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Corporate finance is the area of finance dealing with the sources of funding and the capital structure of corporations and the actions that managers take to increase the value of the firm to the shareholders, as well as the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value.1 Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.Investment analysis (or capital budgeting) is concerned with the setting of criteria about which valueadding projects should receive investment funding, and whether to finance that investment with equity or debt capital. Working capital management is the management of the companys monetary funds that deal with the shortterm operating balance of current assets and current liabilities; the focus here is on managing cash, inventories, and shortterm borrowing and lending (such as the terms on credit extended to customers)
Solutions Manual Fundamentals of Corporate Finance 8 th edition Ross, Westerfield, and Jordan Updated 03-05-2007 CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Answers to Concepts Review and Critical Thinking Questions 1. Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm’s credit collection policy with its customers). 2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise capital funds. Some advantages: simpler, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates. 3. The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, unlimited life, and so forth. 4. In response to Sarbanes-Oxley, small firms have elected to go dark because of the costs of compliance. The costs to comply with Sarbox can be several million dollars, which can be a large percentage of a small firms profits. A major cost of going dark is less access to capital. Since the firm is no longer publicly traded, it can no longer raise money in the public market. Although the company will still have access to bank loans and the private equity market, the costs associated with raising funds in these markets are usually higher than the costs of raising funds in the public market. 5. The treasurer’s office and the controller’s office are the two primary organizational groups that report directly to the chief financial officer. The controller’s office handles cost and financial accounting, tax management, and management information systems, while the treasurer’s office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the treasury group’s functions. 6. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly- traded or not). 7. In the corporate form of ownership, the shareholders are the owners of the firm. The shareholders elect the directors of the corporation, who in turn appoint the firm’s management. This separation of ownership from control in the corporate form of organization is what causes agency problems to exist. Management may act in its own or someone else’s best interests, rather than those of the shareholders. If such events occur, they may contradict the goal of maximizing the share price of the equity of the firm. 8. A primary market transaction. B-2 SOLUTIONS 9. In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to match buyers and sellers of assets. Dealer markets like NASDAQ consist of dealers operating at dispersed locales who buy and sell assets themselves, communicating with other dealers either electronically or literally over-the-counter. 10. Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize the value of the equity. 11. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. If this is correct, then the statement is false. 12. An argument can be made either way. At the one extreme, we could argue that in a market economy, all of these things are priced. There is thus an optimal level of, for example, ethical and/or illegal behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process. A classic (and highly relevant) thought question that illustrates this debate goes something like this: “A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?” 13. The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions. 14. The goal of management should be to maximize the share price for the current shareholders. If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company. If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer. However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer. Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this. 15. We would expect agency problems to be less severe in other countries, primarily due to the relatively small percentage of individual ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate goals. The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects. In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions’ deeper resources and experiences with their own management. The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S. corporations and a more efficient market for corporate control. CHAPTER 1 B-3 16. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. In recent years, stock prices have soared, so management has cleaned up. It is sometimes argued that much of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases. CHAPTER 2 FINANCIAL STATEMENTS, TAXES AND CASH FLOW Answers to Concepts Review and Critical Thinking Questions 1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It’s desirable for firms to have high liquidity so that they have a large factor of safety in meeting short-term creditor demands. However, since liquidity also has an opportunity cost associated with it—namely that higher returns can generally be found by investing the cash into productive assets—low liquidity levels are also desirable to the firm. It’s up to the firm’s financial management staff to find a reasonable compromise between these opposing needs. 2. The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be “booked” when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid. Note that this way is not necessarily correct; it’s the way accountants have chosen to do it. 3. Historical costs can be objectively and precisely measured whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff between relevance (market values) and objectivity (book values). 4. Depreciation is a non-cash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting. Interest expense is a cash outlay, but it’s a financing cost, not an operating cost. 5. Market values can never be negative. Imagine a share of stock selling for –$20. This would mean that if you placed an order for 100 shares, you would get the stock along with a check for $2,000. How many shares do you want to buy? More generally, because of corporate and individual bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities cannot exceed assets in market value. 6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent wisely, not whether cash flow from assets is positive or negative. 7. It’s probably not a good sign for an established company, but it would be fairly ordinary for a start- up, so it depends. 8. For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would have this effect. Negative net capital spending would mean more long-lived assets were liquidated than purchased. CHAPTER 2 B-5 9. If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest, its cash flow to creditors will be negative. 10. The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the derivatives. 11. Enterprise value is the theoretical takeover price. In the event of a takeover, an acquirer would have to take on the company's debt, but would pocket its cash. Enterprise value differs significantly from simple market capitalization in several ways, and it may be a more accurate representation of a firm's value. In a takeover, the value of a firm's debt would need to be paid by the buyer when taking over a company. This enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation. 12. In general, it appears that investors prefer companies that have a steady earning stream. If true, this encourages companies to manage earnings. Under GAAP, there are numerous choices for the way a company reports its financial statements. Although not the reason for the choices under GAAP, one outcome is the ability of a company to manage earnings, which is not an ethical decision. Even though earnings and cash flow are often related, earnings management should have little effect on cash flow (except for tax implications). If the market is “fooled” and prefers steady earnings, shareholder wealth can be increased, at least temporarily. However, given the questionable ethics of this practice, the company (and shareholders) will lose value if the practice is discovered. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. To find owner’s equity, we must construct a balance sheet as follows: Balance Sheet CA $4,000 CL $3,400 NFA 22,500 LTD 6,800 OE ?? TA $26,500 TL & OE $26,500 We know that total liabilities and owner’s equity (TL & OE) must equal total assets of $26,500. We also know that TL & OE is equal to current liabilities plus long-term debt plus owner’s equity, so owner’s equity is: OE = $26,500 – 6,800 – 3,400 = $16,300 NWC = CA – CL = $4,000 – 3,400 = $600 B-6 SOLUTIONS 2. The income statement for the company is: Income Statement Sales $634,000 Costs 305,000 Depreciation 46,000 EBIT $283,000 Interest 29,000 EBT $254,000 Taxes(35%) 88,900 Net income $165,100 3. One equation for net income is: Net income = Dividends + Addition to retained earnings Rearranging, we get: Addition to retained earnings = Net income – Dividends = $165,100 – 86,000 = $79,100 4. EPS = Net income / Shares = $165,100 / 30,000 = $5.50 per share DPS = Dividends / Shares = $86,000 / 30,000 = $2.87 per share 5. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current assets, we get: CA = NWC + CL = $410,000 + 1,300,000 = $1,710,000 The market value of current assets and fixed assets is given, so: Book value CA = $1,710,000 Market value CA = $1,800,000 Book value NFA = $2,600,000 Market value NFA = $3,700,000 Book value assets = $4,310,000 Market value assets = $5,500,000 6. Taxes = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($325 – 100K) = $110,000 7. The average tax rate is the total tax paid divided by net income, so: Average tax rate = $110,000 / $325,000 = 33.85% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39%. CHAPTER 2 B-7 8. To calculate OCF, we first need the income statement: Income Statement Sales $14,200 Costs 5,600 Depreciation 1,200 EBIT $7,400 Interest 680 Taxable income $6,720 Taxes (35%) 2,352 Net income $4,368 OCF = EBIT + Depreciation – Taxes = $7,400 + 1,200 – 2,352 = $6,248 9. Net capital spending = NFA end – NFA beg + Depreciation = $5.2M – 4.6M + 875K = $1.475M 10. Change in NWC = NWC end – NWC beg Change in NWC = (CA end – CL end ) – (CA beg – CL beg ) Change in NWC = ($1,650 – 920) – ($1,400 – 870) Change in NWC = $730 – 530 = $200 11. Cash flow to creditors = Interest paid – Net new borrowing = $340K – (LTD end – LTD beg ) Cash flow to creditors = $280K – ($3.3M – 3.1M) = $280K – 200K = $80K 12. Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = $600K – [(Common end + APIS end ) – (Common beg + APIS beg )] Cash flow to stockholders = $600K – [($860K + 6.9M) – ($885K + 7.7M)] Cash flow to stockholders = $600K – [$7.76M – 8.585M] = –$225K Note, APIS is the additional paid-in surplus. 13. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders = $80K – 225K = –$145K Cash flow from assets = –$145K = OCF – Change in NWC – Net capital spending = –$145K = OCF – (–$165K) – 760K Operating cash flow = –$145K – 165K + 760K = $450K B-8 SOLUTIONS Intermediate 14. To find the OCF, we first calculate net income. Income Statement Sales $162,000 Costs 93,000 Depreciation 8,400 Other expenses 5,100 EBIT $55,500 Interest 16,500 Taxable income $39,000 Taxes (34%) 14,820 Net income $24,180 Dividends $9,400 Additions to RE $14,780 a. OCF = EBIT + Depreciation – Taxes = $55,500 + 8,400 – 14,820 = $49,080 b. CFC = Interest – Net new LTD = $16,500 – (–6,400) = $22,900 Note that the net new long-term debt is negative because the company repaid part of its long- term debt. c. CFS = Dividends – Net new equity = $9,400 – 7,350 = $2,050 d. We know that CFA = CFC + CFS, so: CFA = $22,900 + 2,050 = $24,950 CFA is also equal to OCF – Net capital spending – Change in NWC. We already know OCF. Net capital spending is equal to: Net capital spending = Increase in NFA + Depreciation = $12,000 + 8,400 = $20,400 Now we can use: CFA = OCF – Net capital spending – Change in NWC $24,950 = $49,080 – 20,400 – Change in NWC Solving for the change in NWC gives $3,730, meaning the company increased its NWC by $3,730. 15. The solution to this question works the income statement backwards. Starting at the bottom: Net income = Dividends + Addition to ret. earnings = $1,200 + 4,300 = $5,500 [...]... interest obligations g Profit margin is the accounting measure of bottom-line profit per dollar of sales h Return on assets is a measure of bottom-line profit per dollar of total assets i Return on equity is a measure of bottom-line profit per dollar of equity j Price-earnings ratio reflects how much value per share the market places on a dollar of accounting earnings for a firm f 5 Common size financial... the degree of leverage for an equity investor of the firm; it measures the dollar worth of firm assets each equity dollar has a claim to e Long-term debt ratio measures the percentage of total firm capitalization funded by long-term debt B-16 SOLUTIONS Times interest earned ratio provides a relative measure of how well the firm’s operating earnings can cover current interest obligations g Profit margin... Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of inventory, generally the least liquid of the firm’s current assets b Cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid asset (cash) c Total asset turnover measures how much in sales is generated by each dollar of firm assets d Equity multiplier... is: Tobin’s Q = (Market value of equity + Book value of debt) / Book value of assets Tobin’s Q = ($860,000 + 126,769) / $245,626 Tobin’s Q = 4.02 Using the book value of debt implicitly assumes that the book value of debt is equal to the market value of debt This will be discussed in more detail in later chapters, but this assumption is generally true Using the book value of assets assumes that the assets... analysis involves comparing the financial ratios and operating performance of a particular firm to a set of peer group firms in the same industry or line of business Comparing a firm to its peers allows the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment activities are out of line with the norm, thereby providing some guidance on appropriate actions... with respect to the equity shareholders The Du Pont identity emphasizes the role of a firm’s profitability, asset utilization efficiency, and financial leverage in achieving an ROE figure For example, a firm with ROE of 20% would seem to be doing well, but this figure may be misleading if it were marginally profitable (low profit margin) and highly levered (high equity multiplier) If the firm’s margins... per share B-28 SOLUTIONS Market-to-book ratio Market-to-book ratio = Share price / Book value per share = $43 / $5.94 = 7.24 times PEG ratio PEG ratio = P/E ratio / Growth rate = 27.11 / 9 = 3.01 times 30 First, we will find the market value of the company’s equity, which is: Market value of equity = Shares × Share price Market value of equity = 20,000($43) = $860,000 The total book value of the company’s... set of firms whose performance the company in question would like to emulate The financial manager often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some managers are evaluated by how well they match the performance of an identified aspirant group 7 Return on equity is probably the most important accounting ratio that measures the bottom-line performance of. .. cheaper, assets If this is true, the book value can overstate the market value of the assets Finally, the book value of assets may not accurately represent the market value of the assets because of depreciation Depreciation is done according to some schedule, generally straight-line or MACRS Thus, the book value and market value can often diverge CHAPTER 4 LONG-TERM FINANCIAL PLANNING AND GROWTH Answers... case (assuming the firm is not 100% equity-financed) As the retention ratio is increased, the firm has more internal sources of funding, so the EFN will decline Conversely, as the retention ratio is decreased, the EFN will rise If the firm pays out all its earnings in the form of dividends, then the firm has no internal sources of funding (ignoring the effects of accounts payable); the internal growth . Solutions Manual Fundamentals of Corporate Finance 8 th edition Ross, Westerfield, and Jordan. maximizing the share price of the equity of the firm. 8. A primary market transaction. B-2 SOLUTIONS 9. In auction markets like the NYSE, brokers and agents meet at a physical location (the. this practice, the company (and shareholders) will lose value if the practice is discovered. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet.