Financial Management: Principles and Practice

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Solutions Manual





FINANCIAL

MANAGEMENT

Principles and Practice


Fourth

Edition







Timothy J. Gallagher

Colorado State University

Joseph D. Andrew, Jr.

Webster University












2006 Freeload Press
, Madison Wisconsin

i







(Insert publication data on this page)





ii






Solutions Manual


to accompany


Financial Management: Principles and Practice


4
rd Edition


by Timothy J. Gallagher and Joseph D. Andrew, Jr.





This solutions manual provides the answers to all the review questions and end
-
of
-
chapter problems
in
Financial Management: Principles and Practice
, by Gallagher and Andrew. The answers and the steps
taken to obtain the answers are shown.


We remind our r
eaders that in finance there is often more than one answer to a question or to a
problem, depending on one’s viewpoint and assumptions. We provide one answer to each question and show
one approach to solving each problem. Other answers and approaches may

be equally valid, or judged even
better according to each individual’s preference.



iii

TABLE OF CONTENTS


Chapter 1 Solutions

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5

Chapter 2 Solutions

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9

Chapter 3 Solutions

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13

Chapter 4 Solutions

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16

Chapter 5 Solutions

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24

Chapter 6 Solutions

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34

Chapter 7 Solutions

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41

Chapter 8 Solutions

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53

Chapter 9 Solutions

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61

Chapter 10 Solutions

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67

Chapter 11 Solutions

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79

Chapter 12 Solut
ions

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93

Chapter 13 Solutions

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103

Chapter 14 Solutions

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113

Chapter 15 Solutions

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120

Chapter 16 Solutions

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124

Chapter 17 Solutions

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131

Chapter 18 Solutions

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138

Chapter 19 Solutions

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147

Chapter
20 Solutions

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163

Chapter 21 Solutions

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167



iv




5

Chapter 1 Solutions



Answers to Review Questions



1.

How is finance related to th
e disciplines of accounting and economics?


Financial management is essentially a combination of accounting and economics. First, financial
managers use accounting information

balance sheets, income statements, and so on

to analyze,
plan, and allocate fina
ncial resources for business firms. Second, financial managers use economic
principles to guide them in making financial decisions that are in the best interest of the firm. In other
words, finance is an applied area of economics that relies on accounting
for input.



2.

List and describe the three career opportunities in the field of finance.


Finance has three main career paths: financial management, financial markets and institutions, and
investments.


Financial management involves managing the finances
of a business. Financial managers

people
who manage a business firm's finances

perform a number of tasks. They analyze and forecast a
firm's finances; assess risk, evaluate investment opportunities, decide when and where to find money
sources and how much
money to raise, and decide how much money to return to the firm's investors.


Bankers, stockbrokers, and others who work in financial markets and institutions focus on the flow of
money through financial institutions and the markets in which financial asse
ts are exchanged. They
track the impact of interest rates on the flow of that money.


People who work in the field of investments locate, select, and manage income
-
producing assets. For
instance, security analysts and mutual fund managers both operate in t
he investment field.



3.

Describe the duties of the financial manager in a business firm.


Financial managers measure the firm's performance, determine what the financial consequences will
be if the firm maintains its present course or changes it, and rec
ommend how the firm should use its
assets. Financial managers also locate external financing sources and recommend the most beneficial
mix of financing sources, and they determine the financial expectations of the firm's owners.


All financial managers mu
st be able to communicate, analyze, and make decisions based on
information from many sources. To do this, they need to be able to analyze financial statements,
forecast and plan, and determine the effect of size, risk, and timing of cash flows.



4.

What

is the basic goal of a business?


The primary financial goal of the business firm is to maximize the wealth of the firm's owners.
Wealth, in turn, refers to value. If a group of people owns a business firm, the contribution that firm
makes to that group
's wealth is determined by the market value of that firm.


6



5.

List and explain the three financial factors that influence the value of a business.


The three factors that affect the value of a firm's stock price are
cash flow
,
timing
, and
risk
.


The
Importance of Cash Flow
: In business, cash is what pays the bills. It is also what the firm
receives in exchange for its products and services. Cash is therefore of ultimate importance, and the
expectation that the firm will generate cash in the future is

one of the factors that gives the firm its
value.


The Effect of Timing on Cash Flows
: Owners and potential investors look at when firms can expect
to receive cash and when they can expect to pay out cash. All other factors being equal, the sooner
compan
ies expect to receive cash and the later they expect to pay out cash, the more valuable the
firm and the higher its stock price will be.


The Influence of Risk
: Risk affects value because the less certain owners and investors are about a
firm's expected f
uture cash flows, the lower they will value the company. The more certain owners
and investors are about a firm's expected future cash flows, the higher they will value the company.
In short, companies whose expected future cash flows are doubtful will hav
e lower values than
companies whose expected future cash flows are virtually certain.



6.

Explain why accounting profits and cash flows are not the same thing.


Stock value depends on future cash flows, their timing, and their riskiness. Profit calculati
ons do not
consider these three factors. Profit, as defined in accounting, is simply the difference between sales
revenue and expenses. It is true that more profits are generally better than less profits, but when the
pursuit of short
-
term profits advers
ely affects the size of future cash flows, their timing, or their
riskiness, then these profit maximization efforts are detrimental to the firm.



7.

What is an agent? What are the responsibilities of an agent?


An agent is a person who has the implied or
actual authority to act on behalf of another. The owners
whom the agents represent are the principals. Agents have a legal and ethical responsibility to make
decisions that further the interests of the principals.



8.

Describe how society's interests ca
n influence financial managers.


Sometimes the interests of a business firm's owners are not the same as the interests of society. For
instance, the cost of properly disposing of toxic waste can be so high that companies may be tempted
to simply dump thei
r waste in nearby rivers. In so doing, the companies can keep costs low and
profits high, and drive their stock prices higher (if they are not caught). However, many people
suffer from the polluted environment. This is why we have environmental and othe
r similar laws:
So that society's best interests take precedence over the interests of individual company owners.


When businesses take a long
-
term view, the interests of the owners and society often (but not always)
coincide. When companies encourage re
cycling, sponsor programs for disadvantaged young people,

7

run media campaigns promoting the responsible use of alcohol, and contribute money to worthwhile
civic causes, the goodwill generated as a result of these activities causes long
-
term increases in th
e
firm's sales and cash flows, which translate into additional wealth for the firm's owners.



9.

Briefly define the terms
proprietorship
,
partnership
, and
corporation
.


A proprietorship is a business owned by one person.


Two or more people who join
together to form a business make up a partnership. This can be done on
an informal basis without a written partnership agreement, or a contract can spell out the rights and
responsibilities of each partner.


A limited liability company is a hybrid between
a partnership and a corporation. Profits and losses
pass through to the members. Members generally enjoy limited liability.


Corporations are legal entities separate from their owners. To form a corporation, the owners specify
the governing rules for the

running of the business in a contract known as the articles of
incorporation. They submit the articles to the government of the state in which the corporation is
formed, and the state issues a charter that creates the separate legal entity.



10.

Compare
and contrast the potential liability of owners of proprietorships, partnerships (general
partners), and corporations.


The sole proprietor has unlimited liability for matters relating to the business. This means that the
sole proprietor is responsible for

all the obligations of the business, even if those obligations exceed
the amount the proprietor has invested in the business.


Each partner in a partnership is usually liable for the activities of the partnership as a whole. Even if
there are a hundred p
artners, each one is technically responsible for all the debts of the partnership.
If ninety
-
nine partners declare personal bankruptcy, the hundredth partner still is responsible for all
the partnership's debts.


A corporation is a legal entity that is li
able for its own activities. Stockholders, the corporation's
owners, have limited liability for the corporation's activities. They cannot lose more than the amount
they paid to buy the corporation’s stock.




Answers to End
-
of
-
Chapter Problems



1.

An ac
countant prepares financial statements while a financial analyst interprets them.



2.

A financial manager’s role in a publicly traded company is to make financial decisions so as to
best serve the principal stockholders.



8


3.

a. The value of the firm woul
d go down due to the increase in the amount of time it takes to
receive the cash inflows.



b. The value of the firm would go up due to the increase in expected cash inflows.



c. If expected future cash flows do not change the value of the firm would go
down due to the
increased riskiness of the firm.



4.

This practice obviously takes advantage of people who are in a difficult financial situation. This
transaction is voluntary, however, and high risk loans have high interest rates.



5.

LLCs have a smal
l number of members like partnerships and each of these members is likely to
have an active voice in the company like a partnership. The LLC is taxed like a partnership.
Unlike a partnership, and more like a corporation, the owners generally enjoy limite
d liability.



9

Chapter 2 Solutions




Answers to Review Questions



1.

What are financial markets? Why do they exist?


Financial markets are where financial securities are bought and sold. They exist primarily to bring
deficit economic units (those needin
g money) and surplus economic units (those having extra money)
together.



2.

What is a security?


Securities are claims on financial assets. They can be described as

claim checks” that give their
owners the right to receive funds in the future. Securit
ies are traded in both the money and capital
markets. Money market securities include Treasury bills, negotiable certificates of deposit,
commercial paper, and banker

s acceptances. Capital market securities include bonds and stock.



3.

What are the
characteristics of an efficient market?


The term market efficiency refers to the ease, speed, and cost of trading securities. In an efficient
market, securities can be traded easily, quickly, and at low cost. Markets lacking these qualities are
considered

to be inefficient.



4.

How are financial trades made on an organized exchange?


Each exchange
-
listed security is traded at a specified location on the trading floor called the post. The
trading is supervised by specialists who act either as brokers (brin
ging together buyers and sellers) or
as dealers (buying or selling the stock themselves). Prominent international securities exchanges
include the New York Stock Exchange (NYSE) and major exchanges in Tokyo, London,
Amsterdam, Frankfurt, Paris, Hong Kong,
and Mexico.



5.

How are financial trades made in an over
-
the
-
counter market? Discuss the role of a dealer in the OTC
market.


In contrast to the organized exchanges, which have physical locations, the over
-
the
-
counter market
has no fixed location
,o
r more
correctly, it is everywhere. The over
-
the
-
counter market, or OTC, is a
network of dealers around the world who maintain inventories of securities for sale. If you wanted to
buy a security that is traded OTC, you would call your broker, who would then shop
among
competing dealers who have the security in their inventory. After locating the dealer with the best
price, your broker would buy the security on your behalf.



10

The role of dealers: Dealers make their living buying securities and reselling them to oth
ers. They
operate just like car dealers who buy cars from manufacturers for resale to others. Dealers make
money by buying securities for one price (called the bid price) and selling them for a higher price,
(called the ask price). The difference, or spr
ead, between the bid price and the ask price represents
the dealer

s fee.



6.

What is the role of a broker in security transactions? How are brokers compensated?


Brokers handle orders to buy or sell securities. Brokers are agents who work on behalf of an

investor.
When investors call with an order, brokers work on their behalf to find someone to take the other side
of the proposed trade. If investors want to buy, brokers find sellers. If investors want to sell, brokers
find buyers. Brokers are compensated

for their services when the person whom they represent
,
the
investor
,
pays them a commission on the sale or purchase of securities.



7.

What is a Treasury bill? How risky is it?


Treasury bills are short
-
term debt instruments issued by the U.S. Treasury
that are sold at a discount
and pay face value at maturity. They are very nearly risk
-
free as they are backed by the U.S.
Government which could, if need by, print money to pay their holders at maturity.



8.

Would there be positive interest rates on
bonds in a world with absolutely no risk (no default risk,
maturity risk, and so on)? Why would a lender demand, and a borrower be willing to pay, a positive
interest rate in such a no
-
risk world?


Yes, there would be a positive rate of interest in a risk
-
free world. This is because regardless of risk,
lenders of money must postpone spending during the time the money is loaned. Lenders, then, lose
the opportunity to invest their money for that period of time. To compensate for the cost of losing
investment

opportunities while they postpone their spending, lenders demand, and borrowers pay, a
basic rate of return
,
the real rate of interest.




Answers to End of Chapter Problems



2
-
1.

a. Surplus economic units have income that exceeds their expenditures.

Wealthy families in the
household sector and most states (which have balanced budget requirements) are surplus economic
units.



b. Deficit economic units have expenditures that exceed their incomes. Home buyers and college
students are likely to be def
icit economic units.


2.2.

a. false


b. false


c. false


d. false


11

2
-
3.

a. 2 3 4 1


b. The money market is dominated by large institutional traders and there is much competition. The
New York Stock Exchange tends to have larger more actively traded stock
s. The over
-
the
-
counter
market tends to have smaller less actively traded securities. The real estate market has very high
transaction costs and trades take months.



2.4.

a. A money market security is short term and actively traded.



b. Treasury bills

and commercial paper are both traded in the money market.



2
-
5.

$66.25/$1,000 = 6 5/8 % coupon rate



2
-
6. The yield on a Bonds
-
R
-
Us bond:


Real rate of interest...................... 2%

Inflation premium........................ 3%

Default risk
premium................... 1%

Liquidity risk premium................ 1%

Maturity risk premium................. 1%


Total yield on Bonds
-
R
-
Us Bond: 8%


(reference figure 2
-
2)


2
-
7. Treasury Yield Curve:


Given:








Treasury Security Yields:






Maturity in Years (for Chart)

Three
-
month T
-
bills

4.50%

0.25


Six
-
month T
-
bills

4.75%

0.5


One
-
year T
-
notes

5.00%

1


Two
-
year T
-
notes

5.25%

2


Three
-
year T
-
bonds

5.50%

3


Five
-
year T
-
bonds

5.75%

5


Ten
-
year T
-
bonds

6.00%

10


Thirty
-
year T
-
bonds

6.50%

30




Chart: (see next page)








12




Implications:


a. For borrowers: Borrowers tend to look for the low point of the curve, which indicates the least
expensive loan maturity. In this case the low point is 3 months, leading the borrower to seek

a short
-
term loan. However, if a firm borrows long
-
term and obtains the higher interest rate, that rate is
locked in for the life of the loan (30 years in this case). If interest rates rise the borrower may be glad
he/she locked in the long
-
term rate.


b. Lenders face the opposite situation. Granting short
-
term
-
term loans at relatively low interest rates
may look unattractive now; but if short
-
term rates rise, the lenders will be able to roll over
investments at higher and higher rates.



13

Chapter 3 So
lutions




Answers to Review Questions



1.

Define
intermediation
.


The financial system makes it possible for surplus and deficit economic units to come together,
exchanging funds for securities, to their mutual benefit. When funds flow from surplus economic
units to a financial institution to a deficit economic unit, the

process is known as
intermediation
. The
financial institution acts as an intermediary between the two economic units.



2.

What can a financial institution often do for a surplus economic unit that it would have difficulty
doing for itself if the surplus
economic unit (SEU) were to deal directly with a deficit economic unit
(DEU)?


Surplus economic units do not usually have the expertise to determine whether deficit economic units
can and will make good on their obligations, so it is difficult for them to
predict when a would
-
be
deficit economic unit will fail to pay what it owes. Such a failure is likely to be devastating to a
surplus economic unit that has lent a proportionately large amount of money. In contrast, a financial
institution is in a better
position to predict who will pay and who won't. It is also in a better position,
having greater financial resources, to occasionally absorb a loss when someone fails to pay. (This is
just one example of the beneficial things financial institutions do for
SEUs)



3.

What can a financial institution often do for a deficit economic unit (DEU)that it would have
difficulty doing for itself if the DEU were to deal directly with an SEU?


SEUs typically want to supply a small amount of funds, while DEUs typically
want to obtain a large
amount of funds. Thus it is often difficult for surplus and deficit economic units to come together on
their own to arrange a mutually beneficial exchange of funds for securities. A financial institution
can step in and save the da
y. A bank, savings and loan, or insurance company can take in small
amounts of funds from many individuals, form a large pool of funds, and then use that large pool to
purchase securities from individual businesses and governments. (This is just one exam
ple of the
beneficial things financial institutions do for DEUs)



4.

What are a bank's
primary reserves
? When the Fed sets reserve requirements, what is its primary
goal?


Vault cash and deposits in the bank's account at the Fed are used to satisfy these

reserve
requirements; they are called
primary reserves
. These primary reserves are non
-
interest
-
earning
assets held by financial institutions.


The Federal Reserve requires all commercial banks to keep a minimum amount of reserves on hand
to meet the wit
hdrawal demands of its depositors and to pay other obligations as they come due.

14

Many would argue, however, that the reserve requirement is set more with monetary policy in mind
than to ensure that banks meet their depositors' withdrawal requests.



5.

Co
mpare and contrast mutual and stockholder
-
owned savings and loan associations.


Some savings and loan associations are owned by stockholders, just as commercial banks and other
corporations are owned by their stockholders. Other S&Ls, called
mutuals
, are

owned by their
depositors. When a person deposits money in an account at a mutual S&L, that person becomes a
part owner of the firm. The mutual S&L's profits (if any) are put into a special reserve account from
which dividends are paid from time to time

to the owner/depositors.



6.

Who owns a credit union? Explain.


Credit unions are owned by their members. When credit union members put money in their credit
union, they are not technically "depositing" the money. Instead, they are purchasing shares
of the
credit union. In general, credit unions exist to pay interest on shares bought by, and collect interest
on loans made to, the members.



7.

Which type of insurance company generally takes on the greater risks: a life insurance company or a
property

and casualty insurance company?


The risks protected against by property and casualty companies are much less predictable than are the
risks insured by life insurance companies. Hurricanes, fires, floods, and trial judgments are all much
more difficult
to predict than the number of sixty
-
year
-
old females who will die this year among a
large number in this risk class. This means that property and casualty insurance companies must
keep more liquid assets than do life insurance companies.



8.

Compare and
contrast a
defined benefit

and a
defined contribution

pension plan.


In a
defined benefit

plan, retirement benefits are determined by a formula that usually considers the
worker's age, salary, and years of service. The employee and/or the firm contribute
the amounts
necessary to reach the goal. In a
defined contribution

plan, the contributions to be made by the
employee and/or employer are spelled out, but retirement benefits depend on the total accumulation
in the individual's account at the retirement d
ate.


9.

Special security software is used such that customers who enter their identification and password
information can keep sensitive information out of the hands of hackers.





15

Answers to End
-
of
-
Chapter Problems


3
-
1.

a) If there were no financial i
nstitutions the SEUs and the DEUs would find that the amount of
money needed by a given DEU did not match the amount of money available by a given SEU. The
money available would not be put to work and the economic activity that would have otherwise taken
place would not.



b) If financial institutions were available in this society they could position themselves between the
SEUs and DEUs. The financial institution could pool the $1,000 available (100 SEUs times $10
each) and pass that money along in $1
00 increments to the DEUs. This could be done via either a
debt or equity claim that the financial institution would accept from the DEU in return for the money.


3
-
2.

a) .10 rate on loans made
-

.05 rate paid to depositors = .05 = 5% interest rate
spread



b)
(.5 x .10) + (.5 x .12) = .11 = 11% weighted average loan rate




(.5 x .05) + (.5 x .07) = .
06 = 6% weighted average deposit rate




11%
-

6% = 5% interest rate spread


3
-
3.

($48
,300,000
-

$7,800,000)
x .03) +
(
(
$60,000,000
-

$48,300,000) x .10) +
(
$20,000,000 x 0) +
($10,000,000 x 0) = $6,732
,000


3
-
4.

a) The FOMC should buy government securities in the open market. This would increase the
reserves of the banking system and would put downward pressure on the fed
eral funds rate.



b)
The Fed’s trader at the New York Federal Reserve Bank would contact various government
securities dealers and would buy the Treasury securities from them. Payment would be made by
crediting the accounts at the Fed of these dealers.

This would make more funds available and would
tend to put downward pressure on the cost of these funds, the federal funds rate.


3
-
5.

a) ($1,000,000 x .08)


($1,000,000 x .07) = $10,000 a profit of $10,000



b) ($1,000,000 x .08)


($1,000,000 x .09)

=
-
$10,000 a loss of $10,000



16

Chapter 4 Solutions




Answers to Review Questions



1.

Why do total assets equal the sum of total liabilities and equity? Explain.


Assets = Liabilities + Equity


Assets are the items of value a business owns. Liabilities
are claims on the business by non
-
owners,
and equity is the owners' claim on the business. The sum of the liabilities and equity is the total
capital contributed to the business, which, by definition, equals the total value of the assets.



2.

What are the

time dimensions of the income statement, the balance sheet, and the statement of cash
flows? Hint: Are they videos or still pictures? Explain.


The income statement is like a video: It measures a firm's profitability over a period of time (which
can be
a week, a month, a year, or any other time period).



The balance sheet is like a still photograph. The balance sheet shows the firm's assets, liabilities, and
equity at a given point in time.


This cash flow statement like the income statement, can be com
pared to a video: It shows how cash
flows into and out of a company over a given period of time.



3.

Define depreciation expense as it appears on the income statement. How does depreciation affect
cash flow?


Accounting depreciation is the allocation of
an asset's initial cost over time. Depreciation expense on
an income statement is the amount of the asset
=
s initial cost allocated to the period covered by the
income statement.


Depreciation expense is not a cash flow. Depreciation as an expense categor
y affects cash flow,
however, because it is tax
-
deductible. Depreciation expense lowers a company’s taxable income
and, therefore its income tax liability. In this way depreciation reduces cash outflows..



4.

What are retained earnings? Why are they im
portant?


Retained earnings represents the sum of all the earnings available to common stockholders of a
business during its entire history, minus the sum of all the common stock dividends which it has ever
paid. Those earnings that were not paid out were,

by definition, retained.


Retained earnings are important because they represent amounts reinvested in a company on behalf
of the company

s owners instead of being paid out in the form of dividends.


17

5.

Explain how earnings available to common stockholders

and common stock dividends paid from the
current income statement affect the balance sheet item retained earnings.


The change in the retained earnings account from one balance sheet to the next equals net income
less preferred stock dividends (which is t
he amount of earnings available to common stockholders)
less common stock dividends.



6.

What is
a
ccumulated depreciation?


Depreciation is the allocation of an asset's initial cost over time. Accumulated depreciation is the
total of all the depreciatio
n expense that has been recognized to date.



7.

What are the three major sections of the statement of cash flows?


Cash flows from Operations

Cash flows from investing activities

Cash flows from financing activities

Net change in cash balance

Cash balance

at beginning of period

Cash balance at end of period



8.

How do financial managers calculate the average tax rate?


Average tax rates are calculated by dividing tax dollars paid by earnings before taxes (EBT).



9.

Why do financial managers calculate the

marginal tax rate?


Financial managers use marginal tax rates to estimate the future after
-
tax cash flows from
investments. Since they are interested in how much of the next dollar earned from new investments
will have to be paid in taxes, they use the m
arginal tax rate (rather than the average tax rate) to
calculate the tax liability.



10.

Identify whether the following items belong on the income statement or the balance sheet.


a. Interest Expense
IS




l. Cash
BS

b. Preferred Stock Dividends Paid
IS


m. C
apital in Excess of Par
BS

c. Plant and Equipment
BS



n. Operating Income
IS

d. Sales
IS





o. Depreciation Expense
IS

e. Notes Payable
BS




p. Marketable Securities
BS

f. Common Stock
BS




q. Accounts Payable
BS

g. Accounts Receivable
BS



r. Prepaid
Expenses
BS

h. Accrued Expenses
BS



s. Inventory
BS

i. Cost of Goods Sold
IS



t. Net Income
IS

j. Preferred Stock
BS




u. Retained Earnings
BS

k. Long
-
Term Debt
BS


18

11.

Indicate in which section the following balance items belong (current assets, fixed
assets, current
liabilities, long
-
term liabilities, or equity).


a. Cash
CA





h. Capital in Excess of Par
EQ

b. Notes Payable
CL




i. Marketable Securities
CA

c. Common Stock
EQ




j. Accounts Payable
CL

d. Accounts Receivable
CA



k. Prepaid Expenses
C
A

e. Accrued Expenses
CL



l. Inventory
CA

f. Preferred Stock
EQ




m. Retained Earnings
EQ

g. Plant and Equipment
FA




Answers to End
-
of
-
Chapter Problems



4
-
1.

CASE A



CASE B

Revenues




200,000



110,000

Expenses




160,000




70,000

Net Income





40,000





40,000


Retained Earnings, Jan 1


300,000



100,000

Dividends Declared




70,000




30,000

Retained Earnings, Dec 31


270,000



110,000

Current Assets, Dec 31




80,000



230,000

Non
-
current Assets, Dec 31


850,000



180,000

Total Assets, De
c 31



930,000



410,000

Current Liabilities, Dec 31



40,000




60,000

Non
-
current Liabilities, Dec 31

100,000



140,000

Total Liabilities, Dec 31


140,000



200,000

CS & Cap. in Excess of Par, Dec 31

520,000



100,000

Total Stockholders’ Equity, Dec 31

790,000



210,000



4
-
2.

CASE A



CASE B

Sales





500,000



250,000

COGS





200,000



100,000

Gross Profit




300,000



150,000

Operating Expenses




60,000




60,000

Operating Income (EBIT)


240,000




90,000

Interest Expense




10,000




10,000

Ear
nings Before Taxes (EBT)


230,000




80,000

Tax Expense (40%)




92,000




32,000

Net Income




138,000




48,000



4
-
3.

a) 15%; $48,000 X 0.15 = $7,200

b) $7,200/$48,000 = 0.15 or 15%


19

4
-
4.

a) Tax = $50,000 X 0.15 + $25,000 X 0.25 + $25,000 X 0.34 + $50,000 X 0.39



= $41,750


b) Effective tax rate = $41,750/$150,000 = 0.2783 or 27.83%



4
-
5.

The marginal tax rate is the tax rate applied to the next dollar of income. Therefore, the margi
nal tax
rate is 34%.

The average tax rate is 34%

50,000 * .15 = 7,500

25,000 * .25 = 6,250

25,000 * .34 = 8,500

235,000 * .39 = 91,650

2,865,000 * .34 = 974,100


$1,088,000

$1,088,000/$3,200,000 = 34%



4
-
6.

$1 + $400,000/200,000 = $3.00 per share



4
-
7.

Sales $10,000,000

-

Operating Costs 5,200,000

-

Interest Expense 200,000

= EBT $4,600,000


-

Taxes (40%) 1,840,000



Net after
-
tax income $2,760,000


Simon’s net after
-
tax income was $2,760,000 for the year.



4
-
8.

Depreciation expense in
2006

= $70,000
-

$60,000 = $10,000.



4
-
9

a)

Cash + Marketa
ble Securities + Inventory + Accounts Receivable + Prepaid expenses.

(11,000,000 + 9,000,000 + 11,000,000 + 3,000,000 + 1,000,000) = 35,000,000

Current Assets = $35,000,000


b)

Fixed assets


depreciation

30,000,000


8,000,000 = 22,000,000

Net Fixed Assets =

$22,000,000


c)

Notes Payable + Accrued Expenses

4,000,000 + 2,000,000 = 6,000,000

Current Liabilities = $6,000,000





20

d)

Current Assets


Current Liabilities

(11,000,000 + 9,000,000 + 11,000,000 + 3,000,000 + 1,000,000)


(4,000,000 + 2,000,000)


35,000,000


6,000,000 = 29,000,000

Net Working Capital = $29,000,000



4
-
10.

a ) Gross Profit



$440,000
-

$200,000 = $240,000

b ) Operating Income (EBIT)

$240,000
-

$40,000
-

85,000 = $115,000

c ) Earning Before Taxes (EBT)

$ 115,000
-

$40,000 = $75,000

d )

Income Taxes



$ 75,000 X 0.4 = $30,000

e ) Net Income



$75,000
-

$30,000 = $45,000



4
-
11

$1,500,000


$200,000 = $1,300,000

Simon and Pieman had a net worth of $1,300,000 at the end of the year.



4
-
12

a )
2006

Depreciation Expense for this process line

($131,000 + $12,000) X (0.245) = $35,035

b ) Amount of tax savings due to this investment.

$35,035 X 0.4 = $14,014



4
-
13.

Operating Income (EBIT) = $768,000

+ Depreciation = $42,000

+
Amortization = $15,000




$825,000


Target Telecom’s EBITDA = $825,000.



4
-
14

a ) The company's
2006

taxable income =

($400,000
-

$130,000 X 0.2)


=


$374,000

b ) Income tax =

$374,000 X 0.34 = $127,160



4
-
15.

a) Earnings = [($600,000
-

50,000) X (1
-

.34)
-

$63,000] = $300,000

Earnings per share = $300,000 / 100,000 = $3 per share

b) Addition to Retained Earnings = $300,000
-

100,000 = $200,000






21

4
-
16.

a ) Current
Assets:



2005
: $5,534 + 14,745 + 10,733 + 952 + 3,234 = $35,198



2006
: $9,037 + 15,943 + 11,574 + 1,801 + 2,357=$40,712

b ) Total Assets:



2005
: $35,198+(57,340
-

29,080)+1,010+2,503 = $66,971



2006
: $40,712+(60,374
-

32,478)+1,007+4,743 = $74,358

c )

Current Liabilities:



2005
: $3,253 + 6,821 = $10,074



2006
: $2,450 + 7,330 = $9,780

d ) Total Liabilities:



2005
: $10,074 + 2,389 = $12,463



2006
: $9,780 + 2,112 = $11,892

e ) Total Stockholders' Equity:

2005
: $8,549 + 45,959 = $54,508

2006
: $10,
879 + 51,587 = $62,466



4
-
17.

2005
: $12,463 TL + $54,508 EQ = $66,971 TA


2006
: $11,892 TL + $62,466 EQ = $74,358 TA



4
-
18.








(Dollars)

a ) Accumulated Depreciation


3,398


Inflow

b ) Accounts Receivable (net)


1,198


Outflow

c ) Inventories





841


Outflow

d ) Prepaid Expenses




877


Inflow

e ) Accounts Payable




803


Outflow

f ) Accrued Expenses





509


Inflow

g ) Plant and Equipment (gross)

3,034


Outflow

h ) Marketable Securities



849


Outflow


i ) Land





3


In
flow

j ) Long Term Investments


2,240


Outflow

k ) Common Stock



2,330


Inflow

l ) Bonds Payable




277


Outflow


4
-
19.




Pinewood Company and Subsidiaries






Statement of Cash Flows


For the year
2006


Operations:

Net Income




10,628

Add:

Depreciation Exp.





3,398

Decrease in Prepaid Expenses



877

Increase in Accrued Expenses



509

Less:

Increase in A/C Receivable


(1,198)

Increase in Marketable Securities

( 849)

Increase in Inventories



( 841)

Decrease in A/C Payable


( 8
03)

Total Cash Flow from Operations



$11,721

Investments:

Add:

Decrease in Land




3

Less:

Increase in Plant and Equipment

(3,034)

Increase in Long Term Investment

(2,240)

Total Cash Flow from Investments



($5,271)


22

Financing:

Add:

Increase in Common Stock



2,330

Less:

Common Stock Dividends


(5,000)

Decrease in Bonds Payable


( 277)

Cash Flow from Financing




($2,947)


Net Cash Flow






$3,503



4
-
20.

$3,503 = $9,037 end of ‘02 cash
-

$5,534 end of ‘0
1 cash


Yes, the net cash flow figure from
problem #16 gives the same answer as calculating the change in the cash figures from the end of
2005

to the
end of
2006

balance sheets.



4
-
21.
Sales




900,000


COGS




300,000


Gross Profit




600,000


Operating Expenses



200,000


Operating Income (EBIT)


400,000


Interest Expense



100,000


Income before taxes (EBT)


300,000


Tax Expense (30%)



90,000


Net Income



$210,000



4
-
22.

Retained Earnings end of
2006

$8,700,000


Retained Earnings end of
2005

8,000,000

Addition to retained earnings
2006

700,000

Earnings Available to Common Stockholders $1,500,000

-
Addition

to Retained Earnings
-
700,000

Dividends paid to Common Stockholders
2006

= $ 800,000




4
-
23.

Year Deprec. % * Depreciable Base = Depreciation

1

10%

$385,000

$38,500

2

18%

$385,000

$69,300

3

14.4%

$385,000

$55,440

4

11.5%

$385,000

$44,275

5

9.2%

$385,000

$35,420

6

7.4%

$385,000

$28,490

7

6.6%

$385,000

$25,410

8

6.6%

$385,000

$25,410

9

6.5%

$385,000

$25,025

10

6.5%

$385,000

$25,025

11

3.3%

$385,000

$12,705



4
-
24.

Basis = $1,000,0
00 + $100,000 +
$50,000 = $1,150
,000


Year 3 depreciation = $1,150,000 * .148 = $170,200


23

4
-
25.

Year 1

$7,000,000 * .1 = $700,000


Year 2 $7,000,000 * .18 = $1,260,000


Year 3 $7,000,000 * .144 = $1,008,000


Year 4 $7,000,000 * .115 = $805,000


Year 5 $7,000,000 * .0
92 = $644,000


Year 6 $7,000,000 *.074 = $518,000


Year 7 $7,000,000 * .066 = $462,000


Year 8 $7,000,000 * .066 = $462,000


Year 9 $7,000,000 * .065 = $455,000


Year 10 $7,000,000 * .065 = $455,000


Year 11 $7,000,000 * .033 = $231,000


24

Chapter 5
Solutions




Answers to Review Questions



1.

What is a financial ratio?


A financial ratio is a number that expresses the value of one financial variable relative to another.
Put more simply, a financial ratio is the result you get when you divide one financial number by
another. Calculating an individual ratio is simple, but

each ratio must be analyzed carefully to
effectively measure a firm's performance.



2.

Why do analysts calculate financial ratios?


Ratios are comparative measures. Because the ratios show relative value, they allow financial
analysts to compare infor
mation that could not be compared in its raw form. For example, ratios may
be used to compare one ratio to a related ratio, a firm's performance to management's goals, a firm's
past and present performance, or a firm's performance to similar firms



3.

Wh
ich ratios would a banker be most interested in when considering whether to approve an
application for a short
-
term business loan? Explain.


Bankers and other lenders use
liquidity

ratios to see whether to extend short
-
term credit to a firm.
Liquidity rat
ios measure the ability of a firm to meet its short
-
term obligations. These ratios are
important because failure to pay such obligations can lead to bankruptcy. Generally, the higher the
liquidity ratio, the more able a firm is to pay its short
-
term obli
gations.



4.

Which ratios would a potential long
-
term bond investor be most interested in? Explain.


Current and potential lenders of long
-
term funds, such as banks and bondholders, are interested in
debt

ratios. When a business's debt ratios increase s
ignificantly, bondholder and lender risk increases
because more creditors compete for that firm's resources if the company runs into financial trouble.



5.

Under what circumstances would market to book value ratios be misleading? Explain.


The Market to

Book ratio is useful, but it is only a rough approximation of how liquidation and going
concern values compare. This is because the Market to Book ratio uses accounting
-
based book
values. The actual liquidation value of a firm is likely to be different t
han the book value. For
instance, the assets of a firm may be worth more or less than the value at which they are currently
carried on the company's balance sheet. In addition, the current market price of the company's bonds
and preferred stock may also
differ from the accounting value of these claims.




25

6.

Why would an analyst use the Modified Du Pont system to calculate ROE when ROE may be
calculated more simply? Explain.


Actually, an analyst would
not

use the Modified Du Pont equation to calculate RO
E for precisely the
reason stated above. What an analyst
would

use the Modified Du Pont equation for is to help analyze
the factors that contribute to a firm's ROE. In other words, analysts use the Modified Du Pont system
to “take apart” ROE to see what
factors are influencing it.



7.

Why are trend analysis and industry comparison important to financial ratio analysis?


Trend analysis helps financial managers and analysts see whether a company's current financial
situation is improving or deteriorating.


Cross
-
sectional analysis, or industry comparison, allows analysts to put the value of a firm's ratios in
the context of its industry.




Answers to End
-
of
-
Chapter Problems



5
-
1.

a) Gross Profit Margin = Gross Profit/Sales


20,000,000/35,0
00,000 = .5714


Gross Profit margin = 57.14%


b) Operating Profit Margin = EBIT/Sales


16,000,000/35,000,000 = .4571


Operating Profit Margin = 45.71%


c) Net Profit Margin = Net Income/Sales


8,100,000/35,000,000 = .2314


Net Profit Margin = 23.14%



5
-
2.

Current Ratio = Total Current Assets/Total Current Liabilities

(5,000) / (500 +850 + 600) = 2.56

Current Ratio = 2.56


Quick Ratio = (Total Current Assets
-

Inventory)/Total Current Liabilities

(5,000


900)/(500 + 850

+ 600) = 2.10

Quick Ratio = 2.10



5
-
3.

Average Daily Credit Sales = Annual credit sales/365

5,000,000/365 = $13,698.63


Average Collection Period = Accounts Receivable/Average Daily Credit Sales

$500,000/13,698.63 = 36.5

Average Collection Period = 36.5
days


26

5
-
4.

Inventory Turnover = Sales/Inventory


35,000,000/2,400,000 = 14.58


Inventory Turnover = 14.58 X



Total Asset Turnover = Sales/Total Assets


35,000,000/(15,000,000 + 20,000,000) = 1


Total Asset Turnover = 1 X



5
-
5.

a) Book value per share

Book

price per share = Common Stock Equity/Number of shares Outstanding

$4,500,000/650,000 =$6.92

BPS = $6.92



b) Market to book value ratio



Market to book value ratio = Market price per share/Book value per share



$25.00/$6.92 = 3.61





Market to book value ratio = 3.61



5
-
6.

a) Gross profit margin:


$47,378/$94,001 = 50.40%

b) Operating profit margin


$12,941/$94,001 = 13.77%

c) Net profit margin




$8,620/$94,001 = 9.17%

d) Return on assets




$8,620/$66,971 = 12.87%

e) Return on equity




$8,620/$54,508 = 15.81%


While the Net profit margin is higher than the industry average, the Return on assets is lower. Pinewood
may consider increasing its debt to leverage profits.



5
-
7.

a) C
urrent assets = $5,534 + $14,745 + $10,733 + $952 + $3,234 = $35,198


Current ratio = $35,198/$10,074 = 3.494

b) Quick ratio = ($35,198
-

$10,733)/$10,074 = 2.429

Pinewood seems highly capable of paying off short
-
term debts.



5
-
8.

a)
Total debt = $3,253 + $6,821 + $2,389 = $12,463


Debt to total assets = $12,463/$66,971 = 18.61%

b) Times interest earned = $12,941/$48 = 270 times


Yes. The Pinewood has very low debt and its earnings are extremely high compared to its interest
expense.



5
-
9.

a. Average collection period



$14,745/($94,001 / 365) = 57.25 days

b. Inventory turnover




$94,001/$10,733 = 8.76

c. Total asset turnover



$94,001/$66,971 = 1.404


We would need to know the industry averages for these figures, a
nd also know about Pinewood’s
credit and inventory management practices to comment meaningfully on the above figures.


27

5
-
10. Modified Du Pont: ROE = Net Profit Margin X Total Asset Turnover X Assets over Equity


= 0.0917 X 1.404 X $66,971/$54,508 = 15.82%



5
-
11.

a) EVA = EBIT (1
-

tax rate)


(invested capital * investor’s required rate of return)



EVA = $12,941,000

* (1
-

0.35)


($
77,389,000 * 0.10) = $672,750



b) Pinewood has a true econo
mic profit of $
672,750
. This is the amount by which its



earnings exceed the returned expected by the firm’s investors.



c) MVA = Total market value


invested capital



MVA =
(
$
75,000,000 + $2
,389,000
)



(
$
54,508
,000

+ $2,389,000)

= $
20,492,000



d) Pinewood has a total market value that is $
20,492
,000 greater that the amount of capital



invested in the firm.



5
-
12.

a) EVA = EBIT (1


Tax Rate)


(invested capital * investors required rate of return)




EVA = $8,000 (.65)


($
33
,000 * .12)


= $5,200


$
3,960


EVA = $1,240



b) The economic value is positive; therefore, Eversharp earned a sufficient amount during the



year to provide more than the expected rate of return from the investors and lenders who




contributed to the capital of the company.



c) MVA = Total market value


invested capital



MVA = $33
,000
-

$21,000 = $
12,
000



d) Eversh
arp’s total market value exceeds its investe
d capital by $12
,000.



5
-
13.

EVA & MVA Calculation:







Income tax rate

35%



Cost of Capital

12%


Ka


Stock Price (ref)

$9



Number of shares outstanding (ref)

3,000



Market Value of Common
Equity (ref)

$27,000



Book Value of Common Equity

$15,210



Debt Capital (ref)

$6,630


(Notes payable + Long
-
Term Debt )


Total Invested Capital (ref)

$33,630


(Debt + Common)


EVA




MVA






a.

EVA

$189


EBIT(1
-
Tr)
-

(Invested Capital * Ka)




b. Comment on EVA: This year T & J earned enough to exceed the return expected by the


contributors of the firm's capital by $189.



28

5
-
14.

a. Du Pont:


ROA


= Net Profit Margin X Total Asset T
urnover


= (80/1,000) X (1,000/500) = 16%




Modified Du Pont:

ROE

= Net Profit Margin X Total Asset Turnover X Assets over
Equity



= ($80/$1,000) X ($1,000/$500) X (1/(1
-
0.5) = 32%


b. ROE = ($80/$1,000) X ($1,000/$500) X (1/(1
-
0.7) =
53.3%


c. ROE = ($80/$1,000) X ($1,000/$500) X (1/(1
-
0.9) = 160%


d. ROE = ($80/$1,000) X ($1,000/$500) X (1/(1
-
0.1) = 17.78%



5
-
15.

Assets







Liabilities + Equity

Cash





$6,000


Accounts Payable



$6,000

Accounts Receivable



15,068


Notes

Payable




2,739

Inventory




6,667


Accrued Expenses




600

Prepaid Expenses



282


Total Current Liabilities


9,339

Total Current Assets



28,017


Bonds Payable





15,661

Fixed Assets




34,483


Common Stock




16,000

R
etained Earnings



21,500

Total Assets



$
62,500


Total Liabilities + Equity

$
62,500


Total Assets = Sales / Total Asset Turnover = $100,000/1.6 = $62,500

Fixed Assets = Sales / Fixed Asset Turnover = $100,000/2.9 = $34,483

Total Current Assets = $62,500
-

$34,483 = $28,017

Accounts Receivable = Sales/day X Ave. Collection Period = ($100,000/365) X 55 = $15,068

Inventory = Sales / Inventory Turnover = $100,000/15 = $6,667

Prepaid Expenses = $28,017
-

($15,068 + $6,667 + $6,000) = $282

Total Debt = Total A
ssets X Debt to Asset Ratio = $62,500 X 0.4 = $25,000

Total Current Liabilities = Total Current Assets / Current Ratio = $28,017/3 = $9,339

Bonds Payable = Total Debt
-

Total Current Liabilities = $25,000
-

$9,339 = $15,661

Retained Earnings = $62,500
-

(
$16,000 + $25,000) = $21,500

Notes Payable = $9,339
-

($600 + $6,000) = $2,739



5
-
16.

NI/$5,000 = 0.10

NI = $500

TE = TA
-

TL = $10,000
-

$6,000 = $4,000

ROE = $500/$4,000 = .125 = 12.5%



5
-
17.

Current Liability = $20,000
-

$18,000 = $2,000

Current
Ratio = $5,000/$2,000 = 2.5 times



5
-
18.

Return on Assets = Net Profit Margin X Total Asset Turnover

0.12 = 0.04 X Total Asset Turnover

Total Asset Turnover = 0.12/0.04 = 3


29

5
-
19.

Gross Profit = 0.50 X $5,000,000 = $2,500,000



5
-
20.

EBIT = $2,500,000
-

$200,000
-

$50,000 = $2,250,000

Operating Profit Margin = $2,250,000/$5,000,000 = .45 = 45%



5
-
21.

Net Income = 0.20 X $5,000,000 = $1,000,000



5
-
22.

Net Income = 0.20 X $5,000,000 = $1,000,000

ROA = $1,000,000/$20,000,000 = .05 = 5%



5
-
23.

Net Income =

0.10 X $15,000,000 = $1,500,000



5
-
24.

Current Ratio = (20,000,000
-

2,000,000)/4,000,000 = 4.5



5
-
25.

Quick Ratio = ($20,000,000
-

$2,000,000
-

$3,000,000)/$4,000,000 = 3.75 times



5
-
26.

Total Debt = 0.30 X $20,000,000 = $6,000,000

Debt to Equity rati
o = $6,000,000/$14,000,000 = 0.43



5
-
27.


Inventory Turnover = 5,000,000/3,000,000 = 1.67



5
-
28.

Return on Assets = 0.20 X 0.25 = 0.05 = 5%



5
-
29. a) Du Pont:

ROA


= Net Profit Margin X Total Asset Turnover


= ($200/$2,000) X ($2,000/$1,000) = .20 = 20%

Modified Du Pont: ROE = Net Profit Margin X Total Asset Turnover X Assets over Equity


= ($200/$2,000) X ($2,000/$1,000) X (1/(1
-
0.6)) = .50 = 50%



b)


ROE = ($200/$2,000) X ($2,000/$1,000) X (1/(1
-
0.8)) = 100%



c)


ROE = ($200/$2,00
0) X ($2,000/$1,000) X (1/(1
-
0.2)) = 25%



5
-
30.

Notoriously Niagara





Niagara’s Notions



a)

NPM = $100,000/$500,000 = 0.20


NPM = $10,000/$500,000 = 0.02


b)

TATO = $500,000/$500,0000 = 0.10


TATO = $500,000/$500,000 = 1.0


c)

ROA = 0.20 X 0.10 =
0.02



ROA = 0.02 X 1.0 = 0.02


30

d)

Notoriously Niagara must have a higher net profit margin because their asset turnover is low
compared to that of Niagara’s Notions even though they have the same ROA. Niagra’s Notions has a high
asset turnover but a low n
et profit margin.



5
-
31.

a )

$2,250,000/1,750,000=$1.29



b )

$40/$1.29 = 31



c )

$15,000,000/1,750,000 = $8.57



d )

$40/$8.57 = 4.67



e )

Yes, the market seems to believe that the company has going
-
concern value as evidenced by
t
he market to book ratio greater than 1.



5
-
32.




Net Profit Margin Current Ratio

Total Asset Turnover




Year



NI/Sales


CA/CL



Sales/TA




2004



10.00%



.94



1.05



2005




9.44%


1.02



1.15



2006




9.36%


1.08



1.18


Golden Products

Industry averages:



9.42%


1.13



2.00


The NPM is about average, although it is deteriorating. The liquidity, as measured by the current
ratio, is below average but improving. Asset utilization, as measured by the total asset turnover i
s way below
average.


5
-
33.

The Industry averages are:



Fixed Asset Turnover


Return on Assets

Debt to Assets Ratio

Return on equity



1.33



11.00%



0.60




26%


YEAR

PM

CR

TATO

FATO

ROA

D/A

ROE

2004

10.00%

0.94

1.05

1.21

10.53%

0.68

33.33%

2005

9.44%

1.02

1.15

1.33

10.90%

0.64

30.36%

2006

9.36%

1.08

1.18

1.36

11.00%

0.60

27.50%


Golden Products has an improving ROA that now equals that of the industry norm. The ROE has
slipped a little, but is still above the industry norm in spite of the fact that Golden has a little less debt
in its capital structure in 2006
. Overall, Johnny s
hould be pleased.



5
-
34. ( Figures in $ '000) Mining Smelting

Rolling Extrusion Whole Company



NPM


3.3% 8.7%


11.7% 10.0%


9.7%



ROA


4.2% 10.4%


17.9% 13.9%


13.4%





31

5
-
35.

National Glass Company








Income Statement (in $ 000's)


Ratios:




2006








ACP

48.7

days

Sales

$45,000


Inventory Turnover

9

X

Cost of Goods Sold

23,000


Debt to Assets

40%


Gross Profit

22,000


Current Ratio

1.6250


Selling
and Admin Expenses

13,000


Total Asset turnover

1.50


Depreciation

3,000


Fixed Asset Turnover

2.6471


Operating Income

6,000


Return on Equity

19.33%


Interest Expense

200


Return on Assets

11.6%


Earnings Before Tax

5,800


Operating Profit
Margin

13.33%


Income Taxes

2,320


Gross Profit Margin

48.89%


Net Income

$3,480











Preferred Dividends

$0





Earnings Available to Common

$3,480











Balance Sheet (in $ 000's)








As of Dec 31





2006





Assets






Current Assets:







Cash

$2,000






Accounts Receivable

6,000






Inventory

5,000





Total Current Assets

13,000





Plant & Equipment, Net

16,000





Land

1,000





Total Assets

$30,000





Liabilities & Equity






Current
Liabilities:







Accounts Payable

$2,000






Notes Payable

3,000





Accrued Expenses

3,000





Total Current Liabilities

8,000





Bonds Payable

4,000





Total Liabilities

12,000





Common Stock

4,000





Retained Earnings

14,000





Total Stockholders' Equity

18,000





Total Liabilities & Equity

$30,000







5
-
36.

a.)




(Industry)



Kingston,
2006


Kingston,
2007


i.

Gross Profit Margin (50%)




48.9%



48.9%

ii.

Operating Profit Margin (15%)




15.1%



13.3%

iii.

Net
Profit Margin (8%)




8.5%



7.5%

iv.

Return on Assets (10%)




11.56%



9.97%

v.

Return on Equity (20%)




19.3%



16.3%

vi.

Current Ratio (1.5)





1.63



1.62

vii.

Quick Ratio (1.0)





1.00



1.04

viii.

Debt to Total Asset (0.5)




.4



.39

ix.

Times Interest Earned (25)




15.5X



14.6X


32

x.

Average Collection Period (45 days)



53.5days



61.6days

xi.

Inventory Turnover (8)




8.18X



8.62X

xii.

Total Asset Turnover (1.6)




1.4X



1.3X



b.) Kingston has about the same net profit margin and

return on equity as the industry norm. The return on
assets ratio for Kingston is about the same as than the industry norm.


c.) Determine the sources and uses of funds and prepare a
statement of cash flows for 2007
.



(1) Sources and Uses of Funds:





Change,




2006

to 200
7




Balance Sheet

Sources

Uses





Net Income


$3,353


Dividends paid



$733

Depreciation


$3,000



Cash

($200)

$200



Accounts Receivable, Net

$1,600


$1,600


Inventory

$220


$220

Property, Plant & Equipment,
Gross

$5,000


$5,000

Land

$0




Accounts Payable

$600

$600



Notes Payable

$300

$300


Accrued expenses

$100

$100


Bonds Payable

$0



Common Stock

$0



Totals


$7,553

$7,553




(2) Statement of Cash Flows:



Kingston Tool Company

Statement

of Cash Flows for the year 2007

( in $ 000s)




Cash Flows from Operations:




Net Income

$3,353


Depreciation

3,000


Decrease(Increase) in Accounts Receivable

(1,600)


Decrease(Increase) in Inventory

(220)


Increase(Decrease) in
Accounts Payable

600


Increase(Decrease) in Notes Payable

300


Increase(Decrease) in Accrued Expenses

100

Total Cash Flows from Operations


$5,533

Cash Flows from Investments:




New Property, Plant, & Equipment

($5,000)

Total Cash Flows from
Investments


($5,000)

Cash Flows from Financing:




Dividends Paid

($733)

Total Cash Flows from Financing


(733)



-

Net Cash Flow


($200)




Beginning Cash Balance


$2,000

Ending Cash Balance


$1,800



33

d.)

Profit margins are eroding and generally a
little below the industry norm. Liquidity is about average.
Debt is low, but interest coverage is below the industry norm in spite of the low debt load. Inventory
turnover is way below average. The negative cash flow of $200,000 came mainly from the bu
ildup of
accounts receivable and plant & equipment.


e.)

The current ratio, quick ratio, and times interest earned would get the most scrutiny from loan officers.



5
-
36b.

EVA = EBIT * (1


tax rate)


(invested capital * investor’s required rate of
return)


EVA = ($4,000 * 0.60)


($60,000 * 0.10) =
-
$3,600


EVA =
-
$3,600



MVA = Total market value


invested capital


MVA = $50,000
-

$60,000 =
-
$10,000


MVA =
-
$10,000



5.37.

a) Accounts Receivable/Average Daily Credit Sales


$564,000.00 / ($3,814,
000 / 365)= 53.71 = 54 days


b)

Super Dot

Com was more profitable in 2006

than it was in
2004
.








2004






2006
_________






$519,000/$2,100,000


$1,115,000/$3,814,000


Net Profit Margin


24.71%




29.23%






$519,000/$2,859,000


$1,115,000/$5,316,000


Return on Assets


18.15%




20.97%




Both the NPM an
d ROA ratios were better in 2006
.


c)

Super Dot Com wa
s less liquid at the end of 2006 than it was at the end of 2004
.









2004






2006
_________






$981,000/$245,000


$1,720,000/$623,000


Current Ratio


4.00




2.76






($981,000
-

$307,000)/$245,000

($1,720,000
-

$960,000)/$623,000


Quick Ratio


2.75




1.22








34

Chapter 6 Solutions




Answers to Review
Questions



1.

Why do businesses spend time, effort, and money to produce forecasts? Explain.


Businesses succeed or fail depending on how well prepared they are to deal with the situations they
confront in the future. Therefore they expend considerable
sums making estimates (forecasts) of
what the future situation is likely to be. Businesses develop new products, set production quotas, and
select financing sources based on forecasts about the future economic environment and the firm's
condition. If eco
nomists predict interest rates will be relatively high, for example, firms may plan to
limit borrowing and defer expansion plans.



2.

What is the primary assumption behind the experience approach to forecasting?


The experience approach to forecasting is
based on the assumption that things will happen a certain
way in the future because they happened that way in the past. For instance, if it has always taken you
fifteen minutes to drive to the grocery store, then you will probably assume that it will take
you about
fifteen minutes the next time you drive to the store. Similarly, financial managers often assume sales,
expenses, or earnings will grow at certain rates in the future because they grew at that rate in the past.



3.

Describe the sales forecasting

process.


Sales forecasting is a group effort. Sales and marketing personnel usually provide assessments of
demand and the competition. Production personnel usually provide estimates of manufacturing
capacity and other production constraints. Top manage
ment will make strategic decisions affecting
the firm as a whole. Financial managers coordinate, collect, and analyze the sales forecasting
information. Figure 6
-
1 in the text shows a diagram of the process.



4.

Explain how the cash budget and the capit
al budget relate to
pro forma

financial statements.


The cash budget shows the projected flow of cash in and out of the firm for specified time periods.
The capital budget shows planned expenditures for major asset acquisitions. Forecasters incorporate
d
ata from these budgets into pro forma financial statements under the assumption that the budget
figures will, in fact, occur.



5.

Explain how management goals are incorporated into
pro forma

financial statements.


Management sets a target goal, and forecasters produce pro forma financial statements under the
assumption that the goal will be reached. For example, if management’s goal is to pay off all short
-
term notes during the coming year, forecasters would incorp
orate this into the
pro forma

balance
sheet by setting Notes Payable to zero.



35

6.

Explain the significance of the term
additional funds needed
.


When the pro forma balance sheet is completed, total assets and total liabilities and equity will rarely
match. The discrepancy between forecasted assets and forecasted liabilities and equity results when
either too little or too much financing is project
ed for the amount of asset growth expected. The
discrepancy is called
additional funds needed

(AFN) when forecast assets exceed forecast liabilities
and equity, and
excess financing

when forecast liabilities and equity exceed forecast assets.



7.

What do

financial managers look for when they analyze
pro forma

financial statements?


After the
pro forma

financial statements are complete, financial managers analyze the forecast to
determine (1) what current trends suggest what will happen to the firm in the
future, (2) what effect
management's current plans and budgets will have on the firm, and (3) what actions to take to avoid
problems revealed in the
pro forma

statements



8.

What action(s) should be taken if analysis of
pro forma

financial statements reve
als positive trends?
Negative trends?


When analyzing the
pro forma

statements, managers often see signs of emerging positive or negative
conditions. If forecasters discover positive indicators, they will recommend that current plans be
continued. If fore
casters see negative indicators, they will recommend corrective action.




Answers to End
-
of
-
Chapter Problems



6
-
1.


Sales Record for The Miniver Corporation


Sales in 200
7

is expected to be approximately $215,000 following the trend of the last six yea
rs as shown
above.


$0
$50,000
$100,000
$150,000
$200,000
$250,000
1997
1998
1999
2000
2001
2002
2003

36

6
-
2.



This year

Next Year

Forecasting Assumption



Sales




100

120



Sales will grow 20%(100 X 1.2)