Foundations of Financial Management 16th Edition Solution Manual

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Chapter 01: The Goals and Functions of Financial Management
Chapter 1
The Goals and Functions of Financial Management
Discussion Questions
1-1. How did the recession of 2007–2009 compare with other recessions since the
Great Depression in terms of length?
It was the longest.
1-2. What effect did the recession of 2007–2009 have on government regulation?
It was greatly increased.
1-3. What advantages does a sole proprietorship offer? What is a major drawback of
this type of organization?
A sole proprietorship offers the advantage of simplicity of decision making and
low organizational and operating costs. A major drawback is that there is
unlimited liability to the owner.
1-4. What form of partnership allows some of the investors to limit their liability?
Explain briefly.
A limited partnership allows some of the partners to limit their liability. Under
this arrangement, one or more partners are designated general partners and have
unlimited liability for the debts of the firm; other partners are designated limited
partners and are liable only for their initial contribution. The limited partners are
normally prohibited from being active in the management of the firm.
1-5. In a corporation, what group has the ultimate responsibility for protecting and
managing the stockholders' interests?
The board of directors.
1-6. What document is necessary to form a corporation?
The articles of incorporation.

Chapter 01: The Goals and Functions of Financial Management
1-7. What issue does agency theory examine? Why is it important in a public
corporation rather than in a private corporation?
Agency theory examines the relationship between the owners of the firm and the
managers of the firm. In privately owned firms, management and the owners are
usually the same people. Management operates the firm to satisfy its own goals,
needs, financial requirements and the like. As a company moves from private to
public ownership, management now represents all owners. This places
management in the agency position of making decisions in the best interest of all
shareholders.
1-8. Why are institutional investors important in today's business world?
Because institutional investors such as pension funds and mutual funds own a
large percentage of major U.S. companies, they are having more to say about the
way publicly owned companies are managed. As a group, they have the ability to
vote large blocks of shares for the election of a board of directors, which is
supposed to run the company in an efficient, competitive manner. The threat of
being able to replace poor performing boards of directors makes institutional
investors quite influential. Since these institutions, like pension funds and mutual
funds, represent individual workers and investors, they have a responsibility to see
that the firm is managed in an efficient and ethical way.
1-9. Why is profit maximization, by itself, an inappropriate goal? What is meant by the
goal of maximization of shareholder wealth?
The problem with a profit maximization goal is that it fails to take account of risk,
the timing of the benefits is not considered, and profit measurement is a very
inexact process. The goal of shareholders’ wealth maximization implies that the
firm will attempt to achieve the highest possible total valuation in the
marketplace. It is the one overriding objective of the firm and should influence
every decision.

Chapter 01: The Goals and Functions of Financial Management
1-10. When does insider trading occur? What government agency is responsible for
protecting against the unethical practice of insider trading?
Insider trading occurs when anyone with non-public information buys or sells
securities to take advantage of that private information. The Securities and
Exchange Commission is responsible for protecting markets against insider
trading. In the past, people have gone to jail for trading on non-public
information. This has included company officers, investment bankers, printers
who have information before it is published, and even truck drivers who deliver
business magazines and read positive or negative articles about a company before
the magazine is on the newsstands and then place trades or have friends place
trades based on that information. The SEC has prosecuted anyone who profits
from inside information.
1-11. In terms of the life of the securities offered, what is the difference between money
and capital markets?
Money markets refer to those markets dealing with short-term securities that have
a life of one year or less. Capital markets refer to securities with a life of more
than one year.
1-12. What is the difference between a primary and a secondary market?
A primary market refers to the use of the financial markets to raise new funds for
the corporation. After the securities are sold to the public (institutions and
individuals), they trade in the secondary market between investors. It is in the
secondary market that prices are continually changing as investors buy and sell
securities based on the expectations of corporate prospects.
1-13. Assume you are looking at many companies with equal risk. Which ones will
have the highest stock prices?
Given companies with equal risk, those companies with expectations of high
return will have higher common stock prices relative to those companies with
expectations of poor returns.

Chapter 01: The Goals and Functions of Financial Management
1-14. What changes can take place under restructuring? In recent times, what group of
investors has often forced restructuring to take place?
Restructuring can result in changes in the capital structure (liabilities and equity
on the balance sheet). It can also result in the selling of low-profit-margin
divisions with the proceeds reinvested in better investment opportunities, and
sometimes restructuring results in the removal of the current management team or
large reductions in the workforce. Restructuring has also included mergers and
acquisitions.
Institutional investors have been very influential in forcing restructuring to take
place in recent years.
1-15. How did the Sarbanes–Oxley Act impact corporations’ financial reports?
The Sarbanes–Oxley Act of 2002 set up a five-member Public Company
Accounting Oversight Board with the responsibility for establishing auditing
standards within companies, controlling the quality of audits, and setting rules
and standards for the independence of the auditors. It also puts great
responsibility on the internal audit committee of each publicly traded company to
enforce compliance with the act. The major focus of the act is to make sure that
publicly traded corporations accurately present their assets, liabilities, and equity
and income on their financial statements.
1-16. Name the departments, offices, or agencies that were created by the Dodd–Frank
legislation.
1) The act created the Financial Stability Oversight Council within the
Treasury Department.
2) The act created the Office of Financial Research within the Treasury
Department.
3) Dodd–Frank established the Federal Insurance Office within the Treasury
Department to oversee the insurance industry and streamline state-based
insurance regulation.
4) The act created the Bureau of Consumer Financial Protection. The
oversight given to the Bureau of Consumer Financial Protection allows it
to dictate the fees that banks charge and the types of products they offer.

Chapter 02: Review of Accounting
Chapter 2
Review of Accounting
Discussion Questions
2-1. Discuss some financial variables that affect the price-earnings ratio.
The price-earnings ratio will be influenced by the earnings and sales growth of
the firm, the risk or volatility in performance, the debt-equity structure of the
firm, the dividend payment policy, the quality of management, and a number of
other factors. The ratio tends to be future-oriented, and the more positive the
outlook, the higher it will be.
2-2. What is the difference between book value per share of common stock and
market value per share? Why does this disparity occur?
Book value per share is arrived at by taking the cost of the assets and
subtracting out liabilities and preferred stock and dividing by the number of
common shares outstanding. It is based on the historical cost of the assets.
Market value per share is based on the current assessed value of the firm in the
marketplace and may bear little relationship to original cost. Besides the
disparity between book and market value caused by the historical cost approach,
other contributing factors are the growth prospects for the firm, the quality of
management, and the industry outlook. To the extent these are quite negative or
positive; market value may differ widely from book value.
2-3. Explain how depreciation generates actual cash flows for the company.
The only way depreciation generates cash flows for the company is by serving
as a tax shield against reported income. This non-cash deduction may provide
cash flow equal to the tax rate times the depreciation charged. This much in
taxes will be saved, while no cash payments occur.
2-4. What is the difference between accumulated depreciation and depreciation
expense? How are they related?
Accumulated depreciation is the sum of all past and present depreciation
charges, while depreciation expense is the current year’s charge. They are
related in that the sum of all prior depreciation expense should be equal to
accumulated depreciation (subject to some differential related to asset
write-offs).

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Chapter 02: Review of Accounting
2-5. How is the income statement related to the balance sheet?
The earnings (less dividends) reported in the income statement is transferred to
the ownership section of the balance sheet as retained earnings. Thus, what we
earn in the income statement becomes part of the ownership interest in the
balance sheet.
2-6. Comment on why inflation may restrict the usefulness of the balance sheet as
normally presented.
The balance sheet is based on historical costs. When prices are rising rapidly,
historical cost data may lose much of their meaning—particularly for plant and
equipment and inventory.
2-7. Explain why the statement of cash flows provides useful information that goes
beyond income statement and balance sheet data.
The income statement and balance sheet are based on the accrual method of
accounting, which attempts to match revenues and expenses in the period in
which they occur. However, accrual accounting does not attempt to properly
assess the cash flow position of the firm. The statement of cash flows fulfills
this need.
2-8. What are the three primary sections of the statement of cash flows? In what
section would the payment of a cash dividend be shown?
The sections of the statement of cash flows are:
Cash flows from operating activities
Cash flows from investing activities
Cash flows from financing activities
The payment of cash dividends falls into the financing activities category.

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Chapter 02: Review of Accounting
2-9. What is free cash flow? Why is it important to leveraged buyouts?
Free cash flow is equal to cash flow from operating activities:
Minus: Capital expenditures required to maintain the productive capacity
of the firm.
Minus: Dividends (required to maintain the payout on common stock and
to cover any preferred stock obligation).
The analyst or banker normally looks at free cash flow to determine whether
there are sufficient excess funds to pay back the loan associated with the
leveraged buyout.
2-10. Why is interest expense said to cost the firm substantially less than the actual
expense, while dividends cost it 100 percent of the outlay?
Interest expense is a tax deductible item to the corporation, while dividend
payments are not. The net cost to the corporation of interest expense is the
amount paid multiplied by the difference of one minus the applicable tax rate.
For example, $100 of interest expense costs the company $65 after taxes when
the corporate tax rate is 35 percent—for example, $100 × (1 – 0.35) = $65.
Chapter 2
Problems
1. Income Statement (LO1) Frantic Fast Foods had earnings after taxes of $420,000 in the
year 20X1 with 309,000 shares outstanding. On January 1, 20X2, the firm issued 20,000
new shares. Because of the proceeds from these new shares and other operating
improvements, earnings after taxes increased by 30 percent.
a. Compute earnings per share for the year 20X1.
b. Compute earnings per share for the year 20X2.
2-1. Solution:

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Chapter 02: Review of Accounting
Frantic Fast Foods
a. Year 20X1Earnings after taxesEarnings per share Shares outstanding
$420,000 = $1.36
309,000
=
=
b. Year 20X2Earnings after taxes $420,000 1.30 $546,000
Shares outstanding 309,000 20,000 329,000
$546,000Earnings per share $1.66
329,000
=  =
= + =
= =
2. Income statement (LO1) Sosa Diet Supplements had earnings after taxes of $800,000 in
the year 20X1 with 200,000 shares of stock outstanding. On January 1, 20X2, the firm
issued 50,000 new shares. Because of the proceeds from these new shares and other
operating improvements, earnings after taxes increased by 30 percent.
a. Compute earnings per share for the year 20X1.
b. Compute earnings per share for the year 20X2.
2-2. Solution:
Sosa Diet Supplements
a. Year 20X1Earnings after taxesEarnings per share = Shares outstanding
$800,000= = $4.00
200,000
b. Year 20X2

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Chapter 02: Review of AccountingEarnings after taxes $800,000 1.30 $1,040,000
Shares outstanding 200,000 50,000 250,000
$1,040,000Earning per share $4.16
250,000
=  =
= + =
= =
3. a. Gross profit (LO1) Swank Clothiers had sales of $383,000 and cost of goods sold of
$260,000. What is the gross profit margin (ratio of gross profit to sales)?
b. If the average firm in the clothing industry had a gross profit of 25 percent, how is the
firm doing?
2-3. Solution:
Swank Clothiers
a. Sales ............................................................. $383,000
Cost of goods sold ................................. 260,000
Gross Profit .................................... $123,000$123,000Gross ProfitGross Profit Margin = 32%
Sales $383,000
=
b. With a gross profit of 32 percent, the firm is outperforming the
industry average of 25 percent.
4. Operating profit (LO1) A-Rod Fishing Supplies had sales of $2,500,000 and cost of
goods sold of $1,710,000. Selling and administrative expenses represented 10 percent of
sales. Depreciation was 6 percent of the total assets of $4,680,000. What was the firm’s
operating profit?
2-4. Solution:

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Chapter 02: Review of Accounting
A-Rod Fishing Supplies
Sales ...............................................................$2,500,000
Cost of goods sold .......................................... 1,710,000
Gross Profit ................................................ 790,000
Selling and administrative expense*.............. 250,000
Depreciation expense** ................................. 280,800
Operating profit ......................................... $ 259,200
* 10% × $2,500,000 = $250,000
** 6% × $4,680,000 = $280,800
5. Income statement (LO1) Arrange the following income statement items so they are in the
proper order of an income statement:
Taxes Earnings per share
Shares outstanding Earnings before taxes
Interest expense Cost of goods sold
Depreciation expense Earnings after taxes
Preferred stock dividends Earnings available to common
Operating profit stockholders
Sales Selling and administrative expense
Gross profit
2-5. Solution:
Sales
– Cost of goods sold
Gross profit
– Selling and administrative expense
– Depreciation expense
Operating profit
– Interest expense
Earnings before taxes
– Taxes
Earnings after taxes
– Preferred stock dividends

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Chapter 02: Review of Accounting
Earnings available to common stockholders
Shares outstanding
Earnings per share
6. Income statement (LO1) Given the following information, prepare an income statement
for the Dental Drilling Company.
Selling and administrative expense ........................................ $ 112,000
Depreciation expense ............................................................. 73,000
Sales ....................................................................................... 489,000
Interest expense ...................................................................... 45,000
Cost of goods sold.................................................................. 156,000
Taxes ...................................................................................... 47,000
2-6. Solution:
Dental Drilling Company
Income Statement
Sales ............................................................... $ 489,000
Cost of goods sold .......................................... $ 156,000
Gross profit ................................................ $ 333,000
Selling and administrative expense................ $ 112,000
Depreciation expense ..................................... $ 73,000
Operating profit ......................................... $ 148,000
Interest expense .............................................. $ 45,000
Earnings before taxes ................................ $ 103,000
Taxes .............................................................. $ 47,000
Earnings after taxes ................................... $ 56,000

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Chapter 02: Review of Accounting
7. Income statement (LO1) Given the following information, prepare in good form an
income statement for Jonas Brothers Cough Drops.
Selling and administrative expense ........................................$ 328,000
Depreciation expense ............................................................. 195,000
Sales ....................................................................................... 1,660,000
Interest expense ...................................................................... 129,000
Cost of goods sold.................................................................. 560,000
Taxes ...................................................................................... 171,000
2-7. Solution:
Jonas Brothers Cough Drops
Income Statement
Sales ...............................................................$1,660,000
Cost of goods sold .......................................... 560,000
Gross profit ................................................ 1,100,000
Selling and administrative expense................ 328,000
Depreciation expense ..................................... 195,000
Operating profit ......................................... 577,000
Interest expense .............................................. 129,000
Earnings before taxes ................................ 448,000
Taxes .............................................................. 171,000
Earnings after taxes ...................................$ 277,000
8. Determination of profitability (LO1) Prepare in good form an income statement for
Franklin Kite Co. Inc. Take your calculations all the way to computing earnings per
share.
Sales ....................................................................................... $900,000
Shares outstanding ................................................................. 50,000
Cost of goods sold.................................................................. 400,000
Interest expense ...................................................................... 40,000
Selling and administrative expense ........................................ 60,000
Depreciation expense ............................................................. 20,000
Preferred stock dividends ....................................................... 80,000
Taxes ...................................................................................... 50,000

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Chapter 02: Review of Accounting
2-8. Solution:
Franklin Kite Company
Income Statement
Sales ............................................................... $900,000
Cost of goods sold .......................................... 400,000
Gross profit ................................................ 500,000
Selling and administrative expense................ 60,000
Depreciation expense ..................................... 20,000
Operating profit ......................................... $420,000
Interest expense .............................................. 40,000
Earnings before taxes ................................ $390,000
Taxes .............................................................. 120,000
Earnings after taxes ................................... $270,000
Preferred stock dividends ............................... 80,000
Earnings available to common stockholders . 190,000
Shares outstanding ......................................... 50,000
Earnings per share .......................................... $3.80

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Chapter 02: Review of Accounting
9. Determination of profitability (LO1) Prepare an income statement for Virginia Slim
Wear. Take your calculations all the way to computing earnings per share.
Sales .......................................................................................$1,360,000
Shares outstanding ................................................................. 104,000
Cost of goods sold.................................................................. 700,000
Interest expense ...................................................................... 34,000
Selling and administrative expense ........................................ 49,000
Depreciation expense ............................................................. 23,000
Preferred stock dividends ....................................................... 86,000
Taxes ...................................................................................... 100,000
2-9. Solution:
Virginia Slim Wear
Income Statement
Sales ...............................................................$1,360,000
Cost of goods sold .......................................... 700,000
Gross profit ................................................ 660,000
Selling and administrative expense................ 49,000
Depreciation expense ..................................... 23,000
Operating profit ......................................... 588,000
Interest expense .............................................. 34,000
Earnings before taxes ................................ 554,000
Taxes .............................................................. 100,000
Earnings after taxes ................................... 454,000
Preferred stock dividends ............................... 86,000
Earnings available to common stockholders .$ 368,000
Shares outstanding ......................................... 104,000
Earnings per share .......................................... $ 3.54
10. Income statement (LO1) Precision Systems had sales of $820,000, cost of goods of
$510,000, selling and administrative expense of $60,000, and operating profit of $103,000.
What was the value of depreciation expense? Set this problem up as a partial income
statement, and determine depreciation expense as the plug figure.

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