Essentials Of Corporate Finance International Edition

Preview text End of Chapter Solutions Essentials of Corporate Finance 6th edition Ross, Westerfield, and Jordan Updated CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Answers to Concepts Review and Critical Thinking Questions 1. Capital budgeting (deciding on 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 credit collection policy with its customers). 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. 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, and unlimited life. The office and the office are the two primary organizational groups that report directly to the chief financial officer. The office handles cost and financial accounting, tax management, and management information systems. The office is responsible for cash and credit management, capital budgeting, and financial planning. Therefore, the study of corporate finance is concentrated within the functions of the office. To maximize the current market value (share price) of the equity of the firm (whether publicly traded or not).

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 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 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. A primary market transaction.

In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to buy and sell their assets. Dealer markets like Nasdaq represent dealers operating in SOLUTIONS 14. How much is too much? Who is worth more, Steve Jobs 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 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.

The biggest reason that a company would is because of the increased audit costs associated with compliance. A company should always do a analysis, and it may be the case that the costs of complying with Sarbox outweigh the benefits. Of course, the company could always be trying to hide financial issues of the company! This is also one of the costs of going dark: Investors surely believe that some companies are going dark to avoid the increased scrutiny from SarbOx. This taints other companies that go dark just to avoid compliance costs. This is similar to the lemon problem with used automobiles: Buyers tend to underpay because they know a certain percentage of used cars are lemons.

So, investors will tend to pay less for the company stock than they otherwise would. It is important to note that even if the company delists, its stock is still likely traded, but on the market pink sheets rather than on an organized exchange.

This adds another cost since the stock is likely to be less liquid now. All else the same, investors pay less for an asset with less liquidity. Overall, the cost to the company is likely a reduced market value. Whether delisting is good or bad for investors depends on the individual circumstances of the company. It is also important to remember that there are already many small companies that file only limited financial information already.

CHAPTER 2 WORKING WITH FINANCIAL STATEMENTS 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.

Desirable for firms to have high liquidity so that they can more safely meet creditor demands. However, liquidity also has an opportunity cost. Firms generally reap higher returns investing in illiquid, productive assets. Up to the financial management staff to find a reasonable compromise between these opposing needs. The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be 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 the way accountants have chosen to do it. 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.

Essentials Of Corporate Finance 7th

Thus, there is a tradeoff between relevance (market values) and objectivity (book values). Depreciation is a 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 a financing cost, not an operating cost. Market values can never be negative. Imagine a share of stock selling for This would mean that if you placed an order for 100 shares, you would get the stock along with a check for 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. For a successful company that is rapidly expanding, capital outlays would typically 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. Probably not a good sign for an established company, but it would be fairly ordinary for a startup, so it depends.

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 NWC would have this effect. Negative net capital spending would mean more assets were liquidated than purchased.

Essentials Of Corporate Finance Quizlet

CHAPTER 2 equity Total liabilities equity Current liabilities debt equity 1,600 6,100 equity Net working capital is current assets minus current liabilities, so: NWC Current assets Current liabilities NWC 1,600 NWC 2. The income statement starts with revenues and subtracts costs to arrive at EBIT.

We then subtract out interest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get: Income Statement Sales Costs Depreciation EBIT Interest Taxable income Taxes Net income 3.

85,050 The dividends paid plus addition to retained earnings must equal net income, so: Net income Dividends Addition to retained earnings Addition to retained earnings Addition to retained earnings 4. Earnings per share is the net income divided the shares outstanding, so: EPS Net income Shares outstanding EPS EPS per share And dividends per share are the total dividends paid divided the shares outstanding, so: DPS Dividends Shares outstanding DPS DPS per share 5.

To find the book value of assets, we first need to find the book value of current assets. We are given the NWC.

NWC is the difference between current assets and current liabilities, so we can use this relationship to find the book value of current assets. Doing so, we find: NWC Current assets Current liabilities Current assets SOLUTIONS Now we can construct the book value of assets. Doing so, we get: Book value of assets Current assets Fixed assets Total assets All of the information necessary to calculate the market value of assets is given, so: Market value of assets Current assets Fixed assets Total assets 6. Using Table 2.3, we can see the marginal tax schedule.

The first of income is taxed at 15 percent, the next is taxed at 25 percent, the next is taxed at 34 percent, and the next is taxed at 39 percent. So, the total taxes for the company will be: Taxes Taxes 7.

The average tax rate is the total taxes paid divided net income, so: Average tax rate Total tax Net income Average tax rate Average tax rate.3368 or The marginal tax rate is the tax rate on the next dollar of income. The company has net income of and the 39 percent tax bracket is applicable to a net income of so the marginal tax rate is 39 percent. To calculate the OCF, we first need to construct an income statement. The income statement starts with revenues and subtracts costs to arrive at EBIT.

We then subtract out interest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get: Income Statement Sales Costs Depreciation EBIT Interest Taxable income Taxes Net income 5,930 1,940 1,460 2,527 SOLUTIONS We also know that cash flow from assets is equal to the operating cash flow minus the change in net working capital and the net capital spending. We can use this relationship to find the operating cash flow. Doing so, we find: Cash flow from assets OCF Change in NWC Net capital spending OCF OCF OCF Intermediate 14. To calculate the OCF, we first need to construct an income statement. The income statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract out interest to get taxable income, and then subtract taxes to arrive at net income.

Doing so, we get: Income Statement Sales Costs 71,500 Other Expenses 4,100 Depreciation 10,100 EBIT Interest 7,900 Taxable income Taxes 17,760 Net income Dividends Addition to retained earnings 21,240 Dividends paid plus addition to retained earnings must equal net income, so: Net income Dividends Addition to retained earnings Addition to retained earnings 5,400 Addition to retained earnings So, the operating cash flow is: OCF EBIT Depreciation Taxes OCF 10,100 17,760 OCF b. The cash flow to creditors is the interest paid, minus any new borrowing.

Since the company redeemed debt, the new borrowing is negative. So, the cash flow to creditors is: Cash flow to creditors Interest paid Net new borrowing Cash flow to creditors Cash flow to creditors CHAPTER 2 c. The cash flow to stockholders is the dividends paid minus any new equity. So, the cash flow to stockholders is: Cash flow to stockholders Dividends paid Net new equity Cash flow to stockholders 2,500 Cash flow to stockholders d. In this case, to find the addition to NWC, we need to find the cash flow from assets.

We can then use the cash flow from assets equation to find the change in NWC. We know that cash flow from assets is equal to cash flow to creditors plus cash flow to stockholders. So, cash flow from assets is: Cash flow from assets Cash flow to creditors Cash flow to stockholders Cash flow from assets 2,900 Cash flow from assets Net capital spending is equal to depreciation plus the increase in fixed assets, so: Net capital spending Depreciation Increase in fixed assets Net capital spending 17,400 Net capital spending Now we can use the cash flow from assets equation to find the change in NWC. Doing so, we find: Cash flow from assets OCF Change in NWC Net capital spending Change in NWC Change in NWC 15. Here we need to work the income statement backward. Starting with net income, we know that net income is: Net income Dividends Addition to retained earnings Net income 2,100 Net income Net income is also the taxable income, minus the taxable income times the tax rate, or: Net income Taxable income (Taxable income)(Tax rate) Net income Taxable income(1 Tax rate) We can rearrange this equation and solve for the taxable income as: Taxable income Net income (1 Tax rate) Taxable income (1.40) Taxable income CHAPTER 2 18. Using Table 2.3, we can see the marginal tax schedule.

For Corporation Growth, the first of income is taxed at 15 percent, the next is taxed at 25 percent, and the next is taxed at 34 percent. So, the total taxes for the company will be: TaxesGrowth TaxesGrowth For Corporation Income, the first of income is taxed at 15 percent, the next is taxed at 25 percent, the next is taxed at 34 percent, the next is taxed at 39 percent, and the next is taxed at 34 percent. So, the total taxes for the company will be: TaxesIncome TaxesIncome b. The marginal tax rate is the tax rate on the next of earnings. Each firm has a marginal tax rate of on the next of taxable income, despite their different average tax rates, so both firms will pay an additional in taxes. The income statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract interest to get taxable income, and then subtract taxes to arrive at net income.

Doing so, we get: Income Statement Sales Cost of goods sold Other expenses Depreciation EBIT Interest Taxable income Taxes 0 Net income The taxes are zero since we are ignoring any carryback or carryforward provisions. The operating cash flow for the year was: OCF EBIT Depreciation Taxes OCF 0 OCF c.

Net income was negative because of the tax deductibility of depreciation and interest expense. However, the actual cash flow from operations was positive because depreciation is a expense and interest is a financing, not an operating, expense. SOLUTIONS 20. A firm can still pay out dividends if net income is it just has to be sure there is sufficient cash flow to make the dividend payments. The assumptions made in the question are: Change in NWC Net capital spending Net new equity 0 To find the new debt, we first need to find the cash flow from assets. The cash flow from assets is: Cash flow from assets OCF Change in NWC Net capital spending Cash flow from assets 0 0 Cash flow from assets We can also find the cash flow to stockholders, which is: Cash flow to stockholders Dividends Net new equity Cash flow to stockholders 0 Cash flow to stockholders Now we can use the cash flow from assets equation to find the cash flow to creditors.

Doing so, we get: Cash flow from assets Cash flow to creditors Cash flow to stockholders Cash flow to creditors Cash flow to creditors Now we can use the cash flow to creditors equation to find: Cash flow to creditors Interest Net new debt Net new debt Net new debt 21. To calculate the OCF, we first need to construct an income statement. The income statement starts with revenues and subtracts costs to arrive at EBIT. We then subtract out interest to get taxable income, and then subtract taxes to arrive at net income. Doing so, we get: Income Statement Sales Cost of goods sold Depreciation EBIT Interest Taxable income Taxes Net income 13,610 2,420 2,420 260 2,160 756 1,404 SOLUTIONS The firm had positive earnings in an accounting sense (NI 0) and had positive cash flow from operations.

The firm invested in new net working capital and in new fixed assets. The firm had to raise from its stakeholders to support this new investment.

It accomplished this raising in the form of new equity. After paying out in the form of dividends to shareholders and in the form of interest to creditors, was left to just meet the cash flow needs for investment. To calculate equity, we first need total liabilities and equity. From the balance sheet relationship we know that this is equal to total assets. We are given the necessary information to calculate total assets. Total assets are current assets plus fixed assets, so: Total assets Current assets Fixed assets Total liabilities and equity For 2007, we get: Total assets 9,504 Total assets Now, we can solve for equity as: Total liabilities and equity Current liabilities debt equity 5,184 equity equity For 2008, we get: Total assets 9,936 Total assets Now we can solve for equity as: Total liabilities and equity Current liabilities debt equity 6,048 equity equity b.

The change in net working capital was: Change in NWC NWCend NWCbeg Change in NWC (CAend CLend) (CAbeg CLbeg) Change in NWC 1,301) 885) Change in NWC c. To find the amount of fixed assets the company sold, we need to find the net capital spending, The net capital spending was: Net capital spending NFAend NFAbeg Depreciation Net capital spending 9,504 2,590 Net capital spending CHAPTER 2 To find the fixed assets sold, we can also calculate net capital spending as: Net capital spending Fixed assets bought Fixed assets sold Fixed assets sold Fixed assets sold To calculate the cash flow from assets, we first need to calculate the operating cash flow. For the operating cash flow, we need the income statement. So, the income statement for the year is: Income Statement Sales Costs Depreciation EBIT Interest Taxable income Taxes Net income 15,380 2,590 480 4,277 7,943 Now we can calculate the operating cash flow which is: OCF EBIT Depreciation Taxes OCF 2,590 4,277 And the cash flow from assets is: Cash flow from assets OCF Change in NWC Net capital spending. Cash flow from assets 3,022 Cash flow from assets d. To find the cash flow to creditors, we first need to find the net new borrowing. The net new borrowing is the difference between the ending debt and the beginning debt, so: Net new borrowing LTDEnding Net new borrowing 5,184 Net new borrowing So, the cash flow to creditors is: Cash flow to creditors Interest Net new borrowing Cash flow to creditors 864 CHAPTER 2 The cash flow to stockholders is a little trickier in this problem.

First, we need to calculate the new equity sold. The equity balance increased during the year. The only way to increase the equity balance is to add addition to retained earnings or sell equity. To calculate the new equity sold, we can use the following equation: New equity Ending equity Beginning equity Addition to retained earnings New equity 287,152 63,214 New equity What happened was the equity account increased of this came from addition to retained earnings, so the remainder must have been the sale of new equity. Now we can calculate the cash flow to stockholders as: Cash flow to stockholders Dividends paid Net new equity Cash flow to stockholders 6,499 Cash flow to stockholders The company paid to creditors and to stockholders. Finally, the cash flow identity is: Cash flow from assets Cash flow to creditors Cash flow to stockholders The cash flow identity balances, which is what we expect. Challenge 24.

Net capital spending NFAend NFAbeg Depreciation (NFAend NFAbeg) (Depreciation ADbeg) ADbeg (NFAend ADend ADbeg (NFAend ADend) (NFAbeg ADbeg) FAend FAbeg 25. The tax bubble causes average tax rates to catch up to marginal tax rates, thus eliminating the tax advantage of low marginal rates for high income corporations. Taxes Average tax rate The marginal tax rate on the next dollar of income is 34 percent.

For corporate taxable income levels of to average tax rates are equal to marginal tax rates. Taxes Average tax rate SOLUTIONS The marginal tax rate on the next dollar of income is 35 percent. For corporate taxable income levels over average tax rates are again equal to marginal tax rates. At the end of the the marginal tax rate on the next dollar should equal the average tax rate on all preceding dollars. Since the upper threshold of the bubble bracket is now the marginal tax rate on dollar should be 34 percent, and the total tax paid on the first should be So, we get: Taxes X X 22.25K.