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Foundations of Financial Management 16th Edition Solution Manual

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    Chapter 01: The Goals and Functions of Financial Management Ch a pter 1 The Goals and Functions of Financial Management Discussion Questions 1 - 1. How did the recession of 2007 – 2009 compare with other recessions since the G reat D epression 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 of this type of organization? A sole proprietorship offers the advantage of simplicity of decision making and low organizational and operating costs. A major drawback is that there is unlimited 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. Under this arrangement, one or more partners are designated general partners and have unlimited liability for the debts of the firm; other partners are designated limited partners and are liable only for their initial contribution. The limited partners are normally prohibited from being active in the management of the firm. 1 - 5. In a corporation, what group has the ultimate responsibility for protecting and managing 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 Functions of Financial Management 1 - 7. What issue does agency theory examine? Why is it important in a public corporation rather than in a private corporation? Agency theory examines the relationship between the owners of the firm and the managers of the firm. In privately owned firms, management and the owners are usually the same people. Management operates the firm to satisfy its own goals, needs, financial requirements and the like. As a company moves from private to public ownership, management now represents all owners. This places management in the agency position of making decisions in the best interest of all shareholders. 1 - 8 . Why are institutional investors important in today's business world? Because institutional investors such as pension funds and mutual funds own a large percentage of major U.S. companies, they are having more to say about the way publicly owned companies are managed. As a group, they have the ability to vote large blocks of shares for the election of a board of directors, which is suppose d to run the company in an efficient, competitive manner. The threat of being able to replace poor performing boards of directors makes institutional investors quite influential. Since these institutions, like pension funds and mutual funds, represent individual workers and investors, they have a responsibility to see that 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 the goal 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 very inexact process. The goal of shareholders ’ wealth maximization implies that the firm will attempt to achieve the highest possible total valuation in the marketplace. It is the one overriding objective of the firm and should influence every decision.

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    Chapter 01: The Goals and Functions of Financial Management 1 - 10. When does insider trading occur? What government agency is responsible for protecting against the unethical practice of insider trading? Insider trading occurs when anyone with non - public information buys or sells securities to take advantage of that private information. The Securities and Exchange Commission is responsible for protecting markets against insider trading. In the past , people have gone to jail for trading on non - public information. This has included company officers, investment bankers, printers who have information before it is publishe d , and even truck drivers who deliver business magazines and read positive or negative articles about a company before the magazine is on the newsstands and then place trades or have friends place trades based on that information. The SEC has prosecuted anyone who profits from inside information. 1 - 11. In terms of the life of the securities offered, what is the difference between money and capital markets? Money markets refer to those markets dealing with short - term securities that have a life of one year or less. Capital markets refer to securities with a life of more than 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 for the corporation. After the securities are sold to the public (institutions and individuals), they trade in the secondary market between investors. It is in the secondary market that prices are continually changing as investors buy and sell securities based on the expectations of corporate prospects. 1 - 13 . Assume you are looking at many companies with equal risk . W hich ones will have the highest stock prices? Given companies with equal risk, those companies with expectations of high return will have higher common stock prices relative to those companies wit h expectations of poor returns.

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    Chapter 01: The Goals and Functions of Financial Management 1 - 14 . What changes can take place under restructuring? In recent times, what group of investors has often forced restructuring to take place? Restructuring can result in changes in the capital structure (liabilities and equity on the balance sheet). It can also result in the selling of low - profit - margin divisions with the proceeds reinvested in better investment opportunities, and sometimes restructuring results in the removal of the current management team or large reductions in the workforce. Restructuring has also included mergers and acquisitions. Institutional investors have been very influential in forcing restructuring to take place in recent years. 1 - 15. How did the Sarbanes – Oxley Act impact corporations ’ financial reports? The Sarbanes – Oxley Act of 2002 set up a five - member Public Company Accounting Oversight Board with the responsibility for establishing auditing standards within companies, controlling the quality of audits, and setting rules and standards for the independence of the auditors. It also puts great responsibility on the internal audit committee of each publicly traded company to enforce compliance with the act. The major focus of the act is to make sure that publicly traded corporations accurately present their assets, liabilities, and equity and income on their financial statements. 1 - 16. Name the departments, offices, or agencies that were created by t he Dodd – Frank legislation. 1 ) The act created the Financial Stability Oversight Council within the Treasury Department . 2 ) The act created the Office of Financial Research within the Treasury Department . 3 ) Dodd – Frank established the Federal Insurance Office within the Treasury Department to oversee the insurance indu stry and streamline state - based insurance regulation. 4 ) The act created the Bureau of Consumer Financial Protection. The oversight given to the Bureau of Consumer Financial Protection allows it to dictate the fees that banks charge and the types of products they offer.

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    Chapter 02: Review of Accounting Ch a pter 2 Review of Accounting Discussion Questions 2 - 1. Discuss some financial variables that affect the price - earnings ratio. The price - earnings ratio will be influenced by the earnings and sales growth of the firm, the risk or volatility in performance, the debt - equity structure of the firm, the dividend payment policy, the quality of management, and a number of other factors. The ratio tends to be future - oriented, and the more positive the outlook, the higher it will be. 2 - 2. What is the difference between book value per share of common stock and market value per share? Why does this disparity occur? Book value per share is arrived at by taking the cost of the assets and subtracting out liabilities and preferred stock and dividing by the number of common shares outstanding. It is based on the historical cost of the assets. Market value per share is based on the current assessed value of the firm in the marketplace and may bear little relationship to original cost. Besides the disparity between book and market value caused by the historical cost approach, other contributing factors are the growth prospec ts for the firm, the quality of management, and the industry outlook. To the extent these are quite negative or positive; 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 serving as a tax shield against reported income. This non - cash deduction may provide cash flow equal to the tax rate times the depreciation charged. This much in taxes will be saved, while no cash payments occur. 2 - 4. What is the difference between accumulated depreciation and depreciation expense? How are they related? Accumulated depreciation is the sum of all past and present depreciation charges, while depreciation expense is the current year ’ s charge. They are related in that the sum of all prior depreciation expense should be equal to accumulated depreciation (subject to some differential related to asset write - offs).

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    Chapter 02: Review of Accounting 2 - 5. How is the income statement related to the balance sheet? The earnings (less dividends) reported in the income statement is transferred to the ownership section of the balance sheet as retained earnings. Thus, what we earn in the income statement becomes part of the ownership interest in the balance sheet. 2 - 6. Comment on why inflation may restrict the usefulness of the balance sheet as normally 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 and equipment and inventory. 2 - 7. Explain why the statement of cash flows provides useful information that goes beyond income statement and balance sheet data. The income statement and balance sheet are based on the accrual method of accounting, which attempts to match revenues and expenses in the period in which they occur. However, accrual accounting does not attempt to properly assess the cash flow position of the firm. The statement of cash flows fulfills this need. 2 - 8. What are the three primary sections of the statement of cash flows? In what section would the payment of a cash dividend be shown? The sections of the statement of cash flows are: Cash flows from operating activities Cash flows from investing activities Cash flows from financing activities The payment of cash dividends falls into the financing activities category.

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    Chapter 02: Review of Accounting 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 capacity of the firm. Minus: Dividends (required to maintain the payout on common stock and to cover any preferred stock obligation). The analyst or banker normally looks at free cash flow to determine whether there are sufficient excess funds to pay back the loan associated with the leveraged buyout. 2 - 10. Why is interest expense said to cost the firm substantially less than the actual expense, while dividends cost it 100 percent of the outlay? Interest expense is a tax deductible item to the corporation, while dividend payments are not. The net cost to the corporation of interest expense is the amount paid multiplied by the difference of one minus the applicable tax rate. For example, $100 of interest expense costs the company $65 a fter taxes when the corporate tax rate is 35 percent — for example, $100 × (1 – 0 .35) = $65. Chapter 2 Problems 1. Income Statement (LO1) Frantic Fast Foods had earnings after t axes of $420,000 in the year 20X1 with 309,000 share s outstanding. On January 1, 20X2 , the firm issued 20,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 30 percent. a. Compute earnings per share for the year 20 X 1 . b. Compute earnings per share for the year 20X2 . 2 - 1. Solution:

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    Chapter 02: Review of Accounting Frantic Fast Foods a. Year 20 X 1 Earnings after taxes Earnings per share Shares outstanding $420,000 = $1.36 309,000 = = b. Year 20 X2 Earnings after taxes $420,000 1.30 $546,000 Shares outstanding 309,000 20,000 329,000 $546,000 Earnings per share $1.66 329,000 =  = = + = = = 2. Income s tatement (LO1) Sosa Diet Supplements had earnings after taxes of $800,000 in the year 20X 1 with 200,000 shares of stock outstanding. On January 1, 20X 2 , the firm issued 50,000 new shares. Because of the proceeds from these new shares and other operating improvements, earnings after taxes increased by 30 percent. a. Compute earnings per share for the year 20 X 1 . b. Compute earnings per share for the year 20X 2 . 2 - 2. Solution: Sosa Diet Supplements a. Year 20 X 1 Earnings after taxes Earnings per share = Shares outstanding $800,000 = = $4.00 200,000 b. Year 20 X 2

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    Chapter 02: Review of Accounting Earnings after taxes $800,000 1.30 $1,040,000 Shares outstanding 200,000 50,000 250,000 $1,040,000 Earning per share $4.16 250,000 =  = = + = = = 3. a. Gross profit (LO1) Swank Clothiers had sales of $383,000 and cost of goods sold of $260,000. 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 of 25 percent, how is the firm doing? 2 - 3. Solution: S wank Clothiers a. Sales ................................ ............................. $ 383 ,000 Cost of goods sold ................................ . 260 , 0 00 Gross Profit ................................ .... $123,0 00 $123,000 Gross Profit Gross Profit Margin = 32% Sales $383,000 = b. With a gross profit of 32 percent, the firm is outperforming the industry average of 25 percent. 4. Operating p rofit (LO1) A - Rod Fishing Supplies had sales of $2,500,000 and cost of goods sold of $1,710,000. Selling and administrative expenses represented 10 percent of sales. Depreciation was 6 percent of the total assets of $4,680,000. What was the firm’s operating profit? 2 - 4 . Solution:

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    Chapter 02: Review of Accounting A - Rod Fishing Supplies Sales ................................ ............................... $ 2,5 0 0 ,000 Cost of goods sold ................................ .......... 1,71 0,000 Gross Profit ................................ ................ 790 ,000 Selling and administrative expense * .............. 250 ,000 Depreciation expense ** ................................ . 28 0 ,8 00 Operating profit ................................ ......... $ 259,2 00 * 10% × $2,500,000 = $ 250,000 ** 6% × $4,680,000 = $ 280,800 5 . Income statement (LO1) Arrange the following income statement items so they are in the proper order of an income statement: Taxes Earnings per share Shares outstanding Earnings before taxes Interest expense Cost of goods sold Depreciation expense Earnings after taxes Preferred stock dividends Earnings available to common Operating profit stockholders Sales Selling and administrative expense Gross profit 2 - 5 . Solution: Sales – Cost of goods sold Gross profit – Selling and administrative expense – Depreciation expense Operating profit – Interest expense Earnings before taxes – Taxes Earnings after taxes – Preferred stock dividends

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    Chapter 02: Review of Accounting Earnings available to common stockholders Shares outstanding Earnings per share 6 . Income statement (LO1) Given the following information , prepare a n income statement for the Dental Drilling Company. Selling and administrative expense ................................ ........ $ 112 ,000 Depreciation expense ................................ ............................. 73 ,000 Sales ................................ ................................ ....................... 4 89 ,000 Interest expense ................................ ................................ ...... 45 ,000 Cost of goods sold ................................ ................................ .. 1 56 ,000 Taxes ................................ ................................ ...................... 47 , 00 0 2 - 6 . Solution: Dental Drilling Company Income Statement Sales ................................ ............................... $ 4 89 ,000 Cost of goods sold ................................ .......... $ 1 56 ,000 Gross p rofit ................................ ................ $ 333 ,000 Selling and administrative expense ................ $ 112 ,000 Depreciation expense ................................ ..... $ 73 ,000 Operating profit ................................ ......... $ 148 ,000 Interest expense ................................ .............. $ 45 ,000 Earnings before taxes ................................ $ 103 ,000 Taxes ................................ .............................. $ 47 , 00 0 Earnings after taxes ................................ ... $ 56 , 000

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    Chapter 02: Review of Accounting 7 . Income s tatement (LO1) Given the following information , prepare in good form an income statement for Jonas Brothers Cough Drops. Selling and administrative expense ................................ ........ $ 328 ,000 Depreciation expense ................................ ............................. 195 ,000 Sales ................................ ................................ ....................... 1,660 ,000 Interest expense ................................ ................................ ...... 129 ,000 Cost of goods sold ................................ ................................ .. 56 0,000 Taxes ................................ ................................ ...................... 171 ,000 2 - 7 . Solution: Jonas Brothers Cough Drops Income Statement Sales ................................ ............................... $ 1,660 ,000 Cost of goods sold ................................ .......... 56 0,000 Gross profit ................................ ................ 1,10 0,000 Selling and administrative expense ................ 328 ,000 Depreciation expense ................................ ..... 19 5 ,000 Operating profit ................................ ......... 577 ,000 Interest expense ................................ .............. 129 ,000 Earnings before taxes ................................ 448 ,000 Taxes ................................ .............................. 171 ,000 Earnings after taxes ................................ ... $ 277 ,000 8. Determination of profitability (LO1) Prepare in good form an income statement for Franklin Kite Co. Inc. Take your calculations all the way to computing earnings per share. Sales ................................ ................................ ....................... $900,000 Shares outstanding ................................ ................................ . 50,000 Cost of goods sold ................................ ................................ .. 400,000 Interest expense ................................ ................................ ...... 40,000 Selling and administrative expense ................................ ........ 60,000 Depreciation expense ................................ ............................. 20,000 Preferred stock dividends ................................ ....................... 80,000 Taxes ................................ ................................ ...................... 50,000

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    Chapter 02: Review of Accounting 2 - 8. Solution: Franklin Kite Company Income Statement Sales ................................ ............................... $ 900 ,000 Cost of goods sold ................................ .......... 400 ,000 Gross profit ................................ ................ 500 ,000 Selling and administrative expense ................ 60 ,000 Depreciation expense ................................ ..... 20,000 Operating profit ................................ ......... $ 420 ,000 In terest expense ................................ .............. 40,000 Earnings before taxes ................................ $ 390 ,000 Taxes ................................ .............................. 120,000 Earnings after taxes ................................ ... $ 270 ,000 Preferred stock dividends ............................... 80,000 Earnings available to common stockholders . 190,000 Shares outstanding ................................ ......... 50,000 Earnings per share ................................ .......... $3.80

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    Chapter 02: Review of Accounting 9 . Determination of profitability (LO1) Prepare an income statement for Virginia Slim Wear. Take your calculations all the way to computing earnings per share. Sales ................................ ................................ ....................... $ 1,360 ,000 Shares outstanding ................................ ................................ . 104 ,000 Cost of goods sold ................................ ................................ .. 7 00,000 Interest expense ................................ ................................ ...... 34 ,000 Sellin g and administrative expense ................................ ........ 49 ,000 Depreciation expense ................................ ............................. 23 ,000 Preferred stock dividends ................................ ....................... 86 ,000 Taxes ................................ ................................ ...................... 100,000 2 - 9 . Solution: Virginia Slim Wear Income Statement Sales ................................ ............................... $1,36 0,000 Cost of goods sold ................................ .......... 7 00,000 Gross profit ................................ ................ 66 0 ,000 Selling and administrative expense ................ 49 ,000 Depreciation expense ................................ ..... 23 ,000 Operating profit ................................ ......... 588 ,000 Interest expense ................................ .............. 34 ,000 Earnings before taxes ................................ 554 ,000 Taxes ................................ .............................. 100,000 Earnings after taxes ................................ ... 454 ,000 Preferred stock dividends ............................... 86,000 Earnings available to common stockholders . $ 368 ,000 Shares outstanding ................................ ......... 104 ,000 Earnings per share ................................ .......... $ 3 . 54 10 . Income s tatement (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 income statement, and determine depreciation expense as the plug figure .

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    Chapter 02: Review of Accounting 2 - 10 . Solution: Precision Systems Sales ................................ ............................... $ 82 0,000 Cost of goods sold ................................ ......... 510 ,000 Gross p rofit ................................ ................ 3 1 0,000 Selling and administrative expense ................ 60,000 Depreciation ( plug figure ) .............................. 14 7 ,000 Operating profit ................................ ......... $ 103 ,000 1 1 . Depreciation and earnings (LO1) Stein Books Inc. sold 1, 900 finance textbooks for $250 each to High Tuition University in 20X1 . These books cost $ 2 1 0 to produce. Stein Books spent $1 2,2 00 (selling expense) to convince the university to buy its books . Depreciation expense for the year was $15,200. In addition, Stein Books borrowed $104,000 on January 1, 20 X1 , on which the company paid 12 percent interest. Both the interest and principal of the loan were paid on December 31, 20 X1 . The publishing firm’s tax rate is 30 percent. Did Stein Book s make a profit in 20X1 ? Please verify with an income statement presented in good form. 2 - 11 . Solution: Stein Books Inc. Income Statement For the Year Ending December 31, 20 X 1 Sales (1,900 books at $250 each) ................................ .. $475 , 0 00 Cost of goods sold ( 1,900 books at $210 each) ........... 399 , 0 00 Gross p rofit ................................ ............................... 76 ,000 Selling expense ................................ ............................. 1 2,2 00 Depreciation expense ................................ .................... 15,2 00 Operating profit …… ................................ ................ $ 48,600 Interest expense ($104,000 × 12%) .............................. 12 , 48 0 Earnings before taxes ................................ ............... 36,12 0

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