Fundamentals of corporate finance 10th edition (ross, westerfield, jordan) solutions manual and test bank

ross - fundamentals of corporate finance - 10e, test bank 0078034639 solutions manual and test bank
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Book Description

Publication Date: January 18, 2012 | ISBN-10: 0078034639 | ISBN-13: 978-0078034633 | Edition: 10
The best-selling Fundamentals of Corporate Finance (FCF) has three basic themes that are the central focus of the book:
1) An emphasis on intuition—the authors separate and explain the principles at work on a common sense, intuitive level before launching into any specifics.
2) A unified valuation approach—net present value (NPV) is treated as the basic concept underlying corporate finance.
3) A managerial focus—the authors emphasize the role of the financial manager as decision maker, and they stress the need for managerial input and judgment.
The Tenth Edition continues the tradition of excellence that has earned Fundamentals of Corporate Finance its status as market leader. Every chapter has been updated to provide the most current examples that reflect corporate finance in today’s world. The supplements package has been updated and improved, and with the enhanced Connect Finance and Excel Master, student and instructor support has never been stronger.

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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 trade-off between relevance (market values) and objectivity (book values).

4.     Depreciation is a noncash 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.


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, 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.
11.   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.

12.   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. However, the final answer for each problem is found without rounding during any step in the problem.

            Basic

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

                                          Balance Sheet
            CA        $   4,800                     CL              $  4,200          
            NFA         27,500                     LTD              10,500          
                                                            OE                     ??
            TA          $32,300                     TL & OE      $32,300

We know that total liabilities and owner’s equity (TL & OE) must equal total assets of $32,300. 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 = $32,300 – 10,500 – 4,200 = $17,600
             
              NWC = CA – CL = $4,800 – 4,200 = $600



2.         The income statement for the company is:
           
                                    Income Statement
                        Sales                           $734,000
                        Costs                           315,000
                        Depreciation                 48,000
                        EBIT                          $371,000
                        Interest                         35,000
                        EBT                            $336,000
                        Taxes (35%)                 117,600
                        Net income                 $218,400

3.         One equation for net income is:

Net income = Dividends + Addition to retained earnings

Rearranging, we get:

Addition to retained earnings = Net income – Dividends = $218,400 – 85,000 = $133,400

4.         EPS   = Net income / Shares = $218,400 / 110,000 = $1.99 per share

            DPS  = Dividends / Shares     = $85,000 / 110,000   = $0.77 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 = $215,000 + 900,000 = $1,115,000
           
            The market value of current assets and fixed assets is given, so:

            Book value CA     = $1,115,000                      Market value CA      = $1,250,000
            Book value NFA    = $3,200,000                      Market value NFA   = $5,300,000
            Book value assets  = $4,315,000                      Market value assets               = $6,550,000
           
6.    Taxes = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($255,000 – 100,000) = $82,700

7.    The average tax rate is the total tax paid divided by net income, so:

Average tax rate = $82,700 / $255,000 = .3243, or 32.43%

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



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

Income Statement
                        Sales                             $39,500        
                        Costs                             18,400        
                        Depreciation                   1,900
                        EBIT                            $19,200
                        Interest                           1,400
                        Taxable income             $17,800
                        Taxes (35%)                    6,230
                        Net income                 $11,570

            OCF = EBIT + Depreciation – Taxes = $19,200 + 1,900 – 6,230 = $14,870          

9.    Net capital spending = NFAend – NFAbeg + Depreciation
Net capital spending = $3,600,000 – 2,800,000 + 345,000
Net capital spending = $1,145,000

10.       Change in NWC = NWCend – NWCbeg
            Change in NWC = (CAend – CLend) – (CAbeg – CLbeg)
            Change in NWC = ($3,460 – 1,980) – ($3,120 – 1,570)
            Change in NWC = $1,480 – 1,550 = –$70

11.       Cash flow to creditors = Interest paid – Net new borrowing
            Cash flow to creditors = Interest paid – (LTDend – LTDbeg)
            Cash flow to creditors = $190,000 – ($2,550,000 – 2,300,000)
            Cash flow to creditors = –$60,000

12.       Cash flow to stockholders = Dividends paid – Net new equity
            Cash flow to stockholders = Dividends paid – [(Commonend + APISend) – (Commonbeg + APISbeg)]
            Cash flow to stockholders = $540,000 – [($715,000 + 4,700,000) – ($680,000 + 4,300,000)]
            Cash flow to stockholders = $105,000

       Note, APIS is the additional paid-in surplus.

13.       Cash flow from assets   = Cash flow to creditors + Cash flow to stockholders                                                                    = –$60,000 + 105,000 = $45,000

            Cash flow from assets   = $45,000 = OCF – Change in NWC – Net capital spending
                                                = $45,000 = OCF – (–$55,000) – 1,300,000  

Operating cash flow     = $45,000 – 55,000 + 1,300,000
Operating cash flow      = $1,290,000



            Intermediate

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

                                    Income Statement
                        Sales                           $235,000       
                        Costs                           141,000                            
                        Other expenses               7,900
                        Depreciation                  17,300                     
                        EBIT                           $ 68,800     
                        Interest                         12,900                     
                        Taxable income            $ 55,900     
                        Taxes                            19,565     
                        Net income               $ 36,335        
                                                                                     
                        Dividends                   $12,300                                          
                        Additions to RE            $24,035        

            a.   OCF = EBIT + Depreciation – Taxes = $68,800 + 17,300 – 19,565 = $66,535

            b.   CFC = Interest – Net new LTD = $12,900 – (–4,500) = $17,400
  
   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 = $12,300 – 6,100 = $6,200

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

                  CFA = $17,400 + 6,200 = $23,600
  
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 = $25,000 + 17,300 = $42,300

      Now we can use:

      CFA = OCF – Net capital spending – Change in NWC
      $22,600 = $66,535 – 42,300 – Change in NWC
      Change in NWC = $635
              
                  This means that the company increased its NWC by $635.

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

Net income = Dividends + Addition to ret. earnings = $1,800 + 5,300 = $7,100


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) = $7,100 / (1 – 0.35) = $10,923

Now you can calculate:

EBIT = EBT + Interest = $10,923 + 4,900 = $15,823

The last step is to use:

EBIT = Sales – Costs – Depreciation 
$15,823 = $52,000 – 27,300 – Depreciation

Solving for depreciation, we find that depreciation = $8,877

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

                                                                     Balance Sheet
            Cash                                   $   127,000            Accounts payable                     $   210,000
            Accounts receivable                  105,000            Notes payable                               160,000
            Inventory                                293,000            Current liabilities                     $   370,000
            Current assets                     $   525,000            Long-term debt                            845,000
                                                                                    Total liabilities                           $1,215,300            Tangible net fixed assets         1,620,000
            Intangible net fixed assets        630,000            Common stock                                       ??
                                                                                    Accumulated ret. earnings          1,278,000
            Total assets                          $2,775,000            Total liab. & owners’ equity       $2,755,000
           
            Total liabilities and owners’ equity is:

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

            Solving for this equation for equity gives us:

            Common stock = $2,755,000 – 1,215,300 – 1,278,000 = $282,000

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 $7,100, equity is equal to $1,300, and if TA is $5,200, equity is equal to $0. We should note here that the book value of shareholders’ equity can be negative.



18.       a.   Taxes Growth = 0.15($50,000) + 0.25($25,000) + 0.34($1,000) = $14,090
                  Taxes Income = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + 0.39($235,000)
                                          + 0.34($7,265,000)
                                          = $2,584,000

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                           $850,000                 
                        COGS                          610,000                             
                        A&S expenses              110,000                 
                        Depreciation                140,000                     
                        EBIT                          –$10,000                     
                        Interest                         85,000                     
                        Taxable income           –$95,000                     
                        Taxes (35%)                       0                     
            a.         Net income                 –$95,000                     
                 
            b.   OCF = EBIT + Depreciation – Taxes = –$10,000 + 140,000 – 0 = $130,000

            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 = $130,000 – 0 – 0 = $130,000
            Cash flow to stockholders = Dividends – Net new equity = $63,000 – 0 = $63,000
            Cash flow to creditors = Cash flow from assets – Cash flow to stockholders
            Cash flow to creditors = $130,000 – 63,000 = $67,000
            Cash flow to creditors = Interest – Net new LTD
            Net new LTD = Interest – Cash flow to creditors = $85,000 – 67,000 = $18,000

21.       a.
                  

Income Statement


Sales           
$27,360


Cost of goods sold
19,260


Depreciation
    4,860


EBIT
$  3,240


Interest
    2,190


Taxable income
$  1,050


Taxes (34%)
       357


Net income
$     693

                        b.   OCF = EBIT + Depreciation – Taxes
                                       = $3,240 + 4,860 – 357 = $7,743           


c.   Change in NWC = NWCend – NWCbeg
                                                         = (CAend – CLend) – (CAbeg – CLbeg)
                                                        = ($7,116 – 3,780) – ($5,760 – 3,240)
                                                        = $3,336 – 2,520 = $816

                              Net capital spending = NFAend – NFAbeg + Depreciation
                                                               = $20,160 – 16,380 + 4,860 = $8,640

                              CFA     = OCF – Change in NWC – Net capital spending
                                          = $7,743 – 816 – 8,640 = –$1,713

                        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 $1,713 in funds from its stockholders and creditors to make these investments.
                       
d.   Cash flow to creditors               = Interest – Net new LTD = $2,190 – 0 = $2,190
                              Cash flow to stockholders         = Cash flow from assets – Cash flow to creditors
                                                                              = –$1,713 – 2,190 = –$3,903

                              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                         = $1,560 – (–3,903) = $5,463
                             
                        The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $816 in new net working capital and $8,640 in new fixed assets. The firm had to raise $1,713 from its stakeholders to support this new investment. It accomplished this by raising $5,463 in the form of new equity. After paying out $1,560 of this in the form of dividends to shareholders and $2,190 in the form of interest to creditors, $1,713 was left to meet the firm’s cash flow needs for investment.

22.       a.   Total assets 2010       = $914 + 3,767 = $4,681  
                  Total liabilities 2010 = $365 + 1,991= $2,356
                  Owners’ equity 2010 = $4,681 – 2,356 = $2,325
                 
                  Total assets 2011       = $990 + 4,536 = $5,526        
                  Total liabilities 2011 = $410 + 2,117 = $2,527
                  Owners’ equity 2011 = $5,526 – 2,527 = $2,999

            b.   NWC 2010          = CA10 – CL10 = $914 – 365 = $549
                  NWC 2011          = CA11 – CL11 = $990 – 410 = $580
                  Change in NWC = NWC11 – NWC10 = $580 – 549 = $31



            c.   We can calculate net capital spending as:

                  Net capital spending = Net fixed assets 2011 – Net fixed assets 2010 + Depreciation
                  Net capital spending = $4,536 – 3,767 + 1,033 = $1,802
                 
So, the company had a net capital spending cash flow of $1,802. We also know that net capital spending is:

                  Net capital spending  = Fixed assets bought – Fixed assets sold
                  $1,802                       = $1,890 – Fixed assets sold
                  Fixed assets sold        = $1,890 – 1,802 = $88

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


Income Statement

Sales
$11,592

Costs
5,405

Depreciation expense
1,033

EBIT
$  5,154

Interest expense
294

EBT
$  4,860

Taxes (35%)
1,701

Net income
$  3,159

So, the operating cash flow is:

                  OCF = EBIT + Depreciation – Taxes = $5,154 + 1,033 – 1,701 = $4,486

                  And the cash flow from assets is:

                  Cash flow from assets   = OCF – Change in NWC – Net capital spending.
                                                      = $4,486 – 31 – 1,802 = $2,653

            d.   Net new borrowing       = LTD11 – LTD10 = $2,117 – 1,991 = $126
                  Cash flow to creditors   = Interest – Net new LTD = $294 – 126 = $168
                  Net new borrowing       = $126 = Debt issued – Debt retired
                  Debt retired                  = $378 – 126 = $252

            Challenge

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



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) = $113,900

                  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)= $6,416,667

                  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) = $68,000
                  $68,000         = 0.15($50,000) + 0.25($25,000) + 0.34($25,000) + X($100,000);
                  X($100,000) = $68,000 – 22,250
                  X                  = $45,750 / $100,000
                  X                  = 45.75%

25.

Balance sheet as of Dec. 31, 2010

Cash
$  6,067



 Accounts payable
$  4,384

Accounts receivable
8,034



 Notes payable
1,171

Inventory
14,283



 Current liabilities
$  5,555

Current assets
$28,384











 Long-term debt
$20,320

Net fixed assets
$50,888



 Owners' equity
$53,397

Total assets
$79,272



 Total liab. & equity
$79,272


Balance sheet as of Dec. 31, 2011

Cash
$  6,466



 Accounts payable
$  4,644

Accounts receivable
9,427



 Notes payable
1,147

Inventory
15,288



 Current liabilities
$  5,791

Current assets
$31,181











 Long-term debt
$24,636

Net fixed assets
$54,273



 Owners' equity
$55,027

Total assets
$85,454



 Total liab. & equity
$85,454



                  2010 Income Statement                                                        2011 Income Statement

Sales
$11,573.00

Sales
$12,936.00

COGS
3,979.00

COGS
4,707.00

Other expenses
946.00

Other expenses
824.00

Depreciation
1,661.00

Depreciation
1,736.00

EBIT
$  4,987.00

EBIT
$  5,669.00

Interest
776.00

Interest
926.00

EBT
$  4,211.00

EBT
$  4,743.00

Taxes (34%)
1,431.74

Taxes (34%)
1,612.62

Net income
$  2,779.26

Net income
$  3,130.38







Dividends
$1,411.00

Dividends
$1,618.00

Additions to RE
1,368.26

Additions to RE
1,512.38

26.       OCF = EBIT + Depreciation – Taxes = $5,669 + 1,736 – 1,612.62 = $5,792.38

            Change in NWC = NWCend – NWCbeg = (CA – CL) end – (CA – CL) beg  
                                      = ($31,181 – 5,791) – ($28,384 – 5,555)
                                       = $2,561

            Net capital spending = NFAend – NFAbeg + Depreciation
                                             = $54,273 – 50,888 + 1,736 = $5,121
           
            Cash flow from assets   = OCF – Change in NWC – Net capital spending
                                                = $5,792.38 – 2,561 – 5,121 = –$1,889.62

            Cash flow to creditors = Interest – Net new LTD
            Net new LTD = LTDend – LTDbeg
            Cash flow to creditors = $926 – ($24,636 – 20,320) = –$3,390

            Net new equity = Common stockend – Common stockbeg
            Common stock + Retained earnings = Total owners’ equity
            Net new equity = (OE – RE) end – (OE – RE) beg
                                    = OEend – OEbeg + REbeg – REend
            REend = REbeg + Additions to RE08
\     Net new equity        = OEend – OEbeg + REbeg – (REbeg + Additions to RE11)
                               = OEend – OEbeg – Additions to RE
Net new equity        = $55,027 – 53,397 – 1,512.38 = $117.62

            CFS     = Dividends – Net new equity
            CFS     = $1,618 – 117.62 = $1,500.38

            As a check, cash flow from assets is –$1,889.62.
                                            
            CFA     = Cash flow from creditors + Cash flow to stockholders
            CFA     = –$3,390 + 1,500.38 = –$1,889.62








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