Financial Management : Theory and Practice, An Asia Edition 1st Edition Solution Manual

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Chapter 1An Overview ofFinancial Managementandthe Financial EnvironmentANSWERS TO END-OF-CHAPTER QUESTIONS1-1a.A proprietorship, or sole proprietorship, is a business owned by one individual.Apartnership exists when two or morepersons associate to conduct a business.Incontrast, a corporation is a legal entity created by a state. The corporation is separateand distinct from its owners and managers.b.In a limited partnership, limited partners’ liabilities, investment returns and controlare limited, while general partners have unlimited liability and control.A limitedliability partnership (LLP), sometimes called a limited liability company (LLC),combines the limited liability advantage of a corporation with the tax advantages of apartnership. A professional corporation (PC), known in some states as a professionalassociation (PA), has most of the benefits of incorporation but the participants are notrelieved of professional (malpractice) liability.c.Stockholder wealth maximization is the appropriate goal for management decisions.The risk and timing associated with expected earnings per share and cash flows areconsidered in order to maximize the price of the firm’s common stock.d.A money market is a financial market for debt securities with maturities of less thanone year (short-term).The New York money market is the world’s largest.Capitalmarkets are the financial markets for long-term debt and corporate stocks.The NewYork Stock Exchange is an example of a capital market.Primary markets are themarkets in which newly issued securities are sold for the first time.Secondarymarkets are where securities are resold after initial issue in the primary market.TheNew York Stock Exchange is a secondary market.

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e.In private markets, transactions are worked out directly between two parties andstructured in any manner that appeals to them. Bank loans and private placements ofdebt with insurance companies are examples of private market transactions. In publicmarkets, standardized contracts are traded on organized exchanges.Securities thatare issued in public markets, such as common stock and corporate bonds, areultimately held by a large number of individuals.Private market securities are moretailor-made but less liquid, whereas public market securities are more liquid butsubject to greater standardization.Derivatives are claims whose value depends onwhat happens to the value of some other asset. Futures and options are two importanttypes of derivatives, and their values depend on what happens to the prices of otherassets, say IBM stock, Japanese yen, or pork bellies.Therefore, the value of aderivative security is derived from the value of an underlying real asset.f.An investment banker is a middleman between businesses and savers. Investmentbanking houses assist in the design of corporate securities and then sell them to savers(investors) in the primary markets. Financial service corporations offer a wide rangeoffinancialservicessuchasbrokerageoperations,insurance,andcommercialbanking. A financial intermediary buys securities with funds that it obtains by issuingits own securities.An example is a common stock mutual fund that buys commonstocks with funds obtained by issuing shares in the mutual fund.g.A mutual fund is a corporation that sells shares in the fund and uses the proceeds tobuy stocks, long-term bonds, or short-term debt instruments. The resulting dividends,interest,andcapitalgainsaredistributedtothefund’sshareholdersafterthededuction of operating expenses.Different funds are designed to meet differentobjectives. Money market funds are mutual funds which invest in short-term debtinstruments and offer their shareholders check writing privileges; thus, they areessentially interest-bearing checking accounts.h.Physical location exchanges, such as the New York Stock Exchange, facilitatecommunication between buyers and sellers of securities.Each physical locationexchange is a physical entity at a particular location and is governed by an electedboard of governors.A computer/telephone network, such as Nasdaq, consists of allthe facilities that provide for security transactions not conducted at a physical locationexchange.These facilities are, basically, the communications network that links thebuyers and sellers.i.An open outcry auction is a method of matching buyers and sellers. In an auction, thebuyers and sellers are face-to-face, with each stating the prices and which they willbuy or sell. In a dealer market, a dealer holds an inventory of the security and makesa market by offering to buy or sell. Others who wish to buy or sell can see the offersmade by thedealers, and can contact the dealerof their choice to arrange a

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transaction.In an ECN, orders from potential buyers and sellers are automaticallymatched, and the transaction is automatically completed.j.Production opportunities are the returns available within an economy frominvestmentin productive assets.The higher the production opportunities, the more producerswould be willing to pay for required capital.Consumption time preferences refer tothe preferred pattern of consumption.Consumer’s time preferences for consumptionestablish how much consumption they are willing to defer, and hence save, atdifferent levels of interest.k.A foreign trade deficit occurs when businesses and individuals in the U. S. importmore goods from foreign countries than are exported.Trade deficits must befinanced, and the main source of financing is debt. Therefore, as the trade deficitincreases, the debt financing increases, driving up interest rates.U. S. interest ratesmust be competitive with foreign interest rates; if the Federal Reserve attempts to setinterest rates lower than foreign rates, foreigners will sell U.S. bonds, decreasingbond prices, resulting in higher U. S. rates. Thus, if the trade deficit is large relativeto the size of the overall economy, it may hinder the Fed’s ability to combat arecession by lowering interest rates.1-2Sole proprietorship, partnership, and corporation are the three principal forms of businessorganization. The advantages of the first two include the ease and low cost of formation.The advantages of the corporation include limited liability, indefinite life, ease ofownership transfer, and access to capital markets.The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sumsof capital; (2) unlimited personal liability for business debts; and (3) limited life.Thedisadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty oftransferring ownership, and (4) difficulty of raising large amounts of capital.Thedisadvantages of a corporation are (1) double taxation of earnings and (2) requirements tofile state and federal reports for registration, which are expensive, complex and time-consuming.1-3A firm’s fundamental, or intrinsic, value is the present value of its free cash flows whendiscounted at the weighted average cost of capital.If the market price reflects allrelevantinformation, then the observed price is also theintrinsic price.1-4Earnings per share in the current year will decline due to the cost of theinvestment madein the current year and no significant performance impact in the short run. However, thecompany’s stock price should increase due to the significant cost savings expected in thefuture.

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1-5In a well-functioning economy, capital willflow efficiently from those who supplycapital to those who demand it.This transfer of capital can take place in three differentways:1.Direct transfers of money and securities occur when a business sells its stocks orbonds directly to savers, without going through any type of financial institution. Thebusiness delivers its securities to savers, who in turn give the firm the money it needs.2.Transfers may also go through an investment banking house which underwrites theissue. An underwriter serves as a middleman and facilitates the issuance of securities.The company sells its stocks or bonds to the investment bank, which in turn sellsthese same securities to savers.The businesses’ securities and the savers’ moneymerely “pass through” the investment banking house.3.Transfers can also be made through a financial intermediary.Here the intermediaryobtains fundsfrom savers in exchange for itsown securities.The intermediary usesthis money to buy and hold businesses’ securities. Intermediaries literally create newforms of capital.The existence of intermediaries greatly increases the efficiency ofmoney and capital markets.1-6Financial intermediaries are business organizations that receive funds in one form andrepackage them for the use of those who need funds.Through financial intermediation,resources are allocated more effectively, and the real output of the economy is therebyincreased.1-7A primary market is the market in which corporations raise capital by issuing newsecurities. An initial public offering is a stock issue in which privately held firms gopublic. Therefore, an IPO would be an example of a primary market transaction.1-8The physical location exchanges are tangible physical entities.Each of thelarger onesoccupies its own building, has a limited number of members, and has an electedgoverning body.A dealer market is defined to include all facilities that are needed toconduct security transactions not made on the physical location exchanges.Thesefacilities include (1) the relatively few dealers who hold inventories of these securitiesand who are said to “make a market” in these securities; (2) the thousands of brokers whoact as agents in bringing the dealers together with investors; and (3) the computers,terminals, and electronic networks that provide a communication link between dealersand brokers.1-9The two leading stock markets today are the New York Stock Exchange (NYSE) and theNasdaq stock market. The NYSE is a physical location exchange, while the Nasdaq is anelectronic dealer-based market.

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Chapter2Financial Statements, Cash Flow, and TaxesANSWERS TO END-OF-CHAPTER QUESTIONS2-1a.The annual report is a report issued annually by a corporation to its stockholders.Itcontains basic financial statements, as well asmanagement’s opinion of the pastyear’s operations and the firm’s future prospects.A firm’s balance sheet is astatement of the firm’s financial position at a specific point in time.It specificallylists the firm’s assets on the left-hand side of the balance sheet, while the right-handside shows its liabilities and equity, or the claims against these assets.An incomestatement is a statement summarizing the firm’s revenues and expenses over anaccounting period.Net sales are shown at the top of each statement, after whichvarious costs, including income taxes, are subtracted to obtain the net incomeavailable to common stockholders. The bottom of the statement reports earnings anddividends per share.b.Common Stockholders’ Equity (Net Worth) is the capital supplied by commonstockholders--capitalstock,paid-incapital, retainedearnings,and,occasionally,certain reserves.Paid-in capital is the difference between the stock’s par value andwhat stockholders paid when they bought newly issued shares.Retained earnings isthe portion of the firm’s earnings that have been saved rather than paid out asdividends.c.The statement of stockholders’ equity shows how much of the firm’s earnings wereretained in the business rather than paid out in dividends. It also shows the resultingbalance of the retained earnings account and the stockholders’ equity account. Notethat retained earnings represents a claim against assets, not assets per se. Firms retainearnings primarily to expand the business, not to accumulate cash in a bank account.The statement of cash flows reports the impact of a firm’s operating, investing, andfinancing activities on cash flows over an accounting period.d.Depreciation is a non-cash charge against tangible assets, such as buildings ormachines.It is taken for the purpose of showing an asset’s estimated dollar cost ofthe capital equipment used up in the production process.Amortization is a non-cashcharge against intangible assets, such as goodwill.EBITDA is earnings beforeinterest, taxes, depreciation, and amortization.

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e.Operating current assets are the current assets used to support operations, such ascash, accounts receivable, and inventory. It does not include short-term investments.Operating current liabilities are the current liabilities that are a natural consequence ofthe firm’s operations, such as accounts payable and accruals.It does not includenotes payable or any other short-term debt that charges interest.Net operatingworking capital is operating current assets minus operating current liabilities.Totalnet operating capital is sum of net operating working capital and operating long-termassets, such as net plant and equipment.Operating capital also is equal to the netamount of capital raised from investors.This is the amount of interest-bearing debtplus preferred stock plus common equity minus short-term investments.f.Accounting profit is a firm’s net income as reported on its income statement.Netcash flow, as opposed to accounting net income, is the sum of net income plus non-cash adjustments.NOPAT, net operating profit after taxes, is the amount of profit acompany would generate if it had no debt and no financial assets.Free cash flow isthe cash flow actually available for distribution to investors after the company hasmade all investments in fixed assets and working capital necessary to sustain ongoingoperations.g.Market value added is the difference between the market value of the firm (i.e., thesum of the market value of common equity, the market value of debt, and the marketvalue of preferred stock) and the book value of the firm’s common equity, debt, andpreferred stock.If the book values of debt and preferred stock are equal to theirmarket values, then MVA is also equal to the difference between the market value ofequity and the amount of equity capital that investors supplied.Economic valueadded represents the residual income that remains after the cost of all capital,including equity capital, has been deducted.h.A progressive tax means the higher one’s income, the larger the percentage paid intaxes.Taxable income is defined as gross income less a set of exemptions anddeductions which are spelled out in the instructions to the tax forms individuals mustfile.Marginal tax rate is defined as the tax rate on the last unit of income.Averagetax rate is calculated by taking the total amount of tax paid divided by taxableincome.i.Capital gain (loss) is the profit (loss) from the sale of a capital asset for more (less)than its purchase price. Ordinary corporate operating losses can be carried backwardfor 2 years or forward for 20 years to offset taxable income in a given year.

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j.Improper accumulation is the retention of earnings by abusiness for the purpose ofenabling stockholders to avoid personal income taxes on dividends. An S corporationis a small corporation which, under Subchapter S of the Internal Revenue Code, electsto be taxed as a proprietorship or a partnership yet retains limited liability and otherbenefits of the corporate form of organization.2-2The four financial statements contained in most annual reports are the balance sheet,income statement, statement of stockholders’ equity, and statement of cash flows.2-3No, because the $20 million of retained earnings doesn’t mean the company has $20million in cash. The retained earnings figure represents cumulative amount of net incomethat the firm has not paid out as dividends during its entire history. Thus, most of thereinvested earnings were probably spent on the firm’s operating assets, such as buildingsand equipment.2-5Operating capital is the amount of interest bearing debt, preferred stock, and commonequity used to acquire the company’s net operating assets.Without this capital a firmcannot exist, as there is no source of funds with which to finance operations.2-6NOPAT is the amount of net income a company would generate if it had no debt and heldno financial assets.NOPAT is a better measure of the performance of a company’soperations because debt lowers income.In order to get a true reflection of a company’soperating performance, one would want to take out debt to get a clearer picture of thesituation.2-7Free cash flow is the cash flow actually available for distribution to investors after thecompany has made all the investments in fixed assets and working capital necessary tosustain ongoing operations.It is the most important measure of cash flows because itshows the exact amount available to all investors.2-8If the business were organized as a partnership or a proprietorship, its income could betaken out by the owners without being subject to double taxation.Also, if you expectedto have losses for a few years while the company was getting started, if you werenotincorporated, and if you had outside income, the business losses could be used to offsetyour other income and reduce your total tax bill.These factors would lead you tonotincorporate the business.An alternative would be to organize as an S Corporation, ifrequirements are met.

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SOLUTIONS TO END-OF-CHAPTER PROBLEMS2-1Corporate yield = 9%; T = 35.5%AT yield = 9%(1-T)= 9%(0.645) = 5.76%.2-2Corporate bond yields 8%. Municipal bondyields 6%.%.25T02.0T08.006.0T08.008.0)T1(%6%8)T1(munionYieldbondon taxableyieldpretaxEquivalent2-3NI = $3,000,000; EBIT = $6,000,000; T = 40%; Interest = ?Need to set up an income statement and work from the bottom up.EBIT$6,000,000Interest1,000,000EBT$5,000,000EBT =Taxes (40%)2,000,000NI$3,000,000Interest = EBIT–EBT = $6,000,000–$5,000,000 = $1,000,000.2-4EBITDA = $7,500,000; NI = $1,800,000; Int = $2,000,000; T = 40%; DA = ?EBITDA$7,500,000DA2,500,000EBITDA–DA = EBIT; DA = EBITDA–EBITEBIT$5,000,000EBIT = EBT + Int = $3,000,000 + $2,000,000Int2,000,000(Given)EBT$3,000,000Taxes (40%)1,200,000NI$1,800,000(Given)6.0$3,000,000T)(1$3,000,0006.0000,800,1$)T1(000,800,1$

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2-5NI = $3,100,000; DEP = $500,000; AMORT = 0; NCF = ?NCF = NI + DEP and AMORT = $3,100,000 + $500,000 = $3,600,000.2-6NI = $50,000,000; R/EY/E= $810,000,000; R/EB/Y= $780,000,000; Dividends = ?R/EB/Y+ NI–Div= R/EY/E$780,000,000 + $50,000,000–Div= $810,000,000$830,000,000–Div= $810,000,000$20,000,000= Div.2-7Income$365,000Less Interest deduction(50,000)Plus: Dividends receiveda4,500Taxable income$319,500aFor a corporation, 70% of dividends received are excluded from taxes; therefore, taxabledividends are calculated as$15,000(1-0.70) = $4,500.Tax = $22,250 + ($319,500-$100,000)(0.39) = $22,250 + $85,605 = $107,855.After-tax income:Taxable income$319,500Taxes(107,855)Plus Non-taxable dividends receivedb10,500Net income$222,145bNon-taxable dividends are calculated as $15,000 x 0.7 = $10,500.The company’s marginal tax rate is 39 percent.The company’s average tax rate is$107,855/$319,500 = 33.76%.2-8a.Tax = $3,400,000 + ($10,500,000-$10,000,000)(0.35) = $3,575,000.b.Tax =$1,000,000(0.35) = $350,000.c.Tax = ($1,000,000)0.30(0.35) = $105,000.

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2-9A-T yield on FLA bond = 5%.A-T yield on AT&T bond = 7.5%-Taxes = 7.5%-7.5%(0.35) = 4.875%.Check: Invest $10,000 @ 7.5% = $750 interest.Pay 35% tax, so A-T income = $750(1-T) = $750(0.65) = $487.50.A-T rate of return = $487.50/$10,000 = 4.875%.A-T yield on AT&T preferred stock:A-T yield = 6%-Taxes = 6%-0.3(6%)(0.35) = 6%-0.63% = 5.37%.Therefore, invest in AT&T preferred stock.We could make this aharder problem byasking for the tax rate that would cause the company to prefer the Florida bond or theAT&T bond.2-10EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40%NI = ?; NCF = ?; OCF = ?First, determine net income by setting up an income statement:EBIT$750,000Interest0EBT$750,000Taxes (40%)300,000NI$450,000NCF = NI + DEP = $450,000 + $200,000 = $650,000.

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2-11a.Income StatementSales revenues$12,000,000Costs exceptdepreciation9,000,000Depreciation1,500,000EBT$ 1,500,000Taxes (40%)600,000Net income$900,000Add back depreciation1,500,000Net cash flow$ 2,400,000b.If depreciation doubled, taxable income would fall to zero and taxes would be zero.Thus, net income would decrease to zero, but net cash flow would rise to $3,000,000.Menendez would save $600,000 in taxes, thus increasing its cash flow:∆CF = T(∆Depreciation) = 0.4($1,500,000) = $600,000.c.If depreciation were halved, taxable income would rise to $2,250,000 and taxes to$900,000.Therefore, net income would rise to $1,350,000, but net cash flow wouldfall to $2,100,000.d.You should prefer to have higher depreciation charges and higher cash flows.Netcash flows are the funds that are available to the owners to withdraw from the firmand, therefore, cash flows should be more important to them than net income.2-12a.EBIT$1,260x (1-Tax rate)60.0%Net operating profit after taxes (NOPAT)$756

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b.20102009Cash$550$500+ Accounts receivable2,7502,500+ Inventories1,6501,500Operating current assets$4,950$4,500Accounts payable$1,100$1,000+ Accruals550500Operating current liabilities$1,650$1,500Operating current assets$4,950$4,500-Operating current liabilities1,6501,500Net operating working capital (NOWC)$3,300$3,000c.20102009Net operating working capital (NOWC)$3,300$3,000+ Net plant and equipment3,8503,500Total net operating capital$7,150$6,500d.2010NOPAT$756-Investment in total net operating capital650Free cash flow$106e.2010NOPAT$756÷ Total net operating capital7,150Return on invested capital (ROIC)10.57%

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f.Uses of FCF2010After-tax interestpayment =$72Reduction (increase) in debt =-$284Payment of dividends =$220Repurchase (Issue) stock =$88Purchase (Sale) of short-term investments =$10Total uses of FCF =$106

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2-13Prior Years20082009Profit earned$150,000$150,000Carry-back credit150,000150,000Adjusted profit$0$0Tax previouslypaid (40%)60,00060,000Taxrefund: Taxespreviously paid$ 60,000$ 60,000Total check from U.S. Treasury = $60,000 + $60,000 = $120,000.Future Years20112012201320142015Estimatedprofit$150,000$150,000$150,000$150,000$150,000Carry-forwardcredit150,000150,00050,00000Adjustedprofit$0$0$100,000$150,000$150,000Tax (at 40%)0$0$ 40,000$ 60,000$ 60,000

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Chapter 3Analysis of Financial StatementsANSWERS TO END-OF-CHAPTER QUESTIONS3-1a.A liquidity ratio is a ratio that shows the relationship of a firm’s cash and othercurrent assets to its current liabilities.The current ratio is found bydividing currentassets by current liabilities.It indicates the extent to which current liabilities arecovered by those assets expected to be converted to cash in the near future.Thequick, or acid test, ratio is found by taking current assets less inventories and thendividing by current liabilities.b.Asset management ratios are a set of ratios that measure how effectively a firm ismanaging its assets.The inventory turnover ratio is sales divided by inventories.Days sales outstanding is used to appraise accounts receivable and indicates thelength of time the firm must wait after making a sale before receiving cash.It isfound by dividing receivables by average sales per day.The fixed assets turnoverratio measures how effectively the firm uses its plant and equipment. It is the ratio ofsales to net fixed assets.Total assets turnover ratio measures the turnover of all thefirm’s assets; it is calculated by dividing sales by total assets.c.Financial leverage ratios measure the use of debt financing. The debt ratio is the ratioof total liabilities to total assets, it measures the percentage of funds provided by non-equity holders.The times-interest-earned ratio is determined by dividing earningsbefore interest and taxes by the interest charges.This ratio measures the extent towhich operating income can decline before the firm is unable to meet its annualinterest costs.The EBITDA coverage ratio is similar to the times-interest-earnedratio, but it recognizes that many firms lease assets and also must make sinking fundpayments. It is found by adding EBITDA and lease payments then dividing this totalby interest charges, lease payments, and sinking fund payments over one minus thetax rate.d.Profitability ratios are a group of ratios, which show the combined effects of liquidity,asset management, and debt on operations. The profit margin on sales, calculated bydividing net income by sales, gives the profit per dollar of sales. Basic earning poweris calculated by dividing EBIT by total assets.This ratio shows the raw earningpower of the firm’s assets, before the influence of taxes and leverage. Return on totalassets is the ratio of net income to total assets. Return on common equity is found by

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