Introduction to Corporate Finance
Answers to Concepts Review and Critical Thinking Questions
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). 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. 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. 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. 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. To maximize the current market value (share price) of the equity of the firm (whether it’s publiclytraded or not). 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. A primary market transaction.
In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to match buyers and sellers of assets.
Dealer markets like NASDAQ consist of dealers operating at dispersed locales-who buy and sell assets themselves, communicating with other dealers either electronically or literally over-the-counter. Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; i., 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. 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. 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? ”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. 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 $, 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 $ 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. We would expect agency problems to be less severe in countries with a relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects.
In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U. S. corporations and a more efficient market for corporate control. B-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. , stock price increases in excess of general market increases.
Financial Statements, Taxes and Cash Flow
Answers to Concepts Review and Critical Thinking QuestionsLiquidity 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. 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. 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). 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.
Market values can never be negative. Imagine a share of stock selling for –$. This would mean that if you placed an order for shares, you would get the stock along with a check for $,. 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. 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. It’s probably not a good sign for an established company, but it would be fairly ordinary for a startup, so it depends. 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 the beginning would have this effect.
Negative net capital spending would mean more long-lived assets were liquidated than purchased…
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, its cash flow to creditors will be negative. 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. Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have to take on the company’s debt but would pocket its cash. Enterprise value differs significantly from simple market capitalization in several ways, and it may be a more accurate representation of a firm’s value. In a takeover, the value of a firm’s debt would need to be paid by the buyer when taking over a company. This enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation. In general, it appears that investors prefer companies that have a steady earnings stream. If true, this encourages companies to manage earnings. Under GAAP, there are numerous choices for the way a company reports its financial statements. Although not the reason for the choices under GAAP, one outcome is the ability of a company to manage earnings, which is not an ethical decision. Even though earnings and cash flow are often related, earnings management should have little effect on cash flow (except for tax implications).
If the market is “fooled” and prefers steady earnings, shareholder wealth can be increased, at least temporarily. However, given the questionable ethics of this practice, the company (and shareholders) will lose value if the practice is discovered. 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.
Working With Financial Statements
Answers to Concepts Review and Critical Thinking Questions
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. Reducing accounts payable with cash increases the current ratio if it was initially greater than.
Reducing short-term debt with cash increases the current ratio if it was initially greater than. 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. 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. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.
Inventory sold for a profit raises cash in excess of the inventory recorded at cost, so the current ratio increases. The firm has increased inventory relative to other current assets; therefore, assuming current liability levels remain unchanged, liquidity has potentially decreased. A current ratio of 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 means the firm has % more current assets than it does current liabilities.
This probably represents an improvement in liquidity; short-term obligations can generally be met completely with a safety factor built in. A current ratio of, 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. 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. The cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid asset (cash).
Total asset turnover measures how much in sales is generated by each dollar of firm assets. 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. Long-term debt ratio measures the percentage of total firm capitalization funded by long-term debt..B- SOLUTIONS Times interest earned ratio provides a relative measure of how well the firm’s operating earnings can cover current interest obligations. Profit margin is the accounting measure of bottom-line profit per dollar of sales. Return on assets is a measure of bottom-line profit per dollar of total assets.
Return on equity is a measure of bottom-line profit per dollar of equity. Price-earnings ratio reflects how much value per share the market places on a dollar of accounting earnings for a firm. 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. 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. 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 % 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.
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. 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. 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.
For a retailer such as Sears, expressing sales on a per square foot basis would be useful in comparing revenue production against other retailers. 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….
For an on-line service provider such as AOL, using a per call basis for costs would allow for comparisons with smaller services. A per-subscriber basis would also make sense. For a hospital such as Holy Cross, revenues and costs expressed on a per bed basis would be useful.
For a college textbook publisher such as McGraw-Hill/Irwin, the leading publisher of finance textbooks for the college market, the obvious standardization would be per book sold. Reporting the sale of Treasury securities as cash flow from operations is an accounting “trick”, and as such, should constitute a possible red flag about the companies accounting practices. For most companies, the gain from a sale of securities should be placed in the financing section. Including the sale of securities in the cash flow from operations would be acceptable for a financial company, such as an investment or commercial bank. Increasing the payables period increases the cash flow from operations.
This could be beneficial for the company as it may be a cheap form of financing, but it is basically a one time change. The payables period cannot be increased indefinitely as it will negatively affect the company’s credit rating if the payables period becomes too long. 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.
If this is true, the book value can overstate the market value of the assets. Finally, the book value of assets may not accurately represent the market value of the assets because of depreciation. Depreciation is done according to some schedule, generally straight-line or MACRS. Thus, the book value and market value can often diverge.
Long-Term Financial Planning and Growth
Answers to Concepts Review and Critical Thinking QuestionsThe 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.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. The internal growth rate is greater than %, because at a % growth rate the negative EFN indicates that there is excess internal financing.
If the internal growth rate is greater than %, then the sustainable growth rate is certainly greater than %, because there is additional debt financing used in that case (assuming the firm is not % equity-financed). As the retention ratio is increased, the firm has more internal sources of funding, so the EFN will decline. Conversely, as the retention ratio is decreased, the EFN will rise. If the firm pays out all its earnings in the form of dividends, then the firm has no internal sources of funding (ignoring the effects of accounts payable); the internal growth rate is zero in this case and the EFN will rise to the change in total assets. The sustainable growth rate is greater than %, because at a % growth rate the negative EFN indicates that there is excess financing still available.
If the firm is % equity financed, then the sustainable and internal growth rates are equal and the internal growth rate would be greater than %. However, when the firm has some debt, the internal growth rate is always less than the sustainable growth rate, so it is ambiguous whether the internal growth rate would be greater than or less than %. If the retention ratio is increased, the firm will have more internal funding sources available, and it will have to take on more debt to keep the debt/equity ratio constant, so the EFN will decline. Conversely, if the retention ratio is decreased, the EFN will rise. If the retention rate is zero, both the internal and sustainable growth rates are zero, and the EFN will rise to the change in total assets. Presumably not, but, of course, f the product had been much less popular, then a similar fate would have awaited due to lack of sales. Since customers did not pay until shipment, receivables rose. The firm’s NWC, but not its cash, increased. At the same time, costs were rising faster than cash revenues, so operating cash flow declined. The firm’s capital spending was also rising. Thus, all three components of cash flow from assets were negatively impacted.
Apparently not! In hindsight, the firm may have underestimated costs and also underestimated the extra demand from the lower price. Financing possibly could have been arranged if the company had taken quick enough action.
Sometimes it becomes apparent that help is needed only when it is too late, again emphasizing the need for planning.All three were important, but the lack of cash or, more generally, financial resources ultimately spelled doom. An inadequate cash resource is usually cited as the most common cause of small business failure. Demanding cash up front, increasing prices, subcontracting production, and improving financial resources via new owners or new sources of credit are some of the options. When orders exceed capacity, price increases may be especially beneficial. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps.
To determine full capacity sales, we divide the current sales by the capacity the company is currently using, so: Full capacity sales = $, / Full capacity sales = $, The maximum sales growth is the full capacity sales divided by the current sales, so: Maximum sales growth = ($, / $,) – Maximum sales growth = or%
To find the new level of fixed assets, we need to find the current percentage of fixed assets to full capacity sales. Doing so, we find: Fixed assets / Full capacity sales = $, / $, Fixed assets / Full capacity sales = Next, we calculate the total dollar amount of fixed assets needed at the new sales figure.
If equity increases, the ROE based on end of period equity is lower than the ROE based on the beginning of period equity. The ROE (and sustainable growth rate) in the abbreviated equation is based on equity that did not exist when the net income was earned.The ROA using end of period assets is: ROA = $, / $, ROA = or% The beginning of period assets had to have been the ending assets minus the addition to retained earnings, so: Beginning assets = Ending assets – Addition to retained earnings Beginning assets = $, – , Beginning assets = $, And the ROA using beginning of period assets is: ROA = $, / $, ROA = or% Using the internal growth rate equation presented in the text, we get: Internal growth rate = (ROA ? b) / [ – (ROA ? b)] Internal growth rate = [. (. )] / [ –(. )] Internal growth rate = or% Using the formula ROA ? b, and end of period assets: Internal growth rate = ?Internal growth rate = or% Using the formula ROA ? b, and beginning of period assets: Internal growth rate = ?Internal growth rate = or%
Assuming costs vary with sales and a percent increase in sales, the pro forma income statement will look like this: MOOSE TOURS IN
Pro Forma Income Statement Sales $ ,, Costs , Other expenses , EBIT $ , Interest , Taxable income $ , Taxes(%) , Net income $ , The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or: Dividends = ($,/$,)($,) Dividends = $, And the addition to retained earnings will be: Addition to retained earnings = $, – , Addition to retained earnings = $, The new retained earnings on the pro forma balance sheet will be: New retained earnings = $, + , New retained earnings = $, The pro forma balance sheet will look like this: MOOSE TOURS IN
The D/E ratio of the company is: D/E = ($, + ,) / $, D/E = So the new total debt amount will be: New total debt =($,) New total debt = $, This is the new total debt for the company. Given that our calculation for EFN is the amount that must be raised externally and does not increase spontaneously with sales, we need to subtract the spontaneous increase in accounts payable. The new level of accounts payable will be, which is the current accounts payable times the sales growth, or: Spontaneous increase in accounts payable = $,(. ) Spontaneous increase in accounts payable = $, This means that $, of the new total debt is not raised externally.
So, the debt raised externally, which will be the EFN is: EFN = New total debt – (Beginning LTD + Beginning CL + Spontaneous increase in AP) EFN = $, – ($, + , + , + ,) = $, The pro forma balance sheet with the new long-term debt will be: MOOSE TOURS IN Pro Forma Balance Sheet Assets Current assets Cash Accounts receivable Inventory Total Fixed assets Net plant and equipment $ $ , , , , , Liabilities and Owners’ Equity Current liabilities Accounts payable Notes payable Total Long-term debt Owners’ equity Common stock and paid-in surplus Retained earnings Total Total liabilities and owners’ equity $ $ , , , , $ $ $ , , , , Total assets $ ,
EFN = Total assets – Total liabilities and equity EFN = $, – , EFN = –$, At a percent growth rate, and assuming the payout ratio is constant, the dividends paid will be: Dividends = ($,/$,)($,) Dividends = $, And the addition to retained earnings will be: Addition to retained earnings = $, – , Addition to retained earnings = $, The new retained earnings on the pro forma balance sheet will be: New retained earnings = $, + , New retained earnings = $,
The pro forma balance sheet will look like this: % Sales Growth: Pro Forma Balance Sheet Assets Current assets Cash Accounts receivable Inventory Total Fixed assets Net plant and equipment $ $ , , , , , Liabilities and Owners’ Equity Current liabilities Accounts payable Notes payable Total Long-term debt Owners’ equity Common stock and paid-in surplus Retained earnings Total Total liabilities and owners’ equity $ $ $ , , , , $ $ $ , , , ,
Total assets So the EFN is: $ , EFN = Total assets – Total liabilities and equity EFN = $, – , EFN = $, At a percent growth rate, and assuming the payout ratio is constant, the dividends paid will be: Dividends = ($,/$,)($,) Dividends = $, And the addition to retained earnings will be: Addition to retained earnings = $, – , Addition to retained earnings = $, The new retained earnings on the pro forma balance sheet will be: New retained earnings = $, + , New retained earnings = $, The pro forma balance sheet will look like this:
Discounting is the process of determining the value today of an amount to be received in the future. Future values grow (assuming a positive rate of return); present values shrink. The future value rises (assuming it’s positive); the present value falls. It would appear to be both deceptive and unethical to run such an ad without a disclaimer or explanation. It’s a reflection of the time value of money. TMCC gets to use the $,. If TMCC uses it wisely, it will be worth more than $, in thirty years. This will probably make the security less desirable. TMCC will only repurchase the security prior to maturity if it is to its advantage, i. interest rates decline.
Given the drop in interest rates needed to make this viable for TMCC, it is unlikely the company will repurchase the security. This is an example of a “call” feature. Such features are discussed at length in a later chapter. The key considerations would be: () Is the rate of return implicit in the offer attractive relative to other, similar risk investments? and () How risky is the investment; i. , how certain are we that we will actually get the $,? Thus, our answer does depend on who is making the promise to repay. The Treasury security would have a somewhat higher price because the Treasury is the strongest of all borrowers….. .
The price would be higher because, as time passes, the price of the security will tend to rise toward $,. This rise is just a reflection of the time value of money. As time passes, the time until receipt of the $, grows shorter, and the present value rises. In, the price will probably be higher for the same reason. We cannot be sure, however, because interest rates could be much higher, or TMCC’s financial position could deteriorate. Either event would tend to depress the security’s price.
Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps.
To answer this question, we can use either the FV or the PV formul Both will give the same answer since they are the inverse of each other. We will use the FV formula, that is: FV = PV( + r)t Solving for r, we get: r = (FV / PV) / t – r = ($, / $,)/ – = or% B- SOLUTIONSTo find the length of time for money to double, triple, et , the present value and future value are irrelevant as long as the future value is twice the present value for doubling, three times as large for tripling, et To answer this question, we can use either the FV or the PV formul Both will give the same answer since they are the inverse of each other.
We will use the FV formula, that is: FV = PV( + r)t Solving for t, we get: t = ln(FV / PV) / ln( + r) The length of time to double your money is: FV = $ = $(. )t t = ln / ln = years The length of time to quadruple your money is: FV = $ = $(. )t t = ln / ln = years Notice that the length of time to quadruple your money is twice as long as the time needed to double your money (the difference in these answers is due to rounding). This is an important concept of time value of money.To answer this question, we can use either the FV or the PV formul Both will give the same answer since they are the inverse of each other.