Solutions Manual for Corporate Finance 12th Edition, Exercises of Corporate Finance

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Solutions Manual

Corporate Finance

Ross, Westerfield, Jaffe, and Jordan

th

edition

Prepared by:

Brad Jordan University of Kentucky

Joe Smolira Belmont Universi

CHAPTER 1

INTRODUCTION TO CORPORATE

FINANCE

Answers to Concept Questions

1. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership 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 the firm. 2. Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize the value of the equity. 3. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-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 illegal behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we could 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 in product 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 of differing social, political, and economic institutions. 6. The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder, 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 of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this.

CHAPTER 2

ACCOUNTING STATEMENTS, TAXES,

AND CASH FLOW

Answers to Concepts Review and Critical Thinking Questions

1. True. Every asset can be converted to cash at some price. However, when we are referring to a liquid asset, the added assumption that the asset can be quickly converted to cash at or near market value is important. 2. The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily 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 not a useful number for analyzing a company. 4. The major difference is the treatment of interest expense. The accounting statement of cash flows treats interest as an operating cash flow, while the financial cash flows treat interest as a financing cash flow. The logic of the accounting statement of cash flows is that since interest appears on the income 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 will have more to say about this in a later chapter. When comparing the two cash flow statements, the financial statement of cash flows is a more appropriate measure of the company’s performance because of its treatment of interest. 5. Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value. 6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, 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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8. For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if the company becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would have this effect. Negative net capital spending would mean more long-lived assets were liquidated than purchased. 9. If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest and principal, its cash flow to creditors will be negative. 10. The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the assets.

Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.

Basic

1. To find owners’ equity, we must construct a balance sheet as follows:

Balance Sheet CA $ 4,300 CL $ 2, NFA 24,000 LTD 10, OE ?? TA $28,300 TL & OE $28,

We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $28,300. We also know that TL & OE is equal to current liabilities plus long-term debt plus owners’ equity, so owners’ equity is:

Owners’ equity = $28,300 – 10,700 – 2, Owners’ equity = $14,

And net working capital is current assets minus current liabilities, so:

NWC = Current assets – Current liabilities NWC = $4,300 – 2, NWC = $1,

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5. To calculate OCF, we first need the income statement:

Income Statement Sales $22, Costs 11, Depreciation 2, EBIT $8, Interest 1, Taxable income $7, Taxes 1, Net income $5,

OCF = EBIT + Depreciation – Taxes OCF = $8,600 + 2,200 – 1, OCF = $9,

6. Net capital spending = NFAend – NFAbeg + Depreciation Net capital spending = $1,430,000 – 1,280,000 + 146, Net capital spending = $296, 7. The long-term debt account will increase by $30 million, the amount of the new long-term debt issue. Since the company sold 4.5 million new shares of stock with a $1 par value, the common stock account will increase by $4.5 million. The capital surplus account will increase by $53.5 million, the value of the new stock sold above its par value. Since the company had a net income of $7.5 million, and paid $1.7 million in dividends, the addition to retained earnings was $5.8 million, which will increase the accumulated retained earnings account. So, the new long-term debt and stockholders’ equity portion of the balance sheet will be:

Long-term debt $ 75,000, Total long-term debt $ 75,000,

Shareholders’ equity Preferred stock $ 2,900, Common stock ($1 par value) 15,500, Accumulated retained earnings 112,800, Capital surplus 102,500, Total equity $ 233,700,

Total liabilities & equity $ 308,700,

8. Cash flow to creditors = Interest paid – Net new borrowing Cash 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, Cash flow to creditors = $90,

CHAPTER 2 - 11

9. Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = $335,000 – [(Common (^) end + APIS (^) end ) – (Common (^) beg + APIS (^) beg )] 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,

Note, APIS is the additional paid-in surplus.

10. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders = $90,000 – 50, = $40,

Cash flow from assets = OCF – Change in NWC – Net capital spending $40,000 = OCF – (–$96,000) – 735, Operating cash flow = $40,000 – 96,000 + 735, Operating cash flow = $679,

Intermediate

11. a. The accounting statement of cash flows explains the change in cash during the year. The accounting statement of cash flows will be:

Statement of cash flows Operations Net income $ Depreciation 92 Changes in other current assets (17) Change in accounts payable 17 Total cash flow from operations $

Investing activities Acquisition of fixed assets $(111) Total cash flow from investing activities $(111)

Financing activities Proceeds of long-term debt $ Dividends (97) Total cash flow from financing activities ($89)

Change in cash (on balance sheet) $

CHAPTER 2 - 13

13. 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 Statement Sales $865, Cost of goods sold 455, Selling costs 210, Depreciation 105, EBIT $ 95, Interest 27, Taxable income $ 67, Taxes 14, Net income $ 53,

b. And the operating cash flow is:

OCF = EBIT + Depreciation – Taxes OCF = $95,000 + 105,000 – 14, OCF = $185,

14. To find the OCF, we first calculate net income.

Income Statement Sales $246, Costs 135, Other expenses 7, Depreciation 19, EBIT $84, Interest 10, Taxable income $74, Taxes 18, Net income $55,

Dividends $9, Additions to RE $46,

a. OCF = EBIT + Depreciation – Taxes OCF = $84,800 + 19,100 – 18, OCF = $85,

b. CFC = Interest – Net new LTD CFC = $10,000 – (–$6,800) CFC = $16,

Note that the net new long-term debt is negative because the company repaid part of its long- term debt.

c. CFS = Dividends – Net new equity CFS = $9,800 – 7, CFS = $1,

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d. We know that CFA = CFC + CFS, so:

CFA = $16,800 + 1, CFA = $18,

CFA 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 + Depreciation Net capital spending = $41,900 + 19, Net capital spending = $61,

Now we can use:

CFA = OCF – Net capital spending – Change in NWC $18,700 = $85,024 – 61,000 – Change in NWC Change in NWC = $5,

This means the company increased its NWC by $5,324.

15. The solution to this question works the income statement backwards. Starting at the bottom:

Net income = Dividends + Addition to retained earnings Net income = $1,720 + 5, Net income = $7,

Now, looking at the income statement:

EBT – (EBT × Tax rate) = Net income

Recognize that EBT × Tax rate is the calculation for taxes. Solving this for EBT yields:

EBT = Net income/(1 – Tax rate) EBT = $7,020/(1 – .21) EBT = $8,886.

Now we can calculate:

EBIT = EBT + Interest EBIT = $8,886.08 + 2, EBIT = $10,936.

The last step is to use:

EBIT = Sales – Costs – Depreciation $10,936.08 = $54,000 – 29,500 – Depreciation Depreciation = $13,563.

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19. a. The income statement is:

Income Statement Sales $24, Cost of goods sold 17, Depreciation 3, EBIT $ 3, Interest 860 Taxable income $ 2, Taxes 525 Net income $1,

b. OCF = EBIT + Depreciation – Taxes OCF = $3,360 + 3,400 – 525 OCF = $6,

c. Change in NWC = NWC (^) end – NWCbeg = (CAend – CL (^) end ) – (CAbeg – CL (^) beg ) = ($6,410 – 3,445) – ($5,560 – 3,040) = $2,965 – 2, = $

Net capital spending = NFAend – NFAbeg + Depreciation = $21,180 – 18,650 + 3, = $5,

CFA = OCF – Change in NWC – Net capital spending = $6,235 – 445 – 5, = –$

The cash flow from assets can be positive or negative, since it represents whether the firm raised funds or distributed funds on a net basis. In this problem, even though net income and OCF are positive, the firm invested heavily in both fixed assets and net working capital; it had to raise a net $140 in funds from its stockholders and creditors to make these investments.

d. Cash flow to creditors = Interest – Net new LTD = $860 – 0 = $

Cash flow to stockholders = Cash flow from assets – Cash flow to creditors = –$140 – 860 = –$1,

We can also calculate the cash flow to stockholders as:

Cash flow to stockholders = Dividends – Net new equity

Solving for net new equity, we get:

Net new equity = $1,000 – (–790) = $1,

CHAPTER 2 - 17

The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $445 in new net working capital and $5,930 in new fixed assets. The firm had to raise $140 from its stakeholders to support this new investment. It accomplished this by raising $1,790 in the form of new equity. After paying out $790 of this in the form of dividends to shareholders and $860 in the form of interest to creditors, $140 was left to meet the firm’s cash flow needs for investment.

20. a. Total assets 2018 = $1,157 + 5,261 = $6, Total liabilities 2018 = $481 + 2,856 = $3, Owners’ equity 2018 = $6,418 – 3,337 = $3,

Total assets 2019 = $1,411 + 6,125 = $7, Total liabilities 2019 = $534 + 3,256 = $3, Owners’ equity 2019 = $7,536 – 3,790 = $3,

b. NWC 2018 = CA – CL = $1,157 – 481 = $ NWC 2019 = CA – CL = $1,411 – 534 = $ Change in NWC = NWC (^) end – NWCbeg = $877 – 676 = $

c. We can calculate net capital spending as:

Net capital spending = Net fixed assetsend – Net fixed assetsbeg + Depreciation Net capital spending = $6,125 – 5,261 + 1, Net capital spending = $2,

So, the company had a net capital spending cash flow of $2,342. We also know that net capital spending is:

Net capital spending = Fixed assets bought – Fixed assets sold $2,342 = $2,820 – Fixed assets sold Fixed assets sold = $2,820 – 2, Fixed assets sold = $

To calculate the cash flow from assets, we must first calculate the operating cash flow. The operating cash flow is calculated as follows (we could also prepare a traditional income statement):

EBIT = Sales – Costs – Depreciation EBIT = $17,688 – 7,118 – 1, EBIT = $9,

EBT = EBIT – Interest EBT = $9,092 – 392 EBT = $8,

Taxes = EBT ×. Taxes = $8,700 ×. Taxes = $1,

CHAPTER 2 - 19

2018 Income Statement 2019 Income Statement Sales $8,462.00 Sales $9,082. COGS 2,912.00 COGS 3,305. Other expenses 690.00 Other expenses 577. Depreciation 1,215.00 Depreciation 1,216. EBIT $3,645.00 EBIT $3,984. Interest 567.00 Interest 652. EBT $3,078.00 EBT $3,332. Taxes 646.38 Taxes 699. Net income $2,431.62 Net income $2,632.

Dividends $1,032.00 Dividends $1,135. Additions to RE 1,399.62 Additions to RE 1,497.

22. OCF = EBIT + Depreciation – Taxes OCF = $3,984 + 1,216 – 699. OCF = $4,500.

Change in NWC = NWC (^) end – NWC (^) beg = (CA – CL)end – (CA – CL) (^) beg Change in NWC = ($22,970 – 5,326) – ($19,756 – 5,519) Change in NWC = $3,

Net capital spending = NFAend – NFAbeg + Depreciation Net capital spending = $39,049 – 37,211 + 1, Net capital spending = $3,

Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $4,500.28 – 3,407 – 3, Cash flow from assets = –$1,960.

Cash flow to creditors = Interest – Net new LTD Net new LTD = LTDend – LTDbeg Cash flow to creditors = $652 – ($17,334 – 14,537) Cash flow to creditors = –$2,

Net new equity = Common stockend – Common stock (^) beg Common stock + Retained earnings = Total owners’ equity Net new equity = (OE – RE)end – (OE – RE) (^) beg Net new equity = OE (^) end – OE (^) beg + REbeg – RE (^) end RE (^) end = REbeg + Additions to RE ∴ Net new equity = OE (^) end – OEbeg + RE (^) beg – (RE (^) beg + Additions to RE) = OE (^) end – OE (^) beg – Additions to RE Net new equity = $39,359 – 36,911 – 1,497.28 = $950.

Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $1,135 – 950. Cash flow to stockholders = $184.

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As a check, cash flow from assets is –$1,960.

Cash flow from assets = Cash flow from creditors + Cash flow to stockholders Cash flow from assets = –$2,145 + 184. Cash flow from assets = –$1,960.

Challenge

23. We will begin by calculating the operating cash flow. First, we need the EBIT, which can be calculated as:

EBIT = Net income + Current taxes + Deferred taxes + Interest EBIT = $187 + 81 + 11 + 38 EBIT = $

Now we can calculate the operating cash flow as:

Operating cash flow Earnings before interest and taxes $ Depreciation 74 Current taxes – Operating cash flow $

The cash flow from assets is found in the investing activities portion of the accounting statement of cash flows, so:

Cash flow from assets Acquisition of fixed assets $ Sale of fixed assets – Capital spending $

The net working capital cash flows are all found in the operations cash flow section of the accounting statement of cash flows. However, instead of calculating the net working capital cash flows as the change in net working capital, we must calculate each item individually. Doing so, we find:

Net working capital cash flow Cash $ Accounts receivable 12 Inventories – Accounts payable – Accrued expenses 6 Other – NWC cash flow $