Corporate Finance Foundations Global Edition Solution Manual

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Chapter 01-The Goals and Activities of Financial Management1-1Chapter 1The Goals and Activities of Financial ManagementDiscussion Questions1-1.How did the recession of 2007–2009 compare with other recessions since theGreatDepression in terms of length?It was the longest.1-2.What effect did the recession of 2007–2009 have on government regulation?It was greatly increased.1-3.What advantages does a sole proprietorship offer? What is a major drawback ofthis type of organization?A sole proprietorship offers the advantage of simplicity of decision making andlow organizational and operating costs. A major drawback is that there isunlimited liability to the owner.1-4.What form of partnership allows some of the investors to limit their liability?Explain briefly.A limited partnership allows some of the partners to limit their liability. Underthis arrangement, one or more partners are designated general partners and haveunlimited liability for the debts of the firm; other partners are designated limitedpartners and are liable only for their initial contribution. The limited partners arenormally prohibited from being active in the management of the firm.1-5.In a corporation, what group has the ultimate responsibility for protecting andmanaging the stockholders' interests?The board of directors.1-6.What document is necessary to form a corporation?The articles of incorporation.

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Chapter 01-The Goals and Activities of Financial Management1-21-7.What issue does agency theory examine? Why is it important in a publiccorporation rather than in a private corporation?Agency theory examines the relationship between the owners of the firm and themanagers of the firm. In privately owned firms, management and the owners areusually the same people. Management operates the firm to satisfy its own goals,needs, financial requirements and the like. As a company moves from private topublic ownership, management now represents all owners. This placesmanagement in the agency position of making decisions in the best interest of allshareholders.1-8.Why are institutional investors important in today's business world?Because institutional investors such as pension funds and mutual funds own alarge percentage of major U.S. companies, they are having more to say about theway publicly owned companies are managed. As a group, they have the ability tovote large blocks of shares for the election of a board of directors, which issupposedto run the company in an efficient, competitive manner. The threat ofbeing able to replace poor performing boards of directors makes institutionalinvestors quite influential. Since these institutions, like pension funds and mutualfunds, represent individual workers and investors, they have a responsibility to seethat the firm is managed in an efficient and ethical way.1-9.Why is profit maximization, by itself, an inappropriate goal? What is meant by thegoal of maximization of shareholder wealth?The problem with a profit maximization goal is that it fails to take account of risk,the timing of the benefits is not considered, and profit measurement is a veryinexact process. The goal of shareholders’wealth maximization implies that thefirm will attempt to achieve the highest possible total valuation in themarketplace. It is the one overriding objective of the firm and should influenceevery decision.

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Chapter 01-The Goals and Activities of Financial Management1-31-10.When does insider trading occur? What government agency is responsible forprotecting against the unethical practice of insider trading?Insider trading occurs when anyone with non-public information buys or sellssecurities to take advantage of that private information. The Securities andExchange Commission is responsible for protecting markets against insidertrading. In the past,people have gone to jail for trading on non-publicinformation. This has included company officers, investment bankers,printerswho have informationbefore it is published, and even truck drivers who deliverbusiness magazines and read positive or negative articles about a company beforethe magazine is on the newsstands and then place trades or have friends placetrades based on that information. The SEC has prosecuted anyone who profitsfrom inside information.1-11.In terms of the life of the securities offered, what is the difference between moneyand capital markets?Money markets refer to those markets dealing with short-term securities that havea life of one year or less. Capital markets refer to securities with a life of morethan one year.1-12.What is the difference between a primary and a secondary market?A primary market refers to the use of the financial markets to raise new funds forthe corporation. After the securities are sold to the public (institutions andindividuals), they trade in the secondary market between investors. It is in thesecondary market that prices are continually changing as investors buy and sellsecurities based on the expectations of corporate prospects.1-13.Assume you are looking at many companies with equal risk.Which ones willhave the highest stock prices?Given companies with equal risk, those companies with expectations of highreturn will have higher common stock prices relative to those companies withexpectations of poor returns.

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Chapter 01-The Goals and Activities of Financial Management1-41-14.What changes can take place under restructuring? In recent times, what group ofinvestors has often forced restructuring to take place?Restructuring can result in changes in the capital structure (liabilities and equityon the balance sheet). It can also result in the selling of low-profit-margindivisions with the proceeds reinvested in better investment opportunities, andsometimes restructuring results in the removal of the current management team orlarge reductions in the workforce. Restructuring has also included mergers andacquisitions.Institutional investors have been very influential in forcing restructuring to takeplace in recent years.1-15.How did the Sarbanes–Oxley Act impact corporations’financial reports?1-16.Name five requirements of the Dodd–Frank legislation.

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Chapter 02: Review of Accounting2-1Chapter 2Review of AccountingDiscussion Questions2-1.Discuss some financial variables that affect the price-earnings ratio.The price-earnings ratio will be influenced by the earnings and sales growth ofthe firm, the risk or volatility in performance, the debt-equity structure of thefirm, the dividend payment policy, the quality of management, and a number ofother factors. The ratio tends to be future-oriented, and the more positive theoutlook, the higher it will be.2-2.What is the difference between book value per share of common stock andmarket value per share? Why does this disparity occur?Book value per share is arrived at by taking the cost of the assets andsubtracting out liabilities and preferred stock and dividing by the number ofcommon shares outstanding. It is based on the historical cost of the assets.Market value per share is based onthecurrent assessed value of the firm in themarketplace and may bear little relationship to original cost. Besides thedisparity between book and market value caused by the historical cost approach,other contributing factors are the growth prospects for the firm, the quality ofmanagement, and the industry outlook. To the extent these are quite negative orpositive; market value may differ widely from book value.2-3.Explain how depreciation generates actual cash flows for the company.The only way depreciation generates cash flows for the company is by servingas a tax shield against reported income. This non-cash deduction may providecash flow equal to the tax rate times the depreciation charged. This much intaxes will be saved, while no cash payments occur.2-4.What is the difference between accumulated depreciation and depreciationexpense? How are they related?Accumulated depreciation is the sum of all past and present depreciationcharges, while depreciation expense is the current year’s charge. They arerelated in that the sum of all prior depreciation expense should be equal toaccumulated depreciation (subject to some differential related to assetwrite-offs).

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Chapter 02: Review of Accounting2-22-5.How is the income statement related to the balance sheet?The earnings (less dividends) reported in the income statement is transferred tothe ownership section of the balance sheet as retained earnings. Thus, what weearn in the income statement becomes part of the ownership interest in thebalance sheet.2-6.Comment on why inflation may restrict the usefulness of the balance sheet asnormally presented.The balance sheet is based on historical costs. When prices are rising rapidly,historical cost data may lose much of their meaning—particularly for plant andequipment and inventory.2-7.Explain why the statement of cash flows provides useful information that goesbeyond income statement and balance sheet data.The income statement and balance sheet are based on the accrual method ofaccounting, which attempts to match revenues and expenses in the period inwhich they occur. However, accrual accounting does not attempt to properlyassess the cash flow position of the firm. The statement of cash flows fulfillsthis need.2-8.What are the three primary sections of the statement of cash flows? In whatsection would the payment of a cash dividend be shown?The sections of the statement of cash flows are:Cash flows from operating activitiesCash flows from investing activitiesCash flows from financing activitiesThe payment of cash dividends falls into the financing activities category.2-9.What is free cash flow? Why is it important to leveraged buyouts?Free cash flow is equal to cash flow from operating activities:Minus:Capital expenditures required to maintain the productive capacityof the firm.Minus:Dividends (required to maintain the payout on common stock andto cover any preferred stock obligation).The analyst or banker normally looks at free cash flow to determine whether

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Chapter 02: Review of Accounting2-3there are sufficient excess funds to pay back the loan associated with theleveraged buyout.2-10.Why is interest expense said to cost the firm substantially less than the actualexpense, while dividends cost it 100 percent of the outlay?Interest expense is a tax deductible item to the corporation, while dividendpayments are not. The net cost to the corporation of interest expense is theamount paid multiplied by the difference of one minus the applicable tax rate.For example, $100 of interest expense costs the company $65 after taxes whenthe corporate tax rate is 35 percent—for example, $100 × (1–0.35) = $65.

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Chapter 02: Review of Accounting2-4Problems1.Income Statement (LO1)Frantic Fast Foods had earnings after taxes of $1,070,000in theyear 2012 with311,000shares outstanding. On January 1, 2013, the firm issued31,000new shares. Because of the proceeds from these new shares and other operatingimprovements, earnings after taxes increased by24percent.a.Compute earnings per share for the year 2012.b.Compute earnings per share for the year 2013.2-1.Solution:Frantic Fast Foodsa.Year 201244.3$311,000$1,070,000goutstandinSharestaxesafterEarningshareperEarnings===b.Year 201388.3$342,000$1,326,800shareperEarnings000,342$000,31$000,311$goutstandinShares800,326,1$24.1000,070,1$safter taxeEarnings===+===2.Income statement (LO1)Sosa Diet Supplements had earnings after taxes of $800,000 inthe year 2011 with 200,000 shares of stock outstanding. On January 1, 2012, the firmissued 50,000 new shares. Because of the proceeds from these new shares and otheroperating improvements, earnings after taxes increased by 30 percent.a.Compute earnings per share for the year 2011.

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Chapter 02: Review of Accounting2-5b.Compute earnings per share for the year 2012.2-2.Solution:SosaDiet Supplementsa.Year 2011Earnings after taxesEarnings per share =Shares outstanding$800,000== $4.00200,000b.Year 2012Earnings after taxes$800,0001.30$1,040,000Shares outstanding200,00050,000250,000$1,040,000Earning per share$4.16250,000===+===3.a.Gross profit (LO1)Hillary Swank Clothiers had sales of $444,000 and cost of goodssold of $296,000. What is the gross profit margin (ratio of gross profit to sales)?b.If the average firm in the clothing industry had a gross profit of30percent, how is thefirm doing?2-3.Solution:Hillary Swank Clothiersa.Sales.............................................................$444,000Cost of goods sold.................................296,000Gross Profit....................................$148,00033.33%444,000$148,000SalesProfitGrossMarginProfitGross==b.With a gross profitof33.33percent, the firm is outperformingtheindustry average of 30percent.

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Chapter 02: Review of Accounting2-64.Operatingprofit (LO1)A-Rod Fishing Supplies had sales of $2,500,000 and cost ofgoods sold of $1,710,000. Selling and administrative expenses represented 10 percent ofsales. Depreciation was 6 percent of the total assets of $4,680,000. What was the firm’soperating profit?2-4.Solution:A-Rod Fishing SuppliesSales...............................................................$2,500,000Cost of goods sold..........................................1,710,000Gross Profit................................................790,000Selling and administrative expense*..............250,000Depreciation expense**.................................280,800Operating profit.........................................$ 259,200* 10% × $2,500,000 = $250,000** 6%×$4,680,000 = $280,8005.Income statement (LO1)Arrange the following income statement items so they are in theproper order of an income statement:TaxesEarnings per shareShares outstandingEarnings before taxesInterest expenseCost of goods soldDepreciation expenseEarnings after taxesPreferred stock dividendsEarnings available to commonOperating profitstockholdersSalesSelling and administrative expenseGross profit2-5.Solution:Sales–Cost of goods soldGross profit–Selling and administrative expense–Depreciation expenseOperating profit–Interest expense

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Chapter 02: Review of Accounting2-7Earnings before taxes–TaxesEarnings after taxes–Preferred stock dividendsEarnings available to common stockholdersShares outstandingEarnings per share6.Income statement (LO1)Given the following information,prepare in good form anincome statement for the Dental Drilling Company.Selling and administrative expense........................................$ 112,000Depreciation expense.............................................................73,000Sales.......................................................................................489,000Interest expense......................................................................45,000Cost of goods sold..................................................................156,000Taxes......................................................................................47,0002-6.Solution:Dental Drilling CompanyIncome StatementSales...............................................................$ 489,000Cost of goods sold..........................................$ 156,000Grossprofit................................................$ 333,000Selling and administrative expense................$ 112,000Depreciation expense.....................................$73,000Operating profit.........................................$ 148,000Interest expense..............................................$45,000Earnings before taxes................................$ 103,000Taxes..............................................................$47,000Earnings after taxes...................................$56,000

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Chapter 02: Review of Accounting2-87.Incomestatement (LO1)Given the following information, prepare in good form anincome statement for Jonas Brothers Cough Drops.Selling and administrative expense........................................$283,000Depreciation expense.............................................................190,000Sales.......................................................................................2,020,000Interest expense......................................................................123,000Cost of goods sold..................................................................506,000Taxes......................................................................................165,0002-7.Solution:Jonas Brothers Cough DropsIncome StatementSales...............................................................$2,020,000Cost of goods sold..........................................506,000Gross profit................................................1,514,000Selling and administrative expense................283,000Depreciation expense.....................................190,000Operating profit.........................................1,041,000Interest expense..............................................123,000Earnings before taxes................................918,000Taxes..............................................................165,000Earnings after taxes...................................$753,0008.Determination of profitability (LO1)Prepare in good form an income statement forFranklin Kite Co.Inc.Take your calculations all the way to computing earnings pershare.Sales.......................................................................................$900,000Shares outstanding.................................................................50,000Cost of goods sold..................................................................400,000Interest expense......................................................................40,000Selling and administrative expense........................................60,000Depreciation expense.............................................................20,000Preferred stock dividends.......................................................80,000Taxes......................................................................................50,000

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Chapter 02: Review of Accounting2-92-8.Solution:Franklin Kite CompanyIncome StatementSales...............................................................$900,000Cost of goods sold..........................................400,000Gross profit................................................500,000Selling and administrative expense................60,000Depreciation expense.....................................20,000Operating profit.........................................$420,000Interest expense..............................................40,000Earnings before taxes................................$390,000Taxes..............................................................120,000Earnings after taxes...................................$270,000Preferred stock dividends...............................80,000Earnings available to common stockholders.190,000Shares outstanding.........................................50,000Earnings per share..........................................$3.809.Determination of profitability (LO1)Prepare in good form an income statement forVirginia Slim Wear. Take your calculations all the way to computing earnings per share.Sales.......................................................................................$1,450,000Shares outstanding.................................................................107,000Cost of goods sold..................................................................920,000Interest expense......................................................................30,000Selling and administrative expense........................................46,000Depreciation expense.............................................................29,000Preferred stock dividends.......................................................89,000Taxes......................................................................................101,0002-9.Solution:Virginia Slim WearIncome StatementSales...............................................................$1,450,000Cost of goods sold..........................................920,000

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Chapter 02: Review of Accounting2-10Grossprofit................................................530,000Selling and administrative expense................46,000Depreciation expense.....................................29,000Operating profit.........................................455,000Interest expense..............................................30,000Earnings before taxes................................425,000Taxes..............................................................101,000Earnings after taxes...................................324,000Preferred stock dividends...............................89,000Earnings available to common stockholders.$235,000Shares outstanding.........................................107,000Earningsper share..........................................$2.2010.Incomestatement (LO1)Precision Systems had sales of $820,000, cost of goods of$510,000, selling and administrative expense of $60,000,and operating profit of $103,000.What was the value of depreciation expense? Set this problem up as a partial incomestatement, and determine depreciation expense as the plug figure.2-10.Solution:Precision SystemsSales...............................................................$820,000Cost of goods sold.........................................510,000Grossprofit................................................310,000Selling and administrative expense................60,000Depreciation (plug figure)..............................147,000Operating profit.........................................$103,00011.Depreciation and earnings (LO1)Stein BooksInc.sold 2,000 finance textbooks for $270each to High Tuition University in 2013. These books cost $240 to produce. Stein Booksspent $12,400 (selling expense) to convince the university to buy its books.Depreciation expense for the year was $15,400. In addition, Stein Books borrowed$106,000 on January 1, 2013, on which the company paid 16percent interest. Both theinterest and principal of the loan were paid on December 31, 2013. The publishing firm’stax rate is 30 percent.Did Stein Books make a profit in 2013? Please verify with an income statementpresented in good form.

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Chapter 02: Review of Accounting2-112-11.Solution:Stein BooksInc.Income StatementFor the Year Ending December 31, 2013Sales(2,000books at $270 each)..................................$540,000Cost of goods sold (2,000 books at $240 each)...........480,000Grossprofit...............................................................60,000Selling expense.............................................................12,400Depreciation expense....................................................15,400Operating profit……................................................$32,200Interest expense ($106,000×16%)..............................16,960Earnings before taxes...............................................15,240Taxes @ 30%................................................................4,572Earnings after taxes..................................................$10,66812.Determination of profitability (LO1)Lemon Auto Wholesalers had sales of $1,570,000in 2013 and cost of goods sold represented 70percent of sales. Selling and administrativeexpenses were 12 percent of sales. Depreciation expense was $14,000 and interest expensefor the year was $15,000. The firm’s tax rate is 30 percent.a.Compute earnings after taxes.b.Assume the firm hires Ms. Carr, an efficiency expert, as a consultant. She suggeststhat by increasing selling and administrative expenses to 14 percent of sales, sales canbe increased to $1,620,600. The extra sales effort will alsoreduce cost of goods soldto 66percent of sales.(There will be a larger markup in prices as a result of moreaggressive selling.) Depreciation expense will remain at $14,000. However, moreautomobiles will have to be carried in inventory to satisfy customers, and interestexpense will go up to $22,600. The firm’s tax rate will remain at 30 percent. Computerevised earnings after taxes based on Ms. Carr’s suggestions for Lemon AutoWholesalers. Will her ideas increase or decrease profitability?

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