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Solutions Manual
Corporate Finance
Ross, Westerfield, and Jaffe
th
edition
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 $ million. However, the firm believes that improving the safety of the product will only save $ 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
FINANCIAL STATEMENTS 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. 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 derivatives. 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 $ 5,300 CL $ 3, NFA 26,000 LTD 14, OE ?? TA $31,300 TL & OE $31,
We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $31,300. We also know that TL & OE is equal to current liabilities plus long-term debt plus owner’s equity, so owner’s equity is:
OE = $31,300 –14,200 – 3,900 = $13,
NWC = CA – CL = $5,300 – 3,900 = $1,
2. The income statement for the company is:
Income Statement Sales $493, Costs 210, Depreciation 35, EBIT $248, Interest 19, EBT $229, Taxes 80, Net income $148,
7. The long-term debt account will increase by $10 million, the amount of the new long-term debt issue. Since the company sold 10 million new shares of stock with a $1 par value, the common stock account will increase by $10 million. The capital surplus account will increase by $33 million, the value of the new stock sold above its par value. Since the company had a net income of $9 million, and paid $2 million in dividends, the addition to retained earnings was $7 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 $ 82,000, Total long-term debt $ 82,000,
Shareholders equity Preferred stock $ 9,000, Common stock ($1 par value) 30,000, Accumulated retained earnings 104,000, Capital surplus 76,000, Total equity $ 219,000,
Total Liabilities & Equity $ 301,000,
8. Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = $118,000 – (LTDend – LTDbeg) Cash flow to creditors = $118,000 – ($1,390,000 – 1,340,000) Cash flow to creditors = $118,000 – 50, Cash flow to creditors = $68, 9. Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = $385,000 – [(Commonend + APISend) – (Commonbeg + APISbeg)] Cash flow to stockholders = $385,000 – [($450,000 + 3,050,000) – ($430,000 + 2,600,000)] Cash flow to stockholders = $385,000 – ($3,500,000 – 3,030,000) Cash flow to stockholders = –$85,
Note, APIS is the additional paid-in surplus.
10. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders = $68,000 – 85, = –$17,
Cash flow from assets = –$17,000 = OCF – Change in NWC – Net capital spending –$17,000 = OCF – (–$69,000) – 875,
Operating cash flow = –$17,000 – 69,000 + 875, Operating cash flow = $789,
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 90 Changes in other current assets (55) Accounts payable (10) Total cash flow from operations $
Investing activities Acquisition of fixed assets $(140) Total cash flow from investing activities $(140)
Financing activities Proceeds of long-term debt $ Dividends (45) Total cash flow from financing activities ($15)
Change in cash (on balance sheet) $
b. Change in NWC = NWCend – NWCbeg = (CAend – CLend) – (CAbeg – CLbeg) = [($50 + 155) – 85] – [($35 + 140) – 95) = $120 – 80 = $
c. To find the cash flow generated by the firm’s assets, we need the operating cash flow, and the capital spending. So, calculating each of these, we find:
Operating cash flow Net income $ Depreciation 90 Operating cash flow $
Note that we can calculate OCF in this manner since there are no taxes.
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 $1,200, Cost of goods sold 450, Selling costs 225, Depreciation 110, EBIT $415, Interest 81, Taxable income $334, Taxes 116, Net income $217,
b. And the operating cash flow is:
OCF = EBIT + Depreciation – Taxes OCF = $415,000 + 110,000 – 116, OCF = $408,
14. To find the OCF, we first calculate net income.
Income Statement Sales $167, Costs 91, Depreciation 8, Other expenses 5, EBIT $62, Interest 11, Taxable income $51, Taxes 18, Net income $33,
Dividends $9, Additions to RE $24,
a. OCF = EBIT + Depreciation – Taxes OCF = $62,600 + 8,000 – 18, OCF = $52,
b. CFC = Interest – Net new LTD CFC = $11,000 – (–$7,100) CFC = $18,
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 = $9,500 – 7, CFS = $2,
d. We know that CFA = CFC + CFS, so:
CFA = $18,100 + 2,250 = $20,
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 = $22,400 + 8, Net capital spending = $30,
Now we can use:
CFA = OCF – Net capital spending – Change in NWC $20,350 = $52,540 – 30,400 – Change in NWC.
Solving for the change in NWC gives $1,790, meaning the company increased its NWC by $1,790.
15. The solution to this question works the income statement backwards. Starting at the bottom:
Net income = Dividends + Addition to ret. earnings Net income = $1,530 + 5, Net income = $6,
Now, looking at the income statement:
EBT – (EBT × Tax rate) = Net income
Recognize that EBT × tax rate is simply the calculation for taxes. Solving this for EBT yields:
EBT = NI / (1– Tax rate) EBT = $6,830 / (1 – 0.65) EBT = $10,507.
Now we can calculate:
EBIT = EBT + Interest EBIT = $10,507.69 + 1, EBIT = $12,407.
The last step is to use:
EBIT = Sales – Costs – Depreciation $12,407.69 = $43,000 – 27,500 – Depreciation Depreciation = $3,092.
Solving for depreciation, we find that depreciation = $3,092.
b. OCF = EBIT + Depreciation – Taxes OCF = ($115,000) + 140,000 – 0 OCF = $25,
c. Net income was negative because of the tax deductibility of depreciation and interest expense. However, the actual cash flow from operations was positive because depreciation is a non-cash expense and interest is a financing expense, not an operating expense.
20. A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficient cash 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 spending Cash flow from assets = $25,000 – 0 – 0 = $25,
Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $30,000 – 0 = $30,
Cash flow to creditors = Cash flow from assets – Cash flow to stockholders Cash flow to creditors = $25,000 – 30, Cash flow to creditors = –$5,
Cash flow to creditors is also:
Cash flow to creditors = Interest – Net new LTD
So:
Net new LTD = Interest – Cash flow to creditors Net new LTD = $70,000 – (–5,000) Net new LTD = $75,
21. a. The income statement is:
Income Statement Sales $15, Cost of good sold 10, Depreciation 2, EBIT $ 2, Interest 520 Taxable income $ 1, Taxes 712 Net income $1,
b. OCF = EBIT + Depreciation – Taxes OCF = $2,300 + 2,100 – 712 OCF = $3,
c. Change in NWC = NWCend – NWCbeg = (CAend – CLend) – (CAbeg – CLbeg) = ($3,950 – 1,950) – ($3,400 – 1,900) = $2,000 – 1,500 = $
Net capital spending = NFAend – NFAbeg + Depreciation = $12,900 – 11,800 + 2, = $3,
CFA = OCF – Change in NWC – Net capital spending = $3,688 – 500 – 3, = –$
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 $12 in funds from its stockholders and creditors to make these investments.
d. Cash flow to creditors = Interest – Net new LTD = $520 – 0 = $
Cash flow to stockholders = Cash flow from assets – Cash flow to creditors = –$12 – 520 = –$
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 = $500 – (–532) = $1,
The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $500 in new net working capital and $3,200 in new fixed assets. The firm had to raise $12 from its stakeholders to support this new investment. It accomplished this by raising $1,032 in the form of new equity. After paying out $500 of this in the form of dividends to shareholders and $520 in the form of interest to creditors, $12 was left to meet the firm’s cash flow needs for investment.
22. a. Total assets 2009 = $780 + 3,480 = $4, Total liabilities 2009 = $318 + 1,800 = $2, Owners’ equity 2009 = $4,260 – 2,118 = $2,
Total assets 2010 = $846 + 4,080 = $4, Total liabilities 2010 = $348 + 2,064 = $2, Owners’ equity 2010 = $4,926 – 2,412 = $2,
Change in NWC = NWCend – NWCbeg = (CA – CL) (^) end – (CA – CL) (^) beg
- Balance sheet as of Dec. 31,
- Cash $2,739 Accounts payable $2,
- Accounts receivable 3,626 Notes payable
- Inventory 6,447 Current liabilities $3,
- Current assets $12, - Long-term debt $9,
- Net fixed assets $22,970 Owners' equity $23,
- Total assets $35,782 Total liab. & equity $35, - Balance sheet as of Dec. 31,
- Cash $2,802 Accounts payable $2,
- Accounts receivable 4,085 Notes payable
- Inventory 6,625 Current liabilities $3,
- Current assets $13, - Long-term debt $10,
- Net fixed assets $23,518 Owners' equity $23,
- Total assets $37,030 Total liab. & equity $37,
- Sales $5,223.00 Sales $5,606. 2009 Income Statement 2010 Income Statement
- COGS 1,797.00 COGS 2,040.
- Other expenses 426.00 Other expenses 356.
- Depreciation 750.00 Depreciation 751.
- EBIT $2,250.00 EBIT $2,459.
- Interest 350.00 Interest 402.
- EBT $1,900.00 EBT $2,057.
- Taxes 646.00 Taxes 699.
- Net income $1,254.00 Net income $1,357.
- Dividends $637.00 Dividends $701.
- Additions to RE 617.00 Additions to RE 656.
- OCF = $2,459 + 751 – 699. 24. OCF = EBIT + Depreciation – Taxes
- OCF = $2,510.
- Change in NWC = $ Change in NWC = ($13,512 – 3,287) – ($12,812 – 3,406)
- Net capital spending = $23,518 – 22,970 + Net capital spending = NFAend – NFAbeg + Depreciation
- Net capital spending = $1,
Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $2,510.62 – 819 – 1, Cash flow from assets = $396.
Cash flow to creditors = Interest – Net new LTD Net new LTD = LTDend – LTDbeg Cash flow to creditors = $402 – ($10,702 – 9,173) Cash flow to creditors = –$1,
Net new equity = Common stockend – Common stockbeg Common stock + Retained earnings = Total owners’ equity Net new equity = (OE – RE) (^) end – (OE – RE) (^) beg Net new equity = OEend – OEbeg + REbeg – REend REend = REbeg + Additions to RE ∴ Net new equity = OEend – OEbeg + REbeg – (REbeg + Additions to RE) = OEend – OEbeg – Additions to RE Net new equity = $23,041 – 23,203 – 656.62 = –$818.
Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $701 – (–$818.62) Cash flow to stockholders = $1,519.
As a check, cash flow from assets is $396.62.
Cash flow from assets = Cash flow from creditors + Cash flow to stockholders Cash flow from assets = –$1,127 + 1,519. Cash flow from assets = $392.
Challenge
25. 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 = $144 + 82 + 16 + 43 EBIT = $
Now we can calculate the operating cash flow as:
Operating cash flow Earnings before interest and taxes $ Depreciation 78 Current taxes (82) Operating cash flow $
26. Net capital spending = NFAend – NFAbeg + Depreciation = (NFAend – NFAbeg) + (Depreciation + ADbeg) – ADbeg = (NFAend – NFAbeg)+ ADend – ADbeg = (NFAend + ADend) – (NFAbeg + ADbeg) = FAend – FAbeg 27. a. The tax bubble causes average tax rates to catch up to marginal tax rates, thus eliminating the tax advantage of low marginal rates for high income corporations.
b. Assuming a taxable income of $335,000, the taxes will be:
Taxes = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($235K) = $113.9K
Average tax rate = $113.9K / $335K = 34%
The marginal tax rate on the next dollar of income is 34 percent.
For corporate taxable income levels of $335K to $10M, average tax rates are equal to marginal tax rates.
Taxes = 0.34($10M) + 0.35($5M) + 0.38($3.333M) = $6,416,
Average tax rate = $6,416,667 / $18,333,334 = 35%
The marginal tax rate on the next dollar of income is 35 percent. For corporate taxable income levels over $18,333,334, average tax rates are again equal to marginal tax rates.
c. Taxes = 0.34($200K) = $68K = 0.15($50K) + 0.25($25K) + 0.34($25K) + X($100K); X($100K) = $68K – 22.25K = $45.75K X = $45.75K / $100K X = 45.75%
CHAPTER 3
FINANCIAL STATEMENTS ANALYSIS
AND LONG-TERM PLANNING
Answers to Concepts Review and Critical Thinking Questions
1. Time trend analysis gives a picture of changes in the company’s financial situation over time. Comparing a firm to itself over time allows the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment activities have changed. Peer group analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate actions to take to adjust these ratios if appropriate. Both allow an investigation into what is different about a company from a financial perspective, but neither method gives an indication of whether the difference is positive or negative. For example, suppose a company’s current ratio is increasing over time. It could mean that the company had been facing liquidity problems in the past and is rectifying those problems, or it could mean the company has become less efficient in managing its current accounts. Similar arguments could be made for a peer group comparison. A company with a current ratio lower than its peers could be more efficient at managing its current accounts, or it could be facing liquidity problems. Neither analysis method tells us whether a ratio is good or bad, both simply show that something is different, and tells us where to look. 2. If a company is growing by opening new stores, then presumably total revenues would be rising. Comparing total sales at two different points in time might be misleading. Same-store sales control for this by only looking at revenues of stores open within a specific period. 3. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees, and, in fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firm’s future need for things like capital assets, employees, inventory, and financing are determined by its future sales level. 4. Two assumptions of the sustainable growth formula are that the company does not want to sell new equity, and that financial policy is fixed. If the company raises outside equity, or increases its debt- equity ratio, it can grow at a higher rate than the sustainable growth rate. Of course, the company could also grow faster than its profit margin increases, if it changes its dividend policy by increasing the retention ratio, or its total asset turnover increases.
