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Solutions Manual

Fundamentals of Corporate Finance 9

th

edition

Ross, Westerfield, and Jordan

Updated 12-20-

CHAPTER 1

INTRODUCTION TO CORPORATE

FINANCE

Answers to Concepts Review and Critical Thinking Questions

1. Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm’s credit collection policy with its customers). 2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise capital funds. Some advantages: simpler, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates. 3. The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life. 4. In response to Sarbanes-Oxley, small firms have elected to go dark because of the costs of compliance. The costs to comply with Sarbox can be several million dollars, which can be a large percentage of a small firms profits. A major cost of going dark is less access to capital. Since the firm is no longer publicly traded, it can no longer raise money in the public market. Although the company will still have access to bank loans and the private equity market, the costs associated with raising funds in these markets are usually higher than the costs of raising funds in the public market. 5. The treasurer’s office and the controller’s office are the two primary organizational groups that report directly to the chief financial officer. The controller’s office handles cost and financial accounting, tax management, and management information systems, while the treasurer’s office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the treasury group’s functions. 6. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly- traded or not). 7. 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. 8. A primary market transaction.

CHAPTER 1 B-

16. How much is too much? Who is worth more, Ray Irani or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases.

CHAPTER 2

FINANCIAL STATEMENTS, TAXES AND

CASH FLOW

Answers to Concepts Review and Critical Thinking Questions

1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in meeting short-term creditor demands. However, since liquidity also has an opportunity cost associated with it—namely that higher returns can generally be found by investing the cash into productive assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial management staff to find a reasonable compromise between these opposing needs. 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. Historical costs can be objectively and precisely measured whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff between relevance (market values) and objectivity (book values). 4. Depreciation is a non-cash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it’s a financing cost, not an operating cost. 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, 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 it 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.

B-6 SOLUTIONS

2. The income statement for the company is:

Income Statement Sales $586, Costs 247, Depreciation 43, EBIT $296, Interest 32, EBT $264, Taxes(35%) 92, Net income $171,

3. One equation for net income is:

Net income = Dividends + Addition to retained earnings

Rearranging, we get:

Addition to retained earnings = Net income – Dividends = $171,600 – 73,000 = $98,

4. EPS = Net income / Shares = $171,600 / 85,000 = $2.02 per share

DPS = Dividends / Shares = $73,000 / 85,000 = $0.86 per share

5. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current assets, we get:

CA = NWC + CL = $380,000 + 1,400,000 = $1,480,

The market value of current assets and fixed assets is given, so:

Book value CA = $1,480,000 Market value CA = $1,600, Book value NFA = $3,700,000 Market value NFA = $4,900, Book value assets = $5,180,000 Market value assets = $6,500,

6. Taxes = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($236K – 100K) = $75, 7. The average tax rate is the total tax paid divided by net income, so:

Average tax rate = $75,290 / $236,000 = 31.90%

The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39%.

CHAPTER 2 B-

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

Income Statement Sales $27, Costs 13, Depreciation 2, EBIT $11, Interest 1, Taxable income $10, Taxes (35%) 3, Net income $ 7,

OCF = EBIT + Depreciation – Taxes = $11,920 + 2,300 – 3,785 = $10,

9. Net capital spending = NFAend – NFAbeg + Depreciation Net capital spending = $4,200,000 – 3,400,000 + 385, Net capital spending = $1,185, 10. Change in NWC = NWCend – NWCbeg Change in NWC = (CAend – CL (^) end ) – (CAbeg – CL (^) beg ) Change in NWC = ($2,250 – 1,710) – ($2,100 – 1,380) Change in NWC = $540 – 720 = –$ 11. Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = Interest paid – (LTDend – LTDbeg ) Cash flow to creditors = $170,000 – ($2,900,000 – 2,600,000) Cash flow to creditors = –$130, 12. Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = Dividends paid – [(Commonend + APIS (^) end ) – (Common (^) beg + APIS (^) beg )] Cash flow to stockholders = $490,000 – [($815,000 + 5,500,000) – ($740,000 + 5,200,000)] Cash flow to stockholders = $115,

Note, APIS is the additional paid-in surplus.

13. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders = –$130,000 + 115,000 = –$15,

Cash flow from assets = –$15,000 = OCF – Change in NWC – Net capital spending = –$15,000 = OCF – (–$85,000) – 940,

Operating cash flow = –$15,000 – 85,000 + 940, Operating cash flow = $840,

CHAPTER 2 B-

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) = $6,600 / (1 – 0.35) = $10,

Now you can calculate:

EBIT = EBT + Interest = $10,154 + 4,500 = $14,

The last step is to use:

EBIT = Sales – Costs – Depreciation $14,654 = $41,000 – 19,500 – Depreciation

Solving for depreciation, we find that depreciation = $6,

16. The balance sheet for the company looks like this:

Balance Sheet Cash $195,000 Accounts payable $405, Accounts receivable 137,000 Notes payable 160, Inventory 264,000 Current liabilities $565, Current assets $596,000 Long-term debt 1,195, Total liabilities $1,760, Tangible net fixed assets 2,800, Intangible net fixed assets 780,000 Common stock ?? Accumulated ret. earnings 1,934, Total assets $4,176,000 Total liab. & owners’ equity $4,176,

Total liabilities and owners’ equity is:

TL & OE = CL + LTD + Common stock + Retained earnings

Solving for this equation for equity gives us:

Common stock = $4,176,000 – 1,934,000 – 1,760,300 = $481,

17. The market value of shareholders’ equity cannot be negative. A negative market value in this case would 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 $8,400, equity is equal to $1,100, and if TA is $6,700, equity is equal to $0. We should note here that the book value of shareholders’ equity can be negative.

B-10 SOLUTIONS

18. a. Taxes Growth = 0.15($50,000) + 0.25($25,000) + 0.34($13,000) = $18, Taxes Income = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($235,000) + 0.34($8,465,000) = $2,992,

b. Each firm has a marginal tax rate of 34% on the next $10,000 of taxable income, despite their different average tax rates, so both firms will pay an additional $3,400 in taxes.

19. Income Statement Sales $730, COGS 580, A&S expenses 105, Depreciation 135, EBIT –$90, Interest 75, Taxable income –$165, Taxes (35%) 0 a. Net income –$165,

b. OCF = EBIT + Depreciation – Taxes = –$90,000 + 135,000 – 0 = $45,

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 = $45,000 – 0 – 0 = $45, Cash flow to stockholders = Dividends – Net new equity = $25,000 – 0 = $25, Cash flow to creditors = Cash flow from assets – Cash flow to stockholders Cash flow to creditors = $45,000 – 25,000 = $20, Cash flow to creditors = Interest – Net new LTD Net new LTD = Interest – Cash flow to creditors = $75,000 – 20,000 = $55,

21. a. Income Statement Sales $22, Cost of goods sold 16, Depreciation 4, EBIT $ 2, Interest 1, Taxable income $ 870 Taxes (34%) 296 Net income $ 574

b. OCF = EBIT + Depreciation – Taxes = $2,700 + 4,050 – 296 = $6,

B-12 SOLUTIONS

c. We can calculate net capital spending as:

Net capital spending = Net fixed assets 2009 – Net fixed assets 2008 + Depreciation Net capital spending = $3,240 – 2,691 + 738 = $1,

So, the company had a net capital spending cash flow of $1,287. We also know that net capital spending is:

Net capital spending = Fixed assets bought – Fixed assets sold $1,287 = $1,350 – Fixed assets sold Fixed assets sold = $1,350 – 1,287 = $

To calculate the cash flow from assets, we must first calculate the operating cash flow. The income statement is:

Income Statement Sales $ 8,280. Costs 3,861. Depreciation expense 738. EBIT $3,681. Interest expense 211. EBT $3,470. Taxes (35%) 1,215. Net income $2,256.

So, the operating cash flow is:

OCF = EBIT + Depreciation – Taxes = $3,681 + 738 – 1,214.50 = $3,204.

And the cash flow from assets is:

Cash flow from assets = OCF – Change in NWC – Net capital spending. = $3,204.50 – 22 – 1,287 = $1,895.

d. Net new borrowing = LTD09 – LTD08 = $1,512 – 1,422 = $ Cash flow to creditors = Interest – Net new LTD = $211 – 90 = $ Net new borrowing = $90 = Debt issued – Debt retired Debt retired = $270 – 90 = $

Challenge

23. Net capital spending = NFAend – NFAbeg + Depreciation = (NFAend – NFAbeg ) + (Depreciation + ADbeg ) – ADbeg = (NFAend – NFAbeg )+ ADend – ADbeg = (NFAend + ADend ) – (NFAbeg + ADbeg ) = FAend – FAbeg

CHAPTER 2 B-

24. 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. Taxes = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($235,000) = $113,

Average tax rate = $113,900 / $335,000 = 34%

The marginal tax rate on the next dollar of income is 34 percent.

For corporate taxable income levels of $335,000 to $10 million, average tax rates are equal to marginal tax rates.

Taxes = 0.34($10,000,000) + 0.35($5,000,000) + 0.38($3,333,333)= $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($200,000) = $68, $68,000 = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + X($100,000); X($100,000) = $68,000 – 22, X = $45,750 / $100, X = 45.75%

25.

Balance sheet as of Dec. 31, 2008 Cash $3,792 Accounts payable $3, Accounts receivable 5,021 Notes payable 732 Inventory 8,927 Current liabilities $4, Current assets $17, Long-term debt $12, Net fixed assets $31,805 Owners' equity 32, Total assets $49,545 Total liab. & equity $49,

Balance sheet as of Dec. 31, 2009 Cash $4,041 Accounts payable $4, Accounts receivable 5,892 Notes payable 717 Inventory 9,555 Current liabilities $4, Current assets $19, Long-term debt $15, Net fixed assets $33,921 Owners' equity 33, Total assets $53,409 Total liab. & equity $53,

CHAPTER 3

WORKING WITH FINANCIAL

STATEMENTS

Answers to Concepts Review and Critical Thinking Questions

1. a. If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0. b. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0. c. Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0. d. As long-term debt approaches maturity, the principal repayment and the remaining interest expense become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was initially greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current ratio since current liabilities are not affected. e. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged. f. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged. g. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases. 2. The firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain unchanged, liquidity has potentially decreased. 3. A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm has 50% more current assets than it does current liabilities. This probably represents an improvement in liquidity; short-term obligations can generally be met com- pletely with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess funds sitting in current assets generally earn little or no return. These excess funds might be put to better use by investing in productive long-term assets or distributing the funds to shareholders. 4. a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm’s current assets. b. Cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid asset (cash). c. Total asset turnover measures how much in sales is generated by each dollar of firm assets. d. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the dollar worth of firm assets each equity dollar has a claim to. e. Long-term debt ratio measures the percentage of total firm capitalization funded by long-term debt.

B-16 SOLUTIONS

f. Times interest earned ratio provides a relative measure of how well the firm’s operating earnings can cover current interest obligations. g. Profit margin is the accounting measure of bottom-line profit per dollar of sales. h. Return on assets is a measure of bottom-line profit per dollar of total assets. i. Return on equity is a measure of bottom-line profit per dollar of equity. j. Price-earnings ratio reflects how much value per share the market places on a dollar of accounting earnings for a firm.

5. Common size financial statements express all balance sheet accounts as a percentage of total assets and all income statement accounts as a percentage of total sales. Using these percentage values rather than nominal dollar values facilitates comparisons between firms of different size or business type. Common-base year financial statements express each account as a ratio between their current year nominal dollar value and some reference year nominal dollar value. Using these ratios allows the total growth trend in the accounts to be measured. 6. 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. An aspirant group would be a set of firms whose performance the company in question would like to emulate. The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluated by how well they match the performance of an identified aspirant group. 7. Return on equity is probably the most important accounting ratio that measures the bottom-line performance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes the role of a firm’s profitability, asset utilization efficiency, and financial leverage in achieving an ROE figure. For example, a firm with ROE of 20% would seem to be doing well, but this figure may be misleading if it were marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm’s margins were to erode slightly, the ROE would be heavily impacted. 8. The book-to-bill ratio is intended to measure whether demand is growing or falling. It is closely followed because it is a barometer for the entire high-tech industry where levels of revenues and earnings have been relatively volatile. 9. 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. 10. a. For an electric utility such as Con Ed, expressing costs on a per kilowatt hour basis would be a way to compare costs with other utilities of different sizes. b. For a retailer such as Sears, expressing sales on a per square foot basis would be useful in comparing revenue production against other retailers. c. For an airline such as Southwest, expressing costs on a per passenger mile basis allows for comparisons with other airlines by examining how much it costs to fly one passenger one mile.

B-18 SOLUTIONS

To find ROE, we need to find total equity. TL & OE = TD + TE TE = TL & OE – TD TE = $17,500,000 – 6,300,000 = $11,200,

ROE = Net income / TE = 2,320,000 / $11,200,000 = .2071 or 20.71%

3. Receivables turnover = Sales / Receivables Receivables turnover = $3,943,709 / $431,287 = 9.14 times

Days’ sales in receivables = 365 days / Receivables turnover = 365 / 9.14 = 39.92 days

The average collection period for an outstanding accounts receivable balance was 39.92 days.

4. Inventory turnover = COGS / Inventory Inventory turnover = $4,105,612 / $407,534 = 10.07 times

Days’ sales in inventory = 365 days / Inventory turnover = 365 / 10.07 = 36.23 days

On average, a unit of inventory sat on the shelf 36.23 days before it was sold.

5. Total debt ratio = 0.63 = TD / TA

Substituting total debt plus total equity for total assets, we get:

0.63 = TD / (TD + TE)

Solving this equation yields:

0.63(TE) = 0.37(TD)

Debt/equity ratio = TD / TE = 0.63 / 0.37 = 1.

Equity multiplier = 1 + D/E = 2.

6. Net income = Addition to RE + Dividends = $430,000 + 175,000 = $605,

Earnings per share = NI / Shares = $605,000 / 210,000 = $2.88 per share

Dividends per share = Dividends / Shares = $175,000 / 210,000 = $0.83 per share

Book value per share = TE / Shares = $5,300,000 / 210,000 = $25.24 per share

Market-to-book ratio = Share price / BVPS = $63 / $25.24 = 2.50 times

P/E ratio = Share price / EPS = $63 / $2.88 = 21.87 times

Sales per share = Sales / Shares = $4,500,000 / 210,000 = $21.

P/S ratio = Share price / Sales per share = $63 / $21.43 = 2.94 times

CHAPTER 3 B-

7. ROE = (PM)(TAT)(EM)

ROE = (.055)(1.15)(2.80) = .1771 or 17.71%

8. This question gives all of the necessary ratios for the DuPont Identity except the equity multiplier, so, using the DuPont Identity:

ROE = (PM)(TAT)(EM) ROE = .1827 = (.068)(1.95)(EM)

EM = .1827 / (.068)(1.95) = 1.

D/E = EM – 1 = 1.38 – 1 = 0.

9. Decrease in inventory is a source of cash Decrease in accounts payable is a use of cash Increase in notes payable is a source of cash Increase in accounts receivable is a use of cash Changes in cash = sources – uses = $375 – 190 + 210 – 105 = $ Cash increased by $ 10. Payables turnover = COGS / Accounts payable Payables turnover = $28,384 / $6,105 = 4.65 times

Days’ sales in payables = 365 days / Payables turnover Days’ sales in payables = 365 / 4.65 = 78.51 days

The company left its bills to suppliers outstanding for 78.51 days on average. A large value for this ratio could imply that either (1) the company is having liquidity problems, making it difficult to pay off its short-term obligations, or (2) that the company has successfully negotiated lenient credit terms from its suppliers.

11. New investment in fixed assets is found by:

Net investment in FA = (NFAend – NFAbeg ) + Depreciation Net investment in FA = $835 + 148 = $

The company bought $983 in new fixed assets; this is a use of cash.

12. The equity multiplier is:

EM = 1 + D/E EM = 1 + 0.65 = 1.

One formula to calculate return on equity is:

ROE = (ROA)(EM) ROE = .085(1.65) = .1403 or 14.03%