Solution Manual For Principles of Managerial Finance, 8th Edition

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nCh. 1 Answers to Review Questions1-1.The goal of a firm, and therefore of all financial managers, is maximizing shareholder wealth.The proper metric for this goal is the price of the firm’s stock. Other things equal, anincreasing price per share of common stock relative to the stock market as a whole indicatesachievement of this goal.1-2Actions that maximize the firm’s current profit may not produce the highest stock pricebecause (1) some firm activities that result in slightly lower profit today generate much largerprofits in the future periods (i.e., focusing on current profit overlooks the time value ofmoney); (2) activities that generate higher accounting profits today may not result in highercash flows to stockholders; and (3) activities that lead to high profits today may involve higherrisk, which could result in significant future losses.1-3Risk is the chance actual outcomes may differ from expected outcomes. Financial managersmust consider risk and return because the two factors tend to have an opposite effect on shareprice. That is, other things equal, an increase in the risk of cash flows to shareholders willdepress firm stock price while higher average cash flows to shareholders will increase stockprice.1-4Maximizing shareholder wealth does not mean overlooking or minimizing the welfare of otherfirm stakeholders. Firms with satisfied employees, customers, and suppliers tend to producehigher (or less risky) cash flows for their shareholders compared with companies that neglectnon-owner stakeholders. That said, customers prefer lower prices for firm output, firmemployees prefer higher wages, and firm suppliers prefer higher prices for the input goods andservices they provide. So actions that produce the highest price of the firm’s stock cannotsimultaneously maximize customer, employee, and supplier satisfaction.1-5Broadly speaking, the decisions made by financial managers fall under three headings: (i)investment, (ii) capital budgeting, and (iii) working capital. Investment decisions involve thefirm’s long-term projects while financing decisions concern the funding of those projects.Working-capital decisions, in contrast are related to the firm’s management of short-termfinancial resources.1-6Financial managers must recognize the tradeoff between risk and return because shareholdersprefer higher cash flows but dislike large swings in cash flows. And, as a general rule, actionsthat boost the firm’s average cash flows also result in greater cash-flow greater volatility.Viewed another way, firm actions to reduce the chance cash flows will be low or negative alsotend to reduce average cash flows over time. Understanding this tradeoff is important becauseshareholders are risk averse. That is, they will only accept larger swings in a firm’s cash flowsonly if compensated over time with higher average cash flows.1-7Finance is often considered applied economics. One reason is firms operate within the largereconomy. More importantly, the bedrock concept in economics—marginal benefit-marginalcost analysis—is also central to managerial finance. Marginal benefit-marginal cost analysis isthe notion a firm (or any other economic actor) should take only those actions for which theextra benefits exceed the extra costs. Nearly, all financial decisions ultimately turn on anassessment of their marginal benefits and marginal costs.

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1-8Accountants and financial managers perform separate but equally important functions for thefirm. Accountants primarily collect and present financial data according to generally acceptedfinancial principles while financial managers make investment, capital-budgeting, andworking-capital decisions with financial data. In part because of their different functions,accountants and financial managers log firm revenues and expenses using differentconventions. Accountants operate on an accrual basis, recognizing revenues as firm output issold (whether or not payment is actually received) and firm expenses as incurred. Financialmanagers, in contrast, focus on actual inflows and outflows of cash, recognizing revenueswhen physically received and expenses when actually paid.1-9Like any economic actor, managers respond to incentives. Managers have a fiduciary duty tomaximize shareholder wealth, but as humans, they also have personal goals—such asmaximizing their own income, wealth, reputation, and quality of life. If the personal benefitsof delivering for shareholders (or the costs of slighting them) are small, a financial managermight opt to further his own interest at the expense of shareholders. For example, CEOs oflarge firms—those with more sales, assets, employees, etc.—tend to receive morecompensation than CEOs of smaller firms. If a CEO has to choose between two operatingstrategies—one that produces modest growth for his firm but a large jump in current stockprice and another that generates rapid growth but a more modest rise in share price—and thefirm’s board is not closely monitoring the CEO, she might pursue the high-growth strategy toboost her future compensation. A partial solution to such a problem is a compensation closelylinking CEO compensation to firm stock price.1-10Sole proprietorships are the most common form of business organization, while corporationstend to be the largest. Large firms tend to organize as corporations to insulate owners fromlosses (limit liability) and facilitate acquisition of financial capital to fund growth.1-11Stockholders are the owners of a corporation. Their ownership (equity) takes the form ofcommon stock or, less frequently, preferred stock. Stockholders elect the board of directors,which has ultimate responsibility for guiding corporate affairs and setting general policy. Theboard usually comprises key corporate personnel and outside directors. The corporation’spresident or chief executive officer (CEO) reports to the board. He or she oversees day-to-dayoperations subject to the general policies established by the board. The corporation’s owners(shareholders) do not have a direct relationship with management; they provide input byelecting board members and voting on major charter issues. Shareholders receivecompensation in two forms: (i) dividends paid on their stock (from corporate earnings) and (ii)capital gains from increases in the price of their shares (which reflect market expectationsabout future dividends).1-12Generally speaking, income from sole proprietorships and partnerships is taxed only once atthe individual level; the owner or owners pay personal income tax on their share of firm’sprofits. In contrast, corporate income is taxed first at the firm level (via the corporate incometax paid on firm profits) and then again at the personal level (via personal income tax paid ondividends or capital gains enjoyed by shareholders).

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1-13Agency problems arise when managers place personal goals ahead of their duty toshareholders to maximize stock price. The attendant costs are called agency costs. Agencycosts can be implicit or explicit; either way they reduce shareholder wealth. An example of an“implicit” agency cost is the dividends or capital gains shareholders miss out on because thefirm’s management team pursued a personal interest (like maximizing sales to boost futurecompensation) rather than maximizing shareholder wealth. Of course, if shareholders sensestock price is not what it should be, they will start monitoring management more closely (as inthe chapter opener with Brookdale Senior Living). The expenses associated with greatermonitoring are an example of an “explicit” agency cost. Agency problems in a firm can bereduced with a properly constructed and followed corporate-governance structure. Such astructure will feature checks and balances that reduce management’s interest in and ability todeviate from shareholder-wealth maximization. Like all corporate decisions, reducing agencycosts is subject to marginal benefit–marginal cost analysis. In other words, the firm shouldinvest in policies to align the incentives of management and shareholders as long as themarginal benefits exceed the marginal costs.1-14Firms most commonly try to mitigate agency problems by linking pay to metrics connectedwith shareholder wealth. Incentive plans tie compensation to share price. For example, theCEO might receive options offering the right to purchase stock at a set price (say currentprice) any time in the next few years. If the CEO takes actions that subsequently boost shareprice, she can profit personally by exercising the option—purchasing stock at the set price—and reselling at the higher market price. The higher the firm’s stock price, the more money theCEO can make, so options create a powerful incentive to focus laser-like on shareholderwealth. There is a downside, however. Sometimes general market trends swamp all the gooddone by management, so even though the CEO obsessed over shareholder wealth, her optionsproved worthless because a bear market hammered the firm’s stock price. This problem hasmade performance plans more popular. These plans link compensation with performancemeasures related to stock price that management can more closely control—such as earningsper share (EPS) and EPS growth. When targets for the performance metrics are attained,managers receive rewards likeperformance shares and/or cash bonuses.1-15If the board of directors fails to keep management focused on shareholder wealth, marketforces can apply the necessary pressure. Two such forces are activism by institutionalinvestors (such as Land and Buildings in the chapter opener) and the threat of hostiletakeovers. Institutions typically hold large quantities of shares in many corporations. Becauseof their large stakes, these investors actively monitor management and vote their shares for thebenefit of all shareholders. Large institutional investors reduce agency problems by using theirvoting clout to elect new directors that will make the changes in policies and personnelnecessary to get underperforming stock to its highest possible price. The threat of hostiletakeover can also keep management focused on shareholders. Say a firm has a stock price of$15, but that price could be $20 with bold action management is reluctant to take. The lure ofa $5 capital gain per share could tempt an outside individual, group of investors or firm notsupported by existing management to purchase controlling interest and force the necessarychanges. Incumbent management knows “necessary changes” means unemployment, so thethreat of takeover could be enough to align their interests with those of the owners.

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nCh. 2 Answers to Review Questions2-1.Financial institutions are intermediaries that facilitate the flow of individual, business, andgovernment savings into loans and investments. Broadly speaking, net savers (primarilyindividuals) prefer low risk and easy access to their money while net borrowers (businesses andgovernment) would like to take risk with the funds and tie them up for a longer term. Financialinstitutions transform loans and investments into forms savers prefer to hold (such as deposits)or help net borrowers issue debt and equity instruments tailored to saver preferences.2-2Overall, the same entities that supply funds—individuals, businesses, and governments—alsodemand them, so these three groups are all financial-institution customers. That said, the keydemanders of funds (net borrowers) are businesses and governments while the key suppliers(net savers) are individuals.2-3Commercial banks, investment banks, and the shadow-banking system are all financial institutions.Broadly speaking, commercial banks transform the deposits of net savers into loans to net borrowers.Investment banks, in contrast, do not “transform” the liquidity and riskiness of financial assets.Instead, they help “match” demanders and issuers of debt and equity instruments. Specifically,investment banks instruct companies on the best vehicles for raising capital, advise them onmergers/restructuring, and engage in trading and market-making to support their consulting function.Finally, the shadow-banking system performs services for net savers and borrowers similar tocommercial banks—but without issuing deposits. By not relying on deposit funding, shadow bankscan evade prudential regulation designed to constrain risk-taking by ordinary banks.2-4.Financial markets facilitate direct interaction of suppliers and demanders of funds. In primarymarkets, debt and equity instruments are sold the first time—a direct exchange between the firmor government issuing securities and the purchasers. An example is Microsoft Corporationselling new shares of common stock to private investors. In secondary markets, previous issuedsecurities are traded subsequent times; the original issuers receive no new funds. An example isan investor buying a share of outstanding Microsoft common stock from another investorthrough a broker. Put simply, primary markets feature sales of “new” securities while “used”security transactions take place in secondary markets. Primary and secondary markets have asymbiotic relationship—the easier the resale of a financial asset in a secondary market, theeasier the initial sale of that asset in a primary market. Similarly, financial institutions andfinancial markets are far from independent. Commercial banks, for example, hold largeinventories of U.S. Treasury securities to improve the liquidity and risk of their asset portfolio,and strong bank demand makes it easier for the Treasury to sell debt in the first place. Becausebanks have taken deposits and made loans since the days of goldsmiths in Medieval Europe,they enjoy a comparative advantage in originating and monitoring commercial loans. Aware ofthis advantage, the capital markets watch bank lending for clues about borrower financialstrength. When a commercial bank announces a new loan to a publicly traded firm, that firm’sstock price typically rises.2-5A private placement is the sale of a new security directly to an investor or a small group ofsophisticated investors (such as insurance companies and pension funds). A public offering, incontrast, is the sale of newly issued stock or bonds to the public at large. Firms typically rely onpublic offerings when they need large sums.

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2-6.The money market features trading in short-term, highly marketable debt instruments; “shortterm” here means an original maturity of one year or less. Money-market instruments typicallycarry low risk of capital losses. Examples of money-market instruments include U.S. Treasurybills, commercial paper, and negotiable certificates of deposit (issued by large commercialbanks). The Eurocurrency market is the international analogue of the U.S. money market. Thismarket features loans of currency held in banks outside the country where it is legal tender.Participants typically use the Eurocurrency market to evade domestic regulations and tax laws.The term stems from the European origin of this market; “Eurocurrency” has nothing to do withthe europer seand is no longer specific to Europe.2-7.The capital market features trading in instruments with original maturities exceeding one yearsuch as bonds and stock (common and preferred). Capital-market instruments are exchanged inbroker and dealer markets. In broker markets, a broker coordinates buy and sell orders,executing trades at the midpoint of the bid/ask spread (the highest price a buyer is willing to payminus the lowest price a seller is willing to accept). The best known broker market is the NYSE,which accounts for more than 25% of stock-market trades. In dealer markets, a market makerexecutes buy and sell orders using her personal inventory and two distinct trades. For example,an investor might sell the dealer Microsoft stock at the bid price and then, in an independenttransaction, another investor would buy Microsoft stock from the dealer at the ask price. “Ask”exceeds “bid,” so the dealer’s reward for maintaining an inventory of Microsoft stock is theopportunity to “buy low, sell high.” The difference, in short, between broker and dealer marketsturns on whether traders or dealers provide the liquidity.2-8Firms see the capital market as a source of external finance for long-term projects. Put anotherway, they sell new bonds and stock to raise funds to build factories, launch marketingcampaigns, and expand into new markets. Accordingly, they want a liquid market—one “deep”enough to accept newly issued securities at favorable prices. Investors, in contrast, see thecapital market as a savings vehicle for long-term needs like retirement. As citizens of themacroeconomy, investors would also like the capital market to steer scarce funds to the mostproductive uses. To these ends, investors want an efficient capital market—one where securitiesprices reflect all available information and react swiftly to new information. Capital-marketefficiency means investors need not waste time trying to identify over or undervalued securitiesor exploitable patterns in securities prices. Instead, they can maximize long-term returns byputting their savings in diversified mutual funds (i.e., avoiding countless hours studyingindividual stocks and bonds). Investors will also enjoy higher aggregate growth of output andemployment from the spotlight securities prices shine on firms most able to profitably use theirsavings.2-9The first years of Great Depression featured the worst contraction in American history. BetweenAugust 1929 and March 1933, industrial production fell 52%, the Dow Jones Industrial Averagetumbled 89%, unemployment soared to nearly 25%, and roughly 9,000 banks failed (37% ofthose operating in December 1929). Franklin Roosevelt won the 1932 election with a mandateto restore prosperity and prevent future depressions. Much of the U.S. framework for financialand financial-institution regulation stems from the First New Deal (1933–34). This frameworkaddressed specific factors thought to have caused the slump. To protect depositors from lossesin bank failures, the Banking Act of 1933 created federal deposit insurance. To prevent failuresin the first place, the Act also barred commercial banks from security underwriting, which wasthought to pose dangerous additional risks. To head off fraudulent investment schemes likethose preceding the stock-market crash of 1929, the Securities Act of 1933 and SecuritiesExchange Act of 1934 forced companies wishing to issue public securities to discloseinformation about their financial condition.

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2-10Both Acts required companies wishing to participate in securities markets to disclose significantinformation to the public. The Securities Act of 1933 focused on the primary market, compellingsellers of new securities provide reasonably accurate portrayals of their firms to prospectiveinvestors. The Securities Exchange Act of 1934, in contrast, regulated trading in secondarymarkets; forcing publicly traded companies to keep investors informed about firm condition onan ongoing basis. The latter Act also created the Securities Exchange Commission to enforcefederal securities laws.2-11Angel investors and venture capitalists are both sources of private equity. “Angels” are usuallywealthy individuals who fund promising start-ups in return for a slice of firm equity. Venturecapitalists,incontrast,arebusinessesthatpoolcontributionsfromindividuals(ofteninstitutional investors like university endowments and pension funds) and invest those funds inpromising start-ups. In short, angels pick “winners” themselves whereas venture capitalists pick“winners” for their clients.2-12Venture capitalists (VCs) are organized as (i) limited partnerships (most common), (ii) smallbusiness investment companies (SBICs), (iii) financial funds, and (iv) corporate funds. Theprincipal difference is how the VC was created. The federal government charters SBICs.Financial institutions (usuallycommercial banks), incontrast, create financial funds assubsidiaries while nonfinancial firms launch corporate funds, sometimes as subsidiaries. Unlikeother VC types, limited partnerships are launched by private individuals. All VCs use a legalagreement to specify deal structure and pricing. Deal structure allocates responsibilities betweenthe start-up and VC and may include constraints on the firm to enhance its chance of successand mitigate VC risk. Pricing depends on the (i) value of the start-up, (ii) perceived risk of itsbusiness operations, and (iii) amount of funding needed. In general, VCs provide less fundingand require a greater ownership stake when the firm is the early stages of development.2-13Firms wishing to go public must (i) secure approval from current shareholders, (ii) obtaincertification of the accuracy of their financial documents from company auditors and lawyers,(iii) hire an originating investment bank, (iv) file a registration statement with the Securities andExchange Commission (SEC), (v) participate in roadshows with the investment bank to sparkinterest among potential investors and learn about a suitable issuing price, (vi) obtain final SECapproval after the investment bank has finalized issue terms and offer price, and (vii) sell theissue to the investment bank at the guarantee price. The investment bank will then assume therisk of placing the issue with primary-market investors.2-14Broadly speaking, an investment bank facilitates a firm’s issuance of new securities. In acommon-stock issue, the bank helps the issuer file a registration statement with the SEC andmarket the offering to potential investors in a roadshow. The bank also sets the offering priceand other terms of the issue. All along the way, the originating investment bank provides adviceto help the issuer maximize the volume of funds raised. Finally, the originating bank buys thenew securities from the issuer at the guarantee price and then resells the issue to primary-marketinvestors. Sometimes the bank will form a syndicate of other investment banks to share thefinancial risk of placing the issue.

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2-15Securitization is the process of creating highly liquid marketable securities out of illiquid assets.The first assets securitized on a large scale were residential mortgages—securitizers “pooled”the mortgages and then issued debt claims backed by cash flows from those pools. In otherwords, the interest and principal on “mortgage-backed” securities (MBSs) paid to investorscame from mortgage payments by residential homeowners. Securitization facilitated investmentin mortgages by unbundling risk. Lenders might need their funds before the mortgage is repaidor lose money if the homeowner defaults. Securitization allows mortgage originators to earnfees from making the loans but then reduce liquidity and credit risk by selling the mortgage toa securitizer (who, in turn, creates a security with cash flows tailored to the preferences ofmarket investors). Securitizing mortgages promotes efficient risk sharing, which in turn, makesthe real-estate sector a more attractive place to invest.2-16A mortgage-backed security (MBS) is a debt instrument backed by residential mortgages.“Backed” means principal and interest paid to MBS investors come from payments byresidential homeowners with mortgages in the underlying pool. The primary MBS risk is creditrisk, the chance homeowners will not make monthly principal and interest payments asstipulated in their mortgage contracts.2-17When a home buyer takes out a mortgage, initial equity—the difference between purchase priceand mortgage-loan balance—is simply the down payment. Over time, equity will rise as theborrower reduces the mortgage balance with monthly principal and interest payments. Shouldhousing prices rise, the gap between house value and mortgage balance will widen further—that is to say, home equity rises even faster. If a borrower needs to skip a mortgage payment,the lender will typically allow her to tap equity. Rising prices also imply a vibrant housingmarket, so a borrower permanently unable to make the monthly payments can easily sell herhome to pay off the mortgage.2-18. A large decline in housing prices could push the value of a borrower’s home below the mortgagebalance. With negative equity, the borrower could hold the loss at the original down paymentby allowing the lender to foreclose. The only cost would be the negative impact on theborrower’s credit score. But if the decline in housing prices has led many other homeowners towalk away from their mortgages, this borrower may not be too concerned about the blot on hercredit report, thinking future lenders will understand the circumstances.2-19The Great Recession of 2007–09 illustrates how a financial-sector crisis can metastasize. In theyears running up to the recession, securitizers increasingly pooled mortgage loans to borrowerswith less-than-stellar credit. At the time, “subprime” loans seemed relatively low risk becauseof rapidly rising housing prices. Then, when home prices began to level off (and even dip insome markets), mortgage delinquencies and defaults started climbing. With payments onunderlying mortgages falling, the value of mortgage-back securities (MBSs) began to fall aswell. Large investment banks (like Lehmann Brothers) and commercial banks (like Citibank)heldconsiderableinventoriesofnow-problematicMBSs.TooffsetrisingMBSlosses,commercial banks sharply curbed lending, which produced an economy-wide decline inconsumer and investment spending. Investment banks, meanwhile, were large players in themoney market—Lehmann, for example, routinely sold a large amount of commercial paper(short-term unsecured corporate debt). When the firm collapsed almost overnight (rendering itscommercial paper worthless), the money market froze as investors became wary of all unsecureddebt. Now, nonfinancial companies that regularly tapped the money market for short-termfunding found themselves in squeeze. They responded by slashing costs and hoarding cash,which put even more downward pressure on economy-wide consumer and investment spending.

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Ch. 3 Answers to Review Questions3-1.Generallyaccepted accounting principles (GAAP), the Financial Accounting Standards Board(FASB), and the Public Company Accounting Oversight Board (PCAOB) all play significantroles in the financial reporting of publicly traded firms. GAAP refers to the basic guidelines firmsshould use in preparing and maintaining financial records and reports; these guidelines areauthorized by the FASB— the accounting profession’s rule-setting body. The PCAOB is a not-for-profit corporation that oversees auditors of public corporations. Consistency in financialreporting and auditing practices/procedures promotes investor confidence in the financialinformation firms release to the public.3-2The four major financial statements are the:•Income Statement, which summarizes firm operating results over a specified time period. Itis a “flow” document— demonstrating whether revenues over a month, quarter, or yearexceed costs with sufficient detail to explain profits or losses.•Balance Sheet, which summarizes firm financial condition at a given point in time. It is a“stock” document— noting assets, liabilities and net financial position (owner’s stake) ona specific date in detail sufficient to explain why that stake is large or small.•Statement of Retained Earnings, which reconciles net income earned during the year (andany cash dividends paid) with the change in retained earnings from the beginning to theend of the year. It is a condensed version of the statement of stockholders’ equity.Retained earnings are important not as a source of surplus funds but rather because theyrepresent reinvestment in the firm. The statement of retained earnings highlights thereason for changes in the level of reinvestment.•TheStatement of Cash Flowssummarizes cash inflows and outflows experienced by afirm over a specific period (like a month, quarter, or year). In general, inflows andoutflows are grouped under three headings: operating, investment, and financing. Thisstatement is important to investors because cash flows, unlike profits, can be used to meetongoing firm obligations.3-3Notes to the Financial Statementsoffer important background details for firm financialstatements. Specifically, these notes explain how a firm’s accounting policies, procedures,calculations, and transactions have affected specific line items, thereby making financialstatements easier to interpret.3-4FASB Statement No. 52 governs rules for consolidating a firm’s foreign and domestic financialstatements.ThestatementrequiresU.S.-basedcompaniestotranslateforeign-currency-denominated assets and liabilities into U.S. dollars using the exchange rate on the last day ofthe fiscal year (current rate). Income-statement items are treated similarly. Equity accounts, incontrast, are translated into dollars using the exchange rate at the time of the parent’s equityinvestment (historical rate).

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3-5Current and prospective shareholders care about ratios bearing on expected cash flows anduncertainty about those flows because risk and return drive stock price. Creditors, on the otherhand, focus on ratios gauging the firm’s short-term liquidity and ability to make scheduledinterest and principal payments. Management needs to track ratios related to both risk/returnand debt service. Managers should focus on maximizing shareholder wealth over the long term,but missing scheduled interest and principal payments could cause bankruptcy and prevent thefirm from living past the short term.3-6Cross-sectional analysisinvolves comparing performance ratios for different firms at a specificpoint in time.Benchmarkingis cross-sectional comparison of one firm’s performance ratioswith those of a key competitor, group of competitors, or the industry average.Time-seriesanalysis, in contrast, looks at the same firm’s performance over time (such as quarter-to-quarteror year-over-year).3-7An analyst should focus on significant differences between firm ratios and those of a designatedpeer (competitor, group of competitors, or industry average), irrespective of whether the ratio isabove or below the benchmark. For example, above-normal inventory-turnover ratio couldindicate highly efficient inventory management or critically low inventory (and lost sales).When benchmarking, an analyst should also examine multiple ratios for a complete picture ofeach aspect of firm condition.3-8Analyzing financial data from different points in the year could lead to inaccurate conclusionsbecause of seasonality. For example, many retailers post more sales in the fourth quarter thanin the other three combined because of Christmas. So, comparing sales in the second and fourthquarters for such firms would make the second quarter look extraordinarily weak or the fourthquarter extraordinarily strong.3-9Thecurrent ratiois a better metric when current assets are all reasonably liquid while thequickratiois preferred if the firm operates with high levels of illiquid inventory.3-10Most firms listed in Table 3.5 are large players in their industries; such firms typically rely oncredit lines with banks for emergency cash. Put another way, small firms “self-insure” againstliquidity risk with a high current ratio while large firms insure through bank credit. WholeFoods, as a natural/organic grocery store with an upscale clientele, needs more liquidity thanthe typical grocery store because of its recession vulnerability. During slowdowns, some WholeFoods’ customers switch to traditional grocery stores to save money, so firm sales fall morethan competitors. Banks frequently reduce credit lines during recessions to minimize loanlosses, so Whole Foods—although a national chain—cannot rely its credit lines to stockfresh/organic products for remaining customers until the economy improves. In short, like smallfirms, Whole Foods self-insures against liquidity risk.3-11Average collection period, or average age of accounts receivable, is useful in evaluating a firmscredit and collection policies. It equals accounts receivable divided by average daily sales.Interpreting the ratio (in cross-section or time series analysis) requires context—specifically,what are the firm’s credit policies, how do they compare with other firms, and have they changedover time? Average payment period is accounts payable divided by average purchases per day.The difficulty in calculating this ratio is that the denominator—average daily purchases—is notavailable in firm financial statements.

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3-12Financial leveragerefers to a firm’s reliance on debt (or other types of fixed-cost financing suchas preferred stock) to fund ongoing operations. Financial leverage is important because greaterreliance on debt can improve returns to shareholders but at the cost of higher bankruptcy risk(i.e., a greater likelihood a cash crunch will leave the firm unable to meet its obligations tocreditors).3-13The debt and debt-to-equity ratios gauge firm indebtedness (leverage). Specifically, the debtratio is thepercentage of firm assets financed by debt, while the debt-to-equity ratio is therelative proportion of debt and equity in the firm’s funding mix. Higher debt and debt-to-equityratios correspond to greater financial leverage. Coverage ratios measure ability to service debtsand other fixed obligations. Specifically, the times-interest-earned ratio captures the firm’sability to pay interest on its debts, while the fixed-payment-coverage ratio shows its capacity tomeet a broader set of fixed obligations (such as lease payments, principal payments on firmdebt, and preferred stock dividends). For both coverage ratios, higher values are preferred,indicating the firm is better able to honor fixed obligations.3-14The three profitability ratios found on a common-size income statement are (1) gross profitmargin, (2) operating profit margin, and (3) net profit margin. Gross margin is thepercentage ofeach sales dollar remaining after the cost of goods sold is covered. Operating marginispercentage of each sales dollar remaining after deducting all firm costs/expenses exceptinterest, taxes, and preferred stock dividends. Net profit margin deducts all firm costs andexpenses. For all three ratios, higher values are preferred.3-15Firms with high gross profit but low net profit margins have high large expenses other than thecost of goods sold. For example, a firm with significant financial leverage will have high interestexpense, which will reduce its net profit margin relative to industry competitors that use littleor no debt.3-16Return on assets (ROA) equals earnings available to common stockholders divided by totalassets; return on equity (ROE) is earnings divided by common stock equity. ROA and ROEhave the same numerator but different denominators. Firms with positive earnings and debt willhave ROEs above their ROAs. Only when assets are entirely financed by common stock willROE equal ROA.3-17Theprice-earnings ratio(P/E) captures what investors will pay for a dollar of earnings whilethemarket/book(M/B) ratio shows market perception of firm value relative to the historical costof assets. Both ratios embody a forward-looking perspective in that their numerators reflectinvestor expectations about future cash flows and the riskiness of those flows. Interpreting theseratios for a specific firm is complicated by “backward-looking” denominators (i.e., earningsalready posted for the P/E ratio and historical cost of assets for the M/B ratio). Another issuewith P/E ratios is the tendency of earnings to plummet during recessions, which can boost theratio to eye-popping levels.3-18.Liquidityratios measure firm capacity to meet current (short-term) financial commitments whileactivity ratioscapture how rapidly a firm can convert various accounts into cash or sales.Debtratiosgauge a firm’s dependence on creditors to finance ongoing operations and ability toservice these obligations, andprofitability ratiosnote a firm’s return with respect to sales, assets,or equity. Finally,market ratiosprovide insight into investor perceptions of firm risk and returnand risk. Creditors will be more concerned with liquidity and debt ratios as these bear on thefirm’s ability to meet its fixed commitments.

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3-19. The analyst should use a “level, peer, trend” approach for each of the five perspectives on firmcondition (liquidity, activity, debt, profitability, and market). “Level” means starting withcomputation of multiple ratios for each of the five perspectives and then determining whetherthe ratios tell a consistent story. If, for example, the current ratio is high (indicating strongliquidity), but the quick ratio low, then the firm is carrying significant inventory. The next stepshould be ascertaining whether that inventory can be sold with minimal losses in a cash crunch.“Peer” means comparing firm ratios with key competitors or the industry average. “Trend”means extending those comparisons over time to see longer-term patterns in each of the fiveareas and how these patterns compare with peer firms.3-20The DuPont system of analysis breaks firm return on equity (ROE) into three components:profitability (net profit margin), asset efficiency (total-asset turnover), and leverage (the debtratio). This breakdown allows an analyst to isolate the impact of each factor on shareholderreturns. For example, suppose firm A posts a significantly higher ROE than firm B. The DuPontsystem will highlight the “big picture” reasons for the difference. If the firms have similar profitmargins and asset efficiency, but firm A has higher leverage, then its higher ROE comes withgreater risk of bankruptcy (and may not be a good thing). If, however, the difference stems fromfirm A’s higher net profit margin, then higher ROE reflects customer perception of firm Aproducts as distinctive (and worth a significant mark-up).

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Ch. 4 Answers to Review Questions4-1.The financial-planning process is a two-step, highly collaborative endeavor to track thefinancial implications of the firm’s specific plan for creating value for shareholders. Step oneis long-term or strategic planning, which involves detailing firm financial initiatives and theexpected consequences of those initiatives over a two-to-ten-year horizon. Step two isdeveloping a short-term (operating) financial plan, consistent with the strategic plan, that laysout the firm’s financial actions and likely results over a one-to-two-year period.4-2The three key outputs of the short-term (operating) financial planning process are the (i) cashbudget, (ii) pro forma income statement, and (iii) pro forma balance sheet.4-3Property classes under the Modified Accelerated Cost Recovery System (MACRS) arecategorized by the length of the depreciation (recovery) period. Thefirstfour classes are 3-, 5,7-, and 10-years:Recovery PeriodDefinition3 yearsResearch and experiment equipment and certain special tools5 yearsComputers,printers, copiers, duplicating equipment, cars, light-duty trucks, qualified technological equipment, and similar assets7 yearsOffice furniture, fixtures, most manufacturing equipment, railroadtrack, and single-purpose agricultural and horticultural structures10 yearsEquipment used in petroleum refining or in the manufacture oftobacco products and certain food productsFor tax purposes, firms usually depreciate assets in the first four MARCS property classes viathe double-declining-balance method, using a half-year convention (i.e., taking one-half year’sdepreciationinthepurchaseyear)andswitchingtostraight-linedepreciationwhenadvantageous.4-4.Cash flow from operating activitiescaptures cash inflows/outflows related to the firm’s productioncycle, beginning with the purchase of raw materials and ending with the finished product. Expensesrelated to this process are considered operating flows.Cash flow from investment activitiestracks cash inflows/outflows from the purchases and sales of fixed assets and equity investmentsin other firms. Finally,cash flow from financing activitieshighlights cash inflows/outflows fromtransactions related to debt and equity financing—such as incurrence/repayment of debt,sales/repurchases of stock, and dividend payments.4-5.A decrease in the cash balance is asourceof cash flow because funds will be used for someother purpose, such as investment in inventory. Similarly, an increase in the cash balance is auseof cash flow because the funds, which the firm obtained by some other action such as anasset sale, are now being held in cash.

Solution Manual For Principles of Managerial Finance, 8th Edition - Page 14 preview image

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4-6.In compiling a cash-flow budget, it is important to recognize depreciation is a noncashexpenditure on the firm’s income statement. Put another way, depreciation expense reducestaxable income but does not involve an actual cash outlay. [In contrast, there was a cash outlaywhen the depreciating asset was purchased.] So depreciation must be added back to net incometo find operating cash flows. The same logic holds for other non-cash deductions from salesrevenues in profit/loss calculation.4-7.Thestatement of cash flowstraces cash inflows/outflows from three different activities:(1) operating, (2) investing, and (3) financing. Traditionally, cash outflows are shown asnegative numbers and cash inflows as positive numbers.4-8.Operating cash flowisolates cash inflows/outflows from routine operations. Interest expenseand taxes are excluded to keep the focus on cash flow from firm operations, independent of howthe firm finances or government taxes those operations.4-9.Operating cash flowis cash flow generated from the firm’s regular production/sales of goodsand services.Free cash flowis the remainder available to providers of debt (creditors) and equityfinance (owners) after the firm has met operating needs and paid for net investment in fixed/andcurrent assets. Formally, FCF = OCF – Net Fixed Asset Investment (NFAI) – Net Current AssetsInvestment (NCAI).4-10. The cash budget is a statement of the firm’s planned cash inflows and outflows. Managementuses this budget to estimate short-term cash needs and identify future periods with likely cashsurpluses and shortages. The sales forecast is key to preparing the cash budget.

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4-11. The basic format of the cash budget appears below.Jan.Feb.…Nov.Dec.Total cash receipts$XX$XX$XX$XXLess: Total cash disbursementsXXXX…XXXXNet cash flowXXXXXXXXAdd: Beginning cashXXXX…XXXXEnding cashXXXXXXXXLess: Minimum cash balanceXXXX…XXXXRequired total financing$XXExcess cash balance$XXThe cash budget includes the following:•Cash receipts: Total cash inflows in a given period (a month in the example above). Themost common receipts are cash sales, collections of accounts receivable, and cashreceived from sources other than sales (dividends and interest received, asset sales, etc.).•Cash disbursements: Total cash outlays in a given period (again, a month above). Themost common disbursements are cash purchases, payments of accounts payable, rent/leasepayments, wages/salaries, tax payments, fixed-asset outlays, interest payments, paymentsof cash dividends, principal payments (loans), and repurchases/retirement of stock.•Net cash flow: Difference between cash receipts and disbursements in a given period (amonth above).•Ending cash: Sum of beginning cash and net cash flow for a given period (a monthabove).•Required total financing: Amount of funds the firm needs if ending cash for the period isless than the desired minimum cash balance. Any short-term borrowing necessary toplug the gap will appear on the balance sheet as “notes payable.”•Excess cash: Amount of surplus funds if the firm’s ending cash exceeds its desiredminimum cash balance. Managers usually invest the surplus in liquid, short-term,interest-paying securities.4-12. The ending cash balance, along with the required minimum cash balance, indicate whether thefirm will need additional cash or enjoy a surplus for the given period. If the ending cashbalance falls short of the desired minimum cash balance, the firm must borrow short term toplug the gap. If ending cash exceeds minimum cash, the firm should invest the surplus shortterm in marketable securities.

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4-13. Uncertainty is the result of forecast error. For example, the linchpin of the cash budget is thesales forecast. No matter how complex the model used—that is, how many company-specific,market-specific, and macroeconomic variables are employed—the sales forecast is ultimatelyan extrapolation based on past relationships. Periodically, unexpected shocks will severhistorical links between company/market/macroeconomic factors and sales, causing actualoutcomes to differ significantly from predictions. One technique for coping with uncertainty isscenario analysis, which involves preparing different cash budgets for a range of specific saleslevels—such as a pessimistic forecast, a most likely forecast, and an optimistic forecast. Amore sophisticated technique is computer simulation, which involves sampling from aprobability distribution for each variable in the sales forecast to produce thousands of possiblesales outcomes. Simulation output can then be used to obtain probability estimates for varioussales levels.4-14. Pro forma statements provide the firm with a framework for analyzing future profitability.They depend on two key inputs: the sales forecast and financial statements from the precedingyear. Specifically, the sales forecast is applied to the latest balance sheet and income statementto obtain projected values for next period’s balance sheet and income statements.4-15. In the percent-of-sales method of generating pro forma income statements, the financialmanager estimates dollar values for individual expense items (such as cost of goods sold,operating expenses, and interest expense) as a fixed percentage of projected sales.4-16. The percent-of-sales method assumes all costs are variable—a weakness because most firmshave some fixed costs. For firms with significant fixed costs, the percent-of-sales methodunderstates estimated profit when sales are projected to rise and overstates estimated profitwhen sales are projected to fall. An analyst can minimize this problem by dividing the expenseportion of the pro forma income statement into fixed and variable components.4-17. The judgmental approach to the pro forma balance sheet involves estimation of some balance-sheet items, with external finance used as a balancing or “plug” factor. This method assumesvariables such as cash, accounts receivable, and inventory can be forced to take certain values,rather than occurring as a natural product of ongoing firm transactions.4-18. The “plug” figure in the judgmental approach is the external financing necessary to bring thepro forma balance sheet into balance. A positive value means the firm must raise fundsexternally to meet operating needs—by incurring debt, issuing equity, or reducing dividends. Anegative plug figure implies the firm expects more than sufficient internal finance to supportasset growth. Surplus funds can be used to repay debt, repurchase stock, or increase dividends.4-19. The simplified approaches to pro forma statements have two weaknesses, each arising from aproblematic assumption—namely, (1) the firm’s past financial condition is an accuratepredictor of its future and (2) the values of certain variables in the statements can be forced totake desired values.4-20. The financial manager uses pro forma statements to provide a baseline for evaluating ongoingperformance as the year begins. For example, she might perform ratio analysis and preparesource/use statements. She could also treat the pro forma statements as actual statements toassess various aspects of firm condition—liquidity, activity, debt, and profitability—and thenadjust planned operations to achieve short-term financial goals.

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