Solution Manual For Corporate Finance, 12th Edition

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Solutions ManualCorporate FinanceRoss, Westerfield,Jaffe, and Jordan12thedition03/13/2019Prepared by:Brad JordanUniversity of KentuckyJoe SmoliraBelmont University

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CHAPTER 1INTRODUCTION TO CORPORATEFINANCEAnswers to Concept Questions1.In the corporate form of ownership, the shareholders are the owners of the firm. Theshareholders 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.2.Such organizations frequently pursue social or political missions, so manydifferent goals areconceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods andservices are offered at the lowest possible cost to society. A better approach might be to observe thateven a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximizethe value of the equity.3.Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows,both short-termandlong-term. If this is correct, then the statement is false.4.An argument can be made either way. At the one extreme, we could argue that in a market economy,all of these things are priced. There is thus an optimal level of, for example, ethical and/or illegalbehavior, and the framework of stock valuation explicitly includes these. At the other extreme, wecould argue that these are non-economic phenomena and are best handled through the political process.A classic (and highly relevant) thought question that illustrates this debate goes something like this:“A firm has estimated that the cost of improving the safety of one of its products is $30 million.However, the firm believes that improving the safety of the product will only save $20 million inproduct liability claims. What should the firm do?”5.The goal will be the same, but the best course of action toward that goal may be different because ofdiffering social, political, and economic institutions.6.The goal of management should be to maximize the share price for the current 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 outsidecompany. If management believes that thisbidder,or other unidentified bidders,will actually pay more than $35 per share to acquire the company,then they should still fight the offer. However, if the current management cannot increase the value ofthefirm 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 managershave an incentive to fight corporate takeoversin situations such as this.

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4–SOLUTIONS MANUAL7.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. The high percentage of institutional ownership mightlead to a higher degree of agreement between owners and managers on decisions concerning riskyprojects. In addition, institutions may be better able to implement effective monitoring mechanismson managers than canindividual owners, based on the institutions’ deeper resources and experienceswith their own management.8.The increase in institutional ownership of stock in the United States and the growing activism of theselarge shareholder groups may lead to a reduction in agency problems for U.S. corporations and a moreefficient market for corporate control. However,this may not always be the case. If the managers ofthe mutual fund or pension plan are not concerned with the interests of the investors, the agencyproblem could potentially remain the same, or even increase,since there is the possibility of agencyproblems between the fund and its investors.9.How much is too much? Who is worth more,Larry Ellisonor Tiger Woods? 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 ofexecutive 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 due to rising stock prices in general, not managerial performance.Perhapsinthefuture,executivecompensationwillbedesignedtorewardonlydifferentialperformance, i.e., stock price increases in excess of general market increases.10.Maximizing the current share price is the same as maximizing the future share price at any futureperiod. The value of a share of stock depends on all of the future cash flows of company. Another wayto look at this is that, barring large cash payments toshareholders, the expected price of the stock mustbe higher in the future than it is today. Who would buy a stock for $100 today when the share price inone year is expected to be $80?

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CHAPTER 2ACCOUNTING STATEMENTS, TAXES,AND CASH FLOWAnswers to Concepts Review and Critical Thinking Questions1.True. Every asset can be converted to cash at some price. However, when we are referring to a liquidasset, the added assumption that the asset can be quickly converted to cash at or near market value isimportant.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.The bottom line number shows the change in the cash balance on the balance sheet. As such, it is nota useful number for analyzing a company.4.The major difference is the treatment of interest expense. The accounting statement of cash flowstreats interest as an operating cash flow, while the financial cash flows treat interest as a financingcash flow. The logic of the accounting statement of cash flows is that since interest appears on theincome statement,which shows the operations for the period, it is an operating cash flow. In reality,interest is a financing expense, which results from the company’s choice of debt and equity. We willhave more to say about this in a later chapter. When comparing the two cash flow statements, thefinancial statement of cash flows is a more appropriate measure of the company’s performance becauseof its treatment of interest.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, for example, capital outlays will 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 positive or negative.7.It’s probably not a good sign for an established company to have negative cash flow from operations,but it would be fairly ordinary for a start-up, so it depends.

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6–SOLUTIONS MANUAL8.For example, if a company were to become more efficient in inventory management, the amount ofinventory needed would decline. The same might be true if the company becomes better at collectingits receivables. In general, anything that leads to a decline in ending NWC relative to beginning wouldhave this effect. Negative net capital spending would mean more long-lived assets were liquidatedthan purchased.9.If a company raises more money from selling stock than itpays in dividends in a particular period, itscash flow to stockholders will be negative. If a company borrows more than it pays in interest andprincipal, its cash flow to creditors will be negative.10.The adjustments discussed were purely accounting changes; they had no cash flow or market valueconsequences unless the new accounting information caused stockholders to revalue theassets.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.To find owners’ equity, we must construct a balance sheet as follows:Balance SheetCA$4,300CL$2,900NFA24,000LTD10,700OE??TA$28,300TL & OE$28,300We know that totalliabilities and owners’ equity (TL & OE) must equal total assets of $28,300. Wealso know that TL & OE is equal to current liabilities plus long-term debt plus owners’ equity, soowners’ equity is:Owners’ equity= $28,300–10,700–2,900Owners’ equity= $14,700And net working capital is current assets minus current liabilities, so:NWC = Current assets–Current liabilitiesNWC= $4,300–2,900NWC= $1,400

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CHAPTER 2-72.The income statement for the company is:IncomeStatementSales$473,000Costs275,000Depreciation42,000EBIT$156,000Interest23,000EBT$133,000Taxes27,930Net income$105,070One equation for net income is:Net income = Dividends + Addition to retained earningsRearranging, we get:Addition to retained earnings = Net income–DividendsAddition to retained earnings = $105,070–25,000Addition to retained earnings = $80,0703.To find the bookvalue of current assets, we use: NWC = CA–CL. Rearranging to solve for currentassets, we get:Current assets= Net working capital+ Current liabilitiesCurrent assets= $850,000 + 2,200,000Current assets= $3,050,000The market value ofcurrent assets and net fixed assets is given, so:Book value CA= $3,050,000Market value CA= $2,700,000Book value NFA=$4,900,000Market value NFA=$6,400,000Book value assets= $7,950,000Market value assets= $9,100,0004.Taxes = .10($9,525) + .12($38,700–9,525) + .22($82,500–38,700) + .24($157,500–82,500)+ .32($189,000–157,500)Taxes = $42,169.50The average tax rate is the total tax paid divided bytaxableincome, so:Average tax rate = $42,169.50/$189,000Average tax rate =.2231, or22.31%The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rateis 32 percent.

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8–SOLUTIONS MANUAL5.To calculate OCF, we first need the income statement:Income StatementSales$22,400Costs11,600Depreciation2,200EBIT$8,600Interest1,370Taxable income$7,230Taxes1,591Net income$5,639OCF = EBIT + Depreciation–TaxesOCF = $8,600 +2,200–1,591OCF = $9,2096.Net capital spending = NFAend–NFAbeg+ DepreciationNet capital spending = $1,430,000–1,280,000 + 146,000Net capital spending = $296,0007.The long-term debt account will increase by $30million, the amount of the new long-term debt issue.Since the company sold4.5million new shares of stock with a $1 par value, the common stock accountwill increase by $4.5million. The capital surplus account will increase by $53.5million, the value ofthe new stock sold above its par value. Since the company had a net income of $7.5million, and paid$1.7million in dividends, the addition to retained earnings was $5.8million, which will increase theaccumulated retained earnings account. So, the new long-term debt and stockholders’ equity portionof the balance sheet will be:Long-term debt$75,000,000Total long-term debt$75,000,000Shareholders’equityPreferred stock$2,900,000Common stock ($1 parvalue)15,500,000Accumulated retained earnings112,800,000Capital surplus102,500,000Total equity$ 233,700,000Totalliabilities &equity$ 308,700,0008.Cash flow to creditors = Interest paid–Net new borrowingCash flow to creditors = $170,000–(LTDend–LTDbeg)Cash flow to creditors = $170,000–($1,645,000–1,565,000)Cash flow to creditors = $170,000–80,000Cash flow to creditors = $90,000

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CHAPTER 2-99.Cash flow to stockholders = Dividends paid–Net new equityCash flow to stockholders = $335,000–[(Commonend+ APISend)–(Commonbeg+ APISbeg)]Cash flow to stockholders = $335,000–[($525,000 + 3,750,000)–($490,000 + 3,400,000)]Cash flow to stockholders = $335,000–($4,275,000–3,890,000)Cash flow to stockholders =–$50,000Note, APIS is the additional paid-in surplus.10.Cash flow from assets= Cash flow to creditors + Cash flow to stockholders= $90,000–50,000= $40,000Cash flow from assets= OCF–Change in NWC–Net capital spending$40,000= OCF–(–$96,000)–735,000Operating cash flow= $40,000–96,000 +735,000Operating cash flow= $679,000Intermediate11.a.Theaccounting statement of cash flows explains the change in cash during the year. Theaccounting statement of cash flows will be:Statement of cash flowsOperationsNet income$129Depreciation92Changes in other current assets(17)Change in accounts payable17Total cash flow from operations$221Investing activitiesAcquisition of fixed assets$(111)Total cash flow from investing activities$(111)Financing activitiesProceeds of long-term debt$8Dividends(97)Total cash flow from financing activities($89)Change in cash (on balance sheet)$21

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10–SOLUTIONS MANUALb.Change in NWC= NWCend–NWCbeg= (CAend–CLend)–(CAbeg–CLbeg)= [($84+192)–146]–[($63+175)–129)= $130–109= $21c.To find the cash flow generated by the firm’s assets, we need the operating cash flow and thecapital spending. So, calculating each of these, we find:Operating cash flowNet income$129Depreciation92Operating cash flow$221Note that we can calculate OCF in this manner since there are no taxes.Capital spendingEnding fixed assets$417Beginning fixed assets–398Depreciation92Capital spending$111Now we can calculate the cash flow generated by the firm’s assets, which is:Cash flow from assetsOperating cash flow$221Capital spending–111Change in NWC–21Cash flow from assets$8912.With the information provided, the cash flows from the firm are the capital spending and the changein net working capital, so:Cash flows from the firmCapital spending–$29,000Additions to NWC–2,400Capital spending and NWC cash flow–$31,400And the cash flows to the investors of the firm are:Cash flows to investors of the firmSale of long-term debt–$16,400Sale of common stock–4,000Dividends paid13,100Cash flows to investors of the firm–$7,300

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CHAPTER 2-1113.a.The interest expense for the company is the amount of debt times the interest rate on the debt.So, the income statement for the company is:Income StatementSales$865,000Cost of goods sold455,000Selling costs210,000Depreciation105,000EBIT$95,000Interest27,200Taxable income$67,800Taxes14,238Net income$53,562b.And the operating cash flow is:OCF = EBIT + Depreciation–TaxesOCF = $95,000 + 105,000–14,238OCF = $185,76214.To find the OCF, we first calculate net income.Income StatementSales$246,000Costs135,000Other expenses7,100Depreciation19,100EBIT$84,800Interest10,000Taxable income$74,800Taxes18,876Net income$55,924Dividends$9,800Additions to RE$46,124a.OCF = EBIT + Depreciation–TaxesOCF = $84,800+ 19,100–18,876OCF = $85,024b.CFC = Interest–Net new LTDCFC = $10,000–(–$6,800)CFC = $16,800Note that the net new long-term debt is negative because the company repaid part of its long-term debt.c.CFS = Dividends–Net new equityCFS = $9,800–7,900CFS = $1,900

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12–SOLUTIONS MANUALd.We know that CFA = CFC + CFS, so:CFA = $16,800 + 1,900CFA= $18,700CFA is also equal to OCF–Net capital spending–Change in NWC. We already know OCF.Net capital spending is equal to:Net capital spending = Increase in NFA + DepreciationNet capital spending = $41,900+ 19,100Net capital spending = $61,000Now we can use:CFA = OCF–Net capital spending–Change in NWC$18,700= $85,024–61,000–Change in NWCChange in NWC = $5,324This meansthe company increased its NWC by $5,324.15.The solution to thisquestion works the income statement backwards. Starting at the bottom:Net income = Dividends + Addition to retainedearningsNet income = $1,720 +5,300Net income = $7,020Now, looking at the income statement:EBT–(EBT × Tax rate) = Net incomeRecognize that EBT ×Taxrate is the calculation for taxes. Solving this for EBT yields:EBT = Net income/(1–Tax rate)EBT = $7,020/(1–.21)EBT = $8,886.08Now we can calculate:EBIT = EBT + InterestEBIT = $8,886.08+2,050EBIT = $10,936.08The last step is to use:EBIT = Sales–Costs–Depreciation$10,936.08= $54,000–29,500–DepreciationDepreciation = $13,563.92

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CHAPTER 2-1316.The market value of shareholders’ equity cannot be negative. A negative market value in this casewould imply that the company would pay you to own the stock. The market value of shareholders’equity can be stated as: Shareholders’ equity = Max [(TA–TL), 0]. So, if TA is $11,900, equity isequal to $1,200, and if TA is $9,400, equity is equal to $0. We should note here that while the marketvalue of equity cannot be negative, the book value of shareholders’ equity can be negative.17.Income StatementSales$630,000COGS465,000A&S expenses85,000Depreciation135,000EBIT–$55,000Interest70,000Taxable income–$125,000Taxes (21%)0a.Net income–$125,000b.OCF = EBIT + Depreciation–TaxesOCF =–$55,000 + 135,000–0OCF = $80,000c.Netincome 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 expense, not an operating expense.18.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.Change in NWC = Net capital spending = Net new equity = 0. (Given)Cash flow from assets = OCF–Change in NWC–Net capital spendingCash flow from assets = $80,000–0–0 = $80,000Cash flow to stockholders = Dividends–Net new equityCash flow to stockholders = $34,000–0 = $34,000Cash flow to creditors = Cash flow from assets–Cash flow to stockholdersCash flow to creditors = $80,000–34,000Cash flow to creditors = $46,000Cash flow to creditors is also:Cash flow to creditors = Interest–Net new LTDSo:Net new LTD = Interest–Cash flow to creditorsNet new LTD = $70,000–46,000Net new LTD = $24,000

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14–SOLUTIONS MANUAL19.a.The income statement is:Income StatementSales$24,360Cost of goodssold17,600Depreciation3,400EBIT$3,360Interest860Taxableincome$ 2,500Taxes525Net income$1,975b.OCF= EBIT + Depreciation–TaxesOCF= $3,360+3,400–525OCF= $6,235c.Change in NWC= NWCend–NWCbeg= (CAend–CLend)–(CAbeg–CLbeg)= ($6,410–3,445)–($5,560–3,040)= $2,965–2,520= $445Net capital spending= NFAend–NFAbeg+ Depreciation= $21,180–18,650+3,400= $5,930CFA= OCF–Change in NWC–Net capital spending= $6,235–445–5,930=–$140The 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 both fixed assets and net working capital; it had to raise anet $140in funds from its stockholders and creditors to make these investments.d.Cash flow to creditors= Interest–Net new LTD= $860–0= $860Cash flow to stockholders= Cash flow from assets–Cash flow to creditors=–$140–860=–$1,000We can also calculate the cash flow to stockholders as:Cash flow to stockholders = Dividends–Net new equitySolving for net new equity, we get:Net new equity= $1,000–(–790)= $1,790

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CHAPTER 2-15The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow fromoperations. The firm invested $445in new net working capital and $5,930in new fixed assets.The firm had to raise $140from its stakeholders to support this new investment. It accomplishedthis by raising $1,790in the form of new equity. After paying out $790of this in the form ofdividends to shareholders and $860 in the form of interest to creditors, $140was left to meet thefirm’s cash flow needs for investment.20.a.Total assets2018= $1,157+5,261= $6,418Total liabilities2018= $481+2,856= $3,337Owners’ equity2018= $6,418–3,337= $3,081Total assets2019= $1,411+6,125= $7,536Total liabilities2019= $534+3,256= $3,790Owners’ equity2019=$7,536–3,790= $3,746b.NWC2018= CA–CL = $1,157–481= $676NWC2019= CA–CL = $1,411–534= $877Change in NWC= NWCend–NWCbeg= $877–676= $201c.We can calculate net capital spending as:Net capital spending = Net fixed assetsend–Net fixed assetsbeg+ DepreciationNet capital spending = $6,125–5,261+1,478Net capital spending = $2,342So, the company had a net capital spending cashflow of $2,342. We also know that net capitalspending is:Net capital spending= Fixed assets bought–Fixed assets sold$2,342= $2,820–Fixed assets soldFixed assets sold= $2,820–2,342Fixed assets sold= $478To calculate the cash flow from assets, we must first calculate the operating cash flow. Theoperating cash flow is calculated as follows (we couldalso prepare a traditional incomestatement):EBIT = Sales–Costs–DepreciationEBIT = $17,688–7,118–1,478EBIT = $9,092EBT = EBIT–InterestEBT = $9,092–392EBT = $8,700Taxes = EBT.22Taxes = $8,700.22Taxes = $1,914

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16–SOLUTIONS MANUALOCF = EBIT + Depreciation–TaxesOCF =$9,092+1,478–1,914OCF = $8,656Cash flow from assets = OCF–Change in NWC–Net capital spendingCash flow from assets = $8,656–201–2,342Cash flow from assets = $6,113d.Net new borrowing = LTDend–LTDbegNet new borrowing = $3,256–2,856Net new borrowing = $400Net new borrowing = $400= Debt issued–Debt retiredDebt retired = $545–400Debt retired= $145Cash flow to creditors = Interest–Net new LTDCash flow to creditors = $392–400Cash flow to creditors =–$821.Balance sheet as of Dec. 31,2018Cash$4,438Accounts payable$4,661Accounts receivable4,874Notes payable858Inventory10,444Current liabilities$5,519Current assets$19,756Long-term debt$14,537Net fixed assets$37,211Owners' equity36,911Total assets$56,967Total liab. & equity$56,967Balance sheet as of Dec. 31,2019Cash$5,620Accounts payable$4,520Accountsreceivable6,617Notes payable806Inventory10,733Current liabilities$5,326Current assets$22,970Long-term debt$17,334Net fixed assets$39,049Owners' equity39,359Total assets$62,019Total liab. & equity$62,019

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