securities.The intermediary usesthis money to buy and hold businesses’ securities. Intermediaries literally create newforms of capital.The existence of intermediaries greatly increases the efficiency ofmoney and capital markets.1-7Financial intermediaries are business organizations that receive funds in one form andrepackage them for the use of those who need funds.Through financial intermediation,resources are allocated more effectively, and the real output of the economy is therebyincreased.1-8a.If transfers between the two markets were costly, interest rates would be different inthe two areas.Area Y, with the relatively young population, would have less insavings accumulation and stronger loan demand.Area O, with the relatively oldpopulation, would have more savings accumulation and weaker loan demand as themembers of the older population have already purchased their houses, and are lessconsumption oriented. Thus, supply/demand equilibrium would be at a higher rate ofinterest in Area Y.b.Yes. Nationwide branching, and so forth, would reduce the cost of financial transfersbetween the areas. Thus, funds would flow from Area O with excess relative supplyto Area Y with excess relative demand.This flow would increase the interest rate inArea O and decrease the interest rate in Y until the rates were roughly equal, thedifference being the transfer cost.1-9The immediate effect would be to lower interest rates.1-10A primary market is the market in which corporations raise capital by issuing newsecurities. An initial public offering (IPO) is a share issue in which privately held firmsgo public. Therefore, an IPO would be an example of a primary market transaction.

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Answers and Solutions:1-51-11The two stock markets today are the Toronto Stock Exchange (TSX) and the TSXVenture Exchange.The TSX trades shares of primarily senior Canadian issuers, whilethe TSX Venture Exchange trades shares of junior or speculative corporations.

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Mini Case:1-6MINI CASEAssume that you have recently graduated and have just reported to work as an investmentadvisor at the brokerage firm of Balik and Kiefer Inc.One of the firm’s clients is SergieTurganev, a professional hockey player who has just come to Canada from Russia.Turganev is a highly ranked hockey player who would like to start a company to produceand market apparel with his signature.He also expects to invest substantial amounts ofmoney through Balik and Kiefer. Turganev is very bright, and, therefore he would like tounderstand in general terms what will happen to his money.Your boss has developed thefollowing set of questions that you must answer to explain the Canadian financial system toTurganev.a.Why is corporate finance important to all managers?Answer:Corporate finance provides the skills managers need to:(1) identify and select thecorporate strategies and individual projects that add value to their firm; and (2)forecastthefundingrequirementsoftheircompany,anddevisestrategiesforacquiring those funds.b.Describe the organizational forms a business might have as it evolves from astart-up to a major corporation. List the advantages and disadvantages of eachform.Answer:The three main forms of business organization are (1) sole proprietorships, (2)partnerships, and (3) corporations.In addition, several hybrid forms are gainingpopularity.These hybrid forms are the limited partnership, the limited liabilitypartnership, and the professional corporation.Theproprietorshiphasthreeimportantadvantages:(1)itiseasilyandinexpensively formed, (2) it is subject to few government regulations, and (3) thebusiness pays no corporate income taxes. The proprietorship also has three importantlimitations: (1) it is difficult for a proprietorship to obtain large sums of capital; (2)the proprietor has unlimited personal liability for the business’s debts, and (3) the lifeof a business organized as a proprietorship is limited to the life of the individual whocreated it.The major advantages of a partnership are its low cost and ease of formation. Thedisadvantages are similar to those associated with proprietorships: (1) unlimitedliability, (2) limited life of the organization, (3) difficulty of transferring ownership,and (4) difficulty of raising large amounts of capital.The tax treatment of apartnership is similar to that for proprietorships, which is often an advantage.

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Mini Case:1-7The corporate form of business has three major advantages: (1) unlimited life, (2)easy transferability of ownership interest, and (3) limited liability.While thecorporate form offers significant advantages over proprietorships and partnerships, itdoes have two primary disadvantages: (1) corporate earnings may be subject todouble taxation and (2) setting up a corporation and filing many required reports ismore complex and time-consuming than for a proprietorship or a partnership.In a limited partnership, the limited partners are liable only for the amount of theirinvestment in the partnership; however, the limited partners typically have no control.The limited liability partnership form of organization combines the limited liabilityadvantage of a corporation with the tax advantages of a partnership.Professionalcorporations provide most of the benefits of incorporation but do not relieve theparticipants of professional liability.c.How do corporations “go public” and continue to grow?What are agencyproblems? What is corporate governance?Answer:A company goes public when it sells shares to the public in an initial public offering.As the firm grows, it might issue additional shares or debt. An agency problem occurswhen the managers of the firm act in their own self interests and not in the interests ofthe shareholders.Corporate governance is the set of rules that control a company’sbehaviourtowardsitsdirectors,managers,employees,shareholders,creditors,customers, competitors, and community.d.What should be the primary objective of managers?Answer:The corporation’s primary goal is shareholder wealth maximization, which translatesto maximizing the price of the firm’s common stock.d.1.Do firms have any responsibilities to society at large?Answer:Firms have an ethical responsibility to provide a safe working environment, to avoidpolluting the air or water, and to produce safe products.However, the mostsignificant cost-increasing actions will have to be put on a mandatory rather than avoluntary basis to ensure that the burden falls uniformly on all businesses.

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Mini Case:1-8d.2.Is stock price maximization good or bad for society?Answer:The same actions that maximize stock prices also benefit society.Stock pricemaximization requires efficient, low-cost operations that produce high-quality goodsand services at the lowest possible cost.Stock price maximization requires thedevelopment of products and services that consumers want and need, so the profitmotive leads to new technology, to new products, and to new jobs. Also, stock pricemaximizationnecessitatesefficientandcourteousservice,adequatestocksofmerchandise, and well-located business establishments—factors that are all necessaryto make sales, which are necessary for profits.d.3.Should firms behave ethically?Answer:Yes. Results of a recent study indicate that the executives of most major firms in theUnited States and Canada believe that firms do try to maintain high ethical standardsin all of their business dealings.Furthermore, most executives believe that there is apositive correlation between ethics and long-run profitability.Conflicts often arisebetween profits and ethics.Companies must deal with these conflicts on a regularbasis, and a failure to handle the situation properly can lead to huge product liabilitysuits and even to bankruptcy.There is no room for unethical behaviour in thebusiness world.e.What three aspects of cash flows affect the value of any investment?Answer:(1) amount of expected cash flows; (2) timing of the cash flow stream; and (3)riskiness of the cash flows.f.What are free cash flows?Answer:Freecashflowsarethecashflowsavailablefordistributiontoallinvestors(shareholders and creditors) after paying expenses (including taxes) and making thenecessary investments to support growth.FCF=sales revenues - operating costs - operating taxes- required investments in operating capital.g.What is the weighted average cost of capital?Answer:The weighted average cost of capital (WACC) is the average rate of return requiredby all of the company’s investors (shareholders and creditors).It is affected by thefirm’s capital structure, interest rates, the firm’s risk, and the market’s overall attitudetoward risk.

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Mini Case:1-9h.How do free cash flows and the weighted average cost of capital interact todetermine a firm’s value?Answer:A firm’s value is the sum of all future expected free cash flows, converted intotoday’s dollars.∞∞+++++=)WACC1(FCF....)WACC1(FCF)WACC1(FCFValue2211i.Who are the providers (savers) and users (borrowers) of capital? How is capitaltransferred between savers and borrowers?Answer:Householdsarenetsavers.Nonfinancialcorporationsarenetborrowers.Governments are also net borrowers, although the government is a net saver when itruns a surplus.Capital is transferred through: (1) direct transfer (e.g., corporationissues commercial paper to insurance company); (2) an investment banking house(e.g., IPO, seasoned equity offering, or debt placement); (3) a financial intermediary(e.g., individual deposits money in bank, bank makes commercial loan to a company).j.What do we call the price that a borrower must pay for debt capital?What isthe price of equity capital?What are the four most fundamental factors thataffect the cost of money, or the general level of interest rates, in the economy?Answer:The interest rate is the price paid for borrowed capital, while the return on equitycapital comes in the form of dividends plus capital gains.The return that investorsrequire on capital depends on (1) production opportunities, (2) time preferences forconsumption, (3) risk, and (4) inflation.Production opportunities refer to the returns that are available from investment inproductive assets: the more productive a producer firm believes its assets will be, themore it will be willing to pay for the capital necessary to acquire those assets.Time preference for consumption refers to consumers’ preferences for currentconsumption versus savings for future consumption: consumers with low preferencesfor current consumption will be willing to lend at a lower rate than consumers with ahigh preference for current consumption.Inflation refers to the tendency of prices to rise, and the higher the expected rateof inflation, the larger the required rate of return.Risk, in a money and capital market context, refers to the chance that the futurecash flows will not be as high as expected—the higher the perceived default risk, thehigher the required rate of return.Risk is also linked to the maturity and liquidity of a security.The longer thematurity and the less liquid (marketable) the security, the higher the required rate ofreturn, other things constant.

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Mini Case:1-10k.What are some economic conditions (including international aspects) that affectthe cost of money?Answer:The cost of money will be influenced by such things as Bank of Canada (BoC) policy,fiscal deficits, business activity, and foreign trade deficits.If the BoC increases growth in the money supply, the cost of money will initiallydecline. If the federal government shows a deficit, interest rates are likely to increase.The cost of money will typically rise before a recession and decline thereafter. Thecost of money for an international investment is also affected by country risk, whichrefers to the risk that arises from investing or doing business in a particular country.This risk depends on the country’s economic, political, and social environment.Country risk also includes the risk that property will be expropriated without adequatecompensation, as well as new host country stipulations about local production,sourcing or hiring practices, and damage or destruction of facilities due to internalstrife.The cost of money for an international investment is also affected by exchangerate risk.When investing overseas the security usually will be denominated in acurrency other than the dollar, which means that the value of the investment willdepend on what happens to exchange rates.Changes in relative inflation or interestrates will lead to changes in exchange rates. International trade deficits/surplusesaffect exchange rates.Also, an increase in country risk will also cause the country’scurrency to fall.l.What are financial securities? Describe some financial instruments.Answer:Financial securities are pieces of paper with contractual obligations.Short-termsecurities (i.e., they mature in less than a year) are instruments with low default risksuch as treasury bills, banker’s acceptances, commercial paper, andEurodollardeposits. Commercial loans (which have maturities up to 7 years) have rates that areusually tied to the prime rate (i.e., the rate that banks charge their best customers) orLIBOR (the London Interbank Offered Rate, which is the rate that banks in the U.K.charge one another.Government of Canada bonds have maturities from 2 to 30years; they are free of default risk.Mortgages have maturities up to 30 years.Corporate bonds have maturities up to 40 years.Corporate bonds are subject todefault risk.Some preferred shares have no maturity date; some do have a specificmaturity date.Common shares have no maturity date, and are riskier than preferredshares.m.List some financial institutions.Answer:Commercial banks, trust companies, and credit unions, life insurance companies,mutual funds, and pension funds are examples of financial institutions.

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Mini Case:1-11n.What are some different types of markets?Answer:A market is a method of exchanging one asset (usually cash) for another asset. Sometypes of markets are: physical assets vs. financial assets; spot versus future markets;money versus capital markets; primary versus secondary markets.

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Answers and Solutions:2-1NOTE:Errata address in 2-11 (last paragraph) and 2-13 Part (a).September 2013.Chapter 2Financial Statements, Cash Flow, and TaxesANSWERS TO END-OF-CHAPTER QUESTIONS2-1a.The annual report is a report issued annually by a corporation to its shareholders.Itcontains basic financial statements, as well as management’s opinion of the pastyear’s operations and the firm’s future prospects.A firm’s balance sheet is astatement of the firm’s financial position at a specific point in time.It specificallylists the firm’s assets on the left-hand side of the balance sheet, while the right-handside shows its liabilities and equity, or the claims against these assets.An incomestatement is a statement summarizing the firm’s revenues and expenses over anaccounting period.Net sales are shown at the top of each statement, after whichvarious costs, including income taxes, are subtracted to obtain the net incomeavailable to common shareholders. The bottom of the statement reports earnings anddividends per share.b.Common shareholders’equity (Networth) isthe capitalsupplied by commonshareholders—capital stock, paid-in capital, retained earnings, and, occasionally,certain reserves.Paid-in capital is the difference between the stock’s par value andwhat shareholders paid when they bought newly issued shares.Retained earnings isthe portion of the firm’s earnings that have been saved rather than paid out asdividends.c.The statement of retained earnings shows how much of the firm’s earnings wereretained in the business rather than paid out in dividends. Note that retained earningsrepresents a claim against assets, not assets per se. Firms retain earnings primarily toexpand the business, not to accumulate cash in a bank account. The statement of cashflows reports the impact of a firm’s operating, investing, and financing activities oncash flows over an accounting period.d.Depreciation is a non-cash charge against tangible assets, such as buildings ormachines.It is taken for the purpose of showing an asset’s estimated dollar cost ofthe capital equipment used up in the production process.Amortization is a non-cashcharge against intangible assets, such as copyrights.EBITDA is earnings beforeinterest, taxes, depreciation, and amortization.

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Answers and Solutions:2-2e.Operating current assets are the current assets used to support operations, such ascash, accounts receivable, and inventory.It does not include short-term investments.Operating current liabilities are the current liabilities that are a natural consequence ofthe firm’s operations, such as accounts payable and accruals.It does not includenotes payable or any other short-term debt that incurs interest charges. Net operatingworking capital is operating current assets minus operating current liabilities.Totalnet operating capital is sum of net operating working capital and operating long-termassets, such as net plant and equipment.Operating capital also is equal to the netamount of capital raised from investors.This is the amount of interest-bearing debtplus preferred stock plus common equity minus short-term investments.f.Accounting profit is a firm’s net income as reported on its income statement.Netcash flow, as opposed to accounting net income, is the sum of net income plus non-cash adjustments.NOPAT, net operating profit after taxes, is the amount of profit acompany would generate if it had no debt and no financial assets.Free cash flow isthe cash flow actually available for distribution to investors after the company hasmade all investments in fixed assets and working capital necessary to sustain ongoingoperations.g.Market value added is the difference between the market value of the firm (i.e., thesum of the market value of common equity, the market value of debt, and the marketvalue of preferred shares) and the book value of the firm’s common equity, debt, andpreferred shares.If the book values of debt and preferred shares are equal to theirmarket values, then MVA is also equal to the difference between the market value ofequity and the amount of equity capital that investors supplied.Economic valueadded represents the residual income that remains after the cost of all capital,including equity capital, has been deducted.h.A progressive tax means the higher one’s income, the larger the percentage paid intaxes.Taxable income is defined as gross income less a set of exemptions anddeductions that are spelled out in the instructions to the tax forms individuals mustfile.Marginal tax rate is defined as the tax rate on the last unit of income.Averagetax rate is calculated by taking the total amount of tax paid divided by taxableincome.i.Capital gain (loss) is the profit (loss) from the sale of a capital asset for more (less)than its purchase price. Ordinary corporate operating losses can be carried back for 3years or forward for 20 years to offset taxable income in a given year.2-2The four financial statements contained in most annual reports are the balance sheet,income statement, statement of retained earnings, and statement of cash flows.2-3No because the $20 million of retained earnings would probably not be held as cash. Theretainedearningsfigurerepresentsthereinvestmentofearningsbythefirm.Consequently, the $20 million would be an investment in all of the firm’s assets.

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Answers and Solutions:2-32-4Operating capital is the amount of interest-bearing debt, preferred stock, and commonequity used to acquire the company’s net operating assets.Without this capital a firmcannot exist, as there is no source of funds with which to finance operations.2-5NOPAT is the amount of net income a company would generate if it had no debt and heldno financial assets.NOPAT is a better measure of the performance of a company’soperations because debt lowers income.In order to get a true reflection of a company’soperating performance, one would want to take out debt to get a clearer picture of thesituation.2-6Free cash flow is the cash flow actually available for distribution to investors after thecompany has made all the investments in fixed assets and working capital necessary tosustain ongoing operations.It is the most important measure of cash flows because itshows the exact amount available to all investors.2-7If the business were organized as a partnership or a proprietorship, its income could betaken out by the owners without being subject to double taxation.Also, if you expectedto have losses for a few years while the company was getting started, if you werenotincorporated, and if you had outside income, the business losses could be used to offsetyour other income and reduce your total tax bill.These factors would lead you tonotincorporate the business.

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Answers and Solutions:2-4SOLUTIONS TO END-OF-CHAPTER PROBLEMS2-1Corporate yield = 6%; T = 35%AT yield = 6%(1 - T)= 6%(0.65) = 3.9%.2-2NI = $3,000,000; EBIT = $6,000,000; T = 40%; Interest = ?Need to set up an income statement and work from the bottom up.EBIT$6,000,000Interest1,000,000EBT$5,000,000EBT =Taxes (40%)2,000,000NI$3,000,000Interest = EBIT – EBT = $6,000,000 – $5,000,000 = $1,000,000.2-3EBITDA = $7,500,000; NI = $1,600,000; Int = $2,000,000; T = 30%; DA = ?EBITDA$7,500,000DA3,214,286EBITDA – DA = EBIT; DA = EBITDA – EBITEBIT$4,285,714EBIT = EBT + Int = $3,000,000 + $2,000,000Int2,000,000(Given)EBT$2,285,714Taxes (30%)685,714NI$1,600,000(Given)2-4NI = $3,100,000; DEP = $500,000; AMORT = 0; NCF = ?NCF = NI + DEP + AMORT = $3,100,000 + $500,000 = $3,600,000.2-5NI = $50,000,000; R/EY/E= $810,000,000; R/EB/Y= $780,000,000; Dividends = ?R/EB/Y+ NI – Div = R/EY/E$780,000,000 + $50,000,000 – Div= $810,000,000$830,000,000 – Div = $810,000,000Div = $20,000,000.0.6$3,000,000T)(1$3,000,000=−0.7$1,600,000T)(1$1,600,000=−

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Answers and Solutions:2-52-6Cash Provided (Used)Operating ActivitiesNet Income$18,000Adjustments:Noncash adjustments:Amortization4,000Due to changes in working capitalIncrease in accounts receivable(4,000)Decrease in inventories8,000Increase in accounts payable4,000Net cash provided by operating activities$30,0002-7Interest Income = $500Capital Gain = $10,000/$50 = 200 shares × $2.50/share = $500Interest IncomeCapital Gain$500 × 16.67% =$83.35$500 × 16.67% × 0.5 =$41.68$500 × 22% =$110.00$500 × 22% × 0.5 =$55.00Total tax =$193.35Total tax =$96.68$500 - $193.35 =$306.65$500 - $96.68 =$403.32

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Answers and Solutions:2-62-8AlphaBetaSales$2,000,000$2,000,000COGS (65%)1,300,0001,300,000Gross Profit$700,000$700,000Operating Expense300,000300,000Depreciation30,00060,000EBT370,000340,000Taxes (32%)118,400108,800Earnings After Tax$251,600$231,200+ Depreciation30,00060,000Cash Flow$281,600$291,200The difference between the cash flows is $9,600 ($291,200 - $281,600).Beta has largercash flows because it claimed higher depreciation expense.Since depreciation is a taxdeductible item, it creates a tax shield.The depreciation tax shield for Beta is $19,200($60,000 × 0.32), while the depreciation tax shield for Alpha is $9,600 ($30,000 × 0.32).The difference in tax shields of $9,600 accounts for the difference in cash flows.2-9EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40%NI = ?; NCF = ?First, determine net income by setting up an income statement:EBIT$750,000Interest0EBT$750,000Taxes (40%)300,000NI$450,000NCF = NI + DEP = $450,000 + $200,000 = $650,000.

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Answers and Solutions:2-72-10a.Income StatementSales revenues$12,000,000Costs exceptdepreciation9,000,000Depreciation1,500,000EBT$ 1,500,000Taxes (40%)600,000Net income$900,000Add back depreciation1,500,000Net cash flow$ 2,400,000b.If depreciation doubled, taxable income would fall to zero and taxes would be zero.Thus, net income would decrease to zero, but net cash flow would rise to $3,000,000.Berndt would save $600,000 in taxes, thus increasing its cash flow:∆CF = T(∆Depreciation) = 0.4($1,500,000) = $600,000.c.If depreciation were halved, taxable income would rise to $2,250,000 and taxes to$900,000.Therefore, net income would rise to $1,350,000, but net cash flow wouldfall to $2,100,000.d.You should prefer to have higher depreciation charges and higher cash flows.Netcash flows are the funds that are available to the owners to withdraw from the firmand, therefore, cash flows should be more important to them than net income.2-11NOPAT = EBIT(1 – Tax rate)= $80 million(1 – 0.30) = $56 millionFCF= NOPAT - Net investment in operating capitalFCF= $56 million - $30 millionFCF= $26 millionMarket Value of 10% of shares = 0.10($22 × 10 million) = $22 million$26 million is the free cash flow available to investors.After $7 million ($10 million x0.70), is paid to creditors in interest, $19 million is available to repurchase shares. Since$22 million is needed to repurchase 10% of its shares, Marine Tech will not be able tofully carry out its repurchase plan.

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Answers and Solutions:2-82-12a.NOPAT= EBIT(1 - Tax rate)= $150,000,000(0.7)= $105,000,000.b.NOWC11= Operating CA – operating CL= $360,000,000 - ($90,000,000 + $60,000,000)= $210,000,000.NOWC12= $372,000,000 - $180,000,000 = $192,000,000.c.Operating capital11=capitalworkingoperatingNetequipmentandplantNet+= $250,000,000 + $210,000,000= $460,000,000.Operating capital12= $300,000,000 + $192,000,000= $492,000,000.d.FCF = NOPAT - Net investment in operating capital= $105,000,000 - ($492,000,000 - $460,000,000)= $73,000,000.e.The large increase in dividends for 2012 can most likely be attributed to a largeincrease in free cash flow from 2011 to 2012, since FCF represents the amount ofcash available to be paid out to shareholders after the company has made allinvestments in fixed assets and working capital necessary to sustain the business.2-13a. MVA= Market Value of Stock – Equity Capital supplied by shareholders= ($15/share) × (50,000,000 shares) - $287,800,000 = $462,200,000.b.ROIC = NOPAT/Operating Capital. NOPAT was previously calculated as $105,000,000.Operating capital was previously calculated to = $492,000,000.ROIC = $105,000,000/$492,000,000 = 0.183 = 21.3%c.EVA= (Operating capital)(ROIC – WACC) = ($492,000,000)(0.213 – 0.14) = $35,916,000.

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Answers and Solutions:2-92-14Standard Industrial Corporation: Statement of Cash Flows for 2012 (Millions of Dollars)Cash Providedor (Used)Operating ActivitiesNet income$89.8Adjustments:Noncash adjustments:Depreciation30.0Due to changes in working capitalIncrease in accounts receivable(30.0)Decrease in inventories20.0Increase in accounts payable18.0Increase in accruals12.0Net cash provided by operating activities139.8Investing ActivitiesCash used to acquire fixed assets(80.0)Change in short-term investments(12.8)Net cash used by investing activities(92.8)Financing ActivitiesIncrease in notes payable15.5Increase in bonds outstanding0.0Payment of dividends(60.5)Net cash used by financing activities(45.0)SummaryIncrease in cash$2.0Cash at beginning of year$10.0Cash at end of year$12.0

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Answers and Solutions:2-102-15Prior Years200920102011Profit earned$150,000$150,000$150,000Carry-back credit150,000150,000150,000Adjusted profit$0$0$0Tax previouslypaid (40%)60,00060,00060,000Tax refund: Taxespreviously paid$ 60,000$ 60,000$ 60,000Total check from Canada Revenue Agency = $60,000 + $60,000 + $60,000 = $180,000.Future Years20122013201420152016Estimatedprofit$(650,000)$150,000$150,000$150,000$150,000Carry-forwardcredit0150,00050,00000Adjustedprofit$0$0$100,000$150,000$150,000Tax (at 40%)$0$0$ 40,000$ 60,000$ 60,000

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Answers and Solutions:2-112-16a.NOPAT = EBIT(1-T)= $1,750,000(0.75)= $1,312,500.NOWC12= Operating CA – Operating CL= ($4,830,000 - $380,000) – ($3,700,000 - $1,050,000)= $1,800,000.NOWC13= $4,980,000 – ($3,878,000 - $903,000)= $2,005,000.Operating Capital12= Net plant & equipment + NOWC= $3,670,000 + $1,800,000= $5,470,000.Operating Capital13= Net plant & equipment + NOWC= $4,320,000 + $2,005,000= $6,325,000.FCF = NOPAT – Net investment in operating capital= $1,312,500 – ($6,325,000 - $5,470,000)= $457,500.b.ROIC=NOPATOperatingCapital=$1,312,500$6,325,000=0.2075=20.75%c.EVA = (Operating capital)(ROIC – WACC) = ($6,325,000)(0.2075 – 0.13)=$490,188.MVA = Market Value of Stock – Equity Capital supplied by shareholders= $20 x 400,000 – $4,922,000 = $3,078,000.

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Answers and Solutions:2-122-17Bristle Brush-Off Corporation: Statement of Cash Flows, Year Ended December 31 2013($000s)Cash Providedor (Used)Operating ActivitiesNet income$822Adjustments:Noncash adjustments:Depreciation750Due to changes in working capitalIncrease in accounts receivable(190)Increase in inventory(360)Increase in accounts payable310Increase in accruals15Net cash provided by operating activities1,347Investing ActivitiesCash used to acquire fixed assets(1,400)Proceed from sale of short-term investments380Net cash used by investing activities(1,020)Financing ActivitiesRepayment of notes payable(147)Change in long-term debt0Payment of cash dividends(200)Net cash used by financing activities(347)SummaryDecrease in cash(20)Cash at beginning of year$60Cash at end of year$40

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Answers and Solutions:2-13SOLUTION TO SPREADSHEET PROBLEM2-16The detailed solution for the spreadsheet problem is in the fileCh 02 Build a ModelSolution.xlsxand is available on the textbook’s website.

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Mini Case:2-14Donna Jamison, a recent graduate of the University of Western Ontario with four years ofbanking experience, was recently brought in as assistant to the chairman of the board ofComputron Industries, a manufacturer of electronic calculators.The company doubled its plant capacity, opened new sales offices outside its hometerritory, and launched an expensive advertising campaign. Computron’s results were notsatisfactory, to put it mildly.Its board of directors, which consisted of its president andvice-president plus its major shareholders (who were all local businesspeople), was mostupset when directors learned how the expansion was going. Suppliers were being paid lateand were unhappy, and the bank was complaining about the deteriorating situation andthreatening to cut off credit.As a result, Al Watkins, Computron’s president, wasinformed that changes would have to be made, and quickly, or he would be fired. Also, atthe board’s insistence, Donna Jamison was brought in and given the job of assistant toFred Campo, a retired banker who was Computron’s chairman and largest shareholder.Campo agreed to give up a few of his golfing days and to help nurse the company back tohealth, with Jamison’s help.Jamison began by gathering financial statements and other data.MINI CASE

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Mini Case:2-15Balance SheetsAssets20122011Cash$7,282$9,000Short-term investments20,00048,600Accounts receivable632,160351,200Inventories1,287,360715,200Total current assets1,946,8021,124,000Gross fixedassets1,202,950491,000Less: accumulated depreciation263,160146,200Net fixed assets939,790344,800Total assets$ 2,886,592$ 1,468,800Liabilities and Equity20122011Accounts payable$324,000$145,600Notes payable720,000200,000Accruals284,960136,000Total current liabilities1,328,960481,600Long-term debt1,000,000323,432Common stock (100,000 shares)460,000460,000Retained earnings97,632203,768Total equity557,632663,768Total liabilities and equity$ 2,886,592$ 1,468,800

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Mini Case:2-16Income Statements20122011Sales$ 5,834,400$ 3,432,000Cost of goods sold4,980,0002,864,000Other expenses720,000340,000Depreciation116,96018,900Total operating costs5,816,9603,222,900EBIT17,440209,100Interest expense176,00062,500EBT(158,560)146,600Taxes (40%)(63,424)58,640Net income$(95,136)$87,960Other Data20122011Stock price$6.00$8.50Shares outstanding100,000100,000EPS$(0.95)$0.88DPS$0.110$0.220

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Mini Case:2-17Statement of Cash Flows, 2012Operating activitiesNet income$(95,136)Adjustments:Noncash adjustments:depreciation116,960Changes in workingcapital:Increasein accounts receivable(280,960)Increasein inventories(572,160)Increasein accounts payable178,400change in accruals148,960Net cashusedby operating activities(503,936)Investing activitiesCash used to acquire fixed assets(711,950)Proceed from sale of short-term investments28,600Net cashusedby operating activities(683,350)Financing activitiesIssue ofnotes payable520,000Issue oflong-term debt676,568Change in common stock-Payment of cash dividends(11,000)Net cash provided by financing activities1,185,568SummaryDecreasein cash(1,718)Cash at beginning of year9,000Cash at end of year$7,282

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Mini Case:2-18a.What effect did the expansion have on sales and net income? What effect did theexpansion have on the asset side of the balance sheet? What effect did it have onliabilities and equity?Answer:Sales increased by over by over $2.4 million, but net income fell by over $180,000.Assets almost doubled. Debt and funds provided by suppliers increased, but retainedearnings fell due to the year’s loss and dividend payments.b.What do you conclude from the statement of cash flows?Answer:Net CF from operations = -$503,936, because of the loss and increases in net workingcapital.The firm spent $711,950 on fixed assets.The firm borrowed heavily andsoldsomeshort-terminvestmentstomeetitscashrequirements.Evenafterborrowing, cash fell by $1,718.c.What is free cash flow? Why is it important? What are the five uses of FCF?Answer:FCF is the amount of cash available from operations for distribution to all investors(including shareholders and debtholders) after making the necessary investments tosupport operations.A company’s value depends upon the amount of FCF it cangenerate. The five uses of FCF are:1. Pay interest on debt.2. Repay principal on debt.3. Pay dividends.4. Buy back stock.5. Buy nonoperating assets (e.g., marketable securities, investments in othercompanies, etc.)

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Mini Case:2-19d.What is Computron’s net operating profit (NOPAT)?What are operatingcurrent assets? What are operating current liabilities? How much net operatingworking capital and total net operating capital does Computron have?Answer:Operatingcurrentassetsarethecurrentassetsneededtosupportoperations.Operating current assets include: cash, inventory, and receivables.Operating currentassets exclude: short-term investments, because these are not a part of operations.Operating current liabilities are the current liabilities resulting as a normal part ofoperations.Operating current liabilities include accounts payable and accruals.Operating current liabilities exclude notes payable, because this is a source offinancing, not a part of operations.NOPAT = EBIT(1 – Tax rate)NOPAT12= $17,440(1 - 0.4)= $10,464.NOPAT11= $125,460.NOWC = operating CA – operating CLNOWC12= ($7,282 + $632,160 + $1,287,360) - ($324,000 + $284,960)= $1,317,842.NOWC11= $793,800.Total operating working capital= NOWC + net fixed assets.Operating capital in 2012 = $1,317,842 + $939,790= $2,257,632.Operating capital in 2011 = $1,138,600.e.What is Computron’s free cash flow (FCF)?Answer:FCF = NOPAT – Net investment in capital= $10,464 - ($2,257,632 - $1,138,600)= $10,464 - $1,119,032= -$1,108,568.

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