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Solution Manual For Principles of Managerial Finance, 8th Edition

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    n Ch. 1 Answers to Review Questions 1-1. 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, an increasing price per share of common stock relative to the stock market as a whole indicates achievement of this goal. 1-2 Actions that maximize the firm’s current profit may not produce the highest stock price because (1) some firm activities that result in slightly lower profit today generate much larger profits in the future periods (i.e., focusing on current profit overlooks the time value of money); (2) activities that generate higher accounting profits today may not result in higher cash flows to stockholders; and (3) activities that lead to high profits today may involve higher risk, which could result in significant future losses. 1-3 Risk is the chance actual outcomes may differ from expected outcomes. Financial managers must consider risk and return because the two factors tend to have an opposite effect on share price. That is, other things equal, an increase in the risk of cash flows to shareholders will depress firm stock price while higher average cash flows to shareholders will increase stock price. 1-4 Maximizing shareholder wealth does not mean overlooking or minimizing the welfare of other firm stakeholders. Firms with satisfied employees, customers, and suppliers tend to produce higher (or less risky) cash flows for their shareholders compared with companies that neglect non-owner stakeholders. That said, customers prefer lower prices for firm output, firm employees prefer higher wages, and firm suppliers prefer higher prices for the input goods and services they provide. So actions that produce the highest price of the firm’s stock cannot simultaneously maximize customer, employee, and supplier satisfaction. 1-5 Broadly speaking, the decisions made by financial managers fall under three headings: (i) investment, (ii) capital budgeting, and (iii) working capital. Investment decisions involve the firm’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-term financial resources. 1-6 Financial managers must recognize the tradeoff between risk and return because shareholders prefer higher cash flows but dislike large swings in cash flows. And, as a general rule, actions that 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 also tend to reduce average cash flows over time. Understanding this tradeoff is important because shareholders are risk averse. That is, they will only accept larger swings in a firm’s cash flows only if compensated over time with higher average cash flows. 1-7 Finance is often considered applied economics. One reason is firms operate within the larger economy. More importantly, the bedrock concept in economics—marginal benefit-marginal cost analysis—is also central to managerial finance. Marginal benefit-marginal cost analysis is the notion a firm (or any other economic actor) should take only those actions for which the extra benefits exceed the extra costs. Nearly, all financial decisions ultimately turn on an assessment of their marginal benefits and marginal costs.

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    1-8 Accountants and financial managers perform separate but equally important functions for the firm. Accountants primarily collect and present financial data according to generally accepted financial principles while financial managers make investment, capital-budgeting, and working-capital decisions with financial data. In part because of their different functions, accountants and financial managers log firm revenues and expenses using different conventions. Accountants operate on an accrual basis, recognizing revenues as firm output is sold (whether or not payment is actually received) and firm expenses as incurred. Financial managers, in contrast, focus on actual inflows and outflows of cash, recognizing revenues when physically received and expenses when actually paid. 1-9 Like any economic actor, managers respond to incentives. Managers have a fiduciary duty to maximize shareholder wealth, but as humans, they also have personal goals—such as maximizing their own income, wealth, reputation, and quality of life. If the personal benefits of delivering for shareholders (or the costs of slighting them) are small, a financial manager might opt to further his own interest at the expense of shareholders. For example, CEOs of large firms—those with more sales, assets, employees, etc.—tend to receive more compensation than CEOs of smaller firms. If a CEO has to choose between two operating strategies—one that produces modest growth for his firm but a large jump in current stock price and another that generates rapid growth but a more modest rise in share price—and the firm’s board is not closely monitoring the CEO, she might pursue the high-growth strategy to boost her future compensation. A partial solution to such a problem is a compensation closely linking CEO compensation to firm stock price. 1-10 Sole proprietorships are the most common form of business organization, while corporations tend to be the largest. Large firms tend to organize as corporations to insulate owners from losses (limit liability) and facilitate acquisition of financial capital to fund growth. 1-11 Stockholders are the owners of a corporation. Their ownership (equity) takes the form of common stock or, less frequently, preferred stock. Stockholders elect the board of directors, which has ultimate responsibility for guiding corporate affairs and setting general policy. The board usually comprises key corporate personnel and outside directors. The corporation’s president or chief executive officer (CEO) reports to the board. He or she oversees day-to-day operations 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 by electing board members and voting on major charter issues. Shareholders receive compensation 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 expectations about future dividends). 1-12 Generally speaking, income from sole proprietorships and partnerships is taxed only once at the individual level; the owner or owners pay personal income tax on their share of firm’s profits. In contrast, corporate income is taxed first at the firm level (via the corporate income tax paid on firm profits) and then again at the personal level (via personal income tax paid on dividends or capital gains enjoyed by shareholders).

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    1-13 Agency problems arise when managers place personal goals ahead of their duty to shareholders to maximize stock price. The attendant costs are called agency costs. Agency costs 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 the firm’s management team pursued a personal interest (like maximizing sales to boost future compensation) rather than maximizing shareholder wealth. Of course, if shareholders sense stock price is not what it should be, they will start monitoring management more closely (as in the chapter opener with Brookdale Senior Living). The expenses associated with greater monitoring are an example of an “explicit” agency cost. Agency problems in a firm can be reduced with a properly constructed and followed corporate-governance structure. Such a structure will feature checks and balances that reduce management’s interest in and ability to deviate from shareholder-wealth maximization. Like all corporate decisions, reducing agency costs is subject to marginal benefit–marginal cost analysis. In other words, the firm should invest in policies to align the incentives of management and shareholders as long as the marginal benefits exceed the marginal costs. 1-14 Firms most commonly try to mitigate agency problems by linking pay to metrics connected with shareholder wealth. Incentive plans tie compensation to share price. For example, the CEO might receive options offering the right to purchase stock at a set price (say current price) any time in the next few years. If the CEO takes actions that subsequently boost share price, 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 the CEO can make, so options create a powerful incentive to focus laser-like on shareholder wealth. There is a downside, however. Sometimes general market trends swamp all the good done by management, so even though the CEO obsessed over shareholder wealth, her options proved worthless because a bear market hammered the firm’s stock price. This problem has made performance plans more popular. These plans link compensation with performance measures related to stock price that management can more closely control—such as earnings per share (EPS) and EPS growth. When targets for the performance metrics are attained, managers receive rewards like performance shares and/or cash bonuses. 1-15 If the board of directors fails to keep management focused on shareholder wealth, market forces can apply the necessary pressure. Two such forces are activism by institutional investors (such as Land and Buildings in the chapter opener) and the threat of hostile takeovers. Institutions typically hold large quantities of shares in many corporations. Because of their large stakes, these investors actively monitor management and vote their shares for the benefit of all shareholders. Large institutional investors reduce agency problems by using their voting clout to elect new directors that will make the changes in policies and personnel necessary to get underperforming stock to its highest possible price. The threat of hostile takeover 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 of a $5 capital gain per share could tempt an outside individual, group of investors or firm not supported by existing management to purchase controlling interest and force the necessary changes. Incumbent management knows “necessary changes” means unemployment, so the threat of takeover could be enough to align their interests with those of the owners.

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    n Ch. 2 Answers to Review Questions 2-1. Financial institutions are intermediaries that facilitate the flow of individual, business, and government savings into loans and investments. Broadly speaking, net savers (primarily individuals) prefer low risk and easy access to their money while net borrowers (businesses and government) would like to take risk with the funds and tie them up for a longer term. Financial institutions 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. 2-2 Overall, the same entities that supply funds—individuals, businesses, and governments—also demand them, so these three groups are all financial-institution customers. That said, the key demanders of funds (net borrowers) are businesses and governments while the key suppliers (net savers) are individuals. 2-3 Commercial 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 on mergers/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 to commercial banks—but without issuing deposits. By not relying on deposit funding, shadow banks can 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 primary markets, debt and equity instruments are sold the first time—a direct exchange between the firm or government issuing securities and the purchasers. An example is Microsoft Corporation selling new shares of common stock to private investors. In secondary markets, previous issued securities are traded subsequent times; the original issuers receive no new funds. An example is an investor buying a share of outstanding Microsoft common stock from another investor through 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 a symbiotic relationship—the easier the resale of a financial asset in a secondary market, the easier the initial sale of that asset in a primary market. Similarly, financial institutions and financial markets are far from independent. Commercial banks, for example, hold large inventories 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. Because banks 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 of this advantage, the capital markets watch bank lending for clues about borrower financial strength. When a commercial bank announces a new loan to a publicly traded firm, that firm’s stock price typically rises. 2-5 A private placement is the sale of a new security directly to an investor or a small group of sophisticated investors (such as insurance companies and pension funds). A public offering, in contrast, is the sale of newly issued stock or bonds to the public at large. Firms typically rely on public offerings when they need large sums.

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    2-6. The money market features trading in short-term, highly marketable debt instruments; “short term” here means an original maturity of one year or less. Money-market instruments typically carry low risk of capital losses. Examples of money-market instruments include U.S. Treasury bills, commercial paper, and negotiable certificates of deposit (issued by large commercial banks). The Eurocurrency market is the international analogue of the U.S. money market. This market 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 with the euro per se and is no longer specific to Europe. 2-7. The capital market features trading in instruments with original maturities exceeding one year such as bonds and stock (common and preferred). Capital-market instruments are exchanged in broker 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 pay minus 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 maker executes 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 independent transaction, 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 the opportunity to “buy low, sell high.” The difference, in short, between broker and dealer markets turns on whether traders or dealers provide the liquidity. 2-8 Firms see the capital market as a source of external finance for long-term projects. Put another way, they sell new bonds and stock to raise funds to build factories, launch marketing campaigns, 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 the capital market as a savings vehicle for long-term needs like retirement. As citizens of the macroeconomy, investors would also like the capital market to steer scarce funds to the most productive uses. To these ends, investors want an efficient capital market—one where securities prices reflect all available information and react swiftly to new information. Capital-market efficiency means investors need not waste time trying to identify over or undervalued securities or exploitable patterns in securities prices. Instead, they can maximize long-term returns by putting their savings in diversified mutual funds (i.e., avoiding countless hours studying individual stocks and bonds). Investors will also enjoy higher aggregate growth of output and employment from the spotlight securities prices shine on firms most able to profitably use their savings. 2-9 The first years of Great Depression featured the worst contraction in American history. Between August 1929 and March 1933, industrial production fell 52%, the Dow Jones Industrial Average tumbled 89%, unemployment soared to nearly 25%, and roughly 9,000 banks failed (37% of those operating in December 1929). Franklin Roosevelt won the 1932 election with a mandate to restore prosperity and prevent future depressions. Much of the U.S. framework for financial and financial-institution regulation stems from the First New Deal (1933–34). This framework addressed specific factors thought to have caused the slump. To protect depositors from losses in bank failures, the Banking Act of 1933 created federal deposit insurance. To prevent failures in the first place, the Act also barred commercial banks from security underwriting, which was thought to pose dangerous additional risks. To head off fraudulent investment schemes like those preceding the stock-market crash of 1929, the Securities Act of 1933 and Securities Exchange Act of 1934 forced companies wishing to issue public securities to disclose information about their financial condition.

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    2-10 Both Acts required companies wishing to participate in securities markets to disclose significant information to the public. The Securities Act of 1933 focused on the primary market, compelling sellers of new securities provide reasonably accurate portrayals of their firms to prospective investors. The Securities Exchange Act of 1934, in contrast, regulated trading in secondary markets; forcing publicly traded companies to keep investors informed about firm condition on an ongoing basis. The latter Act also created the Securities Exchange Commission to enforce federal securities laws. 2-11 Angel investors and venture capitalists are both sources of private equity. “Angels” are usually wealthy individuals who fund promising start-ups in return for a slice of firm equity. Venture capitalists, in contrast, are businesses that pool contributions from individuals (often institutional investors like university endowments and pension funds) and invest those funds in promising start-ups. In short, angels pick “winners” themselves whereas venture capitalists pick “winners” for their clients. 2-12 Venture capitalists (VCs) are organized as (i) limited partnerships (most common), (ii) small business investment companies (SBICs), (iii) financial funds, and (iv) corporate funds. The principal difference is how the VC was created. The federal government charters SBICs. Financial institutions (usually commercial banks), in contrast, create financial funds as subsidiaries while nonfinancial firms launch corporate funds, sometimes as subsidiaries. Unlike other VC types, limited partnerships are launched by private individuals. All VCs use a legal agreement to specify deal structure and pricing. Deal structure allocates responsibilities between the start-up and VC and may include constraints on the firm to enhance its chance of success and mitigate VC risk. Pricing depends on the (i) value of the start-up, (ii) perceived risk of its business operations, and (iii) amount of funding needed. In general, VCs provide less funding and require a greater ownership stake when the firm is the early stages of development. 2-13 Firms wishing to go public must (i) secure approval from current shareholders, (ii) obtain certification 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 and Exchange Commission (SEC), (v) participate in roadshows with the investment bank to spark interest among potential investors and learn about a suitable issuing price, (vi) obtain final SEC approval after the investment bank has finalized issue terms and offer price, and (vii) sell the issue to the investment bank at the guarantee price. The investment bank will then assume the risk of placing the issue with primary-market investors. 2-14 Broadly speaking, an investment bank facilitates a firm’s issuance of new securities. In a common-stock issue, the bank helps the issuer file a registration statement with the SEC and market the offering to potential investors in a roadshow. The bank also sets the offering price and other terms of the issue. All along the way, the originating investment bank provides advice to help the issuer maximize the volume of funds raised. Finally, the originating bank buys the new securities from the issuer at the guarantee price and then resells the issue to primary-market investors. Sometimes the bank will form a syndicate of other investment banks to share the financial risk of placing the issue.

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    2-15 Securitization 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 other words, the interest and principal on “mortgage-backed” securities (MBSs) paid to investors came from mortgage payments by residential homeowners. Securitization facilitated investment in mortgages by unbundling risk. Lenders might need their funds before the mortgage is repaid or lose money if the homeowner defaults. Securitization allows mortgage originators to earn fees from making the loans but then reduce liquidity and credit risk by selling the mortgage to a securitizer (who, in turn, creates a security with cash flows tailored to the preferences of market investors). Securitizing mortgages promotes efficient risk sharing, which in turn, makes the real-estate sector a more attractive place to invest. 2-16 A mortgage-backed security (MBS) is a debt instrument backed by residential mortgages. “Backed” means principal and interest paid to MBS investors come from payments by residential homeowners with mortgages in the underlying pool. The primary MBS risk is credit risk, the chance homeowners will not make monthly principal and interest payments as stipulated in their mortgage contracts. 2-17 When a home buyer takes out a mortgage, initial equity—the difference between purchase price and mortgage-loan balance—is simply the down payment. Over time, equity will rise as the borrower reduces the mortgage balance with monthly principal and interest payments. Should housing 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 housing market, so a borrower permanently unable to make the monthly payments can easily sell her home to pay off the mortgage. 2-18. A large decline in housing prices could push the value of a borrower’s home below the mortgage balance. With negative equity, the borrower could hold the loss at the original down payment by allowing the lender to foreclose. The only cost would be the negative impact on the borrower’s credit score. But if the decline in housing prices has led many other homeowners to walk away from their mortgages, this borrower may not be too concerned about the blot on her credit report, thinking future lenders will understand the circumstances. 2-19 The Great Recession of 2007–09 illustrates how a financial-sector crisis can metastasize. In the years running up to the recession, securitizers increasingly pooled mortgage loans to borrowers with less-than-stellar credit. At the time, “subprime” loans seemed relatively low risk because of rapidly rising housing prices. Then, when home prices began to level off (and even dip in some markets), mortgage delinquencies and defaults started climbing. With payments on underlying mortgages falling, the value of mortgage-back securities (MBSs) began to fall as well. Large investment banks (like Lehmann Brothers) and commercial banks (like Citibank) held considerable inventories of now-problematic MBSs. To offset rising MBS losses, commercial banks sharply curbed lending, which produced an economy-wide decline in consumer and investment spending. Investment banks, meanwhile, were large players in the money market—Lehmann, for example, routinely sold a large amount of commercial paper (short-term unsecured corporate debt). When the firm collapsed almost overnight (rendering its commercial paper worthless), the money market froze as investors became wary of all unsecured debt. Now, nonfinancial companies that regularly tapped the money market for short-term funding 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 Questions 3-1. Generally accepted accounting principles (GAAP), the Financial Accounting Standards Board (FASB), and the Public Company Accounting Oversight Board (PCAOB) all play significant roles in the financial reporting of publicly traded firms. GAAP refers to the basic guidelines firms should use in preparing and maintaining financial records and reports; these guidelines are authorized 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 financial reporting and auditing practices/procedures promotes investor confidence in the financial information firms release to the public. 3-2 The four major financial statements are the: • Income Statement , which summarizes firm operating results over a specified time period. It is a “flow” document— demonstrating whether revenues over a month, quarter, or year exceed 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) on a 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 (and any cash dividends paid) with the change in retained earnings from the beginning to the end 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 they represent reinvestment in the firm. The statement of retained earnings highlights the reason for changes in the level of reinvestment. • The Statement of Cash Flows summarizes cash inflows and outflows experienced by a firm over a specific period (like a month, quarter, or year). In general, inflows and outflows are grouped under three headings: operating, investment, and financing. This statement is important to investors because cash flows, unlike profits, can be used to meet ongoing firm obligations. 3-3 Notes to the Financial Statements offer important background details for firm financial statements. Specifically, these notes explain how a firm’s accounting policies, procedures, calculations, and transactions have affected specific line items, thereby making financial statements easier to interpret. 3-4 FASB Statement No. 52 governs rules for consolidating a firm’s foreign and domestic financial statements. The statement requires U.S.-based companies to translate foreign-currency- denominated assets and liabilities into U.S. dollars using the exchange rate on the last day of the fiscal year (current rate). Income-statement items are treated similarly. Equity accounts, in contrast, are translated into dollars using the exchange rate at the time of the parent’s equity investment (historical rate).

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    3-5 Current and prospective shareholders care about ratios bearing on expected cash flows and uncertainty about those flows because risk and return drive stock price. Creditors, on the other hand, focus on ratios gauging the firm’s short-term liquidity and ability to make scheduled interest and principal payments. Management needs to track ratios related to both risk/return and 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 the firm from living past the short term. 3-6 Cross-sectional analysis involves comparing performance ratios for different firms at a specific point in time. Benchmarking is cross-sectional comparison of one firm’s performance ratios with those of a key competitor, group of competitors, or the industry average. Time-series analysis , in contrast, looks at the same firm’s performance over time (such as quarter-to-quarter or year-over-year). 3-7 An analyst should focus on significant differences between firm ratios and those of a designated peer (competitor, group of competitors, or industry average), irrespective of whether the ratio is above or below the benchmark. For example, above-normal inventory-turnover ratio could indicate highly efficient inventory management or critically low inventory (and lost sales). When benchmarking, an analyst should also examine multiple ratios for a complete picture of each aspect of firm condition. 3-8 Analyzing financial data from different points in the year could lead to inaccurate conclusions because of seasonality. For example, many retailers post more sales in the fourth quarter than in the other three combined because of Christmas. So, comparing sales in the second and fourth quarters for such firms would make the second quarter look extraordinarily weak or the fourth quarter extraordinarily strong. 3-9 The current ratio is a better metric when current assets are all reasonably liquid while the quick ratio is preferred if the firm operates with high levels of illiquid inventory. 3-10 Most firms listed in Table 3.5 are large players in their industries; such firms typically rely on credit lines with banks for emergency cash. Put another way, small firms “self-insure” against liquidity risk with a high current ratio while large firms insure through bank credit. Whole Foods, as a natural/organic grocery store with an upscale clientele, needs more liquidity than the typical grocery store because of its recession vulnerability. During slowdowns, some Whole Foods’ customers switch to traditional grocery stores to save money, so firm sales fall more than competitors. Banks frequently reduce credit lines during recessions to minimize loan losses, so Whole Foods—although a national chain—cannot rely its credit lines to stock fresh/organic products for remaining customers until the economy improves. In short, like small firms, Whole Foods self-insures against liquidity risk. 3-11 Average collection period, or average age of accounts receivable, is useful in evaluating a firms credit 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 changed over 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 not available in firm financial statements.

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    3-12 Financial leverage refers to a firm’s reliance on debt (or other types of fixed-cost financing such as preferred stock) to fund ongoing operations. Financial leverage is important because greater reliance 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 to creditors). 3-13 The debt and debt-to-equity ratios gauge firm indebtedness (leverage). Specifically, the debt ratio is thepercentage of firm assets financed by debt, while the debt-to-equity ratio is the relative proportion of debt and equity in the firm’s funding mix. Higher debt and debt-to-equity ratios correspond to greater financial leverage. Coverage ratios measure ability to service debts and other fixed obligations. Specifically, the times-interest-earned ratio captures the firm’s ability to pay interest on its debts, while the fixed-payment-coverage ratio shows its capacity to meet a broader set of fixed obligations (such as lease payments, principal payments on firm debt, and preferred stock dividends). For both coverage ratios, higher values are preferred, indicating the firm is better able to honor fixed obligations. 3-14 The three profitability ratios found on a common-size income statement are (1) gross profit margin, (2) operating profit margin, and (3) net profit margin. Gross margin is thepercentage of each sales dollar remaining after the cost of goods sold is covered. Operating margin ispercentage of each sales dollar remaining after deducting all firm costs/expenses except interest, taxes, and preferred stock dividends. Net profit margin deducts all firm costs and expenses. For all three ratios, higher values are preferred. 3-15 Firms with high gross profit but low net profit margins have high large expenses other than the cost of goods sold. For example, a firm with significant financial leverage will have high interest expense, which will reduce its net profit margin relative to industry competitors that use little or no debt. 3-16 Return on assets (ROA) equals earnings available to common stockholders divided by total assets; return on equity (ROE) is earnings divided by common stock equity. ROA and ROE have the same numerator but different denominators. Firms with positive earnings and debt will have ROEs above their ROAs. Only when assets are entirely financed by common stock will ROE equal ROA. 3-17 The price-earnings ratio (P/E) captures what investors will pay for a dollar of earnings while the market/book (M/B) ratio shows market perception of firm value relative to the historical cost of assets. Both ratios embody a forward-looking perspective in that their numerators reflect investor expectations about future cash flows and the riskiness of those flows. Interpreting these ratios for a specific firm is complicated by “backward-looking” denominators (i.e., earnings already posted for the P/E ratio and historical cost of assets for the M/B ratio). Another issue with P/E ratios is the tendency of earnings to plummet during recessions, which can boost the ratio to eye-popping levels. 3-18. Liquidity ratios measure firm capacity to meet current (short-term) financial commitments while activity ratios capture how rapidly a firm can convert various accounts into cash or sales. Debt ratios gauge a firm’s dependence on creditors to finance ongoing operations and ability to service these obligations, and profitability ratios note a firm’s return with respect to sales, assets, or equity. Finally, market ratios provide insight into investor perceptions of firm risk and return and risk. Creditors will be more concerned with liquidity and debt ratios as these bear on the firm’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 firm condition (liquidity, activity, debt, profitability, and market). “Level” means starting with computation of multiple ratios for each of the five perspectives and then determining whether the ratios tell a consistent story. If, for example, the current ratio is high (indicating strong liquidity), but the quick ratio low, then the firm is carrying significant inventory. The next step should 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 five areas and how these patterns compare with peer firms. 3-20 The 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 debt ratio). This breakdown allows an analyst to isolate the impact of each factor on shareholder returns. For example, suppose firm A posts a significantly higher ROE than firm B. The DuPont system will highlight the “big picture” reasons for the difference. If the firms have similar profit margins and asset efficiency, but firm A has higher leverage, then its higher ROE comes with greater risk of bankruptcy (and may not be a good thing). If, however, the difference stems from firm A’s higher net profit margin, then higher ROE reflects customer perception of firm A products as distinctive (and worth a significant mark-up).

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    Ch. 4 Answers to Review Questions 4-1. The financial-planning process is a two-step, highly collaborative endeavor to track the financial implications of the firm’s specific plan for creating value for shareholders. Step one is long-term or strategic planning, which involves detailing firm financial initiatives and the expected consequences of those initiatives over a two-to-ten-year horizon. Step two is developing a short-term (operating) financial plan, consistent with the strategic plan, that lays out the firm’s financial actions and likely results over a one-to-two-year period. 4-2 The three key outputs of the short-term (operating) financial planning process are the (i) cash budget, (ii) pro forma income statement, and (iii) pro forma balance sheet. 4-3 Property classes under the Modified Accelerated Cost Recovery System (MACRS) are categorized by the length of the depreciation (recovery) period. The first four classes are 3-, 5, 7-, and 10-years: Recovery Period Definition 3 years Research and experiment equipment and certain special tools 5 years Computers, printers , copiers, duplicating equipment, cars, light- duty trucks, qualified technological equipment, and similar assets 7 years Office furniture, fixtures, most manufacturing equipment, railroad track, and single-purpose agricultural and horticultural structures 10 years Equipment used in petroleum refining or in the manufacture of tobacco products and certain food products For tax purposes, firms usually depreciate assets in the first four MARCS property classes via the double-declining-balance method, using a half-year convention (i.e., taking one-half year’s depreciation in the purchase year) and switching to straight-line depreciation when advantageous. 4-4. Cash flow from operating activities captures cash inflows/outflows related to the firm’s production cycle, beginning with the purchase of raw materials and ending with the finished product. Expenses related to this process are considered operating flows. Cash flow from investment activities tracks cash inflows/outflows from the purchases and sales of fixed assets and equity investments in other firms. Finally, cash flow from financing activities highlights cash inflows/outflows from transactions 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 a source of cash flow because funds will be used for some other purpose, such as investment in inventory. Similarly, an increase in the cash balance is a use of cash flow because the funds, which the firm obtained by some other action such as an asset sale, are now being held in cash.

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    4-6. In compiling a cash-flow budget, it is important to recognize depreciation is a noncash expenditure on the firm’s income statement. Put another way, depreciation expense reduces taxable income but does not involve an actual cash outlay. [In contrast, there was a cash outlay when the depreciating asset was purchased.] So depreciation must be added back to net income to find operating cash flows. The same logic holds for other non-cash deductions from sales revenues in profit/loss calculation. 4-7. The statement of cash flows traces cash inflows/outflows from three different activities: (1) operating, (2) investing, and (3) financing. Traditionally, cash outflows are shown as negative numbers and cash inflows as positive numbers. 4-8. Operating cash flow isolates cash inflows/outflows from routine operations. Interest expense and taxes are excluded to keep the focus on cash flow from firm operations, independent of how the firm finances or government taxes those operations. 4-9. Operating cash flow is cash flow generated from the firm’s regular production/sales of goods and services. Free cash flow is the remainder available to providers of debt (creditors) and equity finance (owners) after the firm has met operating needs and paid for net investment in fixed/and current assets. Formally, FCF = OCF – Net Fixed Asset Investment (NFAI) – Net Current Assets Investment (NCAI). 4-10. The cash budget is a statement of the firm’s planned cash inflows and outflows. Management uses this budget to estimate short-term cash needs and identify future periods with likely cash surpluses 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 $XX Less: Total cash disbursements XX XX … XX XX Net cash flow XX XX XX XX Add: Beginning cash XX XX … XX XX Ending cash XX XX XX XX Less: Minimum cash balance XX XX … XX XX Required total financing $XX Excess cash balance $XX The cash budget includes the following: • Cash receipts : Total cash inflows in a given period (a month in the example above). The most common receipts are cash sales, collections of accounts receivable, and cash received 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). The most common disbursements are cash purchases, payments of accounts payable, rent/lease payments, wages/salaries, tax payments, fixed-asset outlays, interest payments, payments of cash dividends, principal payments (loans), and repurchases/retirement of stock. • Net cash flow : Difference between cash receipts and disbursements in a given period (a month above). • Ending cash : Sum of beginning cash and net cash flow for a given period (a month above). • Required total financing : Amount of funds the firm needs if ending cash for the period is less than the desired minimum cash balance. Any short-term borrowing necessary to plug 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 desired minimum 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 the firm will need additional cash or enjoy a surplus for the given period. If the ending cash balance falls short of the desired minimum cash balance, the firm must borrow short term to plug the gap. If ending cash exceeds minimum cash, the firm should invest the surplus short term 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 the sales 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 ultimately an extrapolation based on past relationships. Periodically, unexpected shocks will sever historical links between company/market/macroeconomic factors and sales, causing actual outcomes to differ significantly from predictions. One technique for coping with uncertainty is scenario analysis, which involves preparing different cash budgets for a range of specific sales levels—such as a pessimistic forecast, a most likely forecast, and an optimistic forecast. A more sophisticated technique is computer simulation, which involves sampling from a probability distribution for each variable in the sales forecast to produce thousands of possible sales outcomes. Simulation output can then be used to obtain probability estimates for various sales 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 preceding year. Specifically, the sales forecast is applied to the latest balance sheet and income statement to 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 financial manager 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 firms have some fixed costs. For firms with significant fixed costs, the percent-of-sales method understates estimated profit when sales are projected to rise and overstates estimated profit when sales are projected to fall. An analyst can minimize this problem by dividing the expense portion 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 assumes variables 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 the pro forma balance sheet into balance. A positive value means the firm must raise funds externally to meet operating needs—by incurring debt, issuing equity, or reducing dividends. A negative plug figure implies the firm expects more than sufficient internal finance to support asset 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 a problematic assumption—namely, (1) the firm’s past financial condition is an accurate predictor of its future and (2) the values of certain variables in the statements can be forced to take desired values. 4-20. The financial manager uses pro forma statements to provide a baseline for evaluating ongoing performance as the year begins. For example, she might perform ratio analysis and prepare source/use statements. She could also treat the pro forma statements as actual statements to assess various aspects of firm condition—liquidity, activity, debt, and profitability—and then adjust planned operations to achieve short-term financial goals.

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