End of Chapter Solutions Corporate Finance 8th edition Ross, Westerfield, and Jaffe Updated 11-21-2006 CHAPTER 1 INTRODUCTION TO CORPORATE FINANCE Answers to Concept Questions 1. 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. 2. 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. 3. 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. 4. 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?” 5. 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. 6. 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. SOLUTIONS B-2 7. 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. 8. 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. However, this may not always be the case. If the managers of the mutual fund or pension plan are not concerned with the interests of the investors, the agency problem could potentially remain the same, or even increase since there is the possibility of agency problems between the fund and its investors. 9. How much is too much? Who is worth more, Jack Welch 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. 10. Maximizing the current share price is the same as maximizing the future share price at any future period. The value of a share of stock depends on all of the future cash flows of company. Another way to look at this is that, barring large cash payments to shareholders, the expected price of the stock must be higher in the future than it is today. Who would buy a stock for $100 today when the share price in one year is expected to be $80? CHAPTER 2 ACCOUNTING STATEMENTS, TAXES, AND CASH FLOW Answers to Concepts Review and Critical Thinking Questions 1. True. Every asset can be converted to cash at some price. However, when we are referring to a liquid asset, the added assumption that the asset can be converted cash at or near market value is important. 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. The bottom line number shows the change in the cash balance on the balance sheet. As such, it is not a useful number for analyzing a company. 4. The major difference is the treatment of interest expense. The accounting statement of cash flows treats interest as an operating cash flow, while the financial cash flows treat interest as a financing cash flow. The logic of the accounting statement of cash flows is that since interest appears on the income statement, which shows the operations for the period, it is an operating cash flow. In reality, interest is a financing expense, which results from the company’s choice of debt and equity. We will have more to say about this in a later chapter. When comparing the two cash flow statements, the financial statement of cash flows is a more appropriate measure of the company’s performance because of its treatment of interest. 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 to have negative cash flow from assets, but it would be fairly ordinary for a start-up, so it depends. SOLUTIONS B-4 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 the company 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. 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 and principal, 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. 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 $5,000 CL $4,300 NFA 23,000 LTD 13,000 OE ?? TA $28,000 TL & OE $28,000 We know that total liabilities and owner’s equity (TL & OE) must equal total assets of $28,000. 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 = $28,000 –13,000 – 4,300 = $10,700 NWC = CA – CL = $5,000 – 4,300 = $700 2. The income statement for the company is: Income Statement Sales $527,000 Costs 280,000 Depreciation 38,000 EBIT $209,000 Interest 15,000 EBT $194,000 Taxes (35%) 67,900 Net income $126,100 CHAPTER 2 B- 5 One equation for net income is: Net income = Dividends + Addition to retained earnings Rearranging, we get: Addition to retained earnings = Net income – Dividends Addition to retained earnings = $126,100 – 48,000 Addition to retained earnings = $78,100 3. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current assets, we get: CA = NWC + CL = $900K + 2.2M = $3.1M The market value of current assets and fixed assets is given, so: Book value CA = $3.1M Market value CA = $2.8M Book value NFA = $4.0M Market value NFA = $3.2M Book value assets = $3.1M + 4.0M = $7.1M Market value assets = $2.8M + 3.2M = $6.0M 4. Taxes = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($273K – 100K) Taxes = $89,720 The average tax rate is the total tax paid divided by net income, so: Average tax rate = $89,720 / $273,000 Average tax rate = 32.86% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39%. 5. To calculate OCF, we first need the income statement: Income Statement Sales $13,500 Costs 5,400 Depreciation 1,200 EBIT $6,900 Interest 680 Taxable income $6,220 Taxes (35%) 2,177 Net income $4,043 OCF = EBIT + Depreciation – Taxes OCF = $6,900 + 1,200 – 2,177 OCF = $5,923 6. Net capital spending = NFAend – NFAbeg + Depreciation Net capital spending = $4,700,000 – 4,200,000 + 925,000 Net capital spending = $1,425,000 SOLUTIONS B-6 7. The long-term debt account will increase by $8 million, the amount of the new long-term debt issue. Since the company sold 10 million new shares of stock with a $1 par value, the common stock account will increase by $10 million. The capital surplus account will increase by $16 million, the value of the new stock sold above its par value. Since the company had a net income of $7 million, and paid $4 million in dividends, the addition to retained earnings was $3 million, which will increase the accumulated retained earnings account. So, the new long-term debt and stockholders’ equity portion of the balance sheet will be: Long-term debt $ 68,000,000 Total long-term debt $ 68,000,000 Shareholders equity Preferred stock $ 18,000,000 Common stock ($1 par value) 35,000,000 Accumulated retained earnings 92,000,000 Capital surplus 65,000,000 Total equity $ 210,000,000 Total Liabilities & Equity $ 278,000,000 8. Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = $340,000 – (LTDend – LTDbeg) Cash flow to creditors = $340,000 – ($3,100,000 – 2,800,000) Cash flow to creditors = $340,000 – 300,000 Cash flow to creditors = $40,000 9. Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = $600,000 – [(Commonend + APISend) – (Commonbeg + APISbeg)] Cash flow to stockholders = $600,000 – [($855,000 + 7,600,000) – ($820,000 + 6,800,000)] Cash flow to stockholders = $600,000 – ($8,455,000 – 7,620,000) Cash flow to stockholders = –$235,000 Note, APIS is the additional paid-in surplus. 10. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders = $40,000 – 235,000 = –$195,000 Cash flow from assets = –$195,000 = OCF – Change in NWC – Net capital spending –$195,000 = OCF – (–$165,000) – 760,000 Operating cash flow = –$195,000 + 165,000 + 760,000 Operating cash flow = $730,000 CHAPTER 2 B- 7 Intermediate 11. a. The accounting statement of cash flows explains the change in cash during the year. The accounting statement of cash flows will be: Statement of cash flows Operations Net income $125 Depreciation 75 Changes in other current assets (25) Total cash flow from operations $175 Investing activities Acquisition of fixed assets $(175) Total cash flow from investing activities $(175) Financing activities Proceeds of long-term debt $90 Current liabilities 10 Dividends (65) Total cash flow from financing activities $35 Change in cash (on balance sheet) $35 b. Change in NWC = NWCend – NWCbeg = (CAend – CLend) – (CAbeg – CLbeg) = [($45 + 145) – 70] – [($10 + 120) – 60) = $120 – 70 = $50 c. To find the cash flow generated by the firm’s assets, we need the operating cash flow, and the capital spending. So, calculating each of these, we find: Operating cash flow Net income $125 Depreciation 75 Operating cash flow $200 Note that we can calculate OCF in this manner since there are no taxes. SOLUTIONS B-8 Capital spending Ending fixed assets $250 Beginning fixed assets (150) Depreciation 75 Capital spending $175 Now we can calculate the cash flow generated by the firm’s assets, which is: Cash flow from assets Operating cash flow $200 Capital spending (175) Change in NWC (50) Cash flow from assets $(25) Notice that the accounting statement of cash flows shows a positive cash flow, but the financial cash flows show a negative cash flow. The cash flow generated by the firm’s assets is a better number for analyzing the firm’s performance. 12. With the information provided, the cash flows from the firm are the capital spending and the change in net working capital, so: Cash flows from the firm Capital spending $(3,000) Additions to NWC (1,000) Cash flows from the firm $(4,000) And the cash flows to the investors of the firm are: Cash flows to investors of the firm Sale of short-term debt $(7,000) Sale of long-term debt (18,000) Sale of common stock (2,000) Dividends paid 23,000 Cash flows to investors of the firm $(4,000) CHAPTER 2 B- 9 13. a. The interest expense for the company is the amount of debt times the interest rate on the debt. So, the income statement for the company is: Income Statement Sales $1,000,000 Cost of goods sold 300,000 Selling costs 200,000 Depreciation 100,000 EBIT $400,000 Interest 100,000 Taxable income $300,000 Taxes (35%) 105,000 Net income $195,000 b. And the operating cash flow is: OCF = EBIT + Depreciation – Taxes OCF = $400,000 + 100,000 – 105,000 OCF = $395,000 14. To find the OCF, we first calculate net income. Income Statement Sales $145,000 Costs 86,000 Depreciation 7,000 Other expenses 4,900 EBIT $47,100 Interest 15,000 Taxable income $32,100 Taxes (40%) 12,840 Net income $19,260 Dividends $8,700 Additions to RE $10,560 a. OCF = EBIT + Depreciation – Taxes OCF = $47,100 + 7,000 – 12,840 OCF = $41,260 b. CFC = Interest – Net new LTD CFC = $15,000 – (–$6,500) CFC = $21,500 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 CFS = $8,700 – 6,450 CFS = $2,250 SOLUTIONS B-10 d. We know that CFA = CFC + CFS, so: CFA = $21,500 + 2,250 = $23,750 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 Net capital spending = $5,000 + 7,000 Net capital spending = $12,000 Now we can use: CFA = OCF – Net capital spending – Change in NWC $23,750 = $41,260 – 12,000 – Change in NWC. Solving for the change in NWC gives $5,510, meaning the company increased its NWC by $5,510. 15. The solution to this question works the income statement backwards. Starting at the bottom: Net income = Dividends + Addition to ret. earnings Net income = $900 + 4,500 Net income = $5,400 Now, looking at the income statement: EBT – (EBT × Tax rate) = Net income Recognize that EBT × tax rate is simply the calculation for taxes. Solving this for EBT yields: EBT = NI / (1– Tax rate) EBT = $5,400 / 0.65 EBT = $8,308 Now we can calculate: EBIT = EBT + Interest EBIT = $8,308 + 1,600 EBIT = $9,908 The last step is to use: EBIT = Sales – Costs – Depreciation $9,908 = $29,000 – 13,000 – Depreciation Depreciation = $6,092 Solving for depreciation, we find that depreciation = $6,092 CHAPTER 2 B- 11 16. The balance sheet for the company looks like this: Balance Sheet Cash $175,000 Accounts payable $430,000 Accounts receivable 140,000 Notes payable 180,000 Inventory 265,000 Current liabilities $610,000 Current assets $580,000 Long-term debt 1,430,000 Total liabilities $2,040,000 Tangible net fixed assets 2,900,000 Intangible net fixed assets 720,000 Common stock ?? Accumulated ret. earnings 1,240,000 Total assets $4,200,000 Total liab. & owners’ equity $4,200,000 Total liabilities and owners’ equity is: TL & OE = CL + LTD + Common stock Solving for this equation for equity gives us: Common stock = $4,200,000 – 1,240,000 – 2,040,000 Common stock = $920,000 17. The market value of shareholders’ equity cannot be zero. A negative market value in this case would imply that the company would pay you to own the stock. The market value of shareholders’ equity can be stated as: Shareholders’ equity = Max [(TA – TL), 0]. So, if TA is $4,300, equity is equal to $800, and if TA is $3,200, equity is equal to $0. We should note here that while the market value of equity cannot be negative, the book value of shareholders’ equity can be negative. 18. a. Taxes Growth = 0.15($50K) + 0.25($25K) + 0.34($10K) = $17,150 Taxes Income = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($235K) + 0.34($8.165M) = $2,890,000 b. Each firm has a marginal tax rate of 34% on the next $10,000 of taxable income, despite their different average tax rates, so both firms will pay an additional $3,400 in taxes. 19. Income Statement Sales $850,000 COGS 630,000 A&S expenses 120,000 Depreciation 130,000 EBIT ($30,000) Interest 85,000 Taxable income ($115,000) Taxes (35%) 0 a. Net income ($115,000) SOLUTIONS B-12 b. OCF = EBIT + Depreciation – Taxes OCF = ($30,000) + 130,000 – 0 OCF = $100,000 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 non-cash expense and interest is a financing expense, not an operating expense. 20. A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficient cash flow to make the dividend payments. Change in NWC = Net capital spending = Net new equity = 0. (Given) Cash flow from assets = OCF – Change in NWC – Net capital spending Cash flow from assets = $100,000 – 0 – 0 = $100,000 Cash flow to stockholders = Dividends – Net new equity Cash flow to stockholders = $30,000 – 0 = $30,000 Cash flow to creditors = Cash flow from assets – Cash flow to stockholders Cash flow to creditors = $100,000 – 30,000 Cash flow to creditors = $70,000 Cash flow to creditors is also: Cash flow to creditors = Interest – Net new LTD So: Net new LTD = Interest – Cash flow to creditors Net new LTD = $85,000 – 70,000 Net new LTD = $15,000 21. a. The income statement is: Income Statement Sales $12,800 Cost of good sold 10,400 Depreciation 1,900 EBIT $ 500 Interest 450 Taxable income $ 50 Taxes (34%) 17 Net income $33 b. OCF = EBIT + Depreciation – Taxes OCF = $500 + 1,900 – 17 OCF = $2,383 CHAPTER 2 B- 13 c. Change in NWC = NWCend – NWCbeg = (CAend – CLend) – (CAbeg – CLbeg) = ($3,850 – 2,100) – ($3,200 – 1,800) = $1,750 – 1,400 = $350 Net capital spending = NFAend – NFAbeg + Depreciation = $9,700 – 9,100 + 1,900 = $2,500 CFA = OCF – Change in NWC – Net capital spending = $2,383 – 350 – 2,500 = –$467 The cash flow from assets can be positive or negative, since it represents whether the firm raised funds or distributed funds on a net basis. In this problem, even though net income and OCF are positive, the firm invested heavily in both fixed assets and net working capital; it had to raise a net $467 in funds from its stockholders and creditors to make these investments. d. Cash flow to creditors = Interest – Net new LTD = $450 – 0 = $450 Cash flow to stockholders = Cash flow from assets – Cash flow to creditors = –$467 – 450 = –$917 We can also calculate the cash flow to stockholders as: Cash flow to stockholders = Dividends – Net new equity Solving for net new equity, we get: Net new equity = $500 – (–917) = $1,417 The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $350 in new net working capital and $2,500 in new fixed assets. The firm had to raise $467 from its stakeholders to support this new investment. It accomplished this by raising $1,417 in the form of new equity. After paying out $500 of this in the form of dividends to shareholders and $450 in the form of interest to creditors, $467 was left to meet the firm’s cash flow needs for investment. 22. a. Total assets 2006 = $650 + 2,900 = $3,550 Total liabilities 2006 = $265 + 1,500 = $1,765 Owners’ equity 2006 = $3,550 – 1,765 = $1,785 Total assets 2007 = $705 + 3,400 = $4,105 Total liabilities 2007 = $290 + 1,720 = $2,010 Owners’ equity 2007 = $4,105 – 2,010 = $2,095