Solution Manual For Principles Of Managerial Finance 13Th Edition By Lawrence J. Gitman

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Solution Manual For Principles Of Managerial Finance 13Th Edition By Lawrence J. Gitman

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COMPLETE TEXT BOOK SOLUTION WITH ANSWERS

 

 

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SAMPLE QUESTIONS

 

 

Chapter 1 The Role of Managerial Finance

 

Opener-in-Review

In the chapter opener you read about Facebook and its founders reluctance to

go public. If Zuckerberg is expected to remain the CEO of Facebook after the

IPO, why would he be worried about going public?

 

Self-Test Problem (

ST11 Emphasis on Cash Flows Worldwide Rugs is a rug importer located in the United

States that resells its import products to local retailers. Last year Worldwide Rugs

imported $2.5 million worth of rugs from around the world, all of which were paid

for prior to shipping. On receipt of the rugs, the importer immediately resold them

to local retailers for $3 million. To allow its retail clients time to resell the rugs,

Worldwide Rugs sells to retailers on credit. Prior to the end of its business year,

Worldwide Rugs collected 85% of its outstanding accounts receivable.

  1. What is the accounting profit that Worldwide Rugs generated for the year?
  2. Did Worldwide Rugs have a successful year from an accounting perspective?
  3. What is the financial cash flow that Worldwide Rugs generated for the year?
  4. Did Worldwide Rugs have a successful year from a financial perspective?
  5. If the current pattern persists, what is your expectation for the future success of

Worldwide Rugs?

 

Warm-Up Exercises

E11 Ann and Jack have been partners for several years. Their firm, A & J Tax

Preparation, has been very successful, as the pair agree on most business-related

questions. One disagreement, however, concerns the legal form of their business.

Ann has tried for the past 2 years to get Jack to agree to incorporate. She believes

that there is no downside to incorporating and sees only benefits. Jack strongly

disagrees; he thinks that the business should remain a partnership forever.

First, take Anns side, and explain the positive side to incorporating the business.

Next, take Jacks side, and state the advantages to remaining a partnership.

Lastly, what information would you want if you were asked to make the decision for

Ann and Jack?

E12 The end-of-year parties at Yearling, Inc., are known for their extravagance.

Management provides the best food and entertainment to thank the employees for

their hard work. During the planning for this years bash, a disagreement broke out

between the treasurers staff and the controllers staff. The treasurers staff contended

that the firm was running low on cash and might have trouble paying its bills over

the coming months; they requested that cuts be made to the budget for the party.

The controllers staff felt that any cuts were unwarranted as the firm continued to be

very profitable.

Can both sides be right? Explain your answer.

E13 You have been made treasurer for a day at AIMCO, Inc. AIMCO develops technology

for video conferencing. A manager of the satellite division has asked you to

authorize a capital expenditure in the amount of $10,000. The manager states that

this expenditure is necessary to continue a long-running project designed to use

satellites to allow video conferencing anywhere on the planet. The manager admits

that the satellite concept has been surpassed by recent technological advances in

telephony, but he feels that AIMCO should continue the project. His reasoning is

based on the fact that $2.5 million has already been spent over the past 15 years on

this project. Although the project has little chance to be viable, the manager believes

it would be a shame to waste the money and time already spent.

Use marginal costbenefit analysis to make your decision regarding whether you

should authorize the $10,000 expenditure to continue the project.

E14 Recently, some branches of Donut Shop, Inc., have dropped the practice of allowing

employees to accept tips. Customers who once said, Keep the change, now have

to get used to waiting for their nickels. Management even instituted a policy of

requiring that the change be thrown out if a customer drives off without it. As a frequent

customer who gets coffee and doughnuts for the office, you notice that the

lines are longer and that more mistakes are being made in your order.

Explain why tips could be viewed as similar to stock options and why the delays

and incorrect orders could represent a case of agency costs. If tips are gone forever,

how could Donut Shop reduce these agency costs?

 

Problems

All problems are available in .

P11 Liability comparisons Merideth Harper has invested $25,000 in Southwest

Development Company. The firm has recently declared bankruptcy and has $60,000

in unpaid debts. Explain the nature of payments, if any, by Ms. Harper in each of

the following situations.

  1. Southwest Development Company is a sole proprietorship owned by Ms. Harper.
  2. Southwest Development Company is a 5050 partnership of Ms. Harper and

Christopher Black.

  1. Southwest Development Company is a corporation.

P12 Accrual income versus cash flow for a period Thomas Book Sales, Inc., supplies

textbooks to college and university bookstores. The books are shipped with a proviso

that they must be paid for within 30 days but can be returned for a full refund

credit within 90 days. In 2009, Thomas shipped and billed book titles totaling

$760,000. Collections, net of return credits, during the year totaled $690,000. The

company spent $300,000 acquiring the books that it shipped.

  1. Using accrual accounting and the preceding values, show the firms net profit for

the past year.

  1. Using cash accounting and the preceding values, show the firms net cash flow

for the past year.

  1. Which of these statements is more useful to the financial manager? Why?

Personal Finance Problem

P13 Cash flows It is typical for Jane to plan, monitor, and assess her financial position

using cash flows over a given period, typically a month. Jane has a savings account,

and her bank loans money at 6% per year while it offers short-term investment rates

of 5%. Janes cash flows during August were as follows:

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Item Cash inflow Cash outflow

Clothes $1,000

Interest received $ 450

Dining out 500

Groceries 800

Salary 4,500

Auto payment 355

Utilities 280

Mortgage 1,200

Gas 222 a. Determine Janes total cash inflows and cash outflows.

  1. Determine the net cash flow for the month of August.
  2. If there is a shortage, what are a few options open to Jane?
  3. If there is a surplus, what would be a prudent strategy for her to follow?

P14 Marginal costbenefit analysis and the goal of the firm Ken Allen, capital budgeting

analyst for Bally Gears, Inc., has been asked to evaluate a proposal. The manager

of the automotive division believes that replacing the robotics used on the

heavy truck gear line will produce total benefits of $560,000 (in todays dollars)

over the next 5 years. The existing robotics would produce benefits of $400,000

(also in todays dollars) over that same time period. An initial cash investment of

$220,000 would be required to install the new equipment. The manager estimates

that the existing robotics can be sold for $70,000. Show how Ken will apply

marginal costbenefit analysis techniques to determine the following:

  1. The marginal (added) benefits of the proposed new robotics.
  2. The marginal (added) cost of the proposed new robotics.
  3. The net benefit of the proposed new robotics.
  4. What should Ken Allen recommend that the company do? Why?
  5. What factors besides the costs and benefits should be considered before the final

decision is made?

P15 Identifying agency problems, costs, and resolutions Explain why each of the following

situations is an agency problem and what costs to the firm might result from it.

Suggest how the problem might be dealt with short of firing the individual(s) involved.

  1. The front desk receptionist routinely takes an extra 20 minutes of lunch time to

run personal errands.

  1. Division managers are padding cost estimates so as to show short-term efficiency

gains when the costs come in lower than the estimates.

  1. The firms chief executive officer has had secret talks with a competitor about the

possibility of a merger in which she would become the CEO of the combined

firms.

  1. A branch manager lays off experienced full-time employees and staffs customer

service positions with part-time or temporary workers to lower employment costs

and raise this years branch profit. The managers bonus is based on profitability.

P16 ETHICS PROBLEM What does it mean to say that managers should maximize

shareholder wealth subject to ethical constraints? What ethical considerations

might enter into decisions that result in cash flow and stock price effects that are less

than they might otherwise have been?

 

 

Chapter 2 The Financial Market Environment

Opener-in-Review

In the chapter opener you read about JPMorgans tumultuous ride through the

2008 financial crisis, and in the chapter itself you learned about capital market

efficiency. What role do you think market efficiency (or inefficiency) played in

the 10 percent fall of JPMorgans share price in a single day?

Self-Test Problem

 

ST21 Corporate taxes Montgomery Enterprises, Inc., had operating earnings of

$280,000 for the year just ended. During the year the firm sold stock that it held in

another company for $180,000, which was $30,000 above its original purchase

price of $150,000, paid 1 year earlier.

  1. What is the amount, if any, of capital gains realized during the year?
  2. How much total taxable income did the firm earn during the year?
  3. Use the corporate tax rate schedule given in Table 2.1 to calculate the firms total

taxes due.

  1. Calculate both the average tax rate and the marginal tax rate on the basis of

your findings.

LG 6

Warm-Up Exercises All problems are available in .

E21 What does it mean to say that individuals as a group are net suppliers of funds for

financial institutions? What do you think the consequences might be in financial

markets if individuals consumed more of their incomes and thereby reduced the

supply of funds available to financial institutions?

E22 You are the chief financial officer (CFO) of Gaga Enterprises, an edgy fashion design

firm. Your firm needs $10 million to expand production. How do you think the

process of raising this money will vary if you raise it with the help of a financial

institution versus raising it directly in the financial markets?

E23 For what kinds of needs do you a think firm would issue securities in the money

market versus the capital market?

E24 Your broker calls to offer you the investment opportunity of a lifetime, the chance to

invest in mortgage-backed securities. The broker explains that these securities are

entitled to the principal and interest payments received from a pool of residential

mortgages. List some of the questions you would ask your broker to assess the risk

of this investment opportunity.

E25 Reston, Inc., has asked your corporation, Pruro, Inc., for financial assistance. As a

long-time customer of Reston, your firm has decided to give that assistance. The

question you are debating is whether Pruro should take Reston stock with a 5%

annual dividend or a promissory note paying 5% annual interest.

Assuming payment is guaranteed and the dollar amounts for annual interest and

dividend income are identical, which option will result in greater after-tax income

for the first year?

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LG 2

Problems All problems are available in .

P21 Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclusive

distributor of a major line of sporting goods. During 2010 the firm earned $92,500

before taxes.

  1. Calculate the firms tax liability using the corporate tax rate schedule given in

Table 2.1.

  1. How much are Tantor Supplys 2010 after-tax earnings?
  2. What was the firms average tax rate, based on your findings in part a?
  3. What is the firms marginal tax rate, based on your findings in part a?

P22 Average corporate tax rates Using the corporate tax rate schedule given in

Table 2.1, perform the following:

  1. Calculate the tax liability, after-tax earnings, and average tax rates for the following

levels of corporate earnings before taxes: $10,000; $80,000; $300,000;

$500,000; $1.5 million; $10 million; and $20 million.

  1. Plot the average tax rates (measured on the y axis) against the pretax income

levels (measured on the x axis). What generalization can be made concerning the

relationship between these variables?

P23 Marginal corporate tax rates Using the corporate tax rate schedule given in

Table 2.1, perform the following:

  1. Find the marginal tax rate for the following levels of corporate earnings before taxes:

$15,000; $60,000; $90,000; $200,000; $400,000; $1 million; and $20 million.

  1. Plot the marginal tax rates (measured on the y axis) against the pretax income

levels (measured on the x axis). Explain the relationship between these variables.

P24 Interest versus dividend income During the year just ended, Shering Distributors,

Inc., had pretax earnings from operations of $490,000. In addition, during the year

it received $20,000 in income from interest on bonds it held in Zig Manufacturing

and received $20,000 in income from dividends on its 5% common stock holding in

Tank Industries, Inc. Shering is in the 40% tax bracket and is eligible for a 70%

dividend exclusion on its Tank Industries stock.

  1. Calculate the firms tax on its operating earnings only.
  2. Find the tax and the after-tax amount attributable to the interest income from

Zig Manufacturing bonds.

  1. Find the tax and the after-tax amount attributable to the dividend income from

the Tank Industries, Inc., common stock.

  1. Compare, contrast, and discuss the after-tax amounts resulting from the interest

income and dividend income calculated in parts b and c.

  1. What is the firms total tax liability for the year?

P25 Interest versus dividend expense Michaels Corporation expects earnings before

interest and taxes to be $40,000 for the current period. Assuming an ordinary tax

rate of 40%, compute the firms earnings after taxes and earnings available for

common stockholders (earnings after taxes and preferred stock dividends, if any)

under the following conditions:

  1. The firm pays $10,000 in interest.
  2. The firm pays $10,000 in preferred stock dividends.

P26 Capital gains taxes Perkins Manufacturing is considering the sale of two nondepreciable

assets, X and Y. Asset X was purchased for $2,000 and will be sold today for

$2,250. Asset Y was purchased for $30,000 and will be sold today for $35,000. The

firm is subject to a 40% tax rate on capital gains.

  1. Calculate the amount of capital gain, if any, realized on each of the assets.
  2. Calculate the tax on the sale of each asset.

P27 Capital gains taxes The following table contains purchase and sale prices for the

nondepreciable capital assets of a major corporation. The firm paid taxes of 40% on

capital gains.

 

 

Chapter 3 Financial Statements and Ratio Analysis

 

Opener-in-Review

In the chapter opener you read about how financial analysts gave Abercrombies

stock a relatively positive outlook based on a current ratio of 2.79, a quick ratio

of 1.79, and a receivables collection period of 43 days. Based on what you

learned in this chapter, do you agree with the analysts assessment? Explain why

or why not.

Self-Test Problems (Solutions in Appendix)

ST31 Ratio formulas and interpretations Without referring to the text, indicate for each

of the following ratios the formula for calculating it and the kinds of problems, if

any, the firm may have if that ratio is too high relative to the industry average. What

if the ratio is too low relative to the industry average? Create a table similar to the

one that follows and fill in the empty blocks.

LG 3 LG 4 LG 5

LG 3 LG 4 LG 5 ST32 Balance sheet completion using ratios Complete the 2012 balance sheet for OKeefe

Industries using the information that follows it.

The following financial data for 2012 are also available:

  1. Sales totaled $1,800,000.
  2. The gross profit margin was 25%.
  3. Inventory turnover was 6.0.
  4. There are 365 days in the year.
  5. The average collection period was 40 days.
  6. The current ratio was 1.60.
  7. The total asset turnover ratio was 1.20.
  8. The debt ratio was 60%.

CHAPTER 3 Financial Statements and Ratio Analysis 93

Warm-Up Exercises All problems are available in .

E31 You are a summer intern at the office of a local tax preparer. To test your basic

knowledge of financial statements, your manager, who graduated from your alma

mater 2 years ago, gives you the following list of accounts and asks you to prepare a

simple income statement using those accounts.

LG 1

Accounts ($000,000)

Depreciation 25

General and administrative expenses 22

Sales 345

Sales expenses 18

Cost of goods sold 255

Lease expense 4

Interest expense 3

  1. Arrange the accounts into a well-labeled income statement. Make sure you label

and solve for gross profit, operating profit, and net profit before taxes.

  1. Using a 35% tax rate, calculate taxes paid and net profit after taxes.
  2. Assuming a dividend of $1.10 per share with 4.25 million shares outstanding,

calculate EPS and additions to retained earnings.

E32 Explain why the income statement can also be called a profit-and-loss statement.

What exactly does the word balance mean in the title of the balance sheet? Why do

we balance the two halves?

E33 Cooper Industries, Inc., began 2012 with retained earnings of $25.32 million.

During the year it paid four quarterly dividends of $0.35 per share to 2.75 million

common stockholders. Preferred stockholders, holding 500,000 shares, were paid

two semiannual dividends of $0.75 per share. The firm had a net profit after taxes

of $5.15 million. Prepare the statement of retained earnings for the year ended

December 31, 2012.

E34 Bluestone Metals, Inc., is a metal fabrication firm that manufactures prefabricated

metal parts for customers in a variety of industries. The firms motto is If you need

it, we can make it. The CEO of Bluestone recently held a board meeting during

which he extolled the virtues of the corporation. The company, he stated confidently,

P32 Financial statement account identification Mark each of the accounts listed in the

following table as follows:

  1. In column (1), indicate in which statementincome statement (IS) or balance

sheet (BS)the account belongs.

  1. In column (2), indicate whether the account is a current asset (CA), current liability

(CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue (R), or

stockholders equity (SE).

Problems

P31 Reviewing basic financial statements The income statement for the year ended

December 31, 2012, the balance sheets for December 31, 2012 and 2011, and the

statement of retained earnings for the year ended December 31, 2012, for Technica,

Inc., are given below and on the following page. Briefly discuss the form and informational

content of each of these statements.

P32 Financial statement account identification Mark each of the accounts listed in the

following table as follows:

  1. In column (1), indicate in which statementincome statement (IS) or balance

sheet (BS)the account belongs.

  1. In column (2), indicate whether the account is a current asset (CA), current liability

(CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue (R), or

stockholders equity (SE).

P33 Income statement preparation On December 31, 2012, Cathy Chen, a selfemployed

certified public accountant (CPA), completed her first full year in business.

During the year, she billed $360,000 for her accounting services. She had two

employees, a bookkeeper and a clerical assistant. In addition to her monthly salary

of $8,000, Ms. Chen paid annual salaries of $48,000 and $36,000 to the bookkeeper

and the clerical assistant, respectively. Employment taxes and benefit costs

for Ms. Chen and her employees totaled $34,600 for the year. Expenses for office

supplies, including postage, totaled $10,400 for the year. In addition, Ms. Chen

spent $17,000 during the year on tax-deductible travel and entertainment associated

with client visits and new business development. Lease payments for the office space

rented (a tax-deductible expense) were $2,700 per month. Depreciation expense on

the office furniture and fixtures was $15,600 for the year. During the year, Ms. Chen

paid interest of $15,000 on the $120,000 borrowed to start the business. She paid

an average tax rate of 30% during 2012.

  1. Prepare an income statement for Cathy Chen, CPA, for the year ended

December 31, 2012.

  1. Evaluate her 2012 financial performance.

P34 Income statement preparation Adam and Arin Adams have collected their personal

income and expense information and have asked you to put together an income and

expense statement for the year ended December 31, 2012. The following information

is received from the Adams family.

CHAPTER 3 Financial Statements and Ratio Analysis 97

LG 1

Adams salary $45,000 Utilities $ 3,200

Arins salary 30,000 Groceries 2,200

Interest received 500 Medical 1,500

Dividends received 150 Property taxes 1,659

Auto insurance 600 Income tax, Social Security 13,000

Home insurance 750 Clothes and accessories 2,000

Auto loan payment 3,300 Gas and auto repair 2,100

Mortgage payment 14,000 Entertainment 2,000

  1. Create a personal income and expense statement for the period ended

December 31, 2012. It should be similar to a corporate income statement.

  1. Did the Adams family have a cash surplus or cash deficit?
  2. If the result is a surplus, how can the Adams family use that surplus?

P35 Calculation of EPS and retained earnings Philagem, Inc., ended 2012 with a net

profit before taxes of $218,000. The company is subject to a 40% tax rate and must

pay $32,000 in preferred stock dividends before distributing any earnings on the

85,000 shares of common stock currently outstanding.

  1. Calculate Philagems 2012 earnings per share (EPS).
  2. If the firm paid common stock dividends of $0.80 per share, how many dollars

would go to retained earnings?

P36 Balance sheet preparation Use the appropriate items from the following list to prepare

in good form Owen Davis Companys balance sheet at December 31, 2012

P37 Balance sheet preparation Adam and Arin Adams have collected their personal

asset and liability information and have asked you to put together a balance sheet as

of December 31, 2012. The following information is received from the Adams family.

98 PART 2 Financial Tools

LG 1

Cash $ 300 Retirement funds, IRA $ 2,000

Checking 3,000 2011 Sebring 15,000

Savings 1,200 2010 Jeep 8,000

IBM stock 2,000 Money market funds 1,200

Auto loan 8,000 Jewelry and artwork 3,000

Mortgage 100,000 Net worth 76,500

Medical bills payable 250 Household furnishings 4,200

Utility bills payable 150 Credit card balance 2,000

Real estate 150,000 Personal loan 3,000

  1. Create a personal balance sheet as of December 31, 2012. It should be similar to

a corporate balance sheet.

  1. What must the total assets of the Adams family be equal to by December 31, 2012?
  2. What was their net working capital (NWC) for the year? (Hint: NWC is the difference

between total liquid assets and total current liabilities.)

P38 Impact of net income on a firms balance sheet Conrad Air, Inc., reported net

income of $1,365,000 for the year ended December 31, 2013. Show how Conrads

balance sheet would change from 2012 to 2013 depending on how Conrad spent

those earnings as described in the scenarios that appear below.

LG 1

Conrad Air, Inc. Balance Sheet as of December 31, 2012

Assets Liabilities and Stockholders Equity

Cash Accounts payable

Marketable securities 35,000 Short-term notes

Accounts receivable 45,000 Current liabilities

Inventories Long-term debt

Current assets Total liabilities

Equipment $2,970,000 Common stock

Buildings Retained earnings

Fixed assets Stockholders equity

Total assets $4,900,000 Total liabilities and equity $4,900,000

$4,570,000 $2,075,000

1,600,000 1,575,000

$ 500,000

$ 330,000 $2,825,000

130,000 2,700,000

$ 125,000

55,000

$ 120,000 $ 70,000

  1. Conrad paid no dividends during the year and invested the funds in marketable

securities.

  1. Conrad paid dividends totaling $500,000 and used the balance of the net income

to retire (pay off) long-term debt.

  1. Conrad paid dividends totaling $500,000 and invested the balance of the net

income in building a new hangar.

  1. Conrad paid out all $1,365,000 as dividends to its stockholders.

P39 Initial sale price of common stock Beck Corporation has one issue of preferred

stock and one issue of common stock outstanding. Given Becks stockholders equity

account that follows, determine the original price per share at which the firm sold its

single issue of common stock.

CHAPTER 3 Financial Statements and Ratio Analysis 99

LG 1

LG 1

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Stockholders Equity ($000)

Preferred stock

Common stock ($0.75 par, 300,000

shares outstanding) 225

Paid-in capital in excess of par on

common stock 2,625

Retained earnings

Total stockholders equity $3,875

900

$ 125

P310 Statement of retained earnings Hayes Enterprises began 2012 with a retained earnings

balance of $928,000. During 2012, the firm earned $377,000 after taxes. From

this amount, preferred stockholders were paid $47,000 in dividends. At year-end

2012, the firms retained earnings totaled $1,048,000. The firm had 140,000 shares

of common stock outstanding during 2012.

  1. Prepare a statement of retained earnings for the year ended December 31, 2012,

for Hayes Enterprises. (Note: Be sure to calculate and include the amount of cash

dividends paid in 2012.)

  1. Calculate the firms 2012 earnings per share (EPS).
  2. How large a per-share cash dividend did the firm pay on common stock during

2012?

P311 Changes in stockholders equity Listed are the equity sections of balance sheets for

years 2011 and 2012 as reported by Mountain Air Ski Resorts, Inc. The overall

value of stockholders equity has risen from $2,000,000 to $7,500,000. Use the

statements to discover how and why this happened.

Mountain Air Ski Resorts, Inc.

Balance Sheets (partial)

Stockholders equity 2011 2012

Common stock ($1.00 par)

Authorized5,000,000 shares

Outstanding1,500,000 shares 2012

500,000 shares 2011

Paid-in capital in excess of par 4,500,000

Retained earnings

Total stockholders equity $2,000,000 $7,500,000

1,000,000 1,500,000

500,000

$ 500,000

$1,500,000

The company paid total dividends of $200,000 during fiscal 2012.

  1. What was Mountain Airs net income for fiscal 2012?
  2. How many new shares did the corporation issue and sell during the year?
  3. At what average price per share did the new stock sold during 2012 sell?
  4. At what price per share did Mountain Airs original 500,000 shares sell?

P312 Ratio comparisons Robert Arias recently inherited a stock portfolio from his uncle.

Wishing to learn more about the companies in which he is now invested, Robert performs

a ratio analysis on each one and decides to compare them to each other. Some

of his ratios are listed below.

100 PART 2 Financial Tools

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Island Burger Fink Roland

Ratio Electric Utility Heaven Software Motors

Current ratio 1.10 1.3 6.8 4.5

Quick ratio 0.90 0.82 5.2 3.7

Debt ratio 0.68 0.46 0.0 0.35

Net profit margin 6.2% 14.3% 28.5% 8.4%

Assuming that his uncle was a wise investor who assembled the portfolio with care,

Robert finds the wide differences in these ratios confusing. Help him out.

  1. What problems might Robert encounter in comparing these companies to one

another on the basis of their ratios?

  1. Why might the current and quick ratios for the electric utility and the fast-food

stock be so much lower than the same ratios for the other companies?

  1. Why might it be all right for the electric utility to carry a large amount of debt,

but not the software company?

  1. Why wouldnt investors invest all of their money in software companies instead

of in less profitable companies? (Focus on risk and return.)

P313 Liquidity management Bauman Companys total current assets, total current liabilities,

and inventory for each of the past 4 years follow:

LG 3

Item 2009 2010 2011 2012

Total current assets $16,950 $21,900 $22,500 $27,000

Total current liabilities 9,000 12,600 12,600 17,400

Inventory 6,000 6,900 6,900 7,200

Inventory turnover 2009 2010 2011 2012

Bauman Company 6.3 6.8 7.0 6.4

Industry average 10.6 11.2 10.8 11.0

  1. Calculate the firms current and quick ratios for each year. Compare the resulting

time series for these measures of liquidity.

  1. Comment on the firms liquidity over the 20092010 period.
  2. If you were told that Bauman Companys inventory turnover for each year in the

20092012 period and the industry averages were as follows, would this information

support or conflict with your evaluation in part b? Why?

P314 Liquidity ratio Josh Smith has compiled some of his personal financial data in

order to determine his liquidity position. The data are as follows.

CHAPTER 3 Financial Statements and Ratio Analysis 101

LG 3

Account Amount

Cash $3,200

Marketable securities 1,000

Checking account 800

Credit card payables 1,200

Short-term notes payable 900

Month of origin Amounts receivable

July $ 3,875

August 2,000

September 34,025

October 15,100

November 52,000

December

Year-end accounts receivable $300,000

193,000

Quarter Inventory

1 $ 400,000

2 800,000

3 1,200,000

4 200,000

  1. Calculate Joshs liquidity ratio.
  2. Several of Joshs friends have told him that they have liquidity ratios of about

1.8. How would you analyze Joshs liquidity relative to his friends?

P315 Inventory management Wilkins Manufacturing has annual sales of $4 million and

a gross profit margin of 40%. Its end-of-quarter inventories are

LG 3

  1. Find the average quarterly inventory and use it to calculate the firms inventory

turnover and the average age of inventory.

  1. Assuming that the company is in an industry with an average inventory turnover

of 2.0, how would you evaluate the activity of Wilkins inventory?

P316 Accounts receivable management An evaluation of the books of Blair Supply,

which follows, gives the end-of-year accounts receivable balance, which is believed

to consist of amounts originating in the months indicated. The company had annual

sales of $2.4 million. The firm extends 30-day credit terms.

LG 3

  1. Use the year-end total to evaluate the firms collection system.
  2. If 70% of the firms sales occur between July and December, would this affect the

validity of your conclusion in part a? Explain.

P317 Interpreting liquidity and activity ratios The new owners of Bluegrass Natural

Foods, Inc., have hired you to help them diagnose and cure problems that the company

has had in maintaining adequate liquidity. As a first step, you perform a liquidity

analysis. You then do an analysis of the companys short-term activity ratios.

Your calculations and appropriate industry norms are listed.

102 PART 2 Financial Tools

LG 3

Ratio Bluegrass Industry norm

Current ratio 4.5 4.0

Quick ratio 2.0 3.1

Inventory turnover 6.0 10.4

Average collection period 73 days 52 days

Average payment period 31 days 40 days

Creek Enterprises Income Statement for the Year Ended December 31, 2012

Sales revenue $30,000,000

Less: Cost of goods sold

Gross profits

Less: Operating expenses

Selling expense $ 3,000,000

General and administrative expenses 1,800,000

Lease expense 200,000

Depreciation expense

Total operating expense

Operating profits $ 3,000,000

Less: Interest expense

Net profits before taxes $ 2,000,000

Less: Taxes (rate 40%)

Net profits after taxes $ 1,200,000

Less: Preferred stock dividends

Earnings available for common stockholders $ 1,100,000

100,000

= 800,000

1,000,000

$ 6,000,000

1,000,000

$ 9,000,000

21,000,000

  1. What recommendations relative to the amount and the handling of inventory

could you make to the new owners?

  1. What recommendations relative to the amount and the handling of accounts

receivable could you make to the new owners?

  1. What recommendations relative to the amount and the handling of accounts

payable could you make to the new owners?

  1. What results, overall, would you hope your recommendations would achieve?

Why might your recommendations not be effective?

P318 Debt analysis Springfield Bank is evaluating Creek Enterprises, which has

requested a $4,000,000 loan, to assess the firms financial leverage and financial

risk. On the basis of the debt ratios for Creek, along with the industry averages (see

top of page 103) and Creeks recent financial statements (following), evaluate and

recommend appropriate action on the loan request.

P319 Common-size statement analysis A common-size income statement for Creek

Enterprises 2011 operations follows. Using the firms 2012 income statement presented

in Problem 318, develop the 2012 common-size income statement and compare

it to the 2011 statement. Which areas require further analysis and investigation?

CHAPTER 3 Financial Statements and Ratio Analysis 103

Creek Enterprises Balance Sheet December 31, 2012

Assets Liabilities and Stockholders Equity

Cash $ 1,000,000 Accounts payable $ 8,000,000

Marketable securities 3,000,000 Notes payable 8,000,000

Accounts receivable 12,000,000 Accruals

Inventories Total current liabilities

Total current assets Long-term debt (includes

Land and buildings $11,000,000 financial leases)b

Machinery and equipment 20,500,000 Preferred stock (25,000

Furniture and fixtures shares, $4 dividend) $ 2,500,000

Gross fixed assets (at cost)a $39,500,000 Common stock (1 million

Less: Accumulated depreciation shares at $5 par) 5,000,000

Net fixed assets Paid-in capital in excess of

Total assets par value 4,000,000

Retained earnings

Total stockholders equity

Total liabilities and

stockholders equity

aThe firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three years of

the lease have yet to run.

bRequired annual principal payments are $800,000.

$50,000,000

$13,500,000

2,000,000

$50,000,000

$26,500,000

13,000,000

8,000,000

$20,000,000

$23,500,000

7,500,000 $16,500,000

500,000

Industry averages

Debt ratio 0.51

Times interest

earned ratio 7.30

Fixed-payment

coverage ratio 1.85

LG 5

Creek Enterprises Common-Size Income Statement

for the Year Ended December 31, 2011

Sales revenue ($35,000,000) 100.0%

Less: Cost of goods sold

Gross profits %

Less: Operating expenses

Selling expense 12.7%

General and administrative expenses 6.3

Lease expense 0.6

Depreciation expense

Total operating expense

Operating profits 10.9%

Less: Interest expense

Net profits before taxes 9.4%

Less: Taxes (rate 40%)

Net profits after taxes 5.6%

Less: Preferred stock dividends

Earnings available for common stockholders 5.5%

P320 The relationship between financial leverage and profitability Pelican Paper, Inc.,

and Timberland Forest, Inc., are rivals in the manufacture of craft papers. Some

financial statement values for each company follow. Use them in a ratio analysis that

compares the firms financial leverage and profitability.

104 PART 2 Financial Tools

LG 4 LG 5

Item Pelican Paper, Inc. Timberland Forest, Inc.

Total assets $10,000,000 $10,000,000

Total equity (all common) 9,000,000 5,000,000

Total debt 1,000,000 5,000,000

Annual interest 100,000 500,000

Total sales 25,000,000 25,000,000

EBIT 6,250,000 6,250,000

Earnings available for

common stockholders 3,690,000 3,450,00

  1. Calculate the following debt and coverage ratios for the two companies. Discuss

their financial risk and ability to cover the costs in relation to each other.

(1) Debt ratio

(2) Times interest earned ratio

  1. Calculate the following profitability ratios for the two companies. Discuss their

profitability relative to each other.

(1) Operating profit margin

(2) Net profit margin

(3) Return on total assets

(4) Return on common equity

  1. In what way has the larger debt of Timberland Forest made it more profitable

than Pelican Paper? What are the risks that Timberlands investors undertake

when they choose to purchase its stock instead of Pelicans?

P321 Ratio proficiency McDougal Printing, Inc., had sales totaling $40,000,000 in fiscal

year 2012. Some ratios for the company are listed below. Use this information to

determine the dollar values of various income statement and balance sheet accounts

as requested.

Calculate values for the following:

  1. Gross profits
  2. Cost of goods sold
  3. Operating profits
  4. Operating expenses
  5. Earnings available for common stockholders
  6. Total assets
  7. Total common stock equity
  8. Accounts receivable

P322 Cross-sectional ratio analysis Use the financial statements below and on page 106

for Fox Manufacturing Company for the year ended December 31, 2012, along with

the industry average ratios below, to:

  1. Prepare and interpret a complete ratio analysis of the firms 2012 operations.
  2. Summarize your findings and make recommendations.

P323 Financial statement analysis The financial statements of Zach Industries for the

year ended December 31, 2012, follow.

P324 IntegrativeComplete ratio analysis Given the following financial statements (following

and on page 109), historical ratios, and industry averages, calculate Sterling

Companys financial ratios for the most recent year. (Assume a 365-day year.)

P325 DuPont system of analysis Use the following ratio information for Johnson

International and the industry averages for Johnsons line of business to:

  1. Construct the DuPont system of analysis for both Johnson and the industry.
  2. Evaluate Johnson (and the industry) over the 3-year period.
  3. Indicate in which areas Johnson requires further analysis. Why?

CHAPTER 3 Financial Statements and Ratio Analysis 109

Historical and Industry Average Ratios for Sterling Company

Industry average,

Ratio Actual 2010 Actual 2011 2012

Current ratio 1.40 1.55 1.85

Quick ratio 1.00 0.92 1.05

Inventory turnover 9.52 9.21 8.60

Average collection period 45.6 days 36.9 days 35.5 days

Average payment period 59.3 days 61.6 days 46.4 days

Total asset turnover 0.74 0.80 0.74

Debt ratio 0.20 0.20 0.30

Times interest earned ratio 8.2 7.3 8.0

Fixed-payment coverage ratio 4.5 4.2 4.2

Gross profit margin 0.30 0.27 0.25

Operating profit margin 0.12 0.12 0.10

Net profit margin 0.062 0.062 0.053

Return on total assets (ROA) 0.045 0.050 0.040

Return on common equity (ROE) 0.061 0.067 0.066

Earnings per share (EPS) $1.75 $2.20 $1.50

Price/earnings (P/E) ratio 12.0 10.5 11.2

Market/book (M/B) ratio 1.20 1.05 1.10

LG 6

Johnson 2010 2011 2012

Financial leverage multiplier 1.75 1.75 1.85

Net profit margin 0.059 0.058 0.049

Total asset turnover 2.11 2.18 2.34

Industry Averages

Financial leverage multiplier 1.67 1.69 1.64

Net profit margin 0.054 0.047 0.041

Total asset turnover 2.05 2.13 2.15

P326 Complete ratio analysis, recognizing significant differences Home Health, Inc., has

come to Jane Ross for a yearly financial checkup. As a first step, Jane has prepared a

complete set of ratios for fiscal years 2011 and 2012. She will use them to look for

significant changes in the companys situation from one year to the next.

 

Chapter 4 Cash Flow and Financial Planning

Opener-in-Review

The chapter opener mentions that in 2010, Apples stock sold for approximately

$200. Apple had just over $40 billion in cash on its balance sheet and just fewer

than 1 billion shares outstanding, so each Apple share represented a claim on

$40 of Apples cash. Suppose that when Apple invests in the resources necessary

to create new technology products, it expects to earn a 20% rate of return.

Suppose also that when it invests its cash, Apple earns just 1%. Given this, what

rate of return should investors expect if they pay $200 to acquire one share of

Apple?

Self-Test Problem

ST41 Depreciation and cash flow A firm expects to have earnings before interest and

taxes (EBIT) of $160,000 in each of the next 6 years. It pays annual interest of

$15,000. The firm is considering the purchase of an asset that costs $140,000,

requires $10,000 in installation cost, and has a recovery period of 5 years. It will be

the firms only asset, and the assets depreciation is already reflected in its EBIT

estimates.

  1. Calculate the annual depreciation for the asset purchase using the MACRS

depreciation percentages in Table 4.2 on page 117.

  1. Calculate the firms operating cash flows for each of the 6 years, using Equation

4.3. Assume that the firm is subject to a 40% tax rate on all the profit that it

earns.

  1. Suppose the firms net fixed assets, current assets, accounts payable, and accruals

had the following values at the start and end of the final year (year 6). Calculate

the firms free cash flow (FCF) for that year.

LG 1 LG 2

Year 6 Year 6

Account start end

Net fixed assets $ 7,500 $ 0

Current assets 90,000 110,000

Accounts payable 40,000 45,000

Accruals 8,000 7,000

Cash

Month Sales disbursements

February $500 $400

March 600 300

April 400 600

May 200 500

June 200 200

  1. Compare and discuss the significance of each value calculated in parts b and c.

ST42 Cash budget and pro forma balance sheet inputs Jane McDonald, a financial analyst

for Carroll Company, has prepared the following sales and cash disbursement

estimates for the period FebruaryJune of the current year.

LG 4 LG 5

McDonald notes that historically, 30% of sales have been for cash. Of credit sales,

70% are collected 1 month after the sale, and the remaining 30% are collected

2 months after the sale. The firm wishes to maintain a minimum ending balance in

its cash account of $25. Balances above this amount would be invested in short-term

government securities (marketable securities), whereas any deficits would be

financed through short-term bank borrowing (notes payable). The beginning cash

balance at April 1 is $115.

  1. Prepare cash budgets for April, May, and June.

 

  1. How much financing, if any, at a maximum would Carroll Company require to

meet its obligations during this 3-month period?

  1. A pro forma balance sheet dated at the end of June is to be prepared from the

information presented. Give the size of each of the following: cash, notes

payable, marketable securities, and accounts receivable.

ST43 Pro forma income statement Euro Designs, Inc., expects sales during 2013 to rise

from the 2012 level of $3.5 million to $3.9 million. Because of a scheduled large

loan payment, the interest expense in 2013 is expected to drop to $325,000. The

firm plans to increase its cash dividend payments during 2013 to $320,000. The

companys year-end 2012 income statement follows.

CHAPTER 4 Cash Flow and Financial Planning 145

Euro Designs, Inc. Income Statement for the

Year Ended December 31, 2012

Sales revenue $3,500,000

Less: Cost of goods sold

Gross profits $1,575,000

Less: Operating expenses

Operating profits $1,155,000

Less: Interest expense

Net profits before taxes $ 755,000

Less: Taxes (rate 40%)

Net profits after taxes $ 453,000

Less: Cash dividends

To retained earnings $ 203,000

250,000

= 302,000

400,000

420,000

1,925,000

LG 5

  1. Use the percent-of-sales method to prepare a 2013 pro forma income statement

for Euro Designs, Inc.

  1. Explain why the statement may underestimate the companys actual 2013 pro

forma income.

Warm-Up Exercises All problems are available in .

E41 The installed cost of a new computerized controller was $65,000. Calculate the

depreciation schedule by year assuming a recovery period of 5 years and using the

appropriate MACRS depreciation percentages given in Table 4.2 on page 117.

E42 Classify the following changes in each of the accounts as either an inflow or an

outflow of cash. During the year (a) marketable securities increased, (b) land and

buildings decreased, (c) accounts payable increased, (d) vehicles decreased,

(e) accounts receivable increased, and (f) dividends were paid.

E43 Determine the operating cash flow (OCF) for Kleczka, Inc., based on the following

data. (All values are in thousands of dollars.) During the year the firm had sales of

$2,500, cost of goods sold totaled $1,800, operating expenses totaled $300, and

depreciation expenses were $200. The firm is in the 35% tax bracket.

 

E44 During the year, Xero, Inc., experienced an increase in net fixed assets of $300,000

and had depreciation of $200,000. It also experienced an increase in current assets

of $150,000 and an increase in accounts payable and accruals of $75,000. If operating

cash flow (OCF) for the year was $700,000, calculate the firms free cash flow

(FCF) for the year.

E45 Rimier Corp. forecasts sales of $650,000 for 2013. Assume the firm has fixed costs

of $250,000 and variable costs amounting to 35% of sales. Operating expenses are

estimated to include fixed costs of $28,000 and a variable portion equal to 7.5% of

sales. Interest expenses for the coming year are estimated to be $20,000. Estimate

Rimiers net profits before taxes for 2013.

146 PART 2 Financial Tools

LG 2

LG 5

Problems All problems are available in .

P41 Depreciation On March 20, 2012, Norton Systems acquired two new assets. Asset

A was research equipment costing $17,000 and having a 3-year recovery period.

Asset B was duplicating equipment having an installed cost of $45,000 and a 5-year

recovery period. Using the MACRS depreciation percentages in Table 4.2 on

page 117, prepare a depreciation schedule for each of these assets.

P42 Depreciation In early 2012, Sosa Enterprises purchased a new machine for

$10,000 to make cork stoppers for wine bottles. The machine has a 3-year recovery

period and is expected to have a salvage value of $2,000. Develop a depreciation

schedule for this asset using the MACRS depreciation percentages in Table 4.2.

P43 MACRS depreciation expense and accounting cash flow Pavlovich Instruments,

Inc., a maker of precision telescopes, expects to report pretax income of $430,000

this year. The companys financial manager is considering the timing of a purchase

of new computerized lens grinders. The grinders will have an installed cost of

$80,000 and a cost recovery period of 5 years. They will be depreciated using the

MACRS schedule.

  1. If the firm purchases the grinders before year-end, what depreciation expense

will it be able to claim this year? (Use Table 4.2 on page 117.)

  1. If the firm reduces its reported income by the amount of the depreciation expense

calculated in part a, what tax savings will result?

P44 Depreciation and accounting cash flow A firm in the third year of depreciating its

only asset, which originally cost $180,000 and has a 5-year MACRS recovery

period, has gathered the following data relative to the current years operations:

LG 1

LG 1 LG 2

LG 1 LG 2

LG 1

Accruals $ 15,000

Current assets 120,000

Interest expense 15,000

Sales revenue 400,000

Inventory 70,000

Total costs before depreciation, interest, and taxes 290,000

Tax rate on ordinary income 40%

  1. Use the relevant data to determine the operating cash flow (see Equation 4.2) for

the current year.

  1. Explain the impact that depreciation, as well as any other noncash charges, has

on a firms cash flows.

P45 Classifying inflows and outflows of cash Classify each of the following items as an

inflow (I) or an outflow (O) of cash, or as neither (N).

CHAPTER 4 Cash Flow and Financial Planning 147

LG 2

Item Change ($) Item Change ($)

Cash 100 Accounts receivable 700

Accounts payable 1,000 Net profits 600

Notes payable 500 Depreciation 100

Long-term debt 2,000 Repurchase of stock 600

Inventory 200 Cash dividends 800

Fixed assets +400 Sale of stock +1,000

+ +

+

+ +

+

+

P46 Finding operating and free cash flows Consider the balance sheets and selected

data from the income statement of Keith Corporation that appear below and on

the next page.

LG 2

Keith Corporation Balance Sheets

December 31

Assets 2012 2011

Cash $ 1,500 $ 1,000

Marketable securities 1,800 1,200

Accounts receivable 2,000 1,800

Inventories

Total current assets

Gross fixed assets $29,500 $28,100

Less: Accumulated depreciation

Net fixed assets

Total assets

Liabilities and Stockholders Equity

Accounts payable $ 1,600 $ 1,500

Notes payable 2,800 2,200

Accruals

Total current liabilities

Long-term debt

Total liabilities

Common stock $10,000 $10,000

Retained earnings

Total stockholders equity

Total liabilities and stockholders equity $23,000 $21,80

  1. Calculate the firms net operating profit after taxes (NOPAT) for the year ended

December 31, 2012, using Equation 4.1.

  1. Calculate the firms operating cash flow (OCF) for the year ended December 31,

2012, using Equation 4.3.

  1. Calculate the firms free cash flow (FCF) for the year ended December 31, 2012,

using Equation 4.5.

  1. Interpret, compare, and contrast your cash flow estimates in parts b and c.

P47 Cash receipts A firm has actual sales of $65,000 in April and $60,000 in May. It

expects sales of $70,000 in June and $100,000 in July and in August. Assuming that

sales are the only source of cash inflows and that half of them are for cash and the

remainder are collected evenly over the following 2 months, what are the firms

expected cash receipts for June, July, and August?

P48 Cash disbursements schedule Maris Brothers, Inc., needs a cash disbursement

schedule for the months of April, May, and June. Use the format of Table 4.9 (on

page 130) and the following information in its preparation.

Sales: February $500,000; March $500,000; April $560,000;

May $610,000; June $650,000; July $650,000

Purchases: Purchases are calculated as 60% of the next months sales, 10% of

purchases are made in cash, 50% of purchases are paid for 1 month after purchase,

and the remaining 40% of purchases are paid for 2 months after purchase.

Rent: The firm pays rent of $8,000 per month.

Wages and salaries: Base wage and salary costs are fixed at $6,000 per month

plus a variable cost of 7% of the current months sales.

Taxes: A tax payment of $54,500 is due in June.

Fixed asset outlays: New equipment costing $75,000 will be bought and paid for

in April.

Interest payments: An interest payment of $30,000 is due in June.

Cash dividends: Dividends of $12,500 will be paid in April.

Principal repayments and retirements: No principal repayments or retirements

are due during these months.

P49 Cash budgetBasic Grenoble Enterprises had sales of $50,000 in March and

$60,000 in April. Forecast sales for May, June, and July are $70,000, $80,000, and

$100,000, respectively. The firm has a cash balance of $5,000 on May 1 and wishes

to maintain a minimum cash balance of $5,000. Given the following data, prepare

and interpret a cash budget for the months of May, June, and July.

(1) The firm makes 20% of sales for cash, 60% are collected in the next month,

and the remaining 20% are collected in the second month following sale.

(2) The firm receives other income of $2,000 per month.

(3) The firms actual or expected purchases, all made for cash, are $50,000,

$70,000, and $80,000 for the months of May through July, respectively.

(4) Rent is $3,000 per month.

(5) Wages and salaries are 10% of the previous months sales.

(6) Cash dividends of $3,000 will be paid in June.

(7) Payment of principal and interest of $4,000 is due in June.

(8) A cash purchase of equipment costing $6,000 is scheduled in July.

(9) Taxes of $6,000 are due in June.

Personal Finance Problem

P410 Preparation of cash budget Sam and Suzy Sizeman need to prepare a cash budget

for the last quarter of 2013 to make sure they can cover their expenditures during

the period. Sam and Suzy have been preparing budgets for the past several years and

have been able to establish specific percentages for most of their cash outflows.

These percentages are based on their take-home pay (that is, monthly utilities normally

run 5% of monthly take-home pay). The information in the following table

can be used to create their fourth-quarter budget for 2013.

CHAPTER 4 Cash Flow and Financial Planning 149

LG 4

LG 4

Income

Monthly take-home pay $4,900

Expenses

Housing 30%

Utilities 5%

Food 10%

Transportation 7%

Medical/dental .5%

Clothing for October and November 3%

Clothing for December $440

Property taxes (November only) 11.5%

Appliances 1%

Personal care 2%

Entertainment for October and November 6%

Entertainment for December $1,500

Savings 7.5%

Other 5%

Excess cash 4.5%

  1. Prepare a quarterly cash budget for Sam and Suzy covering the months October

through December 2013.

  1. Are there individual months that incur a deficit?
  2. What is the cumulative cash surplus or deficit by the end of December 2013?

P411 <

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