FOUNDATIONS OF FINANCIAL MANAGEMENT 12TH EDITION BY STANLEY B BLOCK, GEOFFREY A. HIRT (CHAPTER 1_21 by QuentinAxel

SOLUTIONS MANUAL

FOUNDATIONS OF FINANCIAL MANAGEMENT 12TH EDITION BY STANLEY B BLOCK, GEOFFREY A. HIRT (CHAPTER 1_21) SOLUTIONS MANUAL

Chapter 1 Discussion Questions 1-1.

Regulation was greatly increased with the Dodd – Frank Act and other measures.

1-2. The student should be prepared to pay a higher price for the promised $2 from the Royal Bank. The risk is lower. 1-3.

The goal of shareholder wealth maximization implies that the firm will attempt to achieve the highest possible valuation in the marketplace. It is the one overriding objective of the firm and should influence every decision. The problem with a profit maximization goal is that it fails to take account of risk, the timing of the benefits is not considered, and profit measurement is a very inexact process.

1-4. Agency theory examines the relationship between the owners of the firm and the managers of the firm. In privately owned firms, management and the owners are usually the same people. Management operates the firm to satisfy its own goals, needs, financial requirements and the like. As a company moves from private to public ownership, management now represents all owners. This places management in the agency position of making decisions in the best interest of all shareholders. 1-5.

Because institutional investors such as pension funds (Ontario Teachers‘, CPP) and mutual funds own a large percentage of major companies, they are having more to say about the way publicly owned companies are managed. As a group, they have the ability to vote large blocks of shares for the election of a board of directors, which is supposed to run the company in an efficient, competitive manner. The threat of being able to replace poor performing boards of directors makes institutional investors quite influential. Since these institutions, like pension funds and mutual funds, represent individual workers and investors, they have a responsibility to see that the firm is managed in an efficient and ethical way.

1-6.

Insider trading occurs when someone has information that is not available to the public and then uses the information to profit from trading in a company‘s common stock. The provincial securities commissions are responsible for protecting against insider trading.

1-7. Regulations set the ―rules of the game‖ in which the firm operates. Shareholder wealth maximization can and should still be sought within the rules, for economic efficiency to be achieved. Society judge‘s deregulation benefits against the costs of regulation. 1-8. Management operates within a competitive market and they should be paid their opportunity cost. If managers do not act to maximize shareholder wealth, share prices will become depressed. To the extent manager‘s compensation is tied to share price

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performance, shareholders can fire managers, and there exists a market for corporate control, management will be compensated based on their economic contribution. 1-9.

Daily functions- cash management, inventory control, receipt and disbursement of funds. Occasional- share issue, bond issue, capital budgeting and dividend decisions.

1-10. There is unlimited liability for the sole proprietorship and partnership forms of ownership. Under the limited partnership, only the general partner(s) has unlimited liability, with limited partners obligated only to the extent of their initial contribution. Finally, all shareholders in a corporation have limited liability, although owner/ shareholders of small businesses often have to give banks their personal guarantees. 1-11. The corporate form is best suited to large organizations because of the easy divisibility of ownership through issuance of shares. Also, the corporation has continued existence independent of any shareholder. 1-12. Money markets refer to those markets dealing with short-term securities that have a life of one year or less. Capital markets refer to securities with a life of more than one year. 1-13. A primary market refers to the use of the financial markets to raise new funds. After the securities are sold to the public (institutions and individuals), they trade in the secondary market between investors. It is in the secondary market that prices are continually changing as investors buy and sell securities based on the expectations of corporate prospects. A liquid secondary market promotes a successful primary market. 1-14. Government debt loads require financing. This puts large demands ($1 trillion in accumulated federal and provincial debt in 2017) on the capital markets, putting upward pressure on interest rates and a corporation‘s ability to invest in capital projects. When governments finance their deficits abroad they place Canada‘s economic levers outside of our control and debt servicing payments can impact the foreign exchange markets. As the government debt load relative to GDP been reduced in recent years there has been less pressure on interest rates, corporations have borrowed more, but there have been less ‗risk free‘ government securities available (causing liquidity problems particularly in the money markets). 1-15. Stakeholders include: shareholders, creditors, employees, unions, environmentalists, consumer groups, Canada Revenue Agency, government regulatory bodies, customers, managers and others.

Internet Resources and Questions 1. 2. 3. 4. 5.

www.nobelprize.org www.fin.gc.ca www.bankofcanada.ca http://www.onex.com/Our-Goals/Index?Key‘GenPage=1073751432 http://www.rbc.com/aboutus/visionandvalues.html http://www.bce.ca/responsibility/corporateresponsibility

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Problems 1-1.

Incubus Corporation

a. Common stock (contributed capital) Retained earnings (deficit)

$40,000 (7,000) $33,000

b. Common stock Retained earnings (‒7,000 + 15,000 ‒ 6,000)

$40,000 2,000 $42,000

c. Common stock Retained earnings (+2,000 + 12,000 ‒ 6,000)

$60,000 8,000 $68,000

1-2.

Puppet Corporation

a. Common stock Retained earnings

$20,000 2,000 $22,000

b. Common stock Retained earnings (+2,000 + 9,000 ‒ 3,000)

$20,000 8,000 $28,000

c. Common stock Retained earnings (+8,000 + 5,000 ‒ 2,500)

$30,000 10,500 $40,500

1-3.

Two to Ten Dollar Corporation would be expected to have the higher valuation because the $10 per share dividend (although achieved later) is expected to be sustained for a much longer period of time. Building earnings for longer term sustainability is more valuable than quick returns that peter out.

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1-4.

1-5. a. b.

Share value is a combination of expected earnings (or cash flow) and the risk inherent in those cash flows. Although the financial institution reports lower earnings it is because of restructuring charges that lower reported earnings. Cash flows are not likely to be effected. Future earnings should be more reliable and therefore less risky than those of the new health services company. Therefore the market is likely to suggest a higher value for the financial institution.

Board of Directors Decision A combination of high profit margins and strong consumer acceptance should be positive for share value. However a new product introduces a high degree of risk that will mitigate higher share values. More detailed financial information for investors should increase their confidence in the activities of the firm and lower the risk of their investment. This will be offset by the likely increase costs of providing this information. In an environment of questionable ethics by management this should be slightly positive to share value. Pollution control devices will increase firm costs. The local residents will view the firm more positively which should have some positive cash flow effects as they may be more willing to purchase the firm‘s products and will decrease possible litigations or harassment. Overall it is likely to be a neutral or slightly negative effect on share value. Aligning management compensation motivators with shareholder goals should be positive for share values with implemented. The effect however may be small.

There is no correct answer. It depends on the tradeoff between risk, returns and costs.

Chapter 2

Discussion Questions 2-1.

The price-earnings ratio will be influenced by the earnings and sales growth of the firm, the risk or volatility in performance, the debt-equity structure of the firm, the dividend payment policy, the quality of management, and a number of other factors. The ratio tends to be future-oriented, and will be higher the more positive the outlook

2-2. Book value per share is arrived at by taking the cost of the assets and subtracting out liabilities and preferred stock and dividing by the number of common shares outstanding. It is based on the historical costs of the assets. Market value per share is based on current assessed value of the firm in the marketplace and may bear little relationship to original cost. Besides the disparity between book and market value caused by the historical cost approach, other contributing factors are the growth prospects for the firm, the quality of management, and the industry outlook. To the extent these are quite negative, or positive, market value may differ widely from book value.

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2-3. The only way amortization generates cash flows for the company is by serving as a tax shield against reported income. Allowable amortization for tax purposes is known as capital cost allowance (CCA). In most instances this will be different than accounting amortization. This non-cash deduction may provide cash flow equal to the tax rate times the amortization charged. This much in taxes will be saved, while no cash payments occur. 2-4. Accumulated amortization is the sum of all past and present amortization charges, while amortization expense is the current year's charge. They are related in that the sum of all prior amortization expense should be equal to accumulated amortization (subject to some differential related to asset write-offs). 2-5. The balance sheet, for private companies using ASPE, is based on historical costs. When prices are rising rapidly, historical cost data may lose much of their meaning particularly for plant, equipment and inventory. However, the balance sheet of public companies using IFRS is based on market values and opposite order whereby non-current assets are listed ahead of current assets. The same applies to the liabilities section that lists non-current liabilities first. 2-6. The income statement and balance sheet are based on the accrual method of accounting, which attempts to match revenues and expenses in the period in which they occur. However, accrual accounting does not attempt to properly assess the cash flow position of the firm. The statement of changes in financial position fulfills this need. The values on these statements will differ for public companies using IFRS compared to private firms. 2-7. The sections of the statement of cash flows and sources of information are: Cash flows from operating activities (Income statement) Cash flows from investing activities (non-current assets section of balance sheet) Cash flows from financing activities (non-current liabilities and equity section) The payment of cash dividends falls into the financing activities category. 2-8. We can examine the various sources that were utilized by the firm as indicated on the statement. Possible sources for the financing of an increase in assets might be profits, increases in liabilities, or decreases in other asset accounts. 2-9.

Free cash flow is equal to:

Cash flow from operating activities Minus:

Capital expenditures required to maintain the productive capacity of the firm.

Minus:

Dividends (required to maintain the payout on common stock and to cover any preferred stock obligation).

The analyst or banker normally looks at free cash flow to determine whether there are sufficient excess funds to pay back the loan associated with the leveraged buy-out (a company with limited cash acquiring stocks of another company to acquire control).

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2-10. Interest expense is a tax deductible item to the corporation, while dividend payments are not. The net cost to the corporation of interest expense is the amount paid multiplied by the difference of (one minus the applicable tax rate). The firm must bear the full burden of the cash outflow of dividend payments because they are not an expense, but rather a distribution out of retained earnings.

Internet Resources and Questions 1. 2. 3. 4. 5.

www.cpacanada.ca www.ifrs.org https://home.kpmg/ca/en/home/services/tax.html www.pwc.com/ca/tax www.canada.ca/en/services/taxes.html

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Problems (The following solutions use the 2020 tax rates or rates given in the text).

2-1.

Bradley Bus Inc.

a. Last Year Earnings after taxes Shares outstanding Earnings per share ($600,000/300,000 shares)

$600,000 300,000 $2.00

b. Current Year Earnings after taxes ($600,000 × 125%) Shares outstanding (300,000 + 40,000) Earnings per share ($750,000/340,000 shares)

$750,000 340,000 $2.21

2-2.

Dover River Company

a. Operating profit (EBIT)......................... Interest expense................................. Earnings before taxes (EBT).................. Taxes.................................................. Earnings after taxes (EAT)...................... Preferred dividends ........................... Available to common shareholders........

$200,000 10,000 190,000 38,250 151,750 18,750 $133,000

Common dividends............................ $ 30,000 Increase in retained earnings.................. $ 103,000 EPS = Earnings available to common shareholders/ Number of shares of common stock outstanding = $133,000/20,000 shares = $6.65 per share Dividends per Share = $30,000/20,000 shares = $1.50 per share b. Payout Ratio=Dividend per share/Earnings per share =1.50/6.65 per share = 22.6% c. Increase in retained earnings = 103,000 d. Price/earnings ratio= $41.23/ $6.65 = 6.2 × 2-3. Far East Fast Foods a. 20XX Earnings after taxes Shares outstanding Foundations of Fin. Mgt. 12Ce

$230,000 200,000 3-7

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Earnings per share

$1.15

b. 20XY Earnings after taxes ($230,000 × 125%) Shares outstanding Earnings per share 2-4.

$287,500 230,000 $1.25

Sheridan Travel

a. EPS = $700,000 = $1.75 per share 400,000 b. New Net Income: $700,000 x 135% = $945,000 Shares: 400,000 + 50,000 = 450,000 shares New EPS = $945,000 = $2.10 per share 450,000 2-5.

Botox Facial Care a.

2-6.

P/E ratio (20XX)

$370,000 200,000 = Price/EPS

EPS (20XY)



$436,000 200,000

= $2.18

P/E ratio (20XY)

= Price/EPS

=$42.50

EPS (20XX)



= $1.85 = $31.50 = 17.03x $1.85

= 19.50x

$2.18

c. The stock price increased by 34.92%, [($42.50 ‒ $31.50)/$31.50] the EPS only increased 17.84% [$2.18 ‒ $1.85)/ $1.85]. Stillery Corporation a.

$436,000

EPS (20XX)

P/E ratio (20XX)

= Price/EPS

200,000

= $2.18 $42.00 = = 19.27x $2.18

$206,000

EPS (20XY)

Foundations of Fin. Mgt. 12Ce

= 200,000 3-8

= $1.03 Block, Hirt, Danielsen, Short

P/E ratio (20XY)

= Price/EPS

$27.80 $1.03

= 26.99x

c. When the EPS drops rapidly, the share price might not decline as much because the share price is based on future expectation, and as such the P/E ratio rises. A higher P/E ratio under adverse conditions is not a positive.

2-7. a.

Brad Gravel Pitt Company Sales Cost of goods sold Gross profit Gross profit (%) 

$327,000 135,000 192,000

Gross profit Sales



$192,000  .59  59% $327,000

b. With a gross profit of 59%, Brad Gravel Pitt Company is outperforming the industry average of 52%.

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2-8.

Moore Enterprise/ Kipling Corporation Moore

Kipling

Gross profit.........................

$880,000

Selling and adm. expense...

120,000

760,000

Amortization.......................

360,000

60,000

Operating profit..................

400,000

700,000

Taxes (40%)........................

160,000

280,000

Earnings after-taxes..............

240,000

420,000

Plus: Amortization Expense...

360,000

60,000

Cash Flow...........................

$600,000

$480,000

Moore had $300,000 more in amortization, which provided $120,000 (0.40 × $300,000) more in cash flow. Moore paid 0.40×300,000 (difference in operating income) = $120,000 less taxes.

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2-9.

Yes, Aztec Book Company made a profit of $13,920 for the year ended December 31, 20XX. Aztec Book Company Statement of Income For the Year ended December 31, 20XX Sales (1,400 books at $84 each).................................... $117,600 Cost of goods sold (1,400 books at $63 each).............. 88,200 Gross Profit............................................................... 29,400 Selling expense.............................................................. 2,000 Amortization expense.................................................... 5,000 Operating profit......................................................... 22,400 Interest expense.............................................................. 5,000 Earnings before taxes................................................ 17,400 Taxes @ 20%................................................................. 3,480 Earnings after taxes.................................................... $13,920

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2-10.

Carr Auto Wholesalers Statement of Income For the Year ended December 31, 20XX

a. Sales…………………………………………….. Cost of goods sold @ 65%................................... Gross profit………………………………….. Selling and administration expense @ 9%......... Amortization expense…………………………... Operating profit……………………………… Interest expense…………………………………. Earnings before taxes………………………… Taxes @ 30%........................................................ Earnings after taxes……………………………

$900,000 585,000 315,000 81,000 10,000 224,000 8,000 216,000 64,800 $151,200

b. Sales…………………………………………….. Cost of goods sold @ 60%.................................... Gross profit…………………………………... Selling and administration expense @ 12%......... Amortization expense…………………….…….. Operating profit……………………………… Interest expense…………………………………. Earnings before taxes………………………… Taxes @ 30% …………………………………… Earnings after taxes……………………………

$1,000,000 600,000 400,000 120,000 10,000 270,000 15,000 255,000 76,500 $ 178,500

Ms. Hood‘s idea will increase profitability.

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2-11.

Statement of Income

Sales Cost of goods sold Gross profit Selling and administrative expense Amortization expense Operating profit Interest expense Earnings before taxes Taxes Earnings after taxes Preferred stock dividends Earnings available to common shareholders Shares outstanding Earnings per share

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2-12.

Dog River Company

$250,000 21,000 229,000 45,550 183,450 23,450 $ 160,000

Common dividends............................ Increase in retained earnings..................

50,000 $ 110,000

EPS

= Earnings available to common shareholders Number of shares of common stock outstanding = $160,000/40,000 shares = $4.00 per share

Dividends per Share = $50,000/40,000 shares = $1.25 per share b. Payout ratio = $1.25/ $4.00 = .3125 = c. Increase in retained earnings = d. Price/earnings ratio = $62.00/ $4.00 = 2-13.

31.25% $110,000 15.5×

Thermo Dynamics

a. Retained earnings, December 31, 2015............. Less: Retained earnings, December 31, 2014.... Change in retained earnings............................... Add: Common stock dividends.......................... Earnings available to common shareholders......

$450,000 400,000 50,000 25,000 $ 75,000

b. Earnings per share = $75,000/ 20,000 shares = $3.75 per share c. Payout ratio = $25,000/ $75,000 = .333 = 33.33% d. Price/earnings ratio = $30.00/ $3.75 = 8.0 ×

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2-14.

Brandon Fast Foods Inc.

a. Operating Income – Taxes – Interest = Net income after taxes = $210,000 – $59,300 – $30,000 = $120,700 Net income after taxes – Preferred dividends = Earnings available to common shareholders = $120,700 – $24,700 = $96,000 EPS = $96,000 / 16,000 shares = $6 EPS Common Dividends per Share = Div. paid /shares = $36,000/16,000 shares = $2.25 Dividend per Share b. Increase in RE = Income – Dividends – Preferred Dividend = $120,700 – $36,000 – $24,700 = $60,000.

2-15.

Dental Drilling Company Statement of Income Sales ............................................................... $ 489,000 Cost of goods sold.......................................... $ 156,000 Gross profit ................................................ $ 333,000 Selling and administrative expense................ $ 112,000 Amortization expense .................................... $ 73,000 Operating profit ......................................... $ 148,000 Interest expense .............................................. $ 45,000 Earnings before taxes ................................ $ 103,000 Taxes .............................................................. $ 47,000 Earnings after taxes ................................... $ 56,000

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2-16.

Balance Sheet Items

Common stock – noncurrent Accounts payable – current Preferred stock – noncurrent Prepaid expenses – current Bonds payable – noncurrent Inventory – current Investments – noncurrent Marketable securities – current Accounts receivable – current Plant and equipment – noncurrent Accrued wages payable – current Retained earnings – noncurrent

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2-17.

Balance Sheet Assets

Current Assets Cash................................................... Marketable securities......................... Accounts receivable........................... Less: Allowance for bad debts...... Inventory............................................ Total Current Assets................. Other Assets: Investments........................................ Capital Assets: Plant and equipment.......................... Less: Accumulated amortization.. Net plant and equipment................... Total Assets...........................................

$ 10,000 20,000 $48,000 6,000 42,000 66,000 138,000 20,000 680,000 300,000 380,000 $538,000

Liabilities and Shareholders' Equity Current Liabilities: Accounts payable.............................. Notes payable.................................... Total current Liabilities................ Long-Term Liabilities............................ Bonds payable................................... Total Liabilities............................. Shareholders' Equity: Preferred stock, 1,000 shares outstanding….... Common stock, 100,000 shares outstanding.... Retained earnings............................................. Total Shareholders' Equity........................... Total Liabilities and Shareholders' Equity……....

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$ 35,000 33,000 68,000 136,000 204,000 50,000 188,000 96,000 334,000 $538,000

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2-18.

Bengal Wood Company

Current assets……………………. Capital assets……………………. Total assets………………………. – Current liabilities…………….…. – Long-term liabilities……………. Shareholders‘ equity………….…… – Preferred stock obligation………. Net worth assigned to common……

$100,000 140,000 240,000 60,000 90,000 90,000 20,000 $ 70,000

Common shares outstanding……… Book value (net worth) per share…

17,500 $4.00

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2-19.

Monique’s Boutique

a. Total assets...................................... – Current liabilities......................... – Long-term liabilities.................... Shareholders' equity........................ – Preferred stock.............................. Net worth assigned to common.......

$600,000 150,000 120,000 330,000 75,000 $255,000

Common shares outstanding…............ Book value (net worth) per share…....

30,000 $8.50

b. Earnings available to common.........

$33,600

Shares outstanding........................... Earnings per share............................

30,000 $1.12

P/E ratio × earnings per share 12 × $1.12

= price = $13.44

c. Market value per share (price) to book value per share $13.44/$8.50 = 1.58

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2-20.

Phelps Labs

$1,800,000 595,000 630,000 575,000 165,000 $ 410,000

Common shares outstanding…........... Book value (net worth) per share…....

20,000 $20.50

b. Earnings available to common.........

$45,000

Shares outstanding........................... Earnings per share............................

20,000 $2.25

P/E ratio × earnings per share = price 13 × $2.25 = $29.25 c. Market value per share (price) to book value per share $29.25/$20.50 = 1.43

2-21.

Phelps Labs (Continued)

2 × book value 2 × $20.5 P/E ratio

= price = $41.00 = $41.00/$2.25 = 18.22

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2-22.

Appropriate Financial Statement 1. 2. 3. 4. 5. 6. 7.

Indicate Whether the Item is on Balance Sheet or Income Statement

BS IS BS BS BS

Balance Sheet (BS) Income Statement (IS) Current Assets (CA) Capital Assets (Cap A) Current Liabilities (CL) Long-Term Liabilities (LL) Shareholders‘ Equity (SE)

If the Item is on Balance Sheet, Designate Which Category

BS BS BS BS IS IS BS BS IS BS

CA CL CA Cap A

Foundations of Fin. Mgt. 12Ce

Retained earnings Income tax expense Accounts receivable Common stock Bonds payable, maturity 2022 Notes payable (6 months) Net income Selling and administrative expenses Inventories Accrued expenses Cash Plant and equipment Sales Operating expenses Marketable securities Accounts payable Interest expense Income tax payable

CA SE LL

BS IS IS

Item

CA CL CL

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2-23.

Cash Flow Impact

Increase in inventory -- decreases cash flow (use) Decrease in prepaid expenses -- increases cash flow (source) Decrease in accounts receivable -- increases cash flow (source) Increase in cash -- decreases cash flow (use) Decrease in inventory -- increases cash flow (source) Dividend payment -- decreases cash flow (use) Increase in short-term notes payable -- increases cash flow (source) Amortization expense – does not affect cash flow (However in the cash flow statement it is added to net income to determine cash provided by operations) Decrease in accounts payable -- decreases cash flow (use) Increase in long-term investments -- decreases cash flow (use)

2-24.

Rogers Corporation – Evans Corporation Rogers $880,000 120,000 360,000 400,000 120,000 280,000 360,000 $640,000

Gross profit......................... Selling and adm. expense... Amortization....................... Operating profit.................. Taxes (30%)........................ Earnings aftertaxes.............. Plus amortization expense... Cash Flow...........................

Evans $880,000 120,000 60,000 700,000 210,000 490,000 60,000 $550,000

Rogers had $300,000 (operating profit difference) more in amortization, which provided $90,000 (0.30 × $300,000) more in cash flow. Rogers paid .3×300,000 = $90,000 less taxes.

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2-25. a.

Solitude Corporation Statement of Cash Flows For the Year Ended December 31, 20XX

Operating activities: Net income (earnings aftertaxes)............... $ 73,800 Add items not requiring an outlay of cash: Amortization................................. $ 11,070 11,070 Cash flow from operations 84,870 Changes in non-cash working capital: Decrease in accounts receivable.... 7,380 Increase in inventory..................... (22,140) Increase in accounts payable......... 25,830 Decrease in taxes payable............... (7,380) Net change in non-cash working capital.... 3,690 Cash provided by operating activities........ 88,560 Investing activities: Increase in plant and equipment........... (25,830) Cash used in investing activities................

(25,830)

Financing activities: Issue of common stock ........................ 22,140 Common stock dividends paid............. (36,900) Cash used in financing activities………... (14,760) Net increase in cash (equivalents) during the year.. $ 47,970 Cash, beginning of year………. Cash, end of year……………...

29,520 $ 77,490

Major accounts contributing to positive change in cash position are: net income, payables and common stock issuance. Negative change comes from inventory, plant and equipment and dividends paid. 2-26. Waif Corporation a. Statement of Cash Flows For the Year Ended December 31, 20XX Operating activities: Foundations of Fin. Mgt. 12Ce

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Net income (earnings after taxes)............... $ 91,000 Add items not requiring an outlay of cash: Amortization................................. $ 22,000 22,000 Cash flow from operations 113,000 Changes in non-cash working capital: Increase in accounts receivable.... (12,600) Decrease in inventory..................... 7,100 Decrease in accounts payable......... (10,000) Net change in non-cash working capital.... (15,500) Cash provided by operating activities........ 97,500 Investing activities: Increase in plant and equipment........... (48,000) Sale of land…………………………… 27,000 Cash used in investing activities................

(21,000)

Financing activities: Retirement of bonds payable............... (40,000) Issue of common stock........................ 40,000 Common stock dividends paid……… (39,400) Cash used in financing activities………... Net increase in cash (equivalents) during the year

(39,400) 37,100

Cash, beginning of year………. Cash, end of year……………...

17,400 $ 54,500

Major accounts contributing to positive change in cash position are: net income, amortization, sale of land and common stock issuance. Negative change from plant and equipment, bond retirement, and dividends paid. 2-27. Maris Corporation Statement of Cash Flows For the Year Ended December 31, 20XX Operating activities: Net income (earnings after taxes)................ $250,000 Add items not requiring an outlay of cash: Amortization.............................. $ 230,000 230,000 Cash flow from operations 480,000 Foundations of Fin. Mgt. 12Ce

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Increase in accounts receivable.. (10,000) Increase in inventory.................. (30,000) Decrease in prepaid expenses.... 30,000 Increase in accounts payable..... 250,000 Decrease in accrued expenses... (20,000) Net change in non-cash working capital..... 220,000 Cash provided by operating activities......... 700,000 Investing activities: Decrease in investments..................... 10,000 Increase in plant and equipment......... (600,000) Cash used in investing activities................ (590,000) Financing activities: Increase in bonds payable .................. 60,000 Preferred stock dividends paid........... (10,000) Common stock dividends paid........... (140,000) Cash used in financing activities……….. Net increase (decrease) in cash

(90,000) 20,000

Cash, at beginning of year Cash, end of year

100,000 $120,000

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2-28.

Maris Corporation (continued)

Cash flow provided by operating activities exceeds net income by $450,000. This occurs primarily because we add back amortization of $230,000 and accounts payable increases by $250,000. Thus, the reader of the cash flow statement gets important insights as to how much cash flow was developed from daily operations. 2-29.

Maris Corporation (continued)

The buildup in plant and equipment of $600,000 (gross) and $370,000 (net) has been financed, in part, by the large increase in accounts payable ($250,000). This is not a very satisfactory situation. Short-term sources of funds can always dry up, while capital asset needs are permanent in nature. The firm may wish to consider more long-term financing, such as a mortgage, to go along with profits, the increase in bonds payable, and the add-back of amortization. 2-30.

Maris Corporation (continued)

Book value per share

= Shareholders' equity - Preferred stock Common shares outstanding

Book value per share (20XX)

= ($1,390,000 - $90,000) = $1,300,000 = $8.67 150,000 150,000

Book value per share (20XX)

= ($1,490,000 - $90,000) = $1,400,000 = $9.33 150,000 150,000

2-31.

Maris Corporation (continued)

Market value P/E ratio 2-32.

= 2.8 × $9.33 = $26.12 = $26.12/ $1.60 = 16.33 or 16x Winfield Corporation Statement of Cash Flows December 31, 20XX

Operating activities: Net income (earnings after taxes)............... Foundations of Fin. Mgt. 12Ce

3 - 26

$ 14,000 Block, Hirt, Danielsen, Short

Add items not requiring an outlay of cash: Amortization (buildings)..... $10,500 Gain on sale of investment…….. (5,250) Loss on sale of equipment........... 1,050 6,300 20,300

Cash flow from operations: Changes in non-cash working capital: Increase in accounts receivable... (2,450) Increase in inventory................... (5,250) Increase in prepaid expenses....... (175) Decrease in accounts payable..... (1,750) Increase in accrued expenses...... 1,925 Decrease in interest payable........ (175) Net change in non-cash working capital...... (7,875) Cash provided by operating activities…...... 12,425 Investing activities: Proceeds from the sale of stock............ 8,750 Proceeds from the sale of equipment.... 2,450 Purchase of equipment.......................... (15,750) Cash used in investing activities………….. (4,550) Financing activities: Payment towards notes payable............ (6,125) Increase in bonds payable..................... 5,250 Common stock dividends paid.............. (6,650) Cash used in financing activities………….. (7,525) Net increase in cash 350 Cash, beginning of year 1,400 Cash, end of year $ 1,750 2-33. Gardner Corporation a. Income Statement For the Year Ending December 31, 20XY Sales…………………………………………….. Cost of goods sold @ 60%................................... Gross profit………………………………….. Selling and administration expense…………...... Amortization expense…………………………... Foundations of Fin. Mgt. 12Ce

3 - 27

$220,000 132,000 88,000 22,000 20,000 Block, Hirt, Danielsen, Short

Operating profit……………………………… Interest expense (1)…………………………….. Earnings before taxes………………………… Taxes @ 18%........................................................ Earnings after taxes……………………………

46,000 6,000 40,000 7,200 $32,800

(1) Interest expense = (10% × $20,000 + 8% × $50,000) = $6,000

Gardner Corporation Balance Sheet December 31, 20XY

Cash $ 10,000 Accounts receivable 16,500 Inventory 27,500 Prepaid expenses 12,000 66,000 Current assets Capital assets: Plant and Equipment 285,000 less: acc. amortization 70,000 Net plant & equipment 215,000 Total assets $281,000

Accounts payable Notes payable Bonds payable Current liabilities Shareholders‘ equity: Common stock Retained earnings

$ 15,000 26,000 40,000 81,000 75,000 125,000

Total liabilities & equity $281,000

Acc. Amortization = $50,000 + $20,000 = $70,000 Retained Earnings = $105,000 + $20,000 = $125,000

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Gardner Corporation Statement of Cash Flows For the Year Ended December 31, 20XY

Operating activities: Net income (earnings after taxes)................ Add items not requiring an outlay of cash: Amortization.............................. $ 20,000 Cash flow from operations Increase in accounts receivable.. (1,500) Increase in inventory.................. (2,500) Increase in accounts payable..... 3,000 Increase in notes payable*……. 6,000 Net change in non-cash working capital..... Cash provided by operating activities.........

$32,800 20,000 52,800

5,000 57,800

Investing activities: Increase in plant and equipment......... (35,000) Cash used in investing activities................

(35,000)

Financing activities: Decrease in bonds payable.................. (10,000) Common stock dividends paid........... (12,800) Cash used in financing activities……….. Net increase (decrease) in cash

(22,800) 0

Cash, at beginning of year Cash, end of year

10,000 $10,000

* Note: There is a healthy debate as to whether notes payable (trade related) should be included in operating or financing activities.

d. Major accounts contributing to positive change in cash position are: net income and amortization. Negative change is from plant and equipment, bonds payable and dividends paid.

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2-34.

Ron’s Aerobics Ltd.

a. 20XX Net income Taxes @ 9.0% Income after taxes

$95,000 8,550 $86,450

b. Corporate income paid as dividend (corporate taxes still due) 20XX. For comparison purposes we want the same before tax income in Ron’s hands. Dividend $95,000 Medium income tax (20.53%) 19,504 Total taxes (8,550 + 19,504) $28,054 Total tax rate (28,054/ 95,000) 29.53% c. Corporate income paid as salary (no taxes as corporate income reduced to zero) 20XX Income $95,000 Medium income tax (37.90%) $36,005 Total tax rate (36,005/ 95,000) 37.90% d. No. Taxed as a corporation, the total taxes are less.

2-35.

Coastal Pipeline Corp.

a. Cash flow from operating activities - Capital expenditures - Common share dividends - Preferred share dividends Free cash flow

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$8.00 million 1.50 0.60 0.25 $5.65 million

Block, Hirt, Danielsen, Short

2-36.

Inland Fisheries Corp

a. Cash flow from operating activities - Capital expenditures - Common share dividends - Preferred share dividends Free cash flow

$6.00 million 2.00 0.75 0.35 $2.90 million

b. Free cash flow represents the funds that are available for special financial activities, such as the acquisition of another firm especially when it is a leveraged buyout.

2-37.

Nix Corporation Income Statement Sales............................................................... Cost of goods sold......................................... Gross Profit................................................... Selling and administrative expense............... Amortization expense.................................... Operating profit............................................. Interest expense............................................. Earnings before taxes.................................... Taxes @ 11% (Given)......................................... Earnings after taxes.........................................

2-38.

Nix Corporation (Continued)

Tax savings on amortization

2-39. Alberta

$485,000 205,000 280,000 70,000 60,000 150,000 25,000 125,000 13.750 $111,250

= $60,000 × 11% = $6,600

R.E. Forms Ltd. Net income Taxes @ 10.0%

Foundations of Fin. Mgt. 12Ce

$75,000 7,500 3 - 31

Block, Hirt, Danielsen, Short

Ontario

Income after taxes

$67,500

Net income Taxes @ 12.5% Income after taxes

$75,000 9,375 $65,625

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2-40.

J.B. Wands

a. Investment (bonds) $14,000 Bond interest @ 6.0% x $14,000 = $840.00 Marginal tax rate (Saskatchewan) 33.0% Deduct: Combined taxes payable 33.0% × $840 = 277.20 After tax bond yield (return) $562.80 After tax yield = return / investment x 100% = $562.80/ $14,000 × 100% = 4.02%

Investment (shares) $14,000 $658.00 Share dividend @ 4.7% x $14,000 = Marginal tax rate (Saskatchewan) 9.63% Deduct: Combined taxes payable 9.63% × $658 = 63.37 After tax dividend yield (return) $594.63 After tax yield = return / investment x 100% = $594.63/ $14,000 × 100% = 4.25% The dividend provides a slightly better after tax yield (return).

b. Bond interest is a fixed payment. Share dividends may not be paid and shares are subject to capital gains and losses. This makes the shares riskier. The result illustrates the ―risk – return tradeoff‖.

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2-41.

Billie Fruit

A. Top bracket (Investment of $20,000) Share dividend @ 7.0% x $20,000 = $1,400.00 Marginal tax rate (Alberta) $1,400 × 31.71% Deduct: Combined taxes payable 443.94 After tax dividend yield (return) $956.06 After tax yield = return / investment x 100% = $956.06/ $20,000 × 100% = 4.78% Capital gain @ 7.0% x $20,000 = $1,400.00 Marginal tax rate (Alberta) $1,400 × 24.00% Deduct: Combined taxes payable 336.00 After tax bond yield (return) $1,064.00 After tax yield = return / investment x 100% Better: $1,064.00/ $20,000 × 100% = 5.32% B. Middle bracket (at about $75,000) Share dividend @ 7.0% $1,400.00 Marginal tax rate (Alberta) $1,400 × 7.56% Deduct: Combined taxes payable 105.84 After tax dividend yield (return) $1,294.16 After tax yield Better: $1,294.16/ $20,000 × 100% = 6.47% Capital gain @ 7.0% $1,400.00 Marginal tax rate (Alberta) $1,400 × 15.25% Deduct: Combined taxes payable 213.50 After tax yield (return) $1,186.50 After tax yield $1,186.50/ $20,000 × 100% = 5.93%

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2-42.

Jasper Corporation

Yield is 7% On each $100 investment Interest paid to bondholder...............................

$7.00

Co.‘s Tax savings @ 27%................................ Combined bondholder tax payable @ 45%......

1.89 - 3.15

Net gain to government ($3.15 - $1.89)

$1.26

Chapter 3 Discussion Questions 3-1.

Short-term lenders - liquidity because their concern is with the firm's ability to pay shortterm obligations as they come due. Long-term lenders - leverage because they are concerned with the relationship of debt to total assets. They also will examine profitability to ensure that interest payments can be made. Shareholders - profitability, with secondary consideration given to debt utilization, liquidity, and other ratios. Since shareholders are the ultimate owners of the firm, they are primarily concerned with profits or the return on their investment.

3-2.

a. Return on investment =

Net income Total assets

Inflation may cause net income to be overstated and total assets to be understated. Too high a ratio could be reported.

b. Inventory turnover

= Sales or COGS Inventory

*Sales may be used when COGS is not available (rival private firms). Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect "inflation-influenced" dollars and the net effect will be nil.

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If the firm uses LIFO accounting, inventory will be stated in old dollars and too high a ratio could be reported.

c. Capital asset turnover

Sales Capital assets

Capital assets will be understated relative to sales and too high a ratio could be reported.

d. Debt to total assets

Total debt Total assets

Since both are based on historical costs, no major inflationary impact will take place in the ratio. Assets are likely understated, however, causing ratio to be overstated.

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3-3.

The Du Pont system of analysis breaks out the return on assets between the profit margin and asset turnover. ROA

= Profit Margin

Asset Turnover

Net income Total assets

= Net income Sales

Sales . Total assets

In this fashion, we can assess the joint impact of profitability and asset turnover on the overall return on assets. This is a particularly useful analysis because we can determine the source of strength and weakness for a given firm. For example, a company in the capital goods industry may have a high profit margin and a low asset turnover, while a food-processing firm may suffer from low profit margins, but enjoy a rapid turnover of assets. The modified Du Pont formula shows: ROE

ROA

Return on equity = Return on assets (investment) ×

Equity multiplier Total assets Equity

This indicates that return on shareholders' equity may be influenced by return on assets, the debt-to-assets ratio or a combination of both. Analysts or investors should be particularly sensitive to a high return on shareholders' equity that is influenced by large amounts of debt. 3-4. The fixed charge coverage ratio measures the firm's ability to meet all fixed obligations rather than interest payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the firm. 3-5.

In both instances, we would not reflect a very significant cost of doing business. Of course, one could argue that, to the extent that differential tax rates of financing plans (and associated interest costs) did not reflect the operating capability of the firm, omission of these changes could provide new insights.

3-6. No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or time periods in which ratios are computed. Nevertheless, rules-ofthumb ratios do offer some initial insight into the operations of the firm, and when used with caution by the analyst can provide information. 3-7. Trend analysis allows us to compare the present with the past and evaluate our progress through time. A profit margin of 5 percent may be particularly impressive if it has been running only 3 percent in the last ten years. Trend analysis must also be compared to industry patterns of change. The change in accounting rules with the use of IFRS for public companies and ASPE for private enterprises can result in financial statements being significantly different with those prepared before January 1, 2011 which makes trend analysis inappropriate for decision making. However, the conversion of previous

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years‘ statements will make the years prior to 2011 comparative and useful for trend analysis. 3-8.

Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm's income statement resulting in decreased net income. This is particularly true for firms in highly cyclical industries, such as oil based products, where prices tend to rise and fall quickly.

3-9. Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the dollar. Lower inflation also means that the required return that investors demand on financial assets will be lower, and with this lower demanded return, future earnings or interest should receive a higher current valuation. 3-10. There are many different methods of financial reporting accepted by the accounting profession as promulgated by CPA Canada. The implementation of IFRS (public firms) and ASPE (private firms) should result in better comparison of statements among companies using the same rules of accounting. Though the industry has continually tried to provide uniform guidelines and procedures, many options remain open to the reporting firm. Every item on the income statement and balance sheet must be given careful attention. Two apparently similar firms may show different values for sales, research and development, extraordinary losses, and many other items.

Internet Resources and Questions 1. 2. 3. 4.

https://ca.reuters.com and www.globeinvestor.com www.sedar.com/search/search_form_pc_en.htm www.bmo.com/main/about-bmo/banking/investor-relations/home www.rbc.com/investorrelations/index.html

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Problems 3-1.

Griffey Junior Wear

a. Return on assets 

Net income  $100,000  .125  12.5% Total assets $800,000

Shareholders' equity  Total asssets - total debt  $800,000  $200,000  $600,000 $100,000 Net income   .1667  16.67% Return on equity  Shareholders' equity $600,000

OR Equity multiplier 

Total assets $800,000   1.33 Equity $600,000

ROE  ROA  Equity multiplier  12.5% 1.33  16.67%

c. Sales  total assets  asset turnover  $800,000 2.75  $2,200,000 Net income  $100,000  Profit margin   .0455  4.55% $2,200,000 Sales

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3-2.

Bunny Hip and Hop Brewery

a. 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑠𝑠𝑒𝑡𝑠 =

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

$55,000 $750,000

= .0733 = 7.33%

b. 𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒𝑟𝑠' 𝑒𝑞𝑢𝑖𝑡𝑦 = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑡𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 = $750,000 − $300,000 = $450,000 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 =

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠′ 𝑒𝑞𝑢𝑖𝑡𝑦

$55,000 $450,000

= .1222 =

12.22% OR 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =

𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 $750,000 = = 1.67 𝐸𝑞𝑢𝑖𝑡𝑦 $450,000

𝑅𝑂𝐸 = 𝑅𝑂𝐴 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 7.33% × 1.67 = 12.22% c. 𝑆𝑎𝑙𝑒𝑠 = 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 × 𝑎𝑠𝑠𝑒𝑡 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = $750,000 × 2.2 = $1,650,000 $55,000 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = = .033 = 3.3% 𝑆𝑎𝑙𝑒𝑠 $1,650,000

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3-3.

Haines Corp.

Cost of goods sold Sales

20XX

20XY

$2,130, 000  65.9% 3, 230, 000

$2,850, 000  84.6% 3, 370, 000

It is decreasing profitability. b.

Selling & admin. expense

$298, 000

Sales

3, 230, 000

 9.2%

$227, 000  6.7% 3, 370, 000

 1.5%

$51, 600  1.5% 3, 370, 000

It is increasing profitability. c.

Interest expense

$47, 200

Sales

3, 230, 000

It is not changing profitability.

3-4.

Diet Health Foods Inc. Division A: Profit margin = Net income / Sales = $100,000 / $2,000,000 = 5% Division B: Profit margin = Net income / Sales = $25,000 / $300,000 = 8.33% Division B is superior in terms of profit margin with 8.33% against Division A's profit margin of 5.00%.

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3-5.

Dr. Gupta Diagnostics

a. 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 (20𝑋𝑋) = 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 = $175,000 = .0875 = 8.75% 𝑆𝑎𝑙𝑒𝑠

$2,000,000

b. Sales ($2,000,000 × 1.10)…….………………….. Cost of goods sold ($1,400,000 × 1.20)………… Gross profit…………………………………... Selling and administration expense………........... Operating profit……………………………… Interest expense…………………………………. Income before taxes..………………………… Taxes @ 30% …………………………………… Income after taxes….………………………… 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 (20𝑋𝑌) =

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠

3-6.

$119,000 $2,200,000

$2,200,000 1,680,000 520,000 300,000 220,000 50,000 170,000 51,000 $ 119,000

= .0541 = 5.41%

Watson Data Systems Net income

= = =

Return on assets (investment)

Sales  profit margin $1,200,000  6% $72,000 = = =

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Net income Total assets $ 72,000 $500,000 0.144= 14.4%

Block, Hirt, Danielsen, Short

3-7.

Walker Glove and Bat Shop Net income

= = =

Assets



Sales  profit margin $1,250,000  0.08 $100,000

Sales Total asset turnover = $1,250,000/ 3.4 = $367,647

$100,000  0.2720  27.2% Return on Assets (investments)  Net income  Total assets $367,647

3-8.

Hugh Snore Bedding Sales

= = =

Total assets × total asset turnover $400,000 × 1.5 $600,000

Net income

= = =

Total assets × return on assets $400,000 × 12% $48,000

Profit margin 

Foundations of Fin. Mgt. 12Ce

Net income  $48,000  0.08  8.0%  Sales $600,000

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Billy’s Crystal Stores Inc.

3-9.

Sales  Assets total asset turnover $11,324,000  $5,960,000 1.9 Net income  Assets  Return on assets $476,800  $5,960,000  8% Net income  $476,800/$11,324,000 = 4.21% Sales

3-10.

Sharpe Razor Company Total assets ─ Current assets $2,500,000 ─ 1,000,000

= Capital assets = $1,500,000

Sales = Capital assets × Capital asset turnover = $1,500,000 × 5 = $7,500,000 Total assets ─ debt $2,500,000 ─ 700,000

= Shareholders‘ equity = $1,800,000

Net income = Sales × profit margin = $7,500,000 × 3% = $225,000 ROE 

Net income $225,000  .125  12.5%  Shareholders' equity $1,800,000

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3-11.

Fondren Machine Tools Total assets – Current assets Fixed assets

$3,310,000 879,000 $2,431,000

Sales  Fixed assets  Fixed asset turnover $8,751,600  $2,431,000  3.6 Net income = Sales  Profit margin $8,751,600  4.8% = $420,076.80 $3,310,000  1,750,000  $1,560,000  Net income Return on stockholders' equity  Stockholders' equity

Total assets – Debt Stockholders‘ equity



3-12.

$420,076.80  26.93% $1,560,000

Global Healthcare Products

Global Healthcare has a higher asset turnover ratio than the industry. ROA = Asset turnover × profit margin Asset turnover 

Foundations of Fin. Mgt. 12Ce

12% ROA 18%  1.2    9  versus Profit margin 2% 10%

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3-13.

Acme Transportation Company

Acme Transportation has a lower debt/total assets ratio than the industry because it has a lower equity multiplier. The reciprocal of the equity multiplier is equity to total assets. The industry has more leverage. ROE = ROA × equity multiplier Equity multiplier =

ROE ROA

3-14. a.

12% 24% = 1.33 × versus = 4.0 × 9% 6%

King Card Company Equity multiplier 

Total assets 100%   1.667 1  40% Equity

ROE  ROA  Equity multiplier  12% 1.667  20.0%

b. With no debt: ROE = ROA. In this case 12%.

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3-15.

Lollar Corporation

a. Total asset turnover  Profit margin= Return on total assets (ROA) ?  5% = 13.5% 13.5% Total asset turnover   2.7  5% 

b. Equity multiplier 

100% Total assets   2.5 1  60% Equity

ROE  ROA Equity multiplier  13.5%  2.5  33.75%

c. Equity multiplier 

Total assets 100%   1.67 Equity 1  40%

ROE  ROA Equity multiplier  13.5% 1.67  22.50%

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3-16.

Pony Express Return on assets 

Net income Total assets



$55,000  .0733  7.33% $750,000

Shareholders' equity  Total assets - total debt

 $750,000  $300,000  $450,000 $55,000 Net income  Return on equity   .1222  12.22% Shareholders' equity $450,000

Total assets

$750,000  1.67 $450,000 Equity ROE  ROA Equity multiplier  7.33% 1.67  12.22% Equity multiplier 



c. Sales  total assets  asset turnover  $750,000 2.2  $1,650,000 Profit margin 

Net income Sales

3-17.



$55,000  .033  3.3% $1,650,000

Baker Oats a.

Total asset turnover × Profit margin = Return on total assets 1.6 × ? = 11.2% Profit margin =

11.2%

 7.0%

1.6

b. 1.4

8% = 11.2%

It did not change at all because the increase in profit margin made up for the decrease in the asset turnover. 3-18. a. Net income Foundations of Fin. Mgt. 12Ce

K Y Shoe Stores = Sales  profit margin 4 - 48

Block, Hirt, Danielsen, Short

= $2,000,000  3.8% = $76,000 Shareholders equity

= Total assets  total liabilities

Total assets

= Sales/Total asset turnover = $2,000,000/2.5 = $800,000

Total liabilities

= Current liabilities + long-term liabilities = $60,000 + $140,000 = $200,000

Shareholders' equity = $800,000  $200,000 = $600,000 $76,000 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦 (ROE) = 𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒𝑟𝑠' 𝑒𝑞𝑢𝑖𝑡𝑦 $600,000 = .1267 = 12.67% b. Sales

Net income

= = =

Total assets  total asset turnover $800,000  3 $2,400,000

= = =

Sales  Profit margin $2,400,000  3.8% $91,200

$91,200 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 = 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦(ROE) = 𝑆h𝑎𝑟𝑒h𝑜𝑙𝑑𝑒𝑟𝑠' 𝑒𝑞𝑢𝑖𝑡𝑦 $600,000 = 0.152 = 15.20%

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

3-19.

Interactive Technology and Silicon Software

Interactive Technology Net income  $15,000  a. ROE   15% Equity $100,000

Silicon Software $50,000  31.25% $160,000

$50,000 Net income  $15,000   10%  5% $150,000 $1,000,000 Sales Net income $50,000 $15,000  ROA   9.375%  12.5% Total assets $160,000 $400,000 $150,000 $1,000,000  Sales   0.9375  2.5  $400,000 Total assets $160,000 Debt $240,000 $60,000  37.5%  60%  Total assets $160,000 $400,000

b. Profit margin 

c. Silicon Software has a significantly higher return on equity (31.25% versus 15%). This is despite a lower profit margin (5% vs.10%). However Silicon has achieved a higher return on total assets (12.5% vs. 9.375%) through a strong total asset turnover (2.5× vs. 0.9375×). The superior return on equity is further enhanced with higher use of debt (60% vs. 37.5%). This is called leverage and can magnify shareholder returns.

3-20.

A Firm Average collection period 

Accounts receivable Average daily credit sales

$360,000  $1,200,000  90% / 365 $360,000   122 days $2,959 

3-21.

Foundations of Fin. Mgt. 12Ce

Chamberlain Corporation

4 - 50

Block, Hirt, Danielsen, Short

Average credit sales 

Credit sales 365

To determine credit sales, multiply accounts receivable by accounts receivable turnover. $90,000  12 = $1,080,000 Average credit sales 

$1,080,000

 $2,959

365

3-22.

A Firm

Times Interest Earned Ratio = EBIT/Interest Expense = $193,000/$28,100 = 6.87 times

Fixed Charge Coverage Ratio = EBIT/Fixed Charges = ($193,000 + $48,500)/ ($28,100 + $48,500) = 3.15 times

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

3-23.

2GFU Corporation 20XX

a. Inventory turnover 

20XY

$3,500,000  Sales   14  Inventory $250,000

 Inventory turnover  COGS  $2, 500, 000  10  Inventory $250, 000

$4,200,000   14  $300,000

$3, 500, 000   11.67  $300, 000

c. Based on the sales to inventory ratio the turnover ratio has remained constant at 14 ×. However, based on the cost of goods sold to inventory ratio, it has improved from 10 × to 11.67 ×. The later ratio may be providing a false picture of improvement in this example simply because COGS has gone up as a percentage of sales (from 71.43 percent to 83.33 percent). Inventory is not really turning over any faster. Nevertheless, COGS is used by many analysts in the numerator of the inventory turnover ratio because it is stated on a ‗cost‘ basis as inventory. This is an important theoretical consideration. Dun and Bradstreet, the most widely quoted source for ratio analysis uses sales in the numerator. Furthermore, for private companies, information may be only available for sales and net COGS.

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3-24.

Jim Kovacs Company

a. 1. Accounts receivable turnover = Sales/Accounts Receivable

$4,000,000  5x 800,000 2. Inventory turnover = Sales/Inventory

$4,000,000  10x 400,000 3. Fixed asset turnover = Sales/ (Net Plant & Equipment)

$4,000,000  8x 500,000 4. Total asset turnover = Sales/Total Assets

$4,000,000  2.22x 1,800,000 b. 1. Accounts receivable turnover

$5,000,000  5.56x 900,000 2. Inventory turnover

$5,000,000  5.13x 975,000 3.

Fixed asset turnover

$5,000,000  9.09x 550,000 4.

Total asset turnover

$5,000,000  1.98x 2,525,000 c.

There is a decline in total asset turnover from 2.22x to 1.98x. This development has taken place because of the slowdown in inventory turnover (10x down to 5.13x). The other two ratios are slightly improved.

3-25.

Foundations of Fin. Mgt. 12Ce

Bryan Corporation

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Block, Hirt, Danielsen, Short

a. Current ratio  b. Quick ratio 

$650,000  Current assets   2.6  Current liabilities $250,000

 Current assets - inventory $300,000   1.2  $250,000 Current liabilities

c. Debt to total assets  d. Asset turnover  

Total debt $400,000   38% Total assets $1,060,000

$3,040,000  Sales   2.87  Total assets $1,060,000

Accounts receivable Average daily credit sales $240,000 $240,000     38.42 days $3,040,000  75% / 365 6,247 Average collection period 

3-26.

Simmons Corporation Incomebefore interest and taxes (EBIT) Interest $60,000    5 $12,000

Times interest earned  a.

Fixed charge coverage  Incomebefore fixed charges and taxes Fixed charges b. $60,000  $24,000 $84,000     2.33 $12,000  $24,000 $36,000 

3-27.

Sports Car Tire Company

a. Times interest earned 

Foundations of Fin. Mgt. 12Ce



EBIT $6,000    12  Interest $500

4 - 54

Block, Hirt, Danielsen, Short

 Fixed charge coverage  Incomebefore fixed charges and taxes Fixed charges $6,000  $1,000 $7,000     4.67  $1,000  $500 $1,500 

c. Profit margin 



Net income Sales

d. Asset turnover 

 $3,300  .165  16.5% $20,000

Sales $20,000    0.5  Total assets $40,000

e. Return on assets (ROA) 

Net income $3,300   0.0825  8.25% Total assets $40,000 OR

ROA = Profit margin × asset turnover = 16.5% × 0.5 = 8.25%

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Block, Hirt, Danielsen, Short

3-28.

Century Plaza Enterprises

Grand Vista 6.25%

Net income/Sales

Bronte 4.0%

Caledon 7.50%

Grand Vista

Bronte

Caledon

20.00%

8.00%

12.00%

The Bronte division has the lowest return on sales.

b. Net income/total assets

The Grand Vista division has the highest return on assets.

c. Corporate net income

= $1,000,000 + $160,000 + $600,000 = $1,760,000

Corporate total assets

= $5,000,000 + $2,000,000 + $5,000,000 =$12,000,000

Net income $1,760,000  ROA   0.1467  14.67% Total assets $12,000,000 d. Return on redeployed assets in Grand Vista: 20%  $5,000,000 = $1,000,000 Return on assets for the entire corporation: New corporate net income

= $1,000,000 + $160,000 + $1,000,000 = $2,160,000

Net income $2,160,000  ROA   0.1800  18% Total assets $12,000,000 3-29.

Foundations of Fin. Mgt. 12Ce

Status Quo Company

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Block, Hirt, Danielsen, Short

a. The return on assets for Status Quo will increase over time as the assets are amortized and the denominator gets smaller. Capital assets at the beginning of 2010 equal $300,000 with a ten-year life which means the amortization expense will be $30,000 per year. Book values at year-end are as follows: Year

Capital Assets $270,000 $210,000 $120,000 $60,000 0

2010 2012 2015 2017 2019

Current Assets + $200,000 + $200,000 + $200,000 + $200,000 + $200,000

Return on assets 

2010 2012 2015 2017 2019

Total Assets = $470,000 = $410,000 = $320,000 = $260,000 = $200,000

Income aftertaxes Total assets

$26,000/$470,000 $26,000/$410,000 $26,000/$320,000 $26,000/$260,000 $26,000/$200,000

= 5.53% = 6.34% = 8.13% = 10.00% = 13.00%

b. The increasing return on assets over time is due solely to the fact that annual amortization charges reduce the amount of investment. The increasing return is in no way due to operations. Financial analysts should be aware of the effect of overall asset age on the return-on-investment ratio and be able to search elsewhere for indications of operating efficiency when ROI is very high or very low. c. As income rises, return on assets will be higher than in part (b) and would indicate an increase in return partially from more profitable operations.

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3-30.

JAS Clocks Corp.

a. Net income/ total assets 20XW $110,000/ $1,500,000 = 0.0733 = 7.33% 20XX $125,000/ $1,900,000 = 0.0658 = 6.58% 20XY $150,000/ $2,400,000 = 0.0625 = 6.25% 20XZ $175,000/ $3,000,000 = 0.0583 = 5.83% Comment: There is a strong downward trend in return on assets over the period.

b. Net income/ shareholders‘ equity 20XW $110,000/ $ 750,000 = 0.1467 = 14.67% 20XX $125,000/ $ 825,000 = 0.1515 = 15.15% 20XY $150,000/ $ 900,000 = 0.1667 = 16.67% 20XZ $175,000/ $1,000,000 = 0.1750 = 17.50% Comment: The return on shareholders‘ equity is going up each year. The difference in trends from a to b is due to the increasing portion of assets financed with debt. This can be confirmed (not required) with:

Total debt/ total assets 20XW $ 750,000/ $1,500,000 = 0.5000 = 50.00% 20XX $1,075,000/ $1,900,000 = 0.5658 = 56.58% 20XY $1,500,000/ $2,400,000 = 0.6250 = 62.50% 20XZ $2,000,000/ $3,000,000 = 0.6667 = 66.67%

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3-31.

Quantum Moving Company

a. Net income/total assets Year Quantum Ratio 20XX 20XY 20XZ

12.5% 11.7% 10.0%

Industry Ratio 11.5% 8.4% 5.5%

Although the company has shown a declining return on assets since 2012, it has performed much better than the industry. Praise may be more appropriate than criticism.

b. Debt/total assets Year Quantum Ratio 20XX 20XY 20XZ

58.0% 54.1% 50.7%

Industry Ratio 54.1% 42.0% 33.4%

While the company's debt ratio is improving, it is not improving nearly as rapidly as the industry ratio. Criticism may be more appropriate than praise.

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3-32.

United World Corporation

Computers 6.25%

Net income/sales

Magazines Cable TV 4.00% 7.50%

The magazine division has the lowest return on sales. b.

Computers Net income/total assets 20.00%

Magazines Cable TV 8.00% 12.00%

The computer division has the highest return on assets. c. Corporate net income = $1,000,000 + $160,000 + $600,000 = $1,760,000 Corporate total assets = $5,000,000 + $2,000,000 + $5,000,000 =$12,000,000 ROA 

Net income $1,760,000   0.1467  14.67% Total assets $12,000,000

d. Return on redeployed assets in computers: 20%  $5,000,000 = $1,000,000 Return on assets for the entire corporation: New corporate net income = $1,000,000 + $160,000 + $1,000,000 = $2,160,000 Net income $2,160,000  ROA   0.1800  18% Total assets $12,000,000

3-33.

Quinn Corporation

Income Statement for Dec. 31, 20XY

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

Sales................................... $110,000 (10,000 units at $11) Cost of goods sold.............. 50,000 (10,000 units at $5) Gross profit.................. 60,000 Selling and adm. Expense... 5,500 (5% of sales) Amortization ...................... 10,000 Operating profit............ 44,500 Taxes (34%)........................ 15,130 After tax income.................. $ 29,370 b. Gain in after tax income = $29,370  $23,100 = $6,270 Increase = $ 6,270 Base value (20XX) $23,100

= 27.14%

Aftertax income increased much more than sales because of FIFO inventory policy (in this case, the cost of old inventory did not go up at all), and because of historical cost amortization (which did not change).

Income Statement for Dec. 31, 20XY Sales.................................. $ 93,500 (10,000 units at $9.35*) Cost of goods sold............ 55,000 (10,000 units at $5.50) Gross profit................ 38,500 Selling and adm. expense.. 4,675 (5% of sales) Amortization ................... 10,000 Operating profit......... 23,825 Taxes (34%)..................... 8,100 After tax income................ $15,725 *$11.00  0.85 = $9.35 The low profits indicate the effect of inflation followed by disinflation.

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3-34.

Current assets = 2  $80,000 = $160,000 Current assets (without inventory) = 1.25  $80,000 = $100,000 Inventory = $160,000  $100,000 = $60,000 Account rec. = ($420,000/ 365)  36 = $41,425 Cash = $160,000  $60,000  $41,425 = $58,575 Current assets

Cash Accounts receivable Inventory Total current assets 3-35.

$ 58,575 41,425 60,000 $160,000

Shannon Corporation Sales/total assets Total assets Total assets Cash Cash

= 2.5 times = $750,000/ 2.5 = $300,000

= 2% of total assets = 2%  $300,000 = $6,000

Sales/ accounts receivable = 10 times Accounts receivable = $750,000/ 10 Accounts receivable = $75,000 COGS/ inventory Inventory Inventory Current asset

Foundations of Fin. Mgt. 12Ce

= 10 times = $500,000/ 10 = $50,000

= $6,000 + $75,000 + $50,000 = $131,000 4 - 62

Block, Hirt, Danielsen, Short

Capital assets = Total assets  current assets = $300,000  $131,000 = $169,000 Current assets/ current debt = 2 Current debt = Current assets/ 2 Current debt = $131,000/ 2 Current debt = $65,500 Total debt/total assets Total debt Total debt

= 45% = 45%  $300,000 = $135,000

Long-term debt Long-term debt Long-term debt

= Total debt  current debt = $135,000  $65,500 = $69,500

Net worth Net worth Net worth

= Total assets  total debt = $300,000  $135,000 = $165,000 Balance Sheet Dec. 31, 20XX

Cash....................... A/R........................ Inventory................ Total current assets Capital assets.......... Total assets.............

Foundations of Fin. Mgt. 12Ce

$ 6,000 $ 75,000 $ 50,000 $131,000 $169,000 $300,000

Current debt.......... Longterm debt.... Total debt...........

$ 65,500 $ 69,500 $135,000

Equity.................... $165,000 $300,000 Total debt and shareholders‘ equity

4 - 63

Block, Hirt, Danielsen, Short

3-36.

Pettit Corporation

a. Accounts receivable

= Sales/ receivables turnover = $3,000,000/ 6× = $500,000

b. Current Assets

= Current ratio  current liabilities = 2.5  $700,000 = $1,750,000

Marketable securities

c. Capital assets

= Current assets  (cash + accts rec. + inventory) = $1,750,000  ($150,000 + $500,000 + $850,000) = $1,750,000  1,500,000 = $250,000 = Total assets  current assets

Total assets

= Sales/ asset turnover = $3,000,000/ 1.25x = $2,400,000

Capital assets

= $2,400,000 - $1,750,000 = $650,000

d. Total debt

Long-term debt

Foundations of Fin. Mgt. 12Ce

= Debt to assets  total assets = 40%  $2,400,000 = $960,000 = Total debt  current liabilities = $960,000  $700,000 = $260,000

4 - 64

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3-37.

U Guessed It Company = 2.0  = $20 million/ 2 = $10 million

Sales/total assets Total assets Total assets

Total debt/total assets = 40% Total debt = $10 million  0.40 Total debt = $ 4 million = 4.0  = $20 million  80%/ 4.0  = $4 million

COGS/inventory Inventory Inventory Average daily sales

= $20 million/ 365 days = $54,795 per day Accounts receivable = 18 days  $54,795 = $986,301 (or) Sales 

# of days

 $20 million 

365

Capital assets Current assets

 $986,301

365

= $20 million/ 5.0  = $ 4 million = Total asset  Capital assets = $10 million  $4 million = $6 million

Cash

= Total assets  inventory  accounts receivable  capital assets = $10 million  $4 million  $986,301  $4 million = $1,013,699

Current liabilities

= Current assets/ 3  = $6 million/ 3  = $2 million

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Long-term debt

= Total debt  current debt = $4 million  $2 million = $2 million

Equity

= Total assets  total debt = $10 million  $4 million = $6 million

Cash........................... Accounts receivable... Inventory.................... Total current assets.... Capital assets............. Total assets...................

Foundations of Fin. Mgt. 12Ce

U Guessed It Company December 31, 20XX (Millions) $ 1.014 Current debt........ 0.986 Long-term debt... 4.000 Total debt............ 6.000 Equity.................. 4.000 Total debt $10.000 & equity...........

4 - 66

$ 2.000 2.000 4.000 6.000

$10.000

Block, Hirt, Danielsen, Short

3-38.

Snider Corporation Profitability ratios Profit margin = $120,000/ $1,980,000 = 6.06% Return on assets (investment) = $120,000/ $900,000 = 13.3% Return on equity = $120,000/ $580,000 = 20.69% Assets utilization ratios Receivables turnover = $1,980,000/ $160,000 = Average daily sales = $1,980,000/ 365 = Average collection period = $160,000/ $5,425 =

12.38 × $5,425 29.49 days

Inventory turnover = $1,980,000/ $200,000 = OR = $1,280,000/ $200,000 = Average daily COGS = $1,280,000/ 365 = Inventory holding period = $200,000/ $3,507 =

9.9 × 6.4 × $3,507 57 days

Accounts payable turnover = $1,280,000/ $90,000 = 14.22 × Accounts payable period = $90,000/ $3,507 = 25.67 days Capital asset turnover = $1,980,000/ $410,000 = Total asset turnover = $1,980,000/ $900,000 =

4.83 × 2.2 ×

Liquidity ratio Current ratio = $430,000/ $170,000 = Quick ratio = $230,000/ $170,000 =

2.53 × 1.35 ×

Debt utilization ratios Debt to total assets = $320,000/ $900,000 = Times interest earned = $225,000/ $25,000 = Fixed charge coverage = $260,000/ $60,000 =

Foundations of Fin. Mgt. 12Ce

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35.56% 9× 4.33 ×

Block, Hirt, Danielsen, Short

3-39.

Jet Boat Ltd. Profitability ratios Profit margin = $72,800/ $2,900,000 = 2.5% Return on assets (investment) = $72,800/ $1,200,000 = 6.1% Return on equity = $72,800/ $450,000 = 16.18% Assets utilization ratios Receivables turnover = $2,900,000/ $100,000 = Average daily sales = $2,900,000/ 365 = Average collection period = $100,000/ $7,945=

29 × $7,945 12.59 days

Inventory turnover = $2,900,000/ $375,000 = OR = $2,465,000/ $375,000 = Average daily COGS = $2,465,000/ 365 = Inventory holding period = $375,000/ $6,753 =

7.73 × 6.57 × $6,753 56 days

Accounts payable turnover = $2,465,000/ $100,000 = 25 × Accounts payable period = $100,000/ $6,753 = 15 days Capital asset turnover = $2,900,000/ $600,000 = Total asset turnover = $2,900,000/$1,200,000 =

4.83 × 2.42 ×

Liquidity ratio Current ratio = $600,000/ $250,000 = Quick ratio = $225,000/ $250,000 =

2.40 × .90 ×

Debt utilization ratios Debt to total assets = $750,000/ 1,200,000 = Times interest earned = $185,000/ $94,000 = Fixed charge coverage = $185,000/ $144,000 =

62.50% 1.97 × 1.28 ×

Note: Sinking fund provision included in denominator only.

Comments:

Foundations of Fin. Mgt. 12Ce

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Jet Boat is a good vehicle to introduce seasonal and location considerations into ratio analysis. Note that the year-end is December 31st. Based on that and assuming that Jet Boat is a retailer, the receivable and inventory turnover that look promising at first glance may indicate potentially devastating write-offs/ downs. If Jet Boat is located on Georgian Bay, for example, it would be in mid-off season. If it is located in Sydney, Australia, the threat of stock-outs might be a concern as it would be in mid-selling season. Jet Boat Ltd. has a low profit margin, but a reasonable return on equity. This comes from a strong asset turnover and a high debt load. Du Pont analysis shows return on equity as 2.5% (profit margin) × 2.42 (asset turnover) × 2.67 (equity multiplier) = 16.2%. Equity multiplier = Total assets/ equity = 1/ (1  debt/assets) = 1/ (1  .625) = 2.67. The asset utilization ratios show good efficiency but perhaps hint at over utilization. Sales may be lost if the firm is undercapitalized and is trying to make due by overusing existing assets. The average collection period is very good. Is a discount offered? The liquidity ratios also appear good, with a heavy reliance on inventory. The debt utilization ratios reveal that Jet Boat Ltd. has only a small margin for error. The debt load is heavy.

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3-40.

Jones and Smith Comparison One way of analyzing the situation for each company is to compare the respective ratios for each one, examining those ratios which would be most important to a supplier or short-term lender and a shareholder.

Jones Corp.

Smith Corp.

Profit margin

7.4%

5.25%

Return on assets (investments)

18.5%

12.0%

Return on equity

28.9%

34.4%

Receivable turnover

15.6 ×

14.3 ×

23.4 days

25.6 days

15 × or 25 ×

8 × or 13.3 ×

24.3 days

45.6 days

Accounts payable turnover

7.5 ×

8×

Accounts payable period

49 days

46 days

Capital asset turnover

3.57 ×

4×

Total asset turnover

2.5 ×

2.28 ×

Current ratio

1.5 ×

2.5 ×

Quick ratio

1.0 ×

1.5 ×

Debt to total assets

36%

65%

Times interest earned

24.12 ×

6×

Fixed charge coverage Fixed charge calculation

13.33 × (200/ 15)

4.75 × (133/ 28)

Average collection period Inventory turnover Inventory holding period

a. Since suppliers and short-term lenders are most concerned with liquidity ratios, Smith Corporation would get the nod as having the best ratios in this category. One could argue, however, that Smith had benefited from having

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its debt primarily long term rather than short term. Nevertheless, it appears to have better liquidity ratios. b. Shareholders are most concerned with profitability. In this category, Jones has much better ratios than Smith. Smith does have a higher return on equity than Jones, but this is due to its much larger use of debt. Its return on equity is higher than Jones‘ because it has taken more financial risk. In terms of other ratios, Jones has its interest and fixed charges well covered and in general its long-term ratios and outlook are better than Smith's. Jones has asset utilization ratios equal to or better than Smith and its lower liquidity ratios could reflect better short-term asset management, and that point was covered in part a. Note: Remember that to make actual financial decisions more than one year's comparative data is usually required. Industry comparisons should also be made.

3-41.

Retail Company Gross margin is healthy. Profit is improving. This suggests lower fixed costs increasing profitability. Receivable and inventory turnovers are weakening over years indicating concerns about management, but asset turnover ratios have improved and is catching up with industry average. This suggests a robust growth in sales volume. Liquidity is good compared to industry average, but it has diminished in last year. Debt coverage is good. Weak return on equity is a combination of less than satisfactory profit margin and asset turnover, however the ratios are improving year on year.

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Comprehensive Problems 3-42.

Wizard Industries 20XX 20XW 20XV

Industry

0.1% 5.2% 0.1% 10.3% 0.4% 29.6%

0.4% 0.7% 1.8%

5.8% 8.1% 20.3%

3.9× 93 4.9× 6.3× 74 8.6× 42 9.9× 1.8×

5.1× 72 4.2× 5.6× 86 7.1× 51 10.6× 2.0×

5.2× 70 4.1× 5.3× 90 5.6× 65 8.4× 1.9×

6.3× 58 4.3× NA NA NA NA 8.0× 1.7×

1.72 1.08

1.71 0.93

1.55 0.82

1.6 1.1

71.4% 65.3% 64.7% 1.02× 3.42× 1.15× 1.02× 3.42× 1.15×

60% 4.3× 

Profitability Ratios Profit margin Return on assets Return on equity Asset Utilization Ratios Receivable turnover Avg. Collection period Inventory turnover Inventory turnover (sales) Inventory holding period Accounts payable turnover Accounts payable period Capital asset turnover Total asset turnover Liquidity Ratios Current ratio Quick ratio Debt Utilization Ratios Debt to total assets Times interest earned Fixed charge coverage

The profitability ratios do not appear healthy. Even in 20XW the profit margin did not reach the industry average. The relatively good performance in year 20XW Foundations of Fin. Mgt. 12Ce

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seems to be dependent on strong sales. Good return on assets results from high asset turnover and the high return on equity is due to high debt levels. When sales aren‘t maintained the results are evident in year 20XX. The asset utilization ratios reveal problems. The slowdown in the collection of accounts receivable is of considerable concern. The working capital position has become more dependent on A/R and we must question the quality of these receivables. Turnover is far below the industry average. We note that the accounts payable period has increased significantly which may suggest Wizard is not taking advantage of supplier credit to the full extent possible or suppliers are starting to cut back on credit to Wizard. Capital asset turnover is above the industry average and probably reveals that Wizard is overtrading and may not be reinvesting in assets. The increased inventory turns may also indicate overtrading. The liquidity ratios appear to be good. We should ask why. We have already identified the increasing A/R position. This would increase the liquidity ratios but it is hardly a healthy position. Furthermore, the long-term debt position has been increasing, perhaps as a substitute for short-term borrowings. The debt utilization ratios suggest an increasingly precarious position. The profit failure has severely impacted on the debt load. Interestingly, dividends have been maintained, Creditors are increasingly holding the bag. Do not grant credit! Debt loads are increasing and shareholders are not showing a full commitment to the firm. An equity contribution and reduction of dividends is required. Furthermore sales are weak and this is impacting on profitability measures. Those sales that are made are being collected in a longer time. Are they less creditworthy? There is also evidence of a reluctance to reinvest in equipment (capital assets).

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3-43.

Watson Leisure Time Sporting Goods 20XX

20XW

(Company)

20%

(Industry)

10.02%

9.98%

(Company)

5.56%

5.63%

6.26%

(Industry)

5.81%

5.80%

5.75%

(Company)

6.34%

7.79%

9.39%

(Industry)

8.48%

8.24%

8.22%

(Company)

14.25%

15.73%

17.07%

(Industry)

10.10%

13.62%

13.26%

Receivable turnover

(Company)

6.55 ×

7.83 ×

10.0 ×

(Industry)

9.31 ×

9.5 ×

10.0 ×

Average collection period

(Company)

55.8days

46.6days

36.5 days

(Industry)

35.6 days

37.9 days

36 days

Inventory turnover

(Company)

6.65 × or 4×

6.32 × or 3.93 ×

6.0 × or 3.8 ×

(Industry)

5.84 ×

5.62 ×

5.71 ×

Capital asset Turnover

(Company)

1.85 ×

2.50 ×

2.73 ×

(Industry)

2.20 ×

2.66 ×

2.75 ×

Total asset

(Company)

1.14 ×

1.38 ×

1.50 ×

Turnover

(Industry)

1.46 ×

1.42 ×

1.43 ×

Current ratio

(Company)

1.45 ×

1.78 ×

2.25 ×

(Industry)

2.15 ×

2.08 ×

2.10 ×

(Company)

0.80 ×

0.91 ×

1.00 ×

(Industry)

1.10 ×

1.02 ×

1.05 ×

Growth in sales

Profit margin

Return on assets

Return on equity

Quick ratio

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Debt to total Assets

(Company)

55.48%

50.47%

45.0%

(Industry)

40.10%

39.50%

38.0%

Times interest Earned

(Company)

3.18 ×

4.75 ×

5.67 ×

(Industry)

5.26 ×

5.20 ×

5.0 ×

Fixed charge coverage

(Company)

2.85 ×

3.73×

4.11×

(Industry)

3.97 ×

3.95 ×

3.85 ×

Growth in E.P.S.

(Company)

3.2%

7.7%



(Industry)

9.8%

9.7%



Discussion of Ratios While Watson Leisure is expanding its sales much more rapidly than others in the industry, there are some clear deficiencies in their performance. These can be seen in terms of a trend analysis over time as well as a comparative analysis with industry data. In terms of profitability, the profit margin is declining over time. This is surprising in light of the 44% increase in sales over two years (20% per year). There obviously are no economies of scale for this firm. Higher costs of goods sold and interest expense appear to be causing the problem. The return on asset ratio starts out in 20XV above the industry average (9.39 percent versus 8.22 percent) and ends up well below it (6.34 percent versus 8.48 percent) in 20XX. The decline in return on assets is serious, and can be attributed to the previously mentioned declining profit margin as well as a slowing total asset turnover (going from 1.5 × to 1.14 ×). Return on equity is higher than the industry average the first year, and then also falls far below it. This decline is particularly significant in light of the progressively larger debt that the firm is using. High debt utilization tends to contribute to high return on equity, but not in this case. There is simply too much deterioration in return on assets translating into low return on equity. The previously mentioned slower turnover of assets can be analyzed through the turnover ratios. A problem can be found in accounts receivable where turnover has gone from 10 × to 6.55 ×. This can also be stated in terms of an average collection period that has increased from 37 days to 56 days. While inventory turnover has been and remains superior to the industry, the same cannot be said for capital asset Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

turnover. A decline from 2.73 × to 1.85 × was caused by an increase of 112.5 percent in capital assets (representing $619,000). We can summarize the discussion of the turnover ratios by saying that despite a 44% increase in sales, assets grew even more rapidly causing a decline in total asset turnover from 1.50 × to 1.14 ×. The liquidity ratios also are not encouraging. Both the current and quick ratios are falling against a stable industry norm of approximately two and one respectively. The debt to total assets ratio is particularly noticeable in regard to industry comparisons. Watson Leisure Time has gone from being 7% over the industry average to 15% above the norm (55.48% versus 40.1%). Their heavy debt position is clearly out of line with their competitors. Their downtrend in times interest earned and fixed charge coverage confirms the heavy debt burden on the company. Finally, we see that the firm has a slower growth rate in earnings per share than the industry. This is a function of less rapid growth in earnings as well as an increase in shares outstanding (with the sale of 6,000 shares in2015). Once again, we see that the rapid growth in sales is not being translated down into significant earnings gains. This is true in spite of the fact that there is a very stable economic environment. It does not appear that this is an attractive investment opportunity. Investment Comments In 20XX a total of 6,000 common shares were sold for $90,000 or $15 per share. The P/E ratio was 5.75 ($15/ $2.61). Book value is $18.33 ($843,260/ 46,000). Market value is therefore modest. At $15 and 9,200 shares (46,000 × 20%) Mr. Thomas would require an investment of $138,000. He would probably have difficulty justifying such an investment based on the performance of the firm. There is no dividend payout, so return to the investor would have to come in the form of capital appreciation if and when he was able to resell the shares. The prospects, at this point, would not appear to justify the purchase. This is particularly true when one considers that Mr. Thomas would be buying a minority interest (20%) and would not have control of the firm. Chapter 4 Discussion Questions 4-1. The pro-forma financial statements and cash budget enable the firm to determine its future level of asset needs and the associated financing that will be required. Furthermore, one can track actual events against the projections. Bankers and other lenders also use these financial statements as a guide in credit decisions. 4-2. The collections and purchase schedules measure the speed at which receivables are collected and purchases are paid. To the extent collections do not cover purchasing costs and other financial requirements, the firm must look to borrowing to cover the deficit. Foundations of Fin. Mgt. 12Ce

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4-3.

LIFO inventory valuation assumes the latest purchased inventory becomes part of the cost of goods sold, while the FIFO method assigns inventory items that were purchased first to the cost of goods sold. With inflation, the LIFO method will result in a higher cost of goods sold figure and one that more accurately matches the sales dollars recorded at current dollars.

4-4. The more rapid the turnover of inventory, the greater the need for purchase and replacement. Rapidly turning inventory makes for somewhat greater ease in foreseeing future requirements and reduces the cost of carrying inventory. 4-5. Considering sustainable growth rates, one can envision situations where a firm with moderate profitability (say ROE = 8%) grows much quicker (say sales growth of 30% per year). With no access to outside equity funding the growth in the firm‘s debt ratios required to support the sales growth might alarm lenders so that they are unwilling to advance more funds and may demand repayment of the existing loans. Growing faster than the internally sustainable growth rate is not a good strategy for firms whose return on investment prospects is less than other comparable investments. Incremental profits from sales expansion seldom meet new financing needs. 4-6.

Level production in a cyclical industry has the advantage of allowing for the maintenance of a stable work force and reducing inefficiencies caused by shutting down production during slow periods and accelerating work during crash production periods. A major drawback is that a large stock of inventory may be accumulated during the slow sales period. This inventory may be expensive to finance, with an associated danger of obsolescence.

4-7. The percent-of-sales forecast is only as good as the functional relationship of assets and liabilities to sales. To the extent that past relationships accurately depict the future, the percent-of-sales method will give values that reasonably represent the values derived through the pro-forma statements and the cash budget. 4-8. Estimates of required new funds (RNF) for future years are essential for cash management to plan for new low-cost sources of both short and long-term funds. Lead time, often months, is required to provide lenders extensive information for increases in loans and to maintain existing loans. Sustainable growth rate (SGR) is an estimate of the level of growth in production and/or sales the company can handle with existing resources. If sales are forecasted to be higher than current capacity, the RNF calculations tells the firm new sources of financing, debt or equity, are required The combined information of both the RNF and SGR allows management to make strategic financial and operating decisions. 4-9. The results of your research will differ based on locations, time period and industries compared. In general, Canadian economic indicators often have favorable results compared to most countries in Europe and the U.S. GDP growth, inflation and unemployment rates and trend forecasts are important numbers. The global economy will be challenged with significant challenges and opportunities in a changing environment. Foundations of Fin. Mgt. 12Ce

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Internet Resources and Questions 1. 2. 3. 4. 5. 6.

https://economics.bmo.com/en http://www.rbc.com/economics http://www.bplans.com https://www.conference-board.org/us/ https://www.oracle.com/applications/crystalball/ https://aws.amazon.com/forecast/

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Problems 4-1.

Alonso Corporation (1)

Outcome A B C

(2)

(5) Expected Total Value (2  5) Probability Units Price Value .30 200 $15 3,000 900 .50 320 30 9,600 4,800 .20 410 40 16,400 3,280 Total expected value = $8,980

4-2.

(3)

(4)

Philip Morris Beginning cash No asset buildup Profit Ending cash

$150,000 ----66,000 (12% × $550,000) $216,000

The lesson to be learned is that increased sales can increase the financing requirements and reduce cash even for a profitable firm.

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Block, Hirt, Danielsen, Short

4-3.

Galehouse Gas Stations Inc. a.

Asset buildup Profit Dividends Change in cash

($100,000) 140,000 (63,000) ($23,000)

(50% × $200,000) (8% × $1,750,000) (45% × $140,000)

The cash balance will reduce by $23,000.

b. Dividends would only be $35,000 (25% × $140,000). Asset buildup Profit Dividends Change in cash

($100,000) 140,000 (35,000) $5,000

The cash balance will increase by $5,000.

4-4.

Eli Lilly Beginning cash  Asset buildup Profit Ending cash

$120,000 (320,000) (1/2 × $640,000) 96,000 (8% × $1,200,000) ($104,000) Deficit

No. Cash will be in a deficit. 4-5.

Eli Lilly (continued) Beginning cash  No asset buildup Profit Ending cash

$120,000 0 44,800 (8% × $560,000) $164,800

The lesson to be learned is that increased sales can increase financing requirements and reduce cash even for a profitable firm.

4-6.

Gibson Manufacturing Corp. (1)

Foundations of Fin. Mgt. 12Ce

(2)

(3) 4 - 80

(4)

(5)

Expected

Block, Hirt, Danielsen, Short

Outcome A B C

Total Probability Units Price Value .20 100 $20 2,000 .50 180 25 4,500 .30 210 30 6,300 Total expected value =

4-7.

Value (2  5) 400 2,250 1,890 $4,540

Brampton Truck Parts Outcomes Probability A .20 B .50 C .30

4-8.

Units 300 500 1,000

Total Expected Value Price Value $16 4,800 960 25 12,500 6,250 30 30,000 9,000 $16,210

Central Networks Last year sales: 3,000 units × $50 = $150,000 Projected sales: 3,000 x 1.20 increase = 3,600 units Projected sales in dollars: 3,600 × ($50 ×1.10) Net Sales = $198,000 – returns (6% × $198,000) = $186,120

4-9.

All Metal Bearings Last year sales: 10,000 units × $20 = $200,000 Projected sales: 10,000 × 1.30 increase = 13,000 units Projected sales in dollars: 13,000 × ($20 − .05 × $20) [decrease] Net Sales = $ 247,000 – returns (3% × $247,000) = $239,590

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Ross Pro’s Sports Equipment

4-10.

+ Projected sales...................... + Desired ending inventory .....  Beginning inventory............. Units to be produced................

4-11.

4,800 units 480 (10%  4,800) 300 4,980

Digitex, Inc. + Projected sales.................... + Desired ending inventory........  Beginning inventory.............. Units to be produced.............

4-12.

9,000 units (6,000  1.50) 450 (5%  9,000) 200 9,250

Hoover Electronics + Projected sales..................... + Desired ending inventory....  Beginning inventory............ Units to be produced...............

4-13.

60,000 units 6,600 (30%  22,000) 22,000 44,600

Biomedical Products + Projected sales..................... + Desired ending inventory....  Beginning inventory............ Units to be produced...............

Foundations of Fin. Mgt. 12Ce

4 - 82

80,000 units 18,400 (20%  92,000) 12,800 (16%  80,000) 85,600

Block, Hirt, Danielsen, Short

4-14.

Wolfson Corporation Cost of goods sold on 700 units (FIFO) Old inventory: Quantity (Units)............. Cost per unit................... Total...............................

400 $21 $ 8,400

New inventory: Quantity (Units).............. Cost per unit................... Total................................

300 $24 $ 7,200

Total Cost of Goods Sold....

$15,600

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4-15.

Mineral Labs a. LIFO Accounting Cost of goods sold on 1,500 units New inventory: Quantity (units) ..................................... Cost per unit .......................................... Total....................................................... Old inventory: Quantity (units) ..................................... Cost per unit .......................................... Total....................................................... Total cost of goods sold .............................

900 $ 16 $14,400 600 $ 12 $ 7,200 $21,600

b. FIFO Accounting Cost of goods sold on 1,000 units Old inventory: Quantity (units) ..................................... Cost per unit .......................................... Total.......................................................

775 $ 12 $ 9,300

New inventory: Quantity (units) ..................................... Cost per unit .......................................... Total....................................................... Total cost of goods sold .............................

725 $ 16 $11,600 $20,900

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Block, Hirt, Danielsen, Short

4-16.

Higgins Data System

a. Cost of goods sold on 1,100 units (Average Cost) New inventory: Quantity (Units)............... Cost per unit..................... Total.................................

850 $19 $16,150

Old inventory: Quantity (Units)................ Cost per unit..................... Total..................................

600 $16 $ 9,600

Total Inventory (1,450 units). Cost per unit ($25,750/1,450) Total Cost of Goods Sold......

$25,750 $17.759 $19,534

b. Cost of goods sold on 1,100 units (FIFO) Old inventory: Quantity (Units)................ Cost per unit...................... Total..................................

600 $16 $ 9,600

New inventory: Quantity (Units)................. Cost per unit...................... Total...................................

500 $19 $ 9,500

Total Cost of Goods Sold......

$19,100

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Block, Hirt, Danielsen, Short

4-17.

Cox Corporation FIFO Sales (13,000 @ $16)..... Cost of goods sold: Old inventory: Quantity (units)……… 3,000 Cost per unit................ $ 8 Total............................... New inventory: Quantity (units)……. 10,000 Cost per unit................ $ 9 Total............................... Total cost of goods sold. Gross profit....................

$208,000

$24,000

90,000 114,000 $ 94,000

Value of ending inventory: Beginning inventory (3,000  $8) ................ + Total production (12,000  $9) ...... ...... Total inventory available for sale..........  Cost of goods sold....... Ending inventory..........

$ 24,000 108,000 132,000 114,000 $ 18,000

OR: 2,000 units  $9 = $18,000

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Block, Hirt, Danielsen, Short

4-18.

Cox Corporation (Continued) Average Cost Sales (13,000 @ $16)... Cost of goods sold: (13,000 @ $8.80) Total cost of goods sold Gross profit...................

$208,000

114,400 $ 93,600

Value of ending inventory: Beginning inventory (3,000  $8) + Total production (12,000  $9) Total inventory available for sale Average cost ($132,000/ 15,000) Ending inventory (2,000  $8.80)

Foundations of Fin. Mgt. 12Ce

4 - 87

$ 24,000 108,000 132,000 $8.80 $ 17,600

Block, Hirt, Danielsen, Short

4-19.

Jerrico Wallboard Co. Average cost Sales (31,500 @ $29.60) Cost of goods sold: (31,500 @ $21.63) Total cost of goods sold Gross profit....................

$932,400

681,420 $250,980

Value of ending inventory: Beginning inventory (7,000  $18.10) + Total production (28,500  $22.50) Total inventory available for sale Average cost ($767,950/ 35,500) Ending inventory (4,000  $21.63)

Foundations of Fin. Mgt. 12Ce

4 - 88

$126,700 641,250 767,950 $21.63 $ 86,530

Block, Hirt, Danielsen, Short

4-20.

Power Ridge Corporation September (actual)

October

November December

$50,000

$40,000

$35,000

$60,000

8,000

7,000

12,000

Collections (70% of prior month's sales)

35,000

28,000

24,500

Total cash receipts

$43,000

$35,000

$36,500

Sales Collections (20% of current sales)

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Block, Hirt, Danielsen, Short

Donna’s Fashions

4-21.

Production Schedule January

February

March

April

May

June

July

Forecasted unit sales

1,000

800

900

1,400

1,550

1,800

1,400

+Desired ending inventory

960

1,080

1,680

1,860

2,160

1,680

- Beginning inventory

1,200

960

1,080

1,680

1,860

2,160

= Units to be produced

760

920

1,500

1,580

1,850

1,320

Summary of Cash Payments Dec.

January

February

March

April

May

June

800

760

920

1,500

1,580

1,850

1,320

Material cost ($14/unit) month after purchase

$11,200

$10,640

$12,880

$21,000

$22,120

$25,900

Labour cost ($7/unit) month incurred

5,320

6,440

10,500

11,060

12,950

9,240

Overhead cost

8,000

Units produced

Interest

10,000

Employee bonuses Total cash payments

Foundations of Fin. Mgt. 12Ce

15,500 $24,520

$25,080

4 - 90

$41,380

$40,060

$43,070

$58,640

Block, Hirt, Danielsen, Short

4-22.

Sales Collections (40% of current sales) Collections (30% of prior month‘s sales) Collections (20% of sales 2 months earlier) Total cash receipts

Simpson Glove Company Cash receipts Schedule January

February

March

April

$41,000

$39,000

$41,000 16,400

$50,000 $32,000 $47,000 $58,000 $62,000 20,000 12,800 18,800 23,200 24,800

11,700

12,300

15,000

9,600

14,100

17,400

8,200

7,800

8,200

10,000

6,400

9,400

Foundations of Fin. Mgt. 12Ce

$36,300

4 - 91

May

June

July

August

$40,100 $36,000 $38,400 $43,700 $51,600

Block, Hirt, Danielsen, Short

Ed’s Waterbeds

4-23.

Cash Receipts Schedule

January February

March

April

May

June

July

August

$13,500 $13,000 $12,000

$16,000

$10,000

$14,000

$17,000

$18,000

3,600

4,800

3,000

4,200

5,100

5,400

Collections(40% of prior month's sales)

5,200

4,800

6,400

4,000

5,600

6,800

Collections(20% of sales 2 months earlier)

2,700

2,600

2,400

3,200

2,000

2,800

$11,500 $12,200

$11,800

$11,400

$12,700

$15,000

Sales Collections(30% of current sales)

Total cash receipts

Still due (uncollected) in August: Bad debts: ($12,000 +16,000 +10,000 +14,000 +17,000 +18,000)  10% = (87,000)  10% = $8,700 To be collected from July sales: ($17,000  .20) = $3,400 To be collected from August sales: ($18,000  .60) = $10,800 $8,700 +$3,400 + $10,800 = $22,900 due Expected to be collected: $22,900 due  $8,700 bad debts = $14,200

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

4-24.

UltraVision Inc. Cash Payment Schedule

Dec.

January

February

March

April

$20,000

$30,000

20,000

30,000

Labour

10,000

13,000

10,000

15,000

Fixed overhead

6,000

$36,000

$49,000

$46,000

$51,000

* Purchases **Payment to material purchases

Total Cash Payments

* Monthly purchases equal ($240,000 ×50%)/ 4 = $120,000/ 4 = $30,000 ** Payment is equal to previous month‘s purchases

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Block, Hirt, Danielsen, Short

4-25.

Prince Albert Corporation Cash Payment Schedule

Dec.

Jan.

Feb.

March

April

May

June

July

$10,000

$12,000

$14,000

$20,000

$10,000

$16,000

$18,000

3,600

4,200

6,000

3,000

4,800

5,400

Payment (40% of current purchases)

1,440

1,680

2,400

1,200

1,920

2,160

Payment (60% of prior month's purchases)

1,800

2,160

2,520

3,600

1,800

2,880

Total payment for materials

3,240

3,840

4,920

4,800

3,720

5,040

Labour costs

4,000

Fixed overhead

2,000

Sales Purchases (30% of next month's sales)

$3,000

Interest payments

3,000

Sales commission (1.5% of $82,000) Total payments

Foundations of Fin. Mgt. 12Ce

1,230 $9,240

$9,840

4 - 94

$13,920

$10,800

$9,720

$15,270

Block, Hirt, Danielsen, Short

Boswell Corporation

4-26.

Production Schedule

Forecasted unit sales

March 6,000

April 8,000

May 5,500

+ Desired ending inventory

12,000

8,250

6,000

 Beginning inventory

9,000

12,000

8,250

Units to be produced

9,000

4,250

3,250

Cash Payments February March

April

May

9,000

4,250

3,250

$ 25,000

$ 45,000

$ 21,250

90,000

42,500

32,500

12,000

Units produced

5,000

Materials ($5/unit) month after production Labour ($10/unit) month of production Fixed overhead

June 4,000

Dividends

20,000

Total cash payments

Foundations of Fin. Mgt. 12Ce

$127,000

4 - 95

$ 99,500

$ 85,750

Block, Hirt, Danielsen, Short

Ace Battery Company

4-27.

Production Schedule January

February

March

April

May

June

July

Forecasted unit sales

800

650

600

1,100

1,350

1,500

1,200

+Desired ending inventory

780

720

1,320

1,620

1,800

1,440

- Beginning inventory

960

780

720

1,320

1,620

1,800

= Units to be produced

620

590 1,200 1,400 Summary of Cash Payments

1,530

1,140

Dec.

January

February

March

April

May

June

600

620

590

1,200

1,400

1,530

1,140

$ 7,200

$ 7,440

$ 7,080

$14,400

$16,800

$18,360

Labour cost ($5/unit) month incurred

3,100

2,950

6,000

7,000

7,650

5,700

Overhead cost

6,000

Units produced Material cost ($12/unit) month after purchase

Interest

8,000

Employee bonuses Total cash payments

Foundations of Fin. Mgt. 12Ce

13,200 $16,300

4 - 96

$16,390

$27,080

$27,400

$30,450

$43,260

Block, Hirt, Danielsen, Short

4-28.

Prince Charles Island Company Cash Receipts Schedule September

October

November

December

Sales

$6,000

$10,000

$16,000

$12,000

Credit sales (80%)

4,800

8,000

12,800

9,600

Cash sales (20%)

1,200

2,000

3,200

2,400

3,200

5,120

Collections in month after sales (40%) Collections two months after sale (60%) Total cash receipts

2,880

4,800

$ 9,280

$12,320

Cash Budget

November

December

Cash receipts

$ 9,280

$12,320

Cash payments Net cash flow Beginning cash balance

13,000 (3,720) 5,000

6,000 6,320 5,000

Cumulative cash balance

1,280

11,320

Monthly loan or (repayment)

3,720

(3,720)

Cumulative loan balance

3,720

 0 

$ 5,000

$ 7,600

Ending cash balance

Foundations of Fin. Mgt. 12Ce

4 - 97

Block, Hirt, Danielsen, Short

4-29.

Jim Daniels Health Products Cash Receipts Schedule November December

January

February

March

April

Sales

$200,000

$220,000

$280,000

$320,000

$340,000

$330,000

Credit sales (60%)

120,000

132,000

168,000

192,000

204,000

198,000

Cash sales (40%)

80,000

88,000

112,000

128,000

136,000

132,000

36,000

39,600

50,400

57,600

61,200

Collections (two months after credit sales) 70%

84,000

92,400

117,600

134,400

Total cash receipts

$235,600

$270,800

$311,200

Collections (month after credit sales) 30%

Foundations of Fin. Mgt. 12Ce

4 - 98

Block, Hirt, Danielsen, Short

Jim Daniels Health Products (continued) Cash Payments Schedule January

February

March

Payments for purchases (30% of next month's sales paid in month after purchases - equivalent to 30% of current sales)

$ 84,000

$ 96,000

$102,000

Labour expense (40% of sales)

112,000

128,000

136,000

Selling and admin. expense (5% of sales)

14,000

16,000

17,000

Overhead

28,000

Taxes

8,000

Dividends Total cash payments*

2,000 $246,000

$268,000

$285,000

* The $10,000 of amortization is excluded because it is not a cash expense.

Foundations of Fin. Mgt. 12Ce

4 - 99

Block, Hirt, Danielsen, Short

Jim Daniels Health Products (Continued) Cash Budget January

February

March

Total cash receipts

$235,600

$270,800

$311,200

Total cash payments

246,000

268,000

285,000

Net cash flow

(10,400)

2,800

26,200

Beginning cash balance

80,000

75,000

Cumulative cash balance

69,600

77,800

101,200

Monthly loan or (repayment)

5,400

(2,800)

(2,600)

Cumulative loan balance

5,400

2,600

 0 

$ 75,000

$ 98,600

Ending cash balance

Foundations of Fin. Mgt. 12Ce

4 - 100

Block, Hirt, Danielsen, Short

4-30.

Ellis Electronics Cash Receipts Schedule April

May

June

July

August

September

Sales

$320,000

$300,000

$275,000

$290,000

$330,000

Credit sales (90%)

288,000

270,000

247,500

261,000

297,000

+ Cash sales (10%)

32,000

30,000

27,500

29,000

33,000

57,600

54,000

49,500

52,200

+ Collections (second month after sale) 80%

230,400

216,000

198,000

Total cash receipts

$311,900

$293,000

$276,500

$283,200

+ Collections (month after sale) 20%

Foundations of Fin. Mgt. 12Ce

4 - 101

Block, Hirt, Danielsen, Short

Ellis Electronics (Continued) Cash Payments Schedule April

May

June

July

August

September

$130,000

$120,000

$180,000

$200,000

$170,000

52,000

48,000

72,000

80,000

78,000

72,000

108,000

Labour expense (10% of sales)

27,500

29,000

33,000

Overhead

12,000

Interest payments

30,000

Cash dividend

50,000

Taxes

25,000

Purchases Payments (month after purchase: 40%) Payments (second month after purchase: 60%)

30,000

25,000

Capital outlay

300,000

Total cash payments

Foundations of Fin. Mgt. 12Ce

$270,500

4 - 102

$159,500

$185,000

$588,000

Block, Hirt, Danielsen, Short

Ellis Electronics (Continued) Cash Budget June

July

August

September

Cash receipts.............................

$311,900

$293,000

$276,500

$283,200

Cash payments..............................

270,500

159,500

185,000

588,000

Net cash flow................................

41,400

133,500

91,500

(304,800)

Beginning cash balance................

20,000

50,000

Cumulative cash balance..............

61,400

183,500

141,500

(254,800)

Monthly borrowing or (repayment).

* 33,400

Cumulative loan balance..............

33,400

Marketable securities purchased..

11,400

133,500

91,500

236,400

(sold) Cumulative marketable securities.

11,400

144,900

236,400

Ending cash balance.....................

50,000

15,000

*Cumulative marketable securities (August) $236,400 Cumulative cash balance (September)  254,800 Required (ending) cash balance  15,000 Monthly borrowing  $ 33,400

Foundations of Fin. Mgt. 12Ce

4 - 103

Block, Hirt, Danielsen, Short

4-31.

Carter Paint Company

A L S   S   PS 21  D S1 S1 S  10%$100 million

a. Required new funds 

S  $10 million

($10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛) − ($10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛) 100 100 − .05 ($110 𝑚𝑖𝑙𝑙𝑖𝑜𝑛) (1 − .30) RNF = .90 ($10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛) − .25 ($10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛) − .05 ($110 𝑚𝑖𝑙𝑙𝑖𝑜𝑛) (. 70) RNF = $9.0 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 − $2.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 − $3.85 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 RNF = $2.65 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 The firm needs $2.65 million in external funds. RNF =

Balance Sheet ($ millions) Liabilities and Shareholders’

Assets Equity Cash Accounts receivable Inventory Current assets Capital assets

Total assets c. Current ratio Total debt/ assets

Foundations of Fin. Mgt. 12Ce

$ 5.50 16.50 33.00 55.00 44.00

$99.00

Accounts payable Accrued wages Accrued taxes Current liabilities Long-term debt Common stock Retained earnings Total liabilities and equity

Year 1 2.0 × 61.1%

4 - 104

$ 16.50 6.60 4.40 27.50 32.65 15.00 23.85 $99.00

Year 2 2.0 × 60.8%

Block, Hirt, Danielsen, Short

4-32.

Longbranch Western Wear Company Earnings aftertax $20,000   .10  10% Profit margin  Sales $200,000

Payout ratio  Dividends  $10,000  .50  50% Earnings $20,000 Change in Sales = 20%  $200,000 = $40,000 Spontaneous assets = Current assets = Cash + Accounts receivable + inventory Spontaneous liabilities = Accounts payable + Accrued (wages + taxes)

Required new funds 

S   S   PS 1  D 2

30 8  $40,000  $40,000  .10 $240,0001  .50 200 200 RNF  .15 $40,000  .04 $40,000  .10 $240,000.50 RNF  $6,000  $1,600  $12,000 RNF 

RNF  $7,600 b. Balance Sheet Assets

Liabilities and Shareholders’

Equity Cash $ 6,000 Accounts payable Accounts receivable 12,000 Accrued wages Inventory 18,000 Accrued taxes Current assets 36,000 Current liabilities Capital assets 70,000 Notes payable Foundations of Fin. Mgt. 12Ce

4 - 105

$ 6,000 1,200 2,400 9,600 0* Block, Hirt, Danielsen, Short

Total assets

Long-term debt 14,400* Common stock 20,000 Retained earnings 62,000 $106,000 Total liabilities and equity $106,000

*After the notes payable was reduced, the long-term debt was reduced.

c. Current ratio Total debt/ assets

Foundations of Fin. Mgt. 12Ce

Year 1 3.75 × 30.0%

4 - 106

Year 2 3.75 × 22.6%

Block, Hirt, Danielsen, Short

4-33.

Clyde's Well Servicing

Profit margin  Earnings aftertaxes  $174,000  8.7% Sales $2,000,000 a. Payout ratio 

Dividends $104,400   60% Earnings $174,000

Change in sales (S)

RNF 

= 30%  $2,000,000 = $600,000

A S   L S   PS 2 1  D S1 S1



$275,000 $500,000 $600,000  $600,000  .087$2.6 mil 1  .6 $2,000,000 $2,000,000 = .25($600,000) – .1375($600,000) – .087($2,600,000) (.4) = $150,000 – $82,500 – $90,480 =  $22,980

RNF 

There are excess funds of $22,980. No funds required provided capital assets sufficient.

Foundations of Fin. Mgt. 12Ce

4 - 107

Block, Hirt, Danielsen, Short

Current average collection period = $260,000(365)/ $2,000,000 = 47.45 days With sales of $2,600,000 the accounts receivable balance will be = $2,600,000 × 47.75/365 = $338,000 With sales of $2,600,000 and an average collection period of 43 days, the accounts receivable balance will be = $2,600,000 × 43/365 = $306,301 This represents a decrease in required funds of = $338,000 – $306,301 = $31,699 Therefore required new funding (decrease) = $31,699 + $22,980 = $54,679 This is an excess and could be invested in marketable securities, used to pay down bank loans, or invest in capital assets.

Income Statement (partial) Sales

$2,600,000

Gross profit @ 40% Selling, general and administrative expenses Amortization EBIT Interest EBT Taxes @35% Earnings available to common shareholders

1,040,000 450,000 67,500 522,500 40,000 482,500 168,875 $313,625

Dividends Transfer to retained earnings

120,000 $193,625

Foundations of Fin. Mgt. 12Ce

4 - 108

Block, Hirt, Danielsen, Short

Balance Sheet ($ thousands) Assets Cash Accounts receivable Inventory Current assets Capital assets

Total assets

$ 35.0 306.3 260.0 601.3 675.0

$1,276.3

Liabilities and Equity Account payable $136.5 Accruals 20.0 Bank loan 176.2 Current liabilities 332.7 Long-term debt 175.0 Common stock 175.0 Retained Earnings 593.6 Total liabilities & $1,276.3 shareholders‘ equity

New funds required = $1,276.3  $1,250.1 = $26.2 (the increase in short-term debt)

Foundations of Fin. Mgt. 12Ce

4 - 109

Block, Hirt, Danielsen, Short

4-34.

Harvard Prep Shops RNF 

a. ΔS

A S   L S   PS 2 1  D S1 S1

=25%  $300,000,000 = $75,000,000

RNF 

$210 mil.

$75 mil.  $90 mil. $75 mil.  .15 $375 mil.1  .3

$300 mil. $300 mil. RNF  .70 $75 million  .30 $75 million  .15 $375 million.7 RNF  $52.5 million  $22.5 million  $39.375 million RNF  $9,375,000 A negative figure for required new funds indicates that an excess of funds ($9.375 mil.) is available for new investment. No external funds are needed.

RNF = $52.5 million  $22.5 million  .20($375 mil.)  (1  .65) = $52,500,000  $22,500,000  $26,250,000 = $ 3,750,000 external funds required The net profit margin increased slightly, from 15% to 20%, which decreases the need for external funding. The dividend payout ratio increased from 30% to 65%, necessitating more external financing. The effect of the dividend policy change overpowered the effect of the net profit margin change.

Foundations of Fin. Mgt. 12Ce

4 - 110

Block, Hirt, Danielsen, Short

Comprehensive Problems 4-35.

Mansfield Corporation (External funds requirement)

Δ Sales= .35  $100 million = 35 million Spontaneous assets = 5% + 15% + 20% + 40% = 80% Spontaneous liabilities = 15% + 10% = 25% RNF 

A S   L S   PS 2 1  D S1 S1

RNF  .80 $35 million  .25 $35 million  .10 $135 million1  .5 RNF  $28 million  $8.75 million  $6.75 million RNF  $12.5 million

If Mansfield reduces the payout ratio, the company will retain more earnings and need less external funds. A slower growth rate means that fewer assets will have to be financed and in this case, less external funds would be needed. A declining profit margin will lower retained earnings and force Mansfield Corporation to seek more external funds.

Foundations of Fin. Mgt. 12Ce

4 - 111

Block, Hirt, Danielsen, Short

Mansfield Corporation (Continued)

Pro Forma Balance Sheet - December 31, 20XY ($ millions) Cash $ 6.75 Accounts payable $ 20.25 Accounts receivable 20.25 Accruals (Other 13.50 Payables) Inventory 27.00 Notes payable 19.501 Net capital assets 54.00 Long-term bonds 5.00 Common stock 10.00 Retained earnings 39.752 $108.00 $108.00 1 Original notes payable plus required new funds. This is the plug figure. 2 20XY retained earnings (beginning of 20XY) + PS2 (1 - D)

d. Debt/ assets Debt/ equity Current ratio ROA ROE

Foundations of Fin. Mgt. 12Ce

20XX 46.25% 0.86  1.60  12.50% 23.26%

4 - 112

20XY 53.94% 1.17  1.01  12.50% 27.14%

Block, Hirt, Danielsen, Short

e. Sustainable growth rate:  P1  D1  DT  E   SGR  A 1  DT  D    P1   S1 E     37m  .10 1 .50 1  43m    SGR ( XX )   37m   .1316 or 13.16% .80 10 1 .50 1     43m   58.25m  .10 1 .50 1   49.75m    SGR ( XY )   58.25m   .1570 or 15.70% .80 10 1 .50 1      49.75m 

Foundations of Fin. Mgt. 12Ce

4 - 113

Block, Hirt, Danielsen, Short

4-36.

Adams Corporation (forecasting with seasonal production)

Projected unit sales +Desired ending inventory (2 month supply)  Beginning inventory Units to be produced

December 1,500,000

January 1,700,000

February 1,200,000

March 1,400,000

2,900,000

2,600,000

3,400,000

4,500,000

2,600,000 1,800,000

2,900,000 1,400,000

2,600,000 2,000,000

3,400,000 2,500,000

Monthly Cash Payments December January February

March

Units to be produced 1,800,000 1,400,000 2,000,000 2,500,000 Materials (from $93,600 $84,000 $120,000 previous month) Labour ($20 per thousand units) 28,000 40,000 50,000 Overhead ($10 per thousand units) 14,000 20,000 25,000 Selling & adm. expense (20% of 52,700 37,200 43,400 sales) Interest 8,000 Taxes (40% tax rate) 64,560* Dividends 48,420* Total payments $188,300 $181,200 $359,380 * See the pro forma income statement, which follows this material for the development of these values.

Foundations of Fin. Mgt. 12Ce

4 - 114

Block, Hirt, Danielsen, Short

Monthly Cash Receipts (Adams Corporation)

Sales Collections (50% of prior month) Collections (50% of 2 months earlier) Total collections

Nov. Dec. January February March $175,000 $232,500 $263,500 $186,000 $217,000 87,500

116,250

131,750

93,000

87,500

116,250

131,750

$203,750 $248,000 $224,750

Monthly Cash Flow January

February

March

Cash receipts

$203,750

$248,000

$224,750

Cash payments

188,300

181,200

359,380

Net cash flow

$ 15,450

$ 66,800

$(134,630)

Foundations of Fin. Mgt. 12Ce

4 - 115

Block, Hirt, Danielsen, Short

Adams Corporation (Continued) Cash Budget January February

March

Net cash flow

$15,450

$66,800

$(134,630)

Beginning cash balance

30,000

25,000

Cumulative cash balance

$45,450

$91,800

($109,630)

Loans and (Repayments)

 0 

47,380

Cumulative loans Marketable securities

 0  20,450

 0  66,800

47,380 (87,250)

Cumulative marketable securities Ending cash balance

20,450 $25,000

87,250 $25,000

 0  $ 25,000

Sales

Adams Corporation Pro Forma Income Statement January February March $263,500 $186,000 $217,000

Total $666,500

Cost of goods sold

139,400

98,400

126,000

363,800

Gross profit

124,100

87,600

91,000

302,700

Selling & administration expense Interest expense

52,700 2,667

37,200 2,667

43,400 2,666

133,300 8,000

Net profit before taxes

68,733

47,733

44,934

161,400

Taxes

27,493

19,093

17,974

64,560

$ 41,240

$ 28,640

$ 26,960

$ 96,840 48,420

Net profit aftertax Less: Common dividends Increase in retained earnings

Foundations of Fin. Mgt. 12Ce

$ 48,420

4 - 116

Block, Hirt, Danielsen, Short

Material Labour Overhead

Cost of Goods Sold Unit Cost per thousand Unit cost per thousand before January 1st after January 1st $52 $60 20 20 10 10 $82 $90

Ending inventory as of December 31 was 2,600,000, therefore, sales for January and February had a cost of goods sold per thousand units of $82, and March sales reflect the increased cost of $90 per thousand units using FIFO inventory methods.

Pro forma Balance Sheet (March) Assets Liabilities & equity Current assets: Current liabilities: Cash $ 25,000 Accounts payable Accounts receivable 310,000 Notes payable Inventory 405,000 Long-term debt Plant & equipment: Shareholders' equity: 800,000 Common stock Net plant Retained earnings Total liabilities & Total assets $1,540,000 shareholders' equity Explanation of changes in the Balance Sheet: Cash = ending cash balance from cash budget in March Accounts receivable = March sales plus 50% of Feb. sales

$150,000 47,380 400,000 504,200 438,420 $1,540,000

$217,000 93,000 $310,000

Inventory = ending inventory in March of 4,500,000 units at $90 per thousand Plant and equipment did not change since we did not include amortization. RE = Old RE + (NI - dividends) = $390,000 + ($96,840 - $48,240) = $438,420

Foundations of Fin. Mgt. 12Ce

4 - 117

Block, Hirt, Danielsen, Short

4-37.

Comprehensive Financial Forecasting Problem ($ thousands) Toys For You

May

June

July

August

Sept.

October

Nov.

Dec.

$630.0

$592.5

$585.0

630.0

592.5

585.0

900.0

892.5

Labour

195.0

Selling & admin.

254.5

269.1

286.7

307.1

321.8

333.5

Other

375.0

Purchases Payment Accounts payable

945.0

Note payable

675.0

Interest

270.0

Taxes

338.0

Dividends Total payments

Foundations of Fin. Mgt. 12Ce

22.5 $1,477.0

4 - 118

22.5 $2,106.6

$1,441.7

$2,092.6

$2,151.8

$1,488.5

Block, Hirt, Danielsen, Short

Toys For You (Continued) May Cost of goods produced

June

July

1,155.0

August 1,155.0

COGS Inventory

Foundations of Fin. Mgt. 12Ce

Sept. 1,155.0

October 1,155.0

Nov.

Dec.

1,155.0

4,362.8 $8,231.0

$9,386.0

$10,541.0

4 - 119

$7,333.3

5,181.8 $8,488.2

$9,643.2

$5,616.5

Block, Hirt, Danielsen, Short

Toys For You (Continued) * Note: Totals may differ due to rounding

Sales

May

June

July

August

Sept.

October

Nov.

Dec.

$1,732.5

$1,845.0

$1,957.5

$2,070.0

$2,205.0

$2,362.5

$2,475.0

$2,565.0

1,732.5

1,845.0 1,995.0

1,380.0

Collections 60 days 50 days

652.5

42 days

1,323.0

0.0 2,299.5

35 days

945.0 2,062.5

Total collections

1,732.5

2,497.5

1,995.0

2,703.0

2,299.5

3,007.5

3,802.5

3,375.0

3,585.0

3,244.5

3,420.0

2,977.5

Receipts

1,732.5

2,497.5

1,995.0

2,703.0

2,299.5

3,007.5

less payments

1,477.0

2,106.6

1,441.7

2,092.6

2,151.8

1,488.5

Net receipts

255.5

390.9

553.4

610.4

147.8

1,519.1

$921.5

$1,312.4

$1,865.8

$2,476.2

$2,623.9

$4,143.0

Accounts receivable

Accumulated cash

Foundations of Fin. Mgt. 12Ce

3,577.5

$666.0

4 - 120

Block, Hirt, Danielsen, Short

Toys For You Ltd. Income Statement September

December

Sales

$6,232.5

$7,402.5

COGS

4,362.8

5,181.8

Gross profit

1,869.8

2,220.8

Selling & administration

810.2

962.3

Amortization

114.0

Operating profit

945.5

1,144.4

0.0

270.0

Profit before taxes

945.5

874.4

Taxes at 42%

397.1

367.3

Net income

$ 548.4

$ 507.2

Dividends

22.5

$ 525.9

$ 484.7

Interest

To retained earnings

Foundations of Fin. Mgt. 12Ce

4 - 121

Block, Hirt, Danielsen, Short

Toys For You Ltd. Projected Balance Sheet June 30

Sept. 30

Dec. 31

Assets Current assets Cash

$ 666.0

$ 1,865.8

$ 4,143.0

Accounts receivable

3,578.0

3,585.0

2,977.5

Inventory

8,231.0

7,333.3

5,616.5

Total current assets

12,475.0

12,784.0

12,737.0

Capital assets Plant & equipment

11,273.0

less accumulated amortization

4,784.0

4,898.0

5,012.0

Total assets

Foundations of Fin. Mgt. 12Ce

6,489.0

6,375.0

6,261.0

$18,964.0

$19,159.0

$18,998.0

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Block, Hirt, Danielsen, Short

Toys For You Ltd. June 30

Sept. 30

Dec.31

Liabilities and Shareholders’ Equity Current liabilities Accounts payable

$ 945.0

$ 892.5

Notes payable

3,700.0

3,025.0

2,350.0

Accrued liabilities

2,596.0

Accrued taxes Total current liabilities

0.0 7,241.0

397.1 6,910.6

426.4 6,264.9

Long term debt

4,725.0

Common stock

4,500.0

Retained earnings

2,498.0

3,023.9

3,508.6

$18,964.0

$19,159.5

$18,998.5

Total liabilities and shareholders‘ equity

Although current assets have remained about the same, lots of cash has been freed up by tightening credit and drawing down inventories. There is lower investment in accounts receivable and inventories.

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Comprehensive Financial Forecasting Problem Toys For You (Credit remains at 60 days) May

June

July

Nov.

Dec.

$630.0

$592.5

$585.0

630.0

592.5

585.0

900.0

892.5

Labour

195.0

Selling &Admin.

254.5

269.1

286.7

307.1

321.8

333.5

Other

375.0

Purchases Payment Accounts payable

945.0

August

Note payable

Sept.

October

675.0

Interest

270.0

Taxes

338.0

Dividends Total payments

Foundations of Fin. Mgt. 12Ce

22.5 $1,477.0

4 - 124

22.5 $2,106.6

$1,441.7

$2,092.6

$2,151.8

$1,488.5

Block, Hirt, Danielsen, Short

Toys For You

May Cost of goods produced

June

July

1,155.0

August 1,155.0

COGS Inventory

Foundations of Fin. Mgt. 12Ce

Sept. 1,155.0

October 1,155.0

Nov.

Dec.

1,155.0

4,362.8 $8,231.0

$9.386.0

$10,541.0

4 - 125

$7,333.3

5,181.8 $8,488.2

$9,643.2

$5,616.5

Block, Hirt, Danielsen, Short

Toys For You (Continued)

May

June

July

August

Sept.

October

Nov.

Dec.

$1,732.5

$1,845.0

$1,957.5

$2,070.0

$2,205.0

$2,362.5

$2,475.0

$2,565.0

1,732.5

1,845.0

1,957.5

2,070.0

2,205.0

2,362.5

1,732.5

1,845.0

1,957.5

2,070.0

2,205.0

2,362.5

$3,802.5

4,027.5

4,275.0

4,567.5

4,837.5

5,040.0

Receipts

1,732.5

1,845.0

1,957.5

2,070.0

2,205.0

2,362.5

less payments

1,477.0

2,106.6

1,441.7

2,092.6

2,151.8

1,488.5

Net receipts

255.5

(261.6)

515.9

(22.6)

53.3

874.1

$921.5

$659.9

$1,175.8

$1,153.2

$1,206.4

$2,080.5

Sales Collections 60 days 50 days 42 days 35 days Total collections Accounts receivable

Accumulated cash

Foundations of Fin. Mgt. 12Ce

3,577.5

$666.0

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Block, Hirt, Danielsen, Short

Toys For You Ltd. Income Statement September

December

Sales

$6,232.5

$7,402.5

COGS

4,362.8

5,181.8

Gross profit

1,869.8

2,220.8

Selling & administration

810.2

962.3

Amortization

114.0

Operating profit

945.5

1,144.4

0.0

270.0

Profit before taxes

945.5

874.4

Taxes at 42%

397.1

367.3

Net income

$ 548.4

$ 507.2

Dividends

22.5

$ 525.9

$ 484.7

Interest

To retained earnings

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Block, Hirt, Danielsen, Short

Toys For You Ltd. Projected Balance Sheet June 30 Assets

Sept. 30

Dec. 31

Current assets Cash

$ 666.0

$ 1,175.8

$ 2,080.5

Accounts receivable

3,578.0

4,275.0

5,040.0

Inventory

8,231.0

7,333.3

5,616.5

Total current assets

12,475.0

12,784.0

12,737.0

Plant & equipment

11,273.0

less accumulated amortization

4,784.0

4,898.0

5,012.0

Total assets

Foundations of Fin. Mgt. 12Ce

6,489.0

6,375.0

6,261.0

$18,964.0

$19,159.0

$18,998.0

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June 30 Sept. 30 Liabilities and Shareholders’ Equity Current liabilities Accounts payable

$ 945,0

$ 892.5

Notes payable

3,700.0

3,025.0

Accrued liabilities

2,596.0

0.0

397.1

Total current liabilities

7,241.0

6,910.6

Long term debt

4,725.0

Common stock

4,500.0

Retained earnings

2,498.0

3,023.9

$18,964.0

$19,159.5

Accrued taxes

Total liabilities and shareholders‘ equity Chapter 5 Discussion Questions 5-1.

Such analysis allows the firm to determine at what level of operations it will break even and to explore the relationship between volume, costs, and profits. Linear B/E assumes the same percentage changes among variables. Non-linear B/E is more realistic because it considers other factors (i.e. overtime labour costs, etc) that cause higher or lower percentage variations.

5-2. A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an automobile company, which is generally subject to the influences of the business cycle. An automobile manufacturer may not be able to service a large amount of debt when there is a downturn in the economy. 5-3. A labour-intensive company will have low fixed costs and a correspondingly low breakeven point. However, the impact of operating leverage on the firm is small and there will be little magnification of profits as volume increases. A capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the positive influences of operating leverage as volume increases. 5-4.

For break-even analysis based on accounting flows, amortization is considered part of fixed costs. For cash flow purposes, it is eliminated from fixed costs.

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The accounting flows perspective is longer-term in nature because we must consider the problems of equipment replacement. 5-5.

Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources. This is inherently risky because the obligation to make payments remains regardless of the condition of the company or the economy.

5-6. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using financial leverage tend to be greatest in industries that are highly cyclical in nature. 5-7.

The higher the interest rate on new debt, the less attractive financial leverage is to the firm.

5-8. Operating leverage primarily affects the operating income of the firm. At this point, financial leverage takes over and determines the overall impact on earnings per share. A delineation of the combined effect of operating and financial leverage is presented in Table 5-6 and Figure 5-5. 5-9. At progressively higher levels of operation than the break-even point, the percentage change in operating income as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical -- as we move to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less. 5-10. The starting level of sales is significant because we measure what can happen at that point. Note that in formula 5-3, we must specify the quantity or beginning point at which degree of operating leverage is being computed. 5-11. Financial leverage, or the use of debt, not only determines how much interest we must pay but also the number of shares of common stock that we must issue to support the non-debt portion of our capital structure. Only by examining ―earnings per share‖ can we pick up the effect of outstanding shares on the operation of the firm. 5-12. The indifference point only measures indifference based on earnings per share. Since our ultimate goal is market value maximization, we must also be concerned with how these earnings are valued. Two plans that have the same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk component involved because of debt. 5-13. Television broadcasters commit to production schedules, program purchases, etc., in the spring, create the fall/winter program schedule, and then send the salespeople out to sell advertising air time for the coming season. Thus, the costs are virtually 100% locked in before any revenues are generated. A minor fluctuation in advertising revenue, therefore, has a major effect on operating earnings. 5-14. Students may come up with many points worth discussing. Emphasis should be directed to the tremendous debt load that required servicing. Consumer demand slowed down affecting cash flows, and increased interest rates at the end of an economic cycle had the Foundations of Fin. Mgt. 12Ce

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same effect. Coupled with the excessive prices paid (particularly for Federated Stores) this caused problems. There was only a small margin for error. Discussion may also include Robert Campeau‘s ego, failure to follow advice, and failure to achieve asset sales at projected prices. Campeau‘s gamble was risky but it was close. LBOs in the 80‘s and 90‘s were financed at interest rates generally over 10% in comparison to much lower rates of today. This makes the LBO less costly but there are fewer opportunities.

Internet Resources and Questions 1.

http://www.sedar.com/search/search_form_pc_en.htm

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Problems 5-1.

SUS Appliances

FC $80,000  $80,000  16,000  toasters a. BE  P - VC $20  $15 $5 b.

Sales – variable costs Contribution margin – fixed costs Total operating profit

5-2.

$320,000 (16,000 × $20) 240,000 (16,000 × $15) 80,000 80,000 $ 0

Harmon Corporation

a. BE 

FC $40,000 $40,000   3,636 bats  P - VC $25.00  $14.00 $11.00

b. 𝑸 =

FC+Profit $40,000+$25,000 $65,000 = = = 5, 909 bats P-VC $25.00−$14.00 $11.00

5-3.

Ensco Lighting Company

a. BE 

FC $100,000 $100,000   8,000 units  P - VC $28.00  $15.50 $12.50

b. BE 

FC $75,000 $75,000   6,818 units  P - VC $28.00  $17.00 $11.00

The breakeven level decreases. c. With less operating leverage and a smaller contribution margin, profitability is likely to be less at very high-volume levels.

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Block, Hirt, Danielsen, Short

5-4.

Air Filter, Inc. Fixed costs $100,000

Rent Factory labour Executive salaries Raw materials

Variable costs (per unit) $1.20

89,000 $189,000

BE 

0.60 $1.80

FC $189,000 $189,000   45,000 units  P - VC $6.00  $1.80 $4.20

5-5.

Shawn Penn & Pencils

FC $80,000  $80,000  32,000 units  a. BE (before)  P - VC $5.00  $2.50 $2.50 BE (after) 

FC $120,000  $120,000  40,000 units  P - VC $5.00  $2.00 $3.00

b. Q before  FC  Return  $80,0001.30  $104,000  41,600 units P - VC $5.00  $2.50 $2.50 Q after   FC  Return  $120,0001.30  $156,000  52,000 units P - VC $5.00  $2.00 $3.00

5-6.

Calloway Cab Company Cash related fixed costs

BE 

Foundations of Fin. Mgt. 12Ce

= Total fixed costs – amortization = $400,000 – 20% ($400,000) = $400,000 – $80,000 = $320,000

FC $320,000   88,889 units P - VC $3.60

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Block, Hirt, Danielsen, Short

5-7.

Air Purifier Inc. Cash-related fixed costs = Total fixed costs – Amortization = $2,450,000 – 15% (2,450,000) = $2,450,000 – $367,500 = $2,082,500 BE 

2,082,500

 52, 063 units

$40

5-8.

Base Timber Company Cash-related fixed costs = Total fixed costs – Amortization = $6,500,000 – 10% (6,500,000) = $6,500,000 – $650,000 = $5,850,000

BE =

Foundations of Fin. Mgt. 12Ce

5,850,000 $9

= 650,000 units

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Block, Hirt, Danielsen, Short

5-9. Labour intensive and capital-intensive break-even graphs

The company having the high fixed costs will have lower variable costs than its competitor since it has substituted capital for labour. With a lower variable cost, the high fixed cost company will have a larger contribution margin. Therefore, when sales rise, its profits will increase faster than the low fixed cost firm and when the sales decline, the reverse will be true.

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Block, Hirt, Danielsen, Short

5-10.

Sterling Tire Company Q = 20,000, P = $60, VC = $30, FC = $400,000, I = $50,000

Q P  VC 20,000 ($60  $30)  Q (P  VC)  FC 20,000 ($60  $30)  $400,000 20,000 $30 $600,000 CM    20,000 $30  $400,000 $200,000 EBIT  3.0 

DOL 



DFL 

b. c.

 EBIT $200,000   1.33 EBT $150,000

Q P  VC 20,000 ($60  $30)  Q (P  VC)  FC  I 20,000 ($60  $30)  $400,000  $50,000 $600,000 $600,000  CM    $600,000  $400,000  $50,000 $150,000 EBT

DCL 

 4.0  A 20% increase in sales will increase eps by 80% (4.0 × 20% = 80%). Operating leverage will have the greater impact (3.0× versus 1.33×). d. BE 

FC P - VC

e. BE 



$400,000 $400,000   13,333 tires $60  $30 $30

FC $400,000  $50,000   15,000 tires P - VC $30

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Block, Hirt, Danielsen, Short

5-11.

Freudian Slips and Gowns, Inc. Q = 30,000, P = $25, VC = $7, FC = $270,000, I = $170,000

Q (𝑃 − VC)

DOL =

30,000 ($25 − $7)

Q (𝑃 − VC) − FC 30,000 ($25 − $7) − $270,000 30,000 ($18) $540,000 𝐶𝑀 = = = 30,000 ($18) − $270,000 $270,000 𝐸𝐵𝐼𝑇 = 2.0 ×

𝐷𝐹𝐿 =

DCL = =

𝐸𝐵𝐼 𝐸𝐵𝑇

$270,000

$100,000

= 2.7 ×

Q (𝑃 − VC) Q (𝑃 − VC) − FC − 𝐼 30,000 ($25 − $7)

30,000 ($25 − $7) − $270,000 − $170,000 30,000 ($18) $540,000 𝐶𝑀 = = = 30,000 ($18) − $440,000 $100,000 𝐸𝐵𝑇 = 5.4 × A 30% increase in sales will increase eps by 162% (5.4 × 30% = 162%). Financial leverage will have the greater impact (2.7 × versus 2.0×). d. BE =

FC P-VC

e. BE =

FC P-VC

$270,000

$270,000+$170,000

Foundations of Fin. Mgt. 12Ce

$25−$7

$270,000 $18

$18

6 - 137

= 15,000 𝑢𝑛𝑖𝑡𝑠

= 24,444 𝑢𝑛𝑖𝑡𝑠

Block, Hirt, Danielsen, Short

Mo’s Delicious Burgers, Inc.

5-12. a. BE 

FC $80,000  $80,000  16,000  boxes P - VC $15  $10 $5

15,000 boxes

30,000 boxes

Sales @ $15 per box

$225,000

$450,000

Less: Variables Costs($10)

($150,000)

($300,000)

Less: Fixed Costs

($ 80,000)

Profit or Loss

($ 5,000)

$ 70,000

Q P  VC 20,000 ($15  $10)  Q (P  VC)  FC 20,000 ($15  $10)  $80,000 20,000 $5 $100,000 CM    20,000 $5  $80,000 $20,000 EBIT  5.0 

DOL 20,000 

Q P  VC 30,000 ($15  $10)  Q (P  VC)  FC 30,000 ($15  $10)  $80,000 30,000 $5 $150,000 CM    30,000 $5  $80,000 $70,000 EBIT  2.14 

DOL 30,000 

Leverage goes down because we are further away from the breakeven point, thus the firm is operating on a larger profit base and leverage is reduced. d. First determine the profit or loss (EBIT) at 20,000 bags. As indicated in part b, the profit (EBIT) at 25,000 bags is $45,000: Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

20,000 bags Sales @ $15 per box

$300,000

Less: Variable Costs ($10)

(200,000)

Less: Fixed Costs

(80,000)

Profit or Loss

$ 20,000

DFL 20,000 

EBIT $20,000  $20,000   2.0   EBIT  I $20,000  $10,000 $10,000

DFL 30,000 

$70,000  $70,000 EBIT   1.17   EBIT  I $70,000  $10,000 $60,000



e. DCL 20,000

Q P  VC 20,000 ($15  $10)  Q (P  VC)  FC  I 20,000 ($15  $10)  $80,000  $10,000 $20,000 $5 $100,000   20,000 $5  $90,000 $10,000  10.0  



DCL 30,000

Q P  VC 30,000 ($15  $10)  Q (P  VC)  FC  I 30,000 ($15  $10)  $80,000  $10,000 30,000 $5 $150,000 CM    30,000 $5  $90,000 $60,000 EBT  2.5  

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5-13. a.

Cain Auto Supplies and Able Auto Parts

EBIT Less: Interest EBT Less: Taxes @ 30% EAT Shares EPS

Cain $10,000 5,000 5,000 1,500 $ 3,500 10,000 $0.35

Able $10,000 10,000 0 0 $ 0 5,000 $0.00

EBIT Less: Interest EBT Less: Taxes @ 30% EAT Shares EPS

$15,000 5,000 10,000 3,000 $ 7,000 10,000 $0.70

$15,000 10,000 5,000 1,500 $ 3,500 5,000 $0.70

EBIT Less: Interest EBT Less: Taxes @ 30% EAT Shares

$50,000 5,000 45,000 13,500 $31,500 10,000

$50,000 10,000 40,000 12,000 $28,000 5,000

$ 3.15

$ 5.60

EPS

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Block, Hirt, Danielsen, Short

b. Operating profit (EBIT) return on assets ($150,000) = 6.67% ($10,000/ $150,000), 10% and 33.33% at the respective levels of EBIT. When the before-tax return on assets (EBIT/Total Assets) is less than the cost of debt (10%), Cain does better with less debt than Able. When before-tax return on assets is equal to the cost of debt, both firms have equal EPS. This would be where the method of financing has a neutral effect on EPS. As return on assets becomes greater than the interest rate, financial leverage becomes more favorable for Able. c. 12%  $150,000 = $18,000 indifference point. OR: EBIT  SC  I A  S A  I C   10,000  $12,000  5,000  $6,000 SC  S A 10,000  5,000  $18,000 

5-14.

Cain Auto Supplies (Continued)

EBIT Less: Interest EBT Less: Taxes @ 30% EAT Shares EPS P/E Share Price

Foundations of Fin. Mgt. 12Ce

6 - 141

Cain $40,000 5,000 35,000 10,500 $24,500 10,000 $2.45 12x $29.40

Block, Hirt, Danielsen, Short

5-15.

International Data Systems a. Sales (105,000  $14)

$1,470,000

Total variable costs (105,000  $7)

735,000

Fixed costs

55,000

Operating income

$680,000

b. Sales (205,000  $8.80) ....................................

$1,804,000

Total variable costs (205,000  $8.00) .............

1,640,000

Fixed costs .........................................................

55,000

Operating income ..............................................

$109,000

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5-16. a.

Black Berry and Pea Pod Black Berry $120,000 42,000 78,000 15,600 62,400 80,000 $0.78

EBIT Less: Interest EBT Less: Taxes @ 20% EAT Shares EPS

Pea Pod $120,000 14,000 106,000 21,200 84,800 144,000 $0.59

b. Share price = P/E × EPS 18 × $0.78 = $14.04 (Black Berry) 18 × $0.57 = $10.62 (Pea Pod) c.

Black Berry 15 × $0.78 = $11.70

Pea Pod 21 × $0.59 = $12.39

d. Clearly, the ultimate objective should be to maximize the share price. While management would be indifferent between the two plans based on earnings per share, Pea Pod, with the less risky plan, has a higher share price.

5-17.

Mitaka Company Q P  VC 125,000 ($25  $5)  Q (P  VC)  FC  I 125,000 ($25  $5)  $1,800,000  $400,000 125,000 $20 $2,500,000 CM    125,000 $20 $2,200,000 $300,000 EBT

DCL 

 8.33

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

5-18.

Cain Supplies



EBIT Less: Interest EBT Less: Taxes @ 20% EAT Shares EPS P/E Share price

Foundations of Fin. Mgt. 12Ce

6 - 144

Cain $50,000 9,000 $41,000 8,200 $32,800 20,000 $1.64 19x $ 31.16

Block, Hirt, Danielsen, Short

5-19.

Sterling Optical and Royal Optical

 a. Sterling $132,000 79,200 52,800 13,200 39,600 88,000 $0.45

EBIT Less: Interest EBT Less: Taxes @ 25% EAT Shares EPS

Royal $132,000 26,400 105,600 26,400 79,200 176,000 $0.45

b. Share price = P/E × EPS 22 × $0.45 = $9.90 c.

Sterling 16 × $0.45 = $7.20

Royal 24 × $0.45 = $10.80

d. Clearly, the ultimate objective should be to maximize the share price. While management would be indifferent between the two plans based on earnings per share, Royal Optical, with the less risky plan, has a higher share price.

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5-20. a.

Sinclair Manufacturing and Boswell Brothers Q P  VC 50,000 ($20  $10)  Q (P  VC)  FC  I 50,000 ($20  $10)  $300,000  $72,000 50,000 $10 $500,000     50,000 $10  $372,000 $128,000  3.91

DCL 

Q P  VC 50,000 ($20  $16)  Q (P  VC)  FC  I 50,000 ($20  $16)  $0  $0 50,000 $4 $200,000   50,000 $4  $0 $200,000  1.0 

DCL 

 c. The combined leverage is fairly high in part a, because you are combining firms that both use operating and financial leverage. The leverage factor is only 1 × in part b, because Boswell has no financial leverage and Sinclair has no operating leverage.

d. EPS will increase by 100 percent. However, there is no leverage involved. EPS merely grows at the same rate as sales.

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5-21.

Desoto Tools, Inc.

a. Before expansion 𝑆 − TVC $1,500,000 − $450,000 DOL = = 𝑆 − TVC − FC $1,500,000 − $450,000 − $550,000 =

$1,050,000 $500,000

DFL = DCL =

𝐶𝑀 𝐸𝐵𝐼𝑇

= 2. 10 ×

$500,000 EBIT = $500,000−$100,000 EBIT−𝐼

$500,000 $400,000

EBIT = 1. 25 × EBT

$1,500,000 − $450,000 𝑆 − 𝑇𝑉𝐶 = 𝑆 − 𝑇𝑉𝐶 − FC −𝐼 $1,500,000 − $450,000 − $550,000 − $100,000 $1,050,000 $1,050,000 CM = = = = 2. 63 × $1,500,000 − $1,100,000 $400,000 EBT

b. Income Statement after expansion Debt $2,500,000 750,000 1,750,000 800,000 950,000 142,0001 808,000 274,720 533,280 100,000 $ 5.33

Sales Less: Variable Costs (30%) Contribution Margin Fixed Costs EBIT Less: Interest EBT Less: Taxes @ 34% EAT (Net Income) Common Shares EPS

Equity $2,500,000 750,000 1,750,000 800,000 950,000 100,000 850,000 289,000 561,000 110,0002 $ 5.10

(1) New interest expense level if expansion is financed with debt: $100,000 + 14% ($300,000) = $142,000 (2) Number of common shares outstanding if expansion is financed with equity: 100,000 + 10,000 = 110,000

c. DOL (same for both plans)

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𝑆−TVC

$2,500,000−$750,000

DOL = 𝑆−TVC−FC = $2,500,000−$750,000−$800,000 $1,750,000 CM = = = 1. 842 × EBIT $950,000

DFL (debt) =

EBIT EBIT−𝐼

$950,000

$950,000−$142,000

$950,000 $808,000

EBIT EBT

=1. 176 × DFL (equity) =

EBIT EBIT−𝐼

$950,000 $950,000−$100,000

=1. 118 ×

$950,000

$850,000

EBIT = EBT

𝑆−𝑇𝑉𝐶

DCL = 𝑆−𝑇𝑉𝐶−FC−𝐼

$2,500,000 − $750,000

$2,500,000 − $750,000 − $800,000 − $142,000 $1,750,000 $1,750,000 CM = = = = 2. 17 × (𝑑𝑒𝑏𝑡) $2,500,000 − $1,692,000 $808,000 EBT

DCL =

𝑆−𝑇𝑉𝐶 𝑆−𝑇𝑉𝐶−FC−𝐼

$2,500,000 − $750,000 $2,500,000 − $750,000 − $800,000 − $100,000 $1,750,000 $1,750,000 CM = = = = 2. 06 × (𝑒q𝑢𝑖𝑡𝑦) $2,500,000 − $1,650,000 $850,000 EBT

EBIT   S B  I A  S A  I B   110,000  $142,000 100,000  $100,000 S B  SA 110,000 100,000  $562,000 

e. The debt financing plan provides greater earnings per share level, but provides more risk because of the increased use of debt and higher DFL and DCL. The interest coverage ratio in both cases is satisfactory and interest coverage is well protected. The crucial point is expectations for future sales. If sales are expected to decline or advance very slowly, the debt plan will not perform well in comparison to the equity plan. Conversely, with increasing sales, the debt plan becomes more attractive. Based on projected overall sales of $2,500,000, the debt plan should probably be favored, although cyclical swings in sales, earnings, and profit margins should be considered.

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5-22. Dickinson Company a. Income statements Return on assets = 10%; EBIT = $1,200,000 Current Plan D Plan E EBIT $1,200,000 $1,200,000 $1,200,000 Less: Interest 600,0001 960,0002 300,0003 EBT 600,000 240,000 900,000 Less: Taxes (45%) 270,000 108,000 405,000 EAT $ 330,000 $ 132,000 $ 495,000 Common shares 750,0004 375,000 1,125,000 EPS $0.44 $0.35 $0.44 (1) $6,000,000 debt @ 10% (2) $600,000 interest + ($3,000,000 debt @ 12%) (3)($6,000,000 - $3,000,000 debt retired)  10% (4)($6,000,000 common equity)/ ($8 par value) = 750,000 shares Plan E and the original plan provide the same earnings per share because the cost of debt at 10 percent is equal to the operating return on assets of 10 percent. With Plan D, the cost of increased debt rises to 12 percent, and the firm incurs negative leverage reducing EPS and also increasing the financial risk to Dickinson.

Return on assets = 5%; EBIT = $600,000 Current Plan D Plan E EBIT $600,000 $600,000 $600,000 Less: Interest 600,000 960,000 300,000 EBT 0 (360,000) 300,000 Less: Taxes (45%) 0 (162,000) 135,000 EAT 0 $(198,000) $165,000 Common shares 750,000 375,000 1,125,000 EPS $ 0.00 $ (0.53) $ 0.15 Return on assets = 15%; EBIT = $1,800,000

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Current $1,800,000 600,000 1,200,000 540,000 $660,000 750,000 $ 0.88

EBIT Less: Interest EBT Less: Taxes (45%) EAT Common shares EPS

Plan D $1,800,000 960,000 840,000 378,000 $ 462,000 375,000 $1.23

Plan E $1,800,000 300,000 1,500,000 675,000 $825,000 1,125,000 $ 0.73

If the return on assets decreases to 5%, Plan E provides the best EPS, and at 15% return, Plan D provides the best EPS. Plan D is still risky, having an interest coverage ratio of less than 2.0.

EBIT   S B  I A  S A  I B   1,125,000  $960,000  375,000  $300,000 S B  SA 1,125,000  375,000  $1,290,000 

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Return on Assets = 10%; EBIT = $1,200,000 Current Plan D Plan E EBIT $1,200,000 $1,200,000 $1,200,000 EAT $ 330,000 $ 132,000 $ 495,000 1 2 Common shares 750,000 500,000 1,000,000 EPS $ 0.44 $ 0.26 $ 0.50

(1) 750,000 - ($3,000,000/ $12 per share) = 750,000 - 250,000 = 500,000 (2) 750,000 + ($3,000,000/$12 per share) = 750,000 + 250,000 = 1,000,000 As the price of the common stock increases, Plan E becomes more attractive because fewer shares can be retired under Plan D and, by the same logic fewer shares need to be sold under Plan E.

e. EBIT   S B  I A  S A  I B   1,000,000 $960,000  500,000  $300,000 S B  SA 1,000,000  500,000  $1,620,000 

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5-23.

Lopez-Portillo Company

Return on Assets = 15% Current Plan A Plan B EBIT $1,500,000 $2,250,000 $2,250,000 Less: Interest (a) 1,200,000 (c) 1,920,000 (e) 1,200,000 EBT 300,000 330,000 1,050,000 Less: Taxes @ 40% 120,000 132,000 420,000 EAT $ 180,000 $ 198,000 $ 630,000 Common shares (b) 200,000 (d) 300,000 (f) 700,000 EPS $ 0.90 $ 0.66 $ 0.90

(a) (80%  $10,000,000)  15% = $8,000,000  15% = $1,200,000 (b) (20%  $10,000,000)/$10 = $2,000,000/$10 = 200,000 shares (c) $1,200,000 (current) + (80%  $5,000,000)  18% = $1,200,000 + $720,000 = $1,920,000 (d) 200,000 shares (current) + (20%  $5,000,000)/$10 = 200,000 + 100,000 = 300,000 shares (e) Unchanged (f) 200,000 shares (current) + $5,000,000/$10 = 200,000 + 500,000 = 700,000 shares



b. DFL current  

EBIT $1.500,000   5.0  EBIT  I $1,500,000  $1,200,000

 EBIT $2,250,000   6.82  DFL Plan A  EBIT  I $2,250,000  $1,920,000  $2,250,000 EBIT   2.14  DFL Plan B  EBIT  I $2,250,000  $1,200,000

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EBIT   S B  I A  S A  I B   700,000  $1,920,000  300,000  $1,200,000 700,000  300,000 S B  SA 

 $2,460,000

d. EAT Common Shares EPS

Plan A $198,000 250,0001 $0.79

Plan B $630,000 450,0002 $1.40

200,000 shares (current) + (20%  $5,000,000)/$20 = 200,000 + 50,000 = 250,000 shares 2 200,000 shares (current) + $5,000,000/$20 = 200,000 + 250,000 = 450,000 shares 1

Plan B would continue to provide the higher earnings per shares. The difference between plans A and B is even greater than that indicated in part (a). e. EBIT  S B  I A  S A  I B   450,000  $1,920,000  250,000  $1,200,000 S B  SA 450,000  250,000  $2,820,000 

Not only does the price of the common stock create wealth to the shareholder, which is the major objective of the financial manager, but it greatly influences the ability to finance projects at a high or low cost of capital. Cost of capital will be discussed in Chapter 10, and one will see the impact that the cost of capital has on capital budgeting decision.

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5-24. a.

Katz- Doberman Katz Plan Sales (2,000,000 units  $4) – Variable costs – Fixed costs Operating income (EBIT) – Interest1 EBT – Taxes @ 30% EAT Shares2 Earnings per share Assets 

$8,000,000 6,000,000 1,500,000 500,000 72,000 428,000 128,400 $299,600 120,000 $2.50

Sales $8,000,000   $2,000,000 Asset turnover 4

Debt = 40% of Assets = 40%  $2,000,000 = $800,000 Interest = 9%  $800,000 = $72,000 2 Stock = 60% of $2,000,000 = $1,200,000 Shares = $1,200,000/ $10 = 120,000 1

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Doberman Plan Sales (2,800,000 units at $3.75) – Variable Costs (2,800,000 units  $3) – Fixed Costs Operating income (EBIT) – Interest3 EBT – Taxes @ 30% EAT Shares4 Earnings per share Assets 

$10,500,000 8,400,000 1,500,000 600,000 105,000 495,000 148,500 $ 346,500 105,000 $ 3.30

Sales $10,500,000   $2,100,000 Asset turnover 5

Debt = 50% of Assets = 50%  $2,100,000 = $1,050,000 Interest = 10%  $1,050,000 = $105,000 4 Stock = 50% of $2,100,000 = $1,050,000 Shares = $1,050,000/ $10 = $105,000 3

Doberman Plan (based on Mrs. Katz‘s Assumption) Sales (2,800,000 units at $3.75) $10,500,000 8,400,000 – Variable Costs (2,800,000 units  $3) 1,800,000 – Fixed Costs (1,500,000 units  $1.2) Operating income (EBIT) 300,000 – Interest 105,000 EBT 195,000 – Taxes @ 30% 58,500 EAT $136,500 Shares 105,000 Earnings per share $ 1.30 No! Mr. Katz should not shift to the Doberman Plan if Mrs. Katz‘s assumption is correct.

5-25.

Phelps Canning Company a. At break-even before expansion:

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PQ Where:

= FC + VC PQ equals sales volume at break-even point

Sales

= Fixed costs + Variable costs (Variable costs = 50% of sales)

Sales .50 sales Sales

= $1,800,000 + .50 sales = $1,800,000 = $3,600,000

At break-even after expansion: Sales .50 sales Sales

= $2,300,000 + .50 sales = $2,300,000 = $4,600,000

b. Degree of operating leverage, before expansion, at sales of $5,000,000 S  TVC $5,000,000  $2,500,000  S  TVC  FC $5,000,000  $2,500,000  $1,800,000 $2,500,000 CM    3.57  EBIT $700,000

DOL 

Degree of operating leverage after expansion: at sales of $6,000,000.

S  TVC $6,000,000  $3,000,000  S  TVC  FC $6,000,000  $3,000,000  $2,300,000 $3,000,000 CM    4.29  EBIT $700,000

DOL 

 This could also be computed for subsequent years.

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c. DFL before expansion: DFL 

EBIT $700,000   1.40  EBIT  I $700,000  $200,000

DFL after Expansion: Compute EBIT and I for all three plans:

Sales – TVC (.50) – FC EBIT I – Old debt I – New debt Total interest DFL#1 

(100% Debt) (1) $6,000,000 3,000,000 2,300,000 $ 700,000 200,000 260,000 $ 460,000

(100% Equity) (2) $6,000,000 3,000,000 2,300,000 $ 700,000 200,000 0 $ 200,000

(50% Debt and 50%Equity (3) $6,000,000 3,000,000 2,300,000 $ 700,000 200,000 120,000 $ 320,000

EBIT $700,000   2.92  EBIT  I $700,000  $460,000 

 EBIT $700,000   1.40  DFL#2  EBIT  I $700,000  $200,000   $700,000 EBIT   1.84  DFL#3  EBIT  I $700,000  $320,000

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d. EPS @ sales of $6,000,000 (refer back to part c to get the values for EBIT and Total interest)

EBIT Total interest EBT Taxes (34%) EAT Shares (old) Shares (new) Total shares EPS (EAT/ total shares)

Foundations of Fin. Mgt. 12Ce

(100% Debt) (1) $700,000 460,000 240,000 81,600 $158,400 200,000 0 200,000 $ 0.79

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(100% Equity) (2) $700,000 200,000 500,000 170,000 $330,000 200,000 100,000 300,000 $ 1.10

(50% Debt and Equity) (3) $700,000 320,000 380,000 129,200 $250,800 200,000 40,000 240,000 $ 1.05

Block, Hirt, Danielsen, Short

EPS @ sales of $10,000,000 (100% Debt) (1) Sales - TVC - FC EBIT Total interest EBT Taxes (34%) EAT Total shares EPS

$10,000,000 5,000,000 2,300,000 2,700,000 460,000 2,240,000 761,600 $1,478,400 200,000 $ 7.39

(100% Equity) (2) $10,000,000 5,000,000 2,300,000 2,700,000 200,000 2,500,000 850,000 $1,650,000 300,000 $ 5.50

(50% Debt and Equity) (3) $10,000,000 5,000,000 2,300,000 2,700,000 320,000 2,380,000 809,200 $1,570,800 240,000 $ 6.55

In the first year, when sales and profits are relatively low, plan 2 (100% equity) appears to be the best alternative. However, as sales expand up to $10 million, financial leverage begins to produce results as EBIT increases and Plan 1 (100% debt) is the highest yielding alternative.

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5-26. a. Ratio analysis

Ryan Boot Company

Profit margin

$297,000/$7,000,000 $297,000/$8,130,000 $297,000/$2,880,000 $7,000,000/$3,000,000 $7,000,000/$1,000,000 $7,000,000/$2,200,000

Ryan Industry 4.24% 5.75% 3.65% 6.90% 10.31% 9.20% 2.3 × 4.35 × 7× 6.5 × 3.18 x 3.8 x

$7,000,000/$4,000,000 $7,000,000/$8,130,000 $4,130,000/$2,750,000 $3,130,000/$2,750,000 $5,250,000/$8,130,000 $700,000/$250,000 see calculation below

1.75 × 0.86 × 1.50 × 1.14 × 64.58% 2.80 × 1.64 ×

Return on assets Return on equity Receivable turnover Inventory turnover Accounts payable turnover Capital asset turnover Total asset turnover Current ratio Quick ratio Debt to total assets Interest coverage Fixed charge coverage

Fixed charge coverage 

1.85 × 1.20 × 1.45 × 1.10 × 25.05% 5.35 × 4.62 ×

$700,000  $200,000lease   1.64  $250,000  $200,000  $66,000 /1  .34

 The company has a lower profit margin than the industry and the problem is further compounded by the slow turnover of assets (0.86× versus an industry norm of 1.20 ×). This leads to a much lower return on assets. The company has a higher return on equity than the industry, but this is accomplished through the firm's heavy debt ratio rather than through superior profitability. The slow turnover of assets can be directly traced to the unusually high level of accounts receivable. The firm's accounts receivable turnover ratio is only 2.33 ×, versus an industry norm of 4.35 ×. Actually, the firm does quite well with receivable turnover and is only slightly below the industry in capital asset turnover. The previously mentioned heavy debt position becomes more apparent when we examine times interest earned and fixed charge coverage. The latter is particularly low due to lease expenses and sinking fund obligations. Foundations of Fin. Mgt. 12Ce

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Break-even in sales Sales = Fixed costs + variable costs (variable costs are expressed as a percentage of sales) Sales BE .40 S S S

= $2,100,000 + .60 Sales = $2,100,000 = $2,100,000/.40 = $5,250,000

Cash break-even Sales costs Sales BE Sales BE .40 S Sales Sales

= (Fixed costs – non cash expenses*) + variable = ($2,100,000 – $500,000) + .60 Sales = $1,600,000 + .60 Sales = $1,600,000 = $1,600,000/.40 = $4,000,000

* Amortization S  TVC $7,000,000  $4,200,000  S  TVC  FC $7,000,000  $4,200,000  $2,100,000 $2,800,000 CM    4.0  EBIT $700,000

DOL 



DFL 

 EBIT $700,000   1.56  EBT $450,000

S  TVC $7,000,000  $4,200,000  S  TVC  FC  I $7,000,000  $4,200,000  $2,100,000  $250,000 $2,800,000 CM    6.22  4 1.56 $450,000 EBT

DCL 

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c. Ryan is operating at a sales volume that is $1,750,000 above the traditional break-even point and $3,000,000 above the cash break-even point. This can be viewed as somewhat positive. However, the firm has a high degree of leverage, which indicates any reduction in sales volume could have a very negative impact on profitability. The DOL of 4 × is associated with heavy fixed assets and relatively high fixed costs. The DFL of 1.56 × is attributed to high debt reliance. Actually, if we were to include the lease payments of $200,000 with the interest payments of $250,000, the DFL would be almost 3 ×. A banker would have to question the potential use of the funds and the firm's ability to pay back the loan. Actually, the firm already appears to have an abundant amount of assets, so hopefully a large expansion would not take place here. There appears to be a need to reduce accounts receivable rather than increase the level. One possible use of the funds might be to pay off part of the current notes payable of $400,000. This might be acceptable if the firm can demonstrate the ability to meet its future obligations. The banker should request to see pro forma financial statements and projections of future cash flow generation. The loan might only be acceptable if the firm can bring down its inventory position back in line and improve its profitability.

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

RNF 

A S   L S   PS 2 1  D S1 S1



RNF 

$4.13 mil.

$7 mil. 20%  $2.35 mil. $1.2 mil.  4.24%$8.4 mil.1  .4

$7.0 mil.

= .590 ($1,400,000) – .336 ($1,400,000) – $356,160 (.6) = $826,000 – $470,400 – $213,696 = $141,904

RNF

The RNF equation assumes that the profit margin and payout ratios remain constant. With greater efficiencies as sales expand this is unlikely, particularly if capital assets are not expanded in the same manner.

e. Required funds if selected industry ratios were applied Receivables Receivables Inventory Inventory

= Sales/ Receivable turnover = $7,000,000/4.35 = $1,609,195 = Sales/ Inventory turnover = $7,000,000/ 6.50 = $1,076,923

Revised A (assets) = $50,000 + $80,000 + $1,609,195 + $1,076,923 = $2,816,118 Profit Margin = 5.75% RNF 

A S   L S   PS 2 1  D S1 S1



RNF 

$2,816,118

$7 mil. 20% 

$7.0 mil.

RNF

$2.35 mil.

$1.2 mil.  5.75%$8.4 mil.1  .4

$7.0 mil.

= .4023 ($1,400,000) – .336 ($1,400,000) – $483.000(.6) = $563,224 – $470,400 – $289,800 = – $196,976

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Required new funds (RNF) is negative, indicating there will actually be an excess of funds equal to $196,976. This is due to the much more rapid turnover of inventory and the higher profit margin.

f. (1) (2) (3) (4)

If Ryan Boots were at full capacity, more funds would be needed to expand plant and equipment. More funds would be needed to offset the larger payout of earnings to dividends. Fewer funds would be required as sales grow less rapidly. Fewer new assets would be needed to support sales growth. As inflation increased so would the cost of new assets, especially inventory and plant and equipment. Even if sales prices could be increased, more assets would be required to support the same physical level of sales. Increased profits alone would not make up for the higher level of assets required and more funds would be needed.

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5-27.

Rockway Framers Ltd. (Ratio calculations and pro formas)

20XX

20XW

Industry Averages

4.80% 5.12% 13.25% 40.00%

5.36% 5.95% 11.90% 40.00%

3.50% 4.00% 8.20% 38.00%

9.9× 37 2.1× 1.8× 1.1×

9.9× 37 2.6× 2.0× 1.1×

9.7× 38 2.5× 2.1× 1.1×

0.9 0.24

1.8 0.79

1.8 0.7

61.34% 2.6×

50.00% 3.9×

58.00% 3.8×

Profitability Ratios Profit margin Return on assets Return on equity Gross margin Asset Utilization Ratios Receivable turnover Average collection period Inventory turnover Capital asset turnover Total asset turnover Liquidity Ratios Current ratio Quick ratio Debt Utilization Ratios Debt to total assets Times interest earned

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(#27 continued)

Rockway Framers Ltd. Statement of Cash Flows For the Year Ended December 31, 20XX

Operating activities: Net income (earnings aftertaxes)....................... Add items not requiring an outlay of cash: Amortization.................................... $ 23,000 Cash flow from operations Increase in accounts receivable........ (8,000) Increase in inventory ........................... (36,500) Increase in accounts payable............ 25,520 Net change in non-cash working capital............. Cash provided by operating activities................. Investing activities: Purchase of land.............................. (13,200) Purchase of equipment.................... (66,000) Balance sheet adjustment (equipment) (1,000) Cash used in investing activities....................... Financing activities: Increase in notes payable................. 66,750 Decrease in bonds payable.............. (13,000) Common stock dividends paid........ (13,325) Cash used in financing activities... Net increase (decrease) in cash………………

$ 17,055 23,000 40,055

(18,980) 21,075

(80,200)

40,425 (18,700)

Cash, beginning of year

20,000

Cash, end of year

$ 1,300

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Pro forma for20XY: same % of sales as in 20XX maintained Rockway Framers Ltd. Balance Sheets at Dec. 31 20XY

20XX

20XW

Current assets Cash $ 24,625 Accounts receivable 45,000 Inventories 126,250 Total current assets 195,875 Land 57,700 Buildings and equipment 222,000 Less accumulated amortization (108,000) Total assets $367,575

$ 1,300 36,000 101,000 138,300 57,700 222,000 (85,000) $333,000

$ 20,000 28,000 64,500 112,500 44,500 155,000 (62,000) $250,000

Current liabilities Accounts payable Notes payable Total current liabilities Long term debt Common stock Retained earnings Total liabilities and equity

$ 48,770 104,500 153,270 51,000 70,000 58,730 $333,000

$ 23,250 37,750 61,000 64,000 70,000 55,000 $250,000

$ 60,963 104,500 165,463 51,000 70,000 64,918 $351,381

Required funds (no capital investment) = $367,575 – $351,381 = $16,194 Amortization of $23,000 included to increase the cash balance (footnote #2, chap. 4)

RNF 

A S   L S   PS 2 1  D S1 S1

Same payout ratio as in 20XX gives dividend in 20XY of $22,106.

RNF 

$138,300

$88,800  $48,770 $88,800  6.37%$444,0001  .7813

$355,200 RNF = $16,197

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Rockway Framers Ltd. Income Statements for year ending Dec.31 20XY

20XX

20XW

Sales $444,000 Cost of goods sold 266,400 Gross profit 177,600 Sales & administration expense102,675 Amortization 23,000 Operating income 51,925 Interest 14,200 Earnings before taxes 37,725 Taxes 9,431 Net income $28,294

$355,200 213,120 142,080 82,140 23,000 36,940 14,200 22,740 5,685 $17,055

$277,500 166,500 111,000 74,370 10,000 26,630 6,800 19,830 4,958 $14,872

Profit margin increases to 6.37%, amortization and interest expense held constant. Rockway‘s profit margin, although good, has slipped. The gross margin has been maintained. Higher fixed costs (related to equipment purchases?), including interest have cut into profitability. Return on equity and assets still healthy. Efficiency ratios show credit (A/R) under control, but inventory turnover has slipped below the industry average. The asset turnover ratios have also retreated and are below industry norms. This could be the result of the large investment in previous years. However, can sales be increased on these assets and can inventory turnovers be improved? Liquidity is a cause for concern. It is evidenced by the dramatic increase in notes payable with a decrease in longer term debt. Debt ratios are way up primarily due to notes payable. They are also up due to large dividend payments. Rockway‘s need is for longer term capital not short term loans. A one year loan will just perpetuate the liquidity problems. Dividends should be curtailed to build up the equity and longer term capital should be sought. Good potential if the market (sales volume) is in evidence.

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5-28.

Deval Leasehold Improvements Ltd. 20XX

20XW

20XV

2.08% 8.26% 25.76% 41.50%

1.65% 6.45% 22.78% 33.30%

1.50% 5.63% 21.44% 31.40%

6.5× 56 14.6× 25 7.82 47 23.0× 4.0×

6.0× 61 16.7× 22 6.59 55 24.0× 3.9×

5.6× 65 16.5× 22 5.36 68 23.4× 3.7×

2.0 1.6

1.5 1.2

1.3 1.1

67.95% 4.3× 4.3×

71.69% 5.1× 5.1×

73.75% 6.6× 6.6×

Profitability Ratios Profit margin Return on assets Return on equity Gross margin Asset Utilization Ratios Receivable turnover Avg. Collection period Inventory turnover Inventory holding period Accounts payable turnover Accounts payable period Capital asset turnover Total asset turnover Liquidity Ratios Current ratio Quick ratio Debt Utilization Ratios Debt to total assets Times interest earned Fixed charge coverage

Leverage (based on gross profit not sales less variable costs) DOL DFL DCL

12.54 1.304 16.36

13.35 1.242 16.59

14.54 1.178 17.13

The profitability ratios show a weakening, although the return on equity Foundations of Fin. Mgt. 12Ce

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is quite good. The lower profit and gross margins probably relate to fair prices (low?) and good workmanship (expensive). The efficiency ratios indicate a slowing in receivable turnover, but the other turnover ratios appear healthy. The receivables are a concern but not unexpected due to government contracts. The liquidity ratios have weakened which one should expect given cash flow difficulties. This is occurring because of the slower collection of receivables and is resulting in the slower payment of accounts. Most of the liquid assets are tied up in slow moving receivables. The debt ratios are high. This is an indication of the need for equity investment. Perhaps dividends could be curtailed. Increased equity would improve the liquidity ratios. The operating leverage (DOL) is probably not correct as fixed and variable costs are not identified (gross profit is not the best substitute). The high DOL does not seem likely given the limited amount of capital. The financial leverage (DFL) seems reasonable and produces reasonable results as operating profits (EBIT) expands. The high debt ratios (leverage) are a result of the heavy accounts payable which are unlikely to produce interest charges. However, Deval seems to be leaning on its suppliers as noted above with the accounts payable period. As an investment, Deval shows potential. The company has a high return on equity. It has survived five years and it produces good work. Increased equity would strengthen its financial situation. It should, however, examine its pricing, its dividend policy, and look for greater financial expertise. Perhaps R.C. Dare can provide the expertise.

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MINI CASES Glen Mount Furniture Company (Financial leverage) Purpose: The potential impact of changes in the debt level on earnings per share is the central focus of this case. However, the instructor can derive educational benefits that go well beyond this point. The central figure in this case is frustrated by security analyst‘s short-term emphasis on earnings per share and their lack of concern for the long-term fundamentals associated with this firm. This rather common situation can be drawn upon to make for a more dramatic discussion process. The student is given ample opportunities to calculate EPS under different financial leverage strategies and to examine debt ratios, and degrees of leverage.

a. Sales ($45,000,000 + $500,000) Variable cost (58% of sales) Fixed costs Operating income (EBIT) Interest Earnings before taxes (EBT) Taxes (34%) Earnings after taxes (EAT)

$45,500,000 26,390,000 12,900,000 6,210,000 1,275,000 4,935,000 1,677,900 $3,257,100

Shares Earnings per share

2,000,000 $1.63

b. Earnings per share, 20XY Earnings per share, 20XX Increase Increase Earnings per share, 20XX

Foundations of Fin. Mgt. 12Ce

$1.63 1.56 $0.07 $ 0.07 $1.56

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c. Sales ($45,000,000 + $500,000) Variable cost (58% of sales) Fixed costs Operating income (EBIT) Interest* Earnings before taxes (EBT) Taxes (34%) Earnings after taxes (EAT)

$45,500,000 26,390,000 12,900,000 6,210,000 2,400,000 3,810,000 1,295,400 $2,514,600

Shares** Earnings per share

1,375,000 $1.83

*Interest Old debt 10.625% x $12,000,000 = New debt 11.250% x $10,000,000 = Total interest

$1,275,000 1,125,000 $2,400,000

**Shares outstanding 2,000,000 – 625,000 =

1,375,000

d. Earnings per share, 20XY Earnings per share, 20XX Increase Increase Earnings per share, 20XX

$1.83 (based on more debt) 1.56 $ 0.27 $ 0.27 $1.56

= 17.2%

  EBIT $6,210,000   1.26  DFL a  EBT $4,935,000

 DFL c 

 EBIT $6,210,000   1.63 EBT $3,810,000

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S  TVC S  TVC  FC  I $45,500,000  $26,390,000  $45,500,000  $26,390,000  $12,900,000  $1,275,000 $19,110,000   3.87 $45,500,000  $40,565,000

DCL a  

S  TVC S  TVC  FC  I $45,500,000  $26,390,000  $45,500,000  $26,390,000  $12,900,000  $2,400,000 $19,110,000   5.02 $45,500,000  $41,690,000

DCL c  

g. From Figure 2: Total debt/ total assets = $17,500,000/ $40,500,000 = 43.2% After the new debt issue: Total debt/ total assets = $17,500,000 + $10,000,000/ $40,500,000 = 67.9%

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h. There are two conflicting factors that could influence the share price. On the positive side, earnings per share would be twenty cents higher with more debt ($1.83 versus $1.63). Based on a current price-earnings ratio of about 10 (the repurchase price for the shares is for $16 ($10,000,000/625,000) and EPS are currently $1.56, the stock might go up approximately $2.00 as a result of a $.20 increase in EPS. Two dollars represents a healthy 12.5% increase from the current value of $16 per share. However, the student must keep in mind that the debt ratio is increasing from 43.2% to 67.9%, which probably would have a negative effect on the price earnings ratio. The net effect of the increase in earnings per share versus the likely decrease in the price-earnings ratio can only be conjectured. Security analysts following Glen Mount Furniture Company seem to be highly sensitive to earnings per share performance, but there may be some question about whether the type of financial engineering used to increase the earnings per share will satisfy them. Of course, the firm can argue that the share repurchase is a strong sign of confidence by management in future company performances. One clue to the eventual reaction of the market to the recapitalization might lie in the data on the debt ratios of other firms in the industry. If 67.9% is perceived to be on the high end, there might be little positive gain associated with the increase in earnings per share. However, if other companies are in this range and the firm is merely taking advantage of underutilized debt capacity, the market reaction might be positive.

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Chem-Med Company (Ratio Analysis) Purpose: This case allows the student to go into financial analyses in more depth than is possible with end-of-chapter problems. In addition to computing a series of ratios, the student must consider industry data and trends for the purpose of evaluation relative performance. The student must also make use of the Du Pont system of analysis. Of special interest are the debt and performance covenants established by the potential financier. Finally, the student is forced to identify the impact of extraordinary income on ratio analysis and how it can distort one year's performance.

a. Sales Growth = (Sales this year ─ Sales last year)/Sales last year for 20XW: $ 3,814 ─ $3,051 / $3,051 = +25% for 20XX: 5,340 ─ 3,814 / 3,814 = +40% for 20XY: 7,475 ─ 5,340 / 5,340 = +40% for 20XZ: 10,366 ─ 7,475 / 7,475 = +39% b. Net income growth = (Net income this year - Net income last year) / Net Income last year for 20XX: $1,609 ─ $1,150 / $1,150 = +40% for 20XY: $1,942 ─ $1,609 / $1,609= +21% for 20XZ: $2,903 ─ $1,942 / $1,942 = +49% According to Dr. Swan's estimates, net income growth will match sales growth in 20XX, then slack off and rebound in 20XZ. However, Dr. Swan's figures are misleading: in 20XX they include $500,000 worth of extraordinary income expected to be received from the settlement of the suit with Pharmacia. The astute analyst will realize that this amount should be excluded from his/her calculations because (1) receiving the amount is by no means certain, and (2) it is a one-time event which has nothing to do with the operations of the company. When the amount is excluded from 20XX's figures we see that net income growth of 11% as calculated below for 20XX is actually considerably less than 40%. After tax effect of removing $500,000 from gross income = $500 × (1 ─ tax rate) = $500 × (1 ─ .33) = -$335 New net income = $1,609 ─ $335 = $1,274 Appropriate 20XX net income growth = ($1,274 ─ $1,150) / $1,150 = 11%

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Failing to exclude the extraordinary amount has the effect of obscuring the "real" profitability ratios; ROE in 20XX would be 23%, not 29%. Net profit margin would be 24%, not 30%. These are facts a potential investor would want to know.

c. Current ratio = Current assets / Current liabilities: for 20XW = $1,720 / $ 593 = 2.90 for 20XZ = $3,261 / $1,647 = 1.98 Pharmacia has a current ratio in 20XW of 2.9, and the industry average was 2.4. Chem-Med, therefore, in 20XW was slightly more liquid than the average company. This would probably be looked upon favorably by someone considering loaning money to the company; however, the banker with whom Dr. Swan had lunch would have a problem with Chem-Med's current ratio for 20XZ: it falls below the 2.25 to 1 limit he would establish as a restrictive covenant. In view of that, Dr. Swan needs to revise his financial plan for 20XZ in such a way that less money is invested in capital assets, and more is held in cash and equivalents (or, alternatively, shift some current liabilities to long-term debt and/or equity).

d. Total debt to assets ratio = Total liabilities / Total assets for 20XW: = $ 614 / $ 4,491 = .137 for 20XX: = $ 857 / $ 6,343 = .135 for 20XY: = $1,212 / $ 8,641 = .140 for 20XZ: = $1,664 / $11,995 = .139 The variation from year to year is small - no trend can be established, except, of course, that the ratio remains nearly constant, indication that Chem-Med is doing a good job in managing its debt. It was doing especially well in 20XW compared to other companies in the industry, where the average debt to assets was .52 (and Pharmacia's was .55). A potential investor in Chem-Med's stock might be pleased or displeased depending on his/her tolerance for risk and outlook for the future. (Chem-Med has much less financial risk than average, but the company, which is in a growth situation, might be considered to be underleveraged).

e. Chem-Med's average accounts receivable collection period = Accounts receivable/Sales per day for 20XW: = $ 564 / ($ 3,814/365) = 54 days for 20XX: = $ 907 / ($ 5,340/365) = 62 days Foundations of Fin. Mgt. 12Ce

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for 20XY: for 20XZ:

= $1,495 / ($ 7,475/365) = $2,351 / ($10,366/365)

= 73 days = 83 days

This is not a good sign. The average length of time that Chem-Med's customers are taking to pay for products they've bought is increasing steadily every year. If Chem-Med's credit policy is, say, 2/10, net 30, it is clear that very few customers are adhering to it, and the situation is getting worse. Not only is Chem-Med, in effect, granting free credit to those customers by allowing them to delay payment for so long, it is paying for such credit itself. The company's higher balances of accounts receivable must be financed in some way, either through additional debt or equity, and these additions have a cost.

f. Chem-Med's return on equity ratio = Net income / Total equity for 20XW = $1,150 / $3,877 = 29.66% Chem-Med's ROE in 20XW was 29.66%and the industry average was only12.29%. A potential investor in Chem-Med would be very pleased; Chem-Med is offering a handsome return that's almost two and a half times that of the average company in the industry. Now, the investor will want to use the DuPont method to look further at Chem-Med and Pharmacia to determine the source of this return.

Chem-Med: Pharmacia:

ROE = .2966 = .2956 =

Profit Asset Equity Margin × Turnover × Multiplier .3015 × 0.85 × 1.158 .07 × 1.90 × 2.22

Note the drastic difference in the operation of the two companies, even though their ROEs are nearly the same. Chem-Med makes relatively few sales (low asset turnover), but makes a lot of money on each one (30%). Pharmacia is just the opposite: ROE is also being propped up by greater use of debt than Chem-Med (Pharmacia has relatively less equity; so the same amount of income will represent a greater return to Pharmacia‘s equity holders than Chem-Med‘s). All other considerations being equal, a potential investor would probably prefer Chem-Med‘s position, but it‘s by no means certain (for example, it‘s much more serious for Chem-Med to lose a sale).

20XW

20XX

20XY

20XZ

BES:

964

1,520

2,120

2,645

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1 ─ 1,040/3,814

1 ─ 1,716/5,340

1 ─ 2,154/7,475

1 ─ 3,054/10,366

= $2,978

= $3,699

2,120 ─ 522 1 ─ 2,154/7,475

2,645 ─ 588 . 1 ─3,054/10,366

= $1,325

= $2,240

Cash: 964 ─ 346 BES 1 ─ 1,040/3,814

1,520 ─ 413 1 ─ 1,716/5,340

= $850

= $1,631

= $2,245

= $2,916

2,774 1,810

3,624 2,604

5,321 3,201

7,412 4,767

= 1.53

= 1.39

= 1.66

= 1.55

1,810 1,716

2,604 2,402

3,201 2,899

4,767 4,333

= 1.05

= 1.08

= 1.10

1.53 × 1.05

1.39 × 1.08

1.66 × 1.10

1.55 × 1.10

= 1.62

= 1.51

= 1.84

= 1.71

DOL:

DFL:

DCL:

The risk of the company is quite moderate. Chapter 6 Discussion Questions 6-1. Rapidly expanding sales will require a buildup in assets to support the growth. In particular, more and more of the increase in current asset will be permanent in nature. A non-liquidating aggregate stock of current assets will be necessary to allow for floor displays, multiple items for selection, and other purposes. All of these ‗asset‘ investments can drain the cash resources of the firm. 6-2. If sales and production can be matched, the level of inventory and the amount of current assets needed can be kept to a minimum; therefore, lower financing costs will be incurred. Matching sales and production has the advantage of maintaining smaller amounts of current assets than level production, and therefore less financing costs are incurred. However, if sales are seasonal or cyclical, workers will be laid off in a declining sales climate and machinery (capital assets) will be idle. Here lies the tradeoff between level and seasonal production: Full utilization of capital assets with skilled workers and more financing of current assets versus unused capacity, training and retraining workers, with lower financing for current assets. 6-3.

A cash budget helps minimize current assets by providing a forecast of inflows and

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outflows of cash. It also encourages the development of a schedule as to when inventory is produced and maintained for sales (production schedule), and accounts receivables are collected. The cash budget allows us to forecast the level of each current asset and the timing of the buildup and reduction of each. 6-4.

Only a financial manager with unusual insight and timing could design a plan in which asset buildup and the length of financing terms are perfectly matched. One would need to know exactly what parts of current assets are temporary and what parts are permanent. Furthermore, one is never quite sure how much short-term or long-term financing is available at appropriate rates at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis.

6-5. By establishing a long-term financing arrangement for temporary current assets, a firm is assured of having necessary funding in good times as well as bad, thus we say there is low risk. However long-term financing is generally more expensive than short-term financing and profits may be lower than those which could be achieved with a synchronized or normal financing arrangement for temporary current assets. This is demonstrated in Figure 6-12. 6-6.

By financing a portion of permanent current assets on a short-term basis, we run the risk of inadequate financing in tight money periods. However, since short-term financing is less expensive than long-term funds, a firm tends to increase its profitability over the long run (assuming it survives). In answer to the preceding question, we stressed less risk and less return; here the emphasis is on high risk and high return.

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6-7. The term structure of interest rates shows the relative level of short-term and long-term interest rates at a point in time. It is often referred to as a yield curve. 6-8.

Liquidity premium theory, the segmentation theory, and the expectations theory: The liquidity premium theory indicates that long-term rates should be higher than shortterm rates. This premium of long-term rates over short-term rates exists because shortterm securities have greater liquidity, and therefore higher rates have to be offered to potential long-term bond buyer for enticement to hold these less liquid and more price sensitive securities. The segmentation theory states that Treasury securities are divided into market segments by the various financial institutions investing in the market. The changing needs, desires, and strategies of these investors tend to strongly influence the nature and relationship of short- and long-term rates. The expectations hypothesis maintains that the yields on long-term securities are a function of short-term rates. The result of the hypothesis is that when long-term rates are much higher than short-term rates, the market is saying that it expects short-term rates to rise. When long-term rates are lower than short-term rates, the market is expecting shortterm rates to fall.

6-9. An inverted yield curve reflects investor expectations that interest rates will decline in the future. Furthermore, an inverted yield curve has usually preceded a recession. Lower interest rates are generally a reflection of lower inflation and lower inflation is usually the result of an economic slowdown. This information would be valuable for planning purposes. 6-10. The factors that could be discussed include inflation, inflationary pressures, monetary policy and the money supply, fiscal policy (including spending, taxation, and deficits/debt) and the demand for money, and international influences. A supply/demand diagram is useful for discussing the impacts. 6-11. Before interest rates drop, a bond trader would like to lock into longer term interest rates. The trader will see the value of longer-term bonds appreciate faster than short term bonds for a given increase in interest rates. The action of the trader of buying longer term bonds, relative to short term bonds, will drive their price up and their yields down. The yield curve will become inverted. 6-12. Normally, short-term rates are much more volatile than long-term rates. This is demonstrated in Figure 6-12 with a long-run view of interest rates.

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6-13. Corporate liquidity has generally declined as more sophisticated, profit-oriented financial management (at times the profit orientation has been taken too far). The use of the computer has allowed for more volume being conducted with smaller cash balances. Also, inflation has forced a diversion of funds away from liquid assets to handle everexpanding inventory costs. Likewise, decreasing profitability during recessions has diverted funds from liquid assets. However after difficult times liquidity tends to increase to provide a greater safety margin, particularly as loans are harder to negotiate.

Internet Resources and Questions 1. www.bankofcanada.ca/rates/interest-rates 2. www.bloomberg.com/markets/rates-bonds 3. www.rbc.com/economics/economic-reports/financial-market-reports.html

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Problems 6-1.

Bondi Beachwear Company $750,000 .10 75,000 – 22,500 $ 52,500

Sales Profit margin Net income Dividends (30%) Increase in retained earnings

$120,000 – 52,500 $67,500

Increase in assets Increase in retained earnings External funds needed

6-2.

Axle Supply Co. $300,000 .08 24,000 – 4,800 $ 19,200

Sales Profit margin Net income Dividends (20%) Increase in retained earnings

$60,000 – 19,200 $40,800

Increase in assets Increase in retained earnings External funds needed

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6-3.

Garza Electronics

January February March

Beginning Inventory 700 800 1,150

6-4.

+ Production + 600 + 600 + 600

– Sales – 500 – 250 – 1,000

Ending = Inventory = 800 = 1,150 = 750

Antonio Banderos & Scarves a. October November December January

Units sold 1,000 2,000 4,000 3,000

b. October November December January

Foundations of Fin. Mgt. 12Ce

Units produced 2,500 2,500 2,500 2,500

Ending inventory 1,500 2,000 500 0

Change in inventory +1,500 + 500 –1,500 – 500

Cost per unit ($5) $ 7,500 10,000 2,500 0

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Ending inventory 1,500 2,000 500 0

Financing cost @ 6%/12 $37.50 50.00 12.50 0 $100.00

Block, Hirt, Danielsen, Short

6-5.

Bambino Sporting Goods a. March April May June

Units sold 3,000 7,000 11,000 9,000

b. March April May June

6-6.

Units produced 7,500 7,500 7,500 7,500

Ending inventory 4,500 5,000 1,500 0

Change in inventory +4,500 +500 –3,500 –1,500

Cost per unit ($20) $ 90,000 100,000 30,000 0

Ending inventory 4,500 5,000 1,500 0

Financing cost @ 6%/12 $450.00 500.00 150.00 0 $1,100.00

Eastern Auto Parts Inc.

Sales 15% Cash sales 85% Prior month‘s sales* Total cash receipts

Jan

Feb

Mar

Apr

$65,000 9,750 63,750 $73,500

$55,000 8,250 55,250 $63,500

$100,000 15,000 46,750 $61,750

$45,000 6,750 85,000 $91,750

Based on December sales of $75,000

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6-7.

Front Page Video Games

Production and inventory schedule in units Beginning Inventory

Ending = Inventory

January

+ Production – 20,000 + 11,600 –

19,000 =

12,600

February

12,600 +

11,600 –

17,600 =

6,600

March

6,600 +

11,600 –

4,000 =

14,200

April

14,200 +

11,600 –

4,000 =

21,800

May

21,800 +

11,600 –

3,000 =

30,400

June

30,400 +

11,600 –

6,000 =

36,000

July

36,000 +

11,600 –

8,000 =

39,600

August

39,600 +

11,600 –

8,000 =

43,200

September

43,200 +

11,600 –

10,000 =

44,800

October

44,800 +

11,600 –

16,000 =

40,400

November

40,400 +

11,600 –

20,000 =

32,000

December

32,000 +

11,600 –

23,600 =

20,000

Sales

Total annual sales = $696,000 $696,000/ $5 per unit = 139,200 units 139,200 units/ 12 months = 11,600 per month 2 Monthly dollar sales/ $5 price = unit sales

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Cash Receipts Schedule January

February

March

April

May

June

Sales (in dollars)

$95,000

$88,000

$20,000

$15,000

$30,000

30% cash sales

28,500

26,400

6,000

4,500

9,000

70% prior month‘s sales

70,000*

66,500

61,600

14,000

10,500

Total cash receipts

$98,500

$92,900

$67,600

$20,000

$18,500

$19,500

*based on December sales of $100,000 July

August

Sept.

October

Nov.

Dec.

Sales (in dollars)

$40,000

$50,000

$80,000

$100,000

$118,000

30% cash sales

12,000

15,000

24,000

30,000

35,400

70% prior month‘s sales

21,000

28,000

35,000

56,000

70,000

Total cash receipts

$33,000

$40,000

$43,000

$59,000

$86,000

$105,400

Foundations of Fin. Mgt. 12Ce

6 - 186

Block, Hirt, Danielsen, Short

Cash Payments Schedule Constant production January

February

March

April

May

June

11,600 units  $2

$23,200

Other cash payments

40,000

Total cash payments

$63,200

July

August

Sept.

October

Nov.

Dec.

11,600 units  $2

$23,200

Other cash payments

40,000

Total cash payments

$63,200

Foundations of Fin. Mgt. 12Ce

6 - 187

Block, Hirt, Danielsen, Short

Cash Budget January

February

March

Net cash flow

$35,300

$29,700

$ 4,400 $(43,200) $(44,700) $(43,700)

Beginning cash

5,000

40,300

70,000

74,400

31,200

5,000

Cumulative cash balance

40,300

70,000

74,400

31,200

(13,500)

(38,700)

Monthly loan or (repayment)

-0-

18,500

43,700

Cumulative loan

-0-

18,500

62,200

40,300

70,000

74,400

31,200

5,000

July

August

Sept.

October

Nov.

Dec.

($20,200)

($4,200)

$22,800

$42,200

Ending cash balance

Net cash flow Beginning cash

($30,200) ($23,200)

April

May

June

5,000

Cumulative cash balance

(25,200)

(18,200)

(15,200)

800

27,800

47,200

Monthly loan or (repayment)

30,200

23,200

20,200

4,200

(22,800)

(42,200)

Cumulative loan

92,400

115,600

135,800

140,000

117,200

75,000

Ending cash balance

5,000

Foundations of Fin. Mgt. 12Ce

6 - 188

Block, Hirt, Danielsen, Short

6-8.

Seasonal Products Corporation

Production and inventory schedule in units Beginning Inventory

+ Production

– –

Sales

Ending Inventory

10,000

2,000

January

5,000 +

7,000

February

2,000 +

7,000 –

7,500 =

1,500

March

1,500 +

7,000 –

2,500 =

6,000

April

6,000 +

7,000 –

1,500 =

11,500

May

11,500 +

7,000 –

500 =

18,000

June

18,000 +

7,000 –

1,500 =

23,500

July

23,500 +

7,000 –

5,000 =

25,500

August

25,500 +

7,000 –

7,000 =

25,500

September

25,500 +

7,000 –

10,000

22,500

October

22,500 +

7,000 –

12,500

17,000

November

17,000 +

7,000 –

15,000

9,000

December

9,000 +

7,000 –

11,000

5,000

$168,000 sales/$2 price = 84,000 units 84,000 units/12 months = 7,000 units per month 2 Monthly dollar sales/$2 = number of units

Foundations of Fin. Mgt. 12Ce

6 - 189

Block, Hirt, Danielsen, Short

Cash Receipts Schedule (take dollar values from problem statement) January

February

March

April

May

June

Sales (in dollars)

$20,000

$15,000

$ 5,000

$3,000

$1,000

$3,000

20% Cash sales

4,000

3,000

1,000

600

200

600

80% Prior month‘s sales

12,000*

16,000

12,000

4,000

2,400

800

Total receipts

$16,000

$19,000

$13,000

$ 4,600

$ 2,600

$ 1,400

*based on December sales of $15,000 July

August

Sept.

October

Nov.

Dec.

Sales (in dollars)

$10,000

$14,000

$20,000

$25,000

$ 30,000

$ 22,000

20% Cash sales

2,000

2,800

4,000

5,000

6,000

4,400

80% Prior month‘s sales

2,400

8,000

11,200

16,000

20,000

24,000

$ 4,400

$10,800

$15,200

$21,000

$26,000

$ 28,400

Total receipts

Foundations of Fin. Mgt. 12Ce

6 - 190

Block, Hirt, Danielsen, Short

7,000 units  $1 Other cash payments Total payments

Foundations of Fin. Mgt. 12Ce

Cash Payments Schedule: Constant production January

February

March

April

May

June

$ 7,000

6,000

$13,000

July

August

Sept.

October

Nov.

Dec.

$ 7,000

6,000

$13,000

6 - 191

Block, Hirt, Danielsen, Short

Cash Budget January

February

April

May

June

$ 3,000

$ 6,000

($ 8,400)

($10,400)

($11,600)

Beginning cash

1,000

4,000

10,000

1,600

1,000

Cumulative cash balance

4,000

10,000

1,600

(8,800)

(10,600)

Monthly loan or (repayment)

-0-

9,800

11,600

Cumulative loan

-0-

9,800

21,400

$4,000

$10,000

$1,600

$1,000

July

August

Sept.

Nov.

Dec.

($ 8,600)

($ 2,200)

$ 2,200

$8,000

$13,000

$15,400

Beginning cash

1,000

Cumulative cash balance

(7,600)

(1,200)

3,200

9,000

14,000

16,400

Monthly loan or (repayment)

8,600

2,200

(2,200)

(8,000)

(13,000)

(9,000)

Cumulative loan

30,000

32,200

30,000

22,000

9,000

-0-

Ending cash balance

$1,000

$7,400

Cash flow

Ending cash balance

Cash flow

Foundations of Fin. Mgt. 12Ce

6 - 192

March

October

Block, Hirt, Danielsen, Short

e. Cash

Assets Accounts Receivable

Inventory

Total Current

January

$ 4,000

$16,000

$ 2,000

$22,000

February

10,000

12,000

1,500

23,500

March

10,000

4,000

6,000

20,000

April

1,600

2,400

11,500

15,500

May

1,000

800

18,000

19,800

June

1,000

2,400

23,500

26,900

July

1,000

8,000

25,500

34,500

August

1,000

11,200

25,500

37,700

September

1,000

16,000

22,500

39,500

October

1,000

20,000

17,000

38,000

November

1,000

24,000

9,000

34,000

December

7,400

17,600

5,000

30,000

The instructor may wish to point out how current assets are at relatively high levels and illiquid during June through October. In November and particularly December, the asset levels remain high, but they become increasingly more liquid as inventory diminishes relative to cash.

Foundations of Fin. Mgt. 12Ce

6 - 193

Block, Hirt, Danielsen, Short

Liz’s Health Food Stores

6-9. a. Month

Short-term financing On Monthly Rate Amount Basis

Actual Interest

January

0.67%

$8,000

$53.33

February

0.75%

2,000

15.00

March

12%

1.00%

3,000

30.00

April

15%

1.25%

8,000

100.00

May

12%

1.00%

9,000

90.00

June

12%

1.00%

4,000

40.00 $328.33

b. Month

Long-term financing On Monthly Rate Amount Basis

Actual Interest

January

12%

$8,000

$80.00

February

12%

2,000

20.00

March

12%

3,000

30.00

April

12%

8,000

80.00

May

12%

9,000

90.00

June

12%

4,000

40.00

$340.00 Total dollar interest payments would be larger under the long-term financing plan as described in part b.

Foundations of Fin. Mgt. 12Ce

6 - 194

Block, Hirt, Danielsen, Short

6-10.

Liz’s Health Food Stores (Continued) Divide the total interest payments in part (a) of $328.33 by the total amount of funds extended $34,000 and multiply by 12. interest  $328.33  0.966% monthly rate principal $34,000 12  .966% = 11.59% annual rate

6-11.

Gabriel Health Services Ltd. Long-term rate: $1,500,000 × 0.05 × 2 years =

$150,000

Short-term rate: $1,500,000 × 0.0350 × 1 year = $1,500,000 × 0.0625 × 1 year =

$ 52,500 93,750 $146,250

The short-term rates appear less costly.

6-12.

Vincent Black Lightning Co. Long-term rate: $900,000 × 0.045 × 3 years =

$121,500

Short-term rate: $900,000 × 0.03 × 1 year = $900,000 × 0.05 × 1 year = $900,000 × 0.07 × 1 year =

$ 27,000 45,000 63,000 $135,000

The short-term rate appears less costly.

Foundations of Fin. Mgt. 12Ce

6 - 195

Block, Hirt, Danielsen, Short

6-13.

Sauer Food Company

a. If Rates Are Constant $150,000 borrowed  10% per annum  3 years Interest cost (long-term) $150,000 borrowed  8% per annum  3 years Interest cost (short-term) Interest savings if borrowing short-term b. If Short-term Rates Change 1st year $150,000  .08 2nd year $150,000  .13 3rd year $150,000  .18 Total

= = = =

= $45,000 = 36,000 = $ 9,000

$12,000 $19,500 $27,000 $58,500

$58,500 - $45,000 = $13,500 Extra interest costs by borrowing if the short-term rates are changing.

Foundations of Fin. Mgt. 12Ce

6 - 196

Block, Hirt, Danielsen, Short

6-14.

Nighthawk Steel Long-term financing equals: Permanent current assets Capital assets

$2,000,000 1,200,000 $3,200,000

Short-term financing equals: Temporary current assets

$1,000,000

Long-term interest expense = 6.5%  $3,200,000 = $208,000 Short-term interest expense = 4%  $1,000,000 = 40,000 Total interest expense $248,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (25%) Earnings after taxes 6-15.

$860,000 248,000 612,000 153,000 $459,000

Nighthawk Steel (Continued) Long-term interest expense = 4.5%  $3,200,000 = $144,000 Short-term interest expense = 9%  1,000,000 = 90,000 Total interest expense $234,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (25%) Earnings after taxes

$860,000 234,000 626,000 156,500 $469,500

The company has benefited because it is primarily financed by long-term financing, and long-term rates are now much lower than short-term rates, as rates have become inverted.

Foundations of Fin. Mgt. 12Ce

6 - 197

Block, Hirt, Danielsen, Short

6-16.

Colter Steel

Long-term financing equals: Permanent current assets Capital assets

$2,000,000 1,200,000 $3,200,000

Short-term financing equals: Temporary current assets

$1,000,000

Long-term interest expense = 13% × $3,200,000 = Short-term interest expense = 8% × 9/12 ×1,000,000 = Total interest expense

$ 416,000 60,000 $ 476,000

Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes

$ 996,000 476,000 $ 520,000 156,000 $ 364,000

Temporary current assets pay interest for only 9 months.

Foundations of Fin. Mgt. 12Ce

6 - 198

Block, Hirt, Danielsen, Short

6-17.

Atlas Tours

a. Long-term financing equals: Permanent current assets Capital assets

$1,800,000 2,400,000 $4,200,000

Short-term financing equals: Temporary current assets (six months) Temporary current assets (other six months)

$1,200,000 400,000

Long-term interest expense = 5%  $4,200,000 = $ 210,000 Short-term interest expense = 4%  $1,200,000  0.5 = 24,000 (other) Short-term interest expense = 4%  $400,000  0.5 = 8,000 Total interest expense $ 242,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (38%) Earnings after taxes b. Long-term financing equals: Permanent current assets Capital assets

$1,080,000 242,000 838,000 318,440 $ 519,560 $1,800,000 2,400,000 $4,200,000

Short-term financing equals: Temporary current assets (six months) Temporary current assets (other six months)

$1,200,000 400,000

Long-term interest expense = 5%  $4,200,000 = $210,000 Short-term interest expense = 4%  $1,200,000  0.5 = 24,000 (other) Short-term interest expense = 5%  $400,000  0.5 = 10,000 Total interest expense $244,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (38%) Earnings after taxes

Foundations of Fin. Mgt. 12Ce

6 - 199

$1,080,000 244,000 836,000 317,680 $ 518,320

Block, Hirt, Danielsen, Short

6-18.

Collins Systems, Inc.

a. Temporary current assets Permanent current assets Capital assets Total assets

$300,000 200,000 400,000 $900,000

Conservative % of Interest Total Rate Amount $900,000  .80 =  .15 = $720,000 $900,000  .20 =  .10 = $180,000 Total interest charge

Interest Expense $108,000 Long-term 18,000 Short-term $126,000

Aggressive Amount $900,000  .30 $900,000  .70

b. EBIT – Int. EBT Tax 40% EAT

Foundations of Fin. Mgt. 12Ce

% of Interest Total Rate = $270,000 .15 = = $630,000 .10 = Total interest charge

Conservative $180,000 126,000 54,000 21,600 $ 32,400

6 - 200

Interest Expense $40,500 Long-term 63,000 Short-term $103,500

Aggressive $180,000 103,500 76,500 30,600 $ 45,900

Block, Hirt, Danielsen, Short

c. Reversed Conservative % of Interest Total Rate Amount $900,000  .80 =  .10 = $720,000 $900,000  .20 =  .15 = $180,000 Total interest charge

Interest Expense $72,000 Long-term 27,000 Short-term $99,000

Aggressive Amount $900,000  .30 $900,000  .70

EBIT – Int EBT Tax 40% EAT

Foundations of Fin. Mgt. 12Ce

% of Interest Total Rate = $270,000  .10 = = $630,000  .15 = Total interest charge

Conservative $180,000 99,000 81,000 32,400 $ 48,600

6 - 201

Interest Expense $ 27,000 Long-term 94,500 Short-term $121,500

Aggressive $180,000 121,500 58,500 23,400 $ 35,100

Block, Hirt, Danielsen, Short

6-19.

Lear, Inc.

a. Current assets – permanent current assets = temporary current assets $800,000 – $350,000 = $450,000 Long-term interest expense = 10% [$600,000 + ½ ($350,000)] = 10%  ($775,000) = $77,500 Short-term interest expense = 5% [$450,000 + ½ ($350,000)] = 5%  ($625,000) = $31,250 Total interest expense = $77,500 + $31,250 = $108,750 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes

$200,000 108,750 91,250 27,375 $ 63,875

b. Alternative financing plan L. T. interest expense = 10% [$600,000 + $350,000 ($450,000)] = 10% ($1,175,000) = $117,500 Short-term interest expense = 5% [½ ($450,000)] = 5% (225,000) = $11,250 Total interest expense = $117,500 + $11,250 = $128,750 Earnings before interest and taxes Interest Earnings before taxes Taxes (30%) Earnings after taxes Foundations of Fin. Mgt. 12Ce

6 - 202

+ ½

$200,000 128,750 71,250 21,375 $ 49,875 Block, Hirt, Danielsen, Short

c. The alternative financing plan which calls for more financing by high-cost debt is more expensive and reduces aftertax income by $14,000. However, we must not automatically reject this plan because of its higher cost since it has less risk. The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities. It will not be forced to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the short-term loan.

Foundations of Fin. Mgt. 12Ce

6 - 203

Block, Hirt, Danielsen, Short

6-20.

Date Wireless

a. Long-term financing (as share capital) equals: Permanent current assets Capital assets

$1,000,000 7,000,000 $8,000,000

Short-term financing equals: Temporary current assets

$1,000,000

Share capital = $8,000,000 ÷ $25 = Short-term interest expense = 6%  $1,000,000 = Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes

$1,000,000 60,000 940,000 376,000 $ 564,000

Earnings per share

$ 1.76

b. Long-term financing (as share capital) equals: 60% of $9,000,000 (total assets) = Short-term financing equals: 40% of $9,000,000 (total assets) =

$5,400,000 $3,600,000

Share capital = $5,400,000 ÷ $25 = Short-term interest expense = 6%  $3,600,000 = Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes Earnings per share

Foundations of Fin. Mgt. 12Ce

320,000 $60,000

216,000 $216,000 $1,000,000 216,000 784,000 313,600 $ 470,400 $ 2.18

6 - 204

Block, Hirt, Danielsen, Short

c. Short term rates @11% Hedged Share capital = $8,000,000 ÷ $25 = 320,000 Short-term interest expense = 11%  $1,000,000 = $110,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes Earnings per share

$1,000,000 110,000 890,000 356,000 $ 534,000 $ 1.67

Capital structure (40% debt) Share capital = $5,400,000 ÷ $25 = 216,000 Short-term interest expense = 11%  $3,600,000 = $396,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes Earnings per share

Foundations of Fin. Mgt. 12Ce

$1,000,000 396,000 604,000 241,600 $ 362,400 $ 1.68

6 - 205

Block, Hirt, Danielsen, Short

6-21.

King Lyon

a. Long-term financing (40% equity/60% debt) equals: Permanent current assets Capital assets Short-term financing equals: Temporary current assets (8 months) Temporary current assets (4 months) Shares = $8,500,000  0.4 ÷ $17.00 = Long-term debt = $8,500,000  0.6 = Interest Long-term interest = 4%  $5,100,000 = Short-term interest = 2%  $1,500,000  8/12 = Total interest Earnings before interest and taxes Interest expense Earnings before taxes Taxes (20%) Earnings after taxes Earnings per share ($210,000/200,000)

Foundations of Fin. Mgt. 12Ce

6 - 206

$1,000,000 7,500,000 $8,500,000 $1,500,000 $0 200,000 $5,100,000 $204,000 20,000 $224,000 $486,500 224,000 262,500 52,500 $210,000 $ 1.05

Block, Hirt, Danielsen, Short

6-22.

Phu Lighters

a. Long-term financing (50% equity/50% debt) equals: Permanent current assets Capital assets Short-term financing equals: Temporary current assets (9 months) Temporary current assets (3 months)

$400,000 3,000,000 $3,400,000 $1,350,000 $0

Shares = $3,400,000  0.5 ÷ $10 = Long-term interest = 6%  $1,700,000 = Short-term interest = 3%  $1,350,000  9/12 = Total interest

170,000 $102,000 30,375 $132,375

Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes

$620,000 132,375 487,625 195,050 $292,575

Earnings per share

$ 1.72

b. Long-term financing (50% equity/50% debt) equals: 80% of $3,000,000 (capital assets) = Short-term financing equals: $4,750,000 ─ $2,400,000 (9 months) = $3,400,000 ─ $2,400,000 (3 months) =

$2,400,000 $2,350,000 $1,000,000

Shares = $2,400,000  0.5 ÷ $10 = Long-term interest = 6%  $1,200,000 = Short-term interest = 3%  $2,350,000  9/12 = Short-term interest = 3%  $1,000,000  3/12 = Total interest

120,000 $72,000 52,875 7,500 $132,375

Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes

$620,000 132,375 487,625 195,050 $292,575

Earnings per share

Foundations of Fin. Mgt. 12Ce

$ 2.44

6 - 207

Block, Hirt, Danielsen, Short

c. Short term rates @8% Long-term financing (50% equity/50% debt): Shares = $3,400,000  0.5 ÷ $10 = Long-term interest = 6%  $1,700,000 = Short-term interest = 8%  $1,350,000  9/12 = Total interest

170,000 $102,000 81,000 $183,000

Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes

$620,000 183,000 437,000 174,800 $262,200

Earnings per share

$ 1.54

Shares = $2,400,000  0.5 ÷ $10 = Long-term interest = 6%  $1,200,000 = Short-term interest = 8%  $2,350,000  9/12 = Short-term interest = 8%  $1,000,000  3/12 = Total interest

120,000 $ 72,000 141,000 20,000 $233,000

Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes

$620,000 233,000 387,000 154,800 $232,200

Earnings per share

$ 1.94

6-23. Library assignment. Answers will vary with the state of the economy.

Foundations of Fin. Mgt. 12Ce

6 - 208

Block, Hirt, Danielsen, Short

6-24.

Expectations hypothesis

2 year security (4% + 5%)/ 2 = 3 year security (4% + 5% + 7%)/ 3 = 4 year security (4% + 5% + 7% + 9%)/ 4 =

4.50% 5.33% 6.25%

OR:

1  .0450  4.5% 1.041.051.071  .0533  5.33% 4  1  0.623  6.23%

6-25.

Expectations hypothesis

2 year security (5% + 8%)/ 2 = 3 year security (5% + 8% + 7%)/ 3 = 4 year security (5% + 8% + 7% + 10%)/ 4 =

6.50% 6.67% 7.50%

OR:

1  0.0649  6.49% 1.051.081.071  0.0666  6.66% 4   1  0.0748  7.48%

Foundations of Fin. Mgt. 12Ce

6 - 209

Block, Hirt, Danielsen, Short

6-26.

Expectations hypothesis 2 year bond = 6% 2 year bond = (1st year bond + 2nd year bond) / 2 6% = (5% + f2) / 2 f2 = 7.0% OR: (1.06)2 1 + f2 1 + f2 f2 f2

Foundations of Fin. Mgt. 12Ce

= (1.05) (1 + f2) = (1.06)2 / 1.05 = 1.0701 = 0.0701 = 7.01%

6 - 210

Block, Hirt, Danielsen, Short

6-27.

Expectations hypothesis 1 year rate = 2.60% 2 year rate = 3.26% 3 year rate = 3.39% 2nd year rate 3.26% 6.52% f2

= (1st year rate + 2nd year rate) / 2 = (2.60% + f2) / 2 = 2.60 + f2 = 3.92% OR:

(1.0326)2 1 + f2 1 + f2 f2 f2

= (1.0260) (1 + f2) = (1.0326)2 / 1.0260 = 1.0392 = 0.0392 = 3.92%

3rd year rate 3.39% 10.17% f3

= (1st year rate + 2nd year rate + 3rd year rate) / 3 = (2.60% + 3.92% + f3) / 3 = 6.52% + f3 = 3.65% OR:

(1.0339)3 1 + f3 1 + f3 f3 f3

Foundations of Fin. Mgt. 12Ce

= (1.0260) (1.0392) (1 + f3) = (1.0339)3 / (1.0260) (1.0392) = 1.0365 = 0.0365 = 3.65%

6 - 211

Block, Hirt, Danielsen, Short

6-28.

Expectations hypothesis 1 year rate = 5.78% 2 year rate = 5.85% 3 year rate = 6.22% 2nd year rate 5.85% 11.70% f2

= (1st year rate + 2nd year rate) / 2 = (5.78% + f2) / 2 = 5.78% + f2 = 5.92% OR:

(1.0585)2 1 + f2 1 + f2 f2 f2

= (1.0578) (1 + f2) = (1.0585)2 / 1.0578 = 1.0592 = 0.0592 = 5.92%

3rd year rate 6.22% 18.66% f3

= (1st year rate + 2nd year rate + 3rd year rate) / 3 = (5.78% + 5.92% + f3) / 3 = 11.70% + f3 = 6.96% OR:

(1.0622)3 1 + f3 1 + f3 f3 f3

Foundations of Fin. Mgt. 12Ce

= (1.0578) (1.0592) (1 + f3) = (1.0622)3 / (1.0578) (1.0592) = 1.0696 = 0.0696 = 6.96%

6 - 212

Block, Hirt, Danielsen, Short

6-29.

Gary’s Pipe and Steel Company State of Economy Sales Probability Strong $800,000 .20 Steady 500,000 .50 Weak 350,000 .30 Expected level of sales =

6-30.

Expected Outcome $160,000 250,000 105,000 $515,000

Sharpe Knife Company State of Economy Strong Steady Weak

Foundations of Fin. Mgt. 12Ce

Sales Probability $1,500,000 .20 800,000 .50 500,000 .30 Expected level of sales =

6 - 213

Expected Outcome $300,000 400,000 150,000 $850,000

Block, Hirt, Danielsen, Short

6-31.

Stratton Health Clubs, Inc.

a. Most aggressive Low liquidity Short-term financing Anticipated return

$3,000,000  20% = 3,000,000  10% =

$600,000 – 300,000 $300,000

b. Most conservative High liquidity Long-term financing Anticipated return

$3,000,000  13% = 3,000,000  12% =

$390,000 – 360,000 $ 30,000

c. Moderate approach Low liquidity Long-term financing Anticipated return

$3,000,000  20% = 3,000,000  12% =

$600,000 – 360,000 $240,000

High liquidity Short-term financing Anticipated return

OR: $3,000,000  13% = 3,000,000  10% =

$390,000 – 300,000 $ 90,000

d. You may not necessarily select the plan with the highest return. You must also consider the risk inherent in the plan. Of course, some firms are better able to take risks than others. The ultimate concern must be for maximizing the overall valuation of the firm through a judicious consideration of riskreturn options.

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6-32.

Atlas Sporting Goods, Inc.

a. Most aggressive Low liquidity Short-term financing Anticipated return

$800,000  15% = 800,000  8% =

$120,000 – 64,000 $56,000

b. Most conservative High liquidity Long-term financing Anticipated return

$800,000  12% = 800,000  10% =

$96,000 – 80,000 $ 16,000

c. Moderate approach Low liquidity Long-term financing

$800,000  15% = 800,000  10% =

$120,000 – 80,000 $40,000

High liquidity Short-term financing

OR: $800,000  12% = 800,000  8% =

$96,000 – 64,000 $ 32,000

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Mini Case Gale Force Corporation (Working Capital: Level vs., Seasonal Production) Purpose: This case forces the student to view the impact of level versus seasonal production on inventory levels, bank loan requirements, and profitability. It also considers the efficiencies (or inefficiencies) covered by the different production plans. The computations in the case are parallel Tables 1 to 5 in the text, with the only difference being that seasonal production rather than level production is being utilized. The case allows the student to properly track the movement of cash flow through the production process. a. New Tables 2 through 5, with Tim‘s suggestion implemented, are shown in the following pages. Observe that the inventory level is now constant at 400 units or $800,000 a month because all units produced are sold. As a side point, note that there may be no apparent need now to maintain the 400 units a month in inventory that were on hand at the start of the cycle. The inventory level could be reduced to the level that management feels would be sufficient to cover emergencies (or maybe to zero, which is what the Japanese do in a ―just-in-time‖ production concept). Though not required, you may wish to refer to the old and new Table 4 to make a special point. Note that Tim‘s suggestion causes inventory balances to decrease over the time period and total current assets to fluctuate less, but the same balances occur at the end of September for inventory and total current assets. b. New Table 5 shows the new cumulative loan balances and the interest expenses incurred each month. Under the old system (level production), total interest expense (at 1% a month on the cumulative loan balance) was $254,250. Under the proposed system, it decreases to $50,750 for a savings of $203,500. c. The first step is to compute total sales. Using the second row of Table 3 (either the old or new table), the total is $14,400,000. With an added expense burden of 0.5%, expenses will go up by $72,000. This is still far less than the interest savings of $203,500 computed in question 2, so the seasonal production plan is justified. ($203,500 – $72,000 = $131,500). Please note that the values are assumed to be computed on a pretax basis. Foundations of Fin. Mgt. 12Ce

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Table 2: Production schedule and inventory (seasonal production) Beginning Inventory

– –

Sales

150

= =

Ending Inventory

October

400

+ Production + 150

November

400

–

400

December

400

–

400

January

400

–

400

February

400

–

400

March

400

300

–

300

400

April

400

500

–

500

400

May

400

1,000

–

1,000

400

June

400

1,000

–

1,000

400

July

400

1,000

–

1,000

400

August

400

500

–

500

400

September

400

250

–

250

400

4001

Inventory ($2,000 per unit) × 400 = $800,000

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Table 3: Cash Receipts Schedule: (sales price = $3,000/ unit) (in thousands) October November December January February March Sales forecast

150

300

Sales (in dollars)

$450.0

$ 225.0

$75.0

-0-

$ 900.0

50% Cash sales

225.0

112.5

37.5

-0-

450.0

50% Prior month‘s sales

* 375.0

225.0

112.5

37.5

-0-

Total receipts $600.0 $ 337.5 $ 150.0 *based on September sales of $750,000 April May June

$ 37.5

$-0-

$ 450.0

Sales forecast

July

August

September

500

1,000

500

250

Sales (in dollars)

$1,500.0

$3,000.0

$ 3,000.0

$1,500.0

$750.0

50% Cash sales

750.0

1,500.0

750.0

375.0

50% Prior month‘s sales

450.0

750.0

1,500.0

15,00.0

1,500.0

750.0

$1,200.0

$2,250.0

$3,000.0

$2,250.0

$1,125.0

Total receipts

Table 3: Cash Payments Schedule: (Production costs = $2,000/ unit) (in thousands) Foundations of Fin. Mgt. 12Ce

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Production in units Production costs Overhead

October

November

December

150

$ 300.0

$ 150.0

$ 50.0

200.0

January

February 0

0.0 200.0

March 0

300

0.0

$ 600.0

200.0

Dividends & Interest Taxes Total payments

Production in units Production costs Overhead

150.0

$ 150.0

$ 650.0

$ 350.0

$ 250.0

$ 350.0

$ 200.0

$ 800.0

April

May

June

July

August

September

500

1,000

500

250

$1,000.0

$2,000.0

$1,000.0

$ 500.0

200.0

Dividends & Interest Taxes

1,000.0 $ 150.0

300.0

Total payments $1,350.0 $2,200.0 $2,200.0 $2,500.0 $2,200.0 Table 3: Cash Budget: (minimum required balance = $125,000) (in thousands) October November December January February Foundations of Fin. Mgt. 12Ce

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$ 700.0 March

Block, Hirt, Danielsen, Short

Cash flow

October November December $ -50.0 $ -12.5 $ -100.0

January $ -312.5

February $ -200.0

March $ -350.0

Beginning cash

125.0

Cumulative cash balance

75.0

112.5

25.0

-187.5

-75.0

-225.0

Monthly loan (repayment)

50.0

12.5

100.0

312.5

200.0

350.0

Cumulative loan

50.0

62.5

162.5

475.0

675.0

1,025.0

Ending cash balance

$ 125.0 April

$ 125.0 May

$ 125.0 June

$ 125.0 July

Cash flow

$ -150.0

$ 50.0

$ 800.0

$ 500.0

$ 50.0

$ 425.0

Beginning cash

125.0

300.0

350.0

Cumulative cash balance

-25.0

175.0

925.0

625.0

350.0

775.0

Monthly loan (repayment)

150.0

-50.0

-800.0

-325.0

-0-

Cumulative loan

1,175.0

1,125.0

325.0

-0-

Ending cash balance

$ 125.0

$ 300.0

$ 350.0

$ 775.0

Foundations of Fin. Mgt. 12Ce

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$ 125.0 $ 125.0 August September

Block, Hirt, Danielsen, Short

Table 4: Total Current Assets, First Year Cash

*Accounts Receivable

Inventory

Total Current

October

$125.0

$ 225.0

$800

$1,150.0

November

125.0

112.5

800

1,037.5

December

125.0

37.5

800

962.5

January

125.0

800

925.0

February

125.0

800

925.0

March

125.0

450.0

800

1,375.0

April

125.0

750.0

800

1,675.0

May

125.0

1,500.0

800

2,425.0

June

125.0

1,500.0

800

2,425.0

July

300.0

1,500.0

800

2,600.0

August

350.0

750.0

800

1,900.0

September

775.0

375.0

800

1,950.0

*Equals 50 percent of monthly sales

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Table 5: Cumulative Loan Balance and Interest Expense (12% per year OR 1% per month) October

November December

January

February

March

ulative loan (thousands)

$50.0

$62.5

$162.5

$475.0

$675.0

$1,0

est expense at 12%

$ 500

$ 625

$1,625

$4,750

$6,750

$10

April

May

June

July

August

Septe

ulative loan (thousands)

$1,175.0

$1,125.0

$325.0

-0-

est expense at 12%

$11,750

$11,250

$3,250

Interest rate = 12% Total interest expense for the year = $50,750 Chapter 7 Discussion Questions 7-1.

Cash and marketable securities are generally used to meet the transaction needs of the firm and for contingency purposes. Because the funds must be available when needed, the primary concern should be with safety and liquidity rather than the maximum profits.

7-2.

Liquidity is the quality of converting an asset to cash quickly and at fair market value.

7-3. The treasury manager is most concerned with daily cash flows of a corporation as it is the manager‘s responsibility to invest temporary funds into money market instruments and to provide for temporary cash needs through borrowing. Income based on accrual accounting methods will not capture daily cash surpluses and deficits. 7-4.

A firm could operate with a negative balance on the corporate books, as indicated in Table 7-2, knowing float will carry them through at the bank. Cheques written on the corporate books may not clear until many days later at the bank. For this reason, a negative account balance on the corporate books of $100,000 may still represent a positive balance at the bank.

7-5. Both lockbox systems and regional collection offices allow for the rapid processing of checks that originate at distant points. The difference is that a regional collection center requires the commitment of corporate resources and personnel to staff an office, while a lockbox system requires only the use of a post office box and the assistance of a local bank. Clearly, the lockbox system is less expensive. Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

7-6. By slowing down disbursements or the processing of checks against the corporate account, the firm is able to increase float and also to provide a source of short-term financing. 7-7.

The answer to this question may well depend upon the phase of the business cycle at the time the question is considered. In normal times, small CDs and savings accounts may prove adequate. However, in a tight money period, wide differentials may be established between the various instruments and maximum returns may be found in Treasury bills, large CDs, commercial paper, and money market funds.

7-8. Treasury bills are popular because of the large and active market in which they trade. Because of this, the investor may literally pinpoint the maturity desired -- choosing anywhere from one day to a year. The ‗T-bill‘ market provides maximum liquidity and can absorb almost any dollar amount of business. 7-9.

U.S. money market rates until the mid-90s had been lower than Canadian rates on similar risk instruments, due to the underlying inflationary rate being lower in the United States and due to the monetary policy of the U.S. central bank being somewhat less restrictive. These factors reversed by the 90s allowing Canadian rates to dip significantly below U.S. rates. In the 00s Canadian rates were again slightly above U.S. rates

7-10. The money market is a communications network where trades in short-term financial obligations occur. Canada‘s money market is centered in Toronto. The Eurobond market is for financial obligations with longer maturities and exists where the currency of the bond is not in its home jurisdiction. Although centered in London the Euromarkets are around the globe. Canada has tried to establish Euro-centres in Vancouver and Montreal. 7-11. An investment in accounts receivable requires a commitment of funds as is true of any other investment. The key question is: Will the dollar returns from the resource commitment provide a sufficient rate of return to justify the investment? There is no such thing as too many or too few bad debts, only too low a return on capital. 7-12. The EOQ or economic order quantity tells us at what size order point we will minimize the overall inventory costs to the firm, with specific attention to inventory ordering costs and inventory carrying costs. It does not directly tell us the average size of inventory on hand and we must determine this as a separate calculation. It is generally assumed, however, that inventory will be used up at a constant rate over time, going from the order size to zero and then back again. Thus, average inventory is half the order size. 7-13. A safety stock protects against the risk of losing sales to competitors due to being out of an item. A safety stock will guard against late deliveries due to weather, production delays, equipment breakdowns and many other things that can go wrong between the placement of an order and its delivery. With more inventory on hand, the carrying cost of inventory will go up. 7-14. A just-in-time inventory system usually means there will be fewer suppliers, and they will be more closely located to the manufacturer they supply.

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

Internet Resources and Questions 1. www.bankofcanada.ca/rates/daily-digest/ www.federalreserve.gov/releases/h15/update 2. www.bloomberg.com/markets/rates-bonds/government-bonds/us / 3. www.bmo.com/main/business/cash-management 4. www.bankofcanada.ca/rates/daily-digest/ www.boj.or.jp/en/index.htm

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Block, Hirt, Danielsen, Short

Problems 7-1.

7-2.

Porky’s Sausage Co. Bank Books Initial amount $10,000 Deposits + 70,000 Cheques – 25,000 Balance $55,000 Float $15,000 * *Based on the balance on the corporate books of $40,000 compared to the balance on the bank‘s books.

Sheila’s Society Clothing Manufacturer

a. $4,000,000 daily collections  2.5 days speed up = $10,000,000 additional collections $3,000,000 daily disbursements  1.5 days slow down = 4,500,000 delayed disbursement $14,500,000 freed-up funds

b. $14,500,000  6% $ 870,000

Foundations of Fin. Mgt. 12Ce

freed-up funds interest rate interest on freed-up cash

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Block, Hirt, Danielsen, Short

7-3.

Aurora Electrical Company

a. $1,500,000 daily collections  2 days speed up = $800,000 daily disbursements  1 day slow down =

$3,000,000 additional collections 800,000 delayed disbursement $3,800,000 freed-up funds

b. $3,800,000  4% $ 152,000

freed-up funds interest rate interest on freed-up cash

c. $152,000 125,000 $ 27,000

Benefit Cost Net benefit

7-4.

Answer: Proceed!

Megahurtz International Car Rentals

a. Canadian investment = Interest earned @ 12% Total investment yearend Less real depreciation @ 20% = Net investment value

$42,000 5,040 47,040 9,408 $37,632

b. Canadian investment = Interest earned @ 9% Total investment yearend Plus real appreciation @ 10% = Net investment value

$42,000 3,780 45,780 4,578 $50,358

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Block, Hirt, Danielsen, Short

7-5.

Low Ash Cat Foods $225,000 daily receipts × 4 days speed up = Opportunity cost of funds at Annual benefit Annual new bank fee Annual savings from new bank collection system Accept the offer!

7-6.

$900,000 6% 54,000 49,000 $ 5,000

Leeft Bank Average daily receipts $46,355,000/ 365 =

$127,000

$127,000 daily receipts x 2 days speed up = Short term money market rates at Annual benefit Annual new bank fee Annual cost of cash management system Reject the offer!

$ 254,000 5% 12,700 15,000 $ 2,300

7-7.

Your Banker $305,000 daily receipts x 3 days speed up = $915,000 Less compensating balance requirement 75,000 Net funds freed up $840,000 Opportunity benefit (cost) of funds at 9% Annual benefit 75,600 Annual new bank fee 52,500 Annual savings from concentration banking system $ 23,100 Accept the package!

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

Ron’s Checkbook

7-8.

a. $35 + $58 + $22 + $45 + $17 = $177 b. Probability cheque Amount has cleared  80% $35  80% 58  50% 22  50% 45  50% 17

Expected value $ 28.00 46.40 11.00 22.50 8.50 $116.40

c. (a – b) = $177.00 – $116.40 = $60.60 float

7-9.

Lett

a. r 

100  97.29 365   0.0847  8.47% 97.29 120

 100  97.29 120  1  0.0872  8.72%  1  EFF  97.29   365

b. r

 7-10. a. 𝑟 =

Camembert 100−99.16 99.16

365 = 0.0373 = 3.73% 83 365

100−99.16 83 ) − 1 = 0.0378 = 3.78% b. 𝑟EFF = (1 + 99.16

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

 

7-11.

Canmex Inc.

a. r 

100  98.71 365   0.0795  7.95% 98.71 60

 100  98.71 60 1  0.0822  8.22% rEFF  1   98.71   365

7-12.

Treasury Bill

a. r 

100  P



365

 0.0527  5.27%

P 91 P = 98.703149 Discounted price on $1,000,000 = $987,031.49  100  P  91  1  0.0527  5.27%  1   EFF P   P = 98.727723 Discounted price on $1,000,000 = $987,277.23 365

b. r

Sanders’ Prime Time Lighting Co.

7-13.

Average collection period 



Accounts receivable Average daily credit sales

$195,205  $195,205   38 days $1,875,000/ 365 $5,136.99

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Block, Hirt, Danielsen, Short

7-14.

Oral Roberts Dental Supplies Average collection period 

Accounts receivable Average daily credit sales

Credit Sales = 90% × $5,200,000 = $4,680,000

Average collection period = $559,000 $4,680,000 / 365 $559,000  $12,821.92  44 days 

7-15.

Rubble and Flint Stone Quarries

$3,195,027.50 annual credit sales

365 = $8,753.50 credit sales per day

8,753.50 average daily credit sales × 43 average collection period = $376,400.50 average accounts receivable balance

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Block, Hirt, Danielsen, Short

Darla’s Cosmetics

7-16.

$1,003,750 annual credit sales  $2,750 credit sales a day 365 days $2,750 average daily credit sales  36 average collection period = $ 99,000 average accounts receivable balance

Darla’s Cosmetics (Continued)

7-17.

Average collection period 



Accounts receivable Average daily credit sales

$138,600  42 days $1,204,500 / 365

Since the firm has a longer average collection period, it appears that the firm does have a more lenient credit policy.

7-18.

Mervyn’s Fine Fashion Accounts receivable Average collection period  Average daily credit sales $86,302 Credit sales/ 365 $86,302 Credit sales   365 42 days  $750,005 42 days



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Block, Hirt, Danielsen, Short

7-19.

Bugle Boy Company

Average accounts receivable = Annual sales × Average days outstanding/ 365 Average accounts receivable (new) = $5,820,000 × 45/365 = $717,534 Average accounts receivable (old)

= $3,960,000 × 45/365 = $488,219

Increased investment in accounts receivable = $717,534 – $488,219 = $229,315 Opportunity cost of funds tied up in accounts receivable at 10% = $22,932 ($229, 315 × 0.10)

7-20.

Wontaby Ltd.

Average accounts receivable = Annual sales × Average days outstanding/ 365 Average accounts receivable (new) = $5,800,000 × 45/365 = $715,068 Average accounts receivable

= $4,700,000 × 30/365 = $386,301

Increased investment in accounts receivable = $715,068 – 386,301 = $328,767 Annual financing cost of funds tied up in accounts receivable at 10 = $32,877 ($328,767 × 0.10)

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Block, Hirt, Danielsen, Short

7-21.

Johnson Electronics

a. Additional sales $100,000 Accounts uncollectible (10% of new sales) – 10,000 Annual incremental revenue 90,000 Collection costs (3% of new sales) – 3,000 Production and selling costs (79% of new sales) – 79,000 Incremental income before taxes $ 8,000

b. Incremental return on sales

Incremental income Incremental sales = $8,000/$100,000 = 8.0%

c. Receivable turnover Receivables

= Sales/Accounts receivable = 6× = Sales/Receivable turnover = $100,000/6 = $16,666.67

Incremental return on new average investment = $8,000/$16,666.67 = 48%

Note:

This incremental return on the new investment would be compared to the before tax opportunity cost of funds.

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Block, Hirt, Danielsen, Short

7-22.

Henderson Office Supply

a. Investment in accounts receivable 

$60,000

 $12,000

b. Added sales $ 60,000 Accounts uncollectible (8% of new sales) – 4,800 Annual incremental revenue 55,200 Collection costs (5% of new sales) – 3,000 Production and selling costs (78% of new sales) – 46,800 Annual income before taxes $ 5,400 Return on incremental investment 

$5,400  0.45  45% $12,000

c. Yes! 45% exceeds the required return of 25%.

d. Investment in inventory 

$60,000(.78)  $11,700 4

Total incremental investment Inventory Accounts receivable Incremental investment

$11,700 12,000 $23,700

Return on incremental investment 

$5,400  0.2278  22.78% $23,700

e. No! 22.78% is less than the required return of 25%.

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Block, Hirt, Danielsen, Short

7-23. Comiskey Fence Co. a. Added sales......................................................... Accounts uncollectible (12% of new sales) ....... Annual incremental revenue............................... Collection costs................................................... Production and selling costs (70% of new sales) Annual income before taxes................................

$180,000 21,600 158,400 15,700 126,000 $ 16,700

Sales  $180,000  $36,000 Investment in accounts receivable  Turnover 5  Return on incremental investment 

$16,700

 0.464  46.4%

$36,000

Yes, extend credit to these customers as 46.4% incremental return is greater than 15%.

b. Same as above except accounts uncollectible are 15% of $180,000 or $27,000. This is $5,400 more than the value in part a. The value can also be computed as:

Added sales.......................................................... Accounts uncollectible (15% of new sales ........ Annual incremental revenue............................... Collection costs................................................... Production and selling costs (70% of new sales) Annual income before taxes...............................

Return on incremental investment 

$180,000 27,000 153,000 15,700 126,000 $ 11,300

$11,300  0.314  31.4% $36,000

Yes, extend credit. (31.4%>15%) c. If receivable turnover drops to 1.5 ×, the investment in accounts receivable would equal $180,000/ 1.5 = $120,000. The return on this investment, with a 12% uncollectible rate, is 13.92%.

Return on incremental investment 

$16,700  0.1392  13.92% $120,000

The credit should not be extended. 13.92% is less than the desired 15%.

7-24.

Foundations of Fin. Mgt. 12Ce

Comiskey Fence (Continued)

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Block, Hirt, Danielsen, Short

First compute the new accounts receivable balance. Accounts receivable  Average collection period  average daily sales 120 days 

$180,000  120  $493 365

 $59,178 OR:   Accounts receivable turnover  

365 Average collection period

365 days 120 days

 3.0417 

Sales accounts receivable turnover $180,000   $59,178 3.0417

Accounts receivable 

Then compute return on incremental investment. Return on incremental investment 

$16,700

 0.2822  28.22%

$59,178

Yes, extend credit. 28.22% is greater than 15%.

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Block, Hirt, Danielsen, Short

7-25.

Slow Roll Drum Co. a.

Added sales ............................................................. $180,000 Accounts uncollectible (12% of new sales) ............ 21,600 Annual incremental revenue ................................... 158,400 Collection costs ....................................................... 16,200 Production and selling costs (72% of new sales) ................................................ 129,600 Annual income before taxes.................................... 12,600 Taxes (34%) ............................................................ 4,284 Incremental income after taxes ............................... $ 8,316

First compute the accounts receivable balance. Accounts receivable = average collection × average daily period sales 120 days 

$180,000   120  $493.15  $59,178 365 days

Then, compute return on incremental investment. $8,316  0.1405  14.05% $59,178

b. Yes, extend credit. 14.05 percent is greater than 10 percent.

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Block, Hirt, Danielsen, Short

7-26.

Apollo Data Systems

a. Accounts receivable: Inventory:

$600,000/ 5 × = $120,000 $600,000/ 8 × = $75,000

($600,000 × .77)/ 8 × =

Plant and equipment: Total investment

$57,750

$600,000/ 2 × = $300,000 = $495,000

b. Collection costs: .03 × $600,000 = $18,000 Production & selling costs: .77 × $600,000 = $462,000 Total $480,000 c. Inventory carrying costs:

.06 × $75,000 =

$4,500

d. Amortization expense:

.07 ×$300,000 =

$21,000

e. $480,000 + $4,500 + $21,000 = $505,500 f. $600,000 - $505,500 = Taxes: .30 × $94,500 = Net income = g. 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = [

$94,500 $28,350 $66,150

$66,150

] = .134 = 13.4%

$495,000

Since this exceeds the required rate of return of 12% proceed Note: Inventory is calculated using sales and not cost of goods sold.

7-27.

Apollo Data Systems (Continued)

a. Inventory:

$600,000/ 4 × = $150,000

b. Total investment now

= $120,000 + $150,000 + $300,000 = $570,000 $66,150 c. 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = [ ] = .116 = 11.6% $570,000

Not acceptable! Note: Inventory is calculated using sales and not cost of goods sold.

7-28. Foundations of Fin. Mgt. 12Ce

Maddox Resources 12 -

Block, Hirt, Danielsen, Short

a. Sales/365 days = average daily sales $180,000/365 = $493.15 Accounts receivable balance = $493.15  30 days = $14,795 365 Accounts receivable turnover  Average collection period  365 days   12.17   30 days  OR:  $180,000 Sales Turnover   12.17   Accounts receivable $14,795 b. $493.15  10 days = $4,932 new receivable balance c. Old receivables – new receivables = Funds freed by discount $14,795 – $4,932 = $ 9,863 Savings on loan = 12%  $9,863............... Discount on sales = 2%  $180,000........... Net change in income from discount.........

= =

$ 1,184 (3,600) $(2,416)

No! Don't offer the discount since the income from the reduced bank loans, does not offset the loss on the discount.

d. New sales = $180,000  1.20 = $216,000 Change in sales = $216,000 – $180,000 = $36,000 Sales per day = $216,000/365 = $591.78 Average receivables = $591.78  10 = $5,918 Increase profit on new sales = 16%  $36,000 = $5,760 Discount cost = 2%  $216,000 = (4,320) Interest savings ($14,795 – $5,918)  12% = 1,065 Net change in income $2,505 Yes, offer the discount because total profit increases.

7-29.

Lipto Biomedic

a. Credit sales/365 days = average daily sales $740,000/365 = $2,027.40 Accounts receivable balance = $2,027.40  75 days = $152,055

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Block, Hirt, Danielsen, Short

Accounts receivable turnover    OR:



365 Average collection period 365 days 75 days

 Turnover 

$740,000 Sales  Accounts receivable $152,055

 4.87   

 4.87 

b. $2,027.40  10 days = $20,274 new receivable balance c. Old receivables – new receivables $152,055 – $20,274

= Funds freed by discount = $131,781

Savings on loan = 8%  $131,781............ Discount on sales = 3%  $740,000.......... Net change in income from discount.........

= =

$ 10,542 (22,200) $(11,658)

No! Don't offer the discount since the income from the reduced bank loans, does not offset the loss on the discount.

d. New sales = $740,000  1.12 = Change in sales = $828,800 – $740,000 = Sales per day = $828,800/365 = Average receivables = $2,270.68  10 =

$828,800 $88,800 $2,270.68 $22,707

Increase profit on new sales = 19%  $88,800 =$16,872 Discount cost = 3%  $828,800 = (24,864) Interest savings ($152,055 – $22,707)  8% = 10,348 Net change in income $2,356 Yes, offer the discount because total profit increases.

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Block, Hirt, Danielsen, Short

7-30.

Tobin Fisheries Δ Sales ($4,200,000 – $3,100,000) $1,100,000 Δ Contribution margin @ 5.5% Δ Discount expense Present policy 2% (80%) $3,100,000 49,600 New policy 3% (60%) $4,200,000 75,600 (26,000) Δ Investment in accounts receivable Present policy $3,100,000 × 15/365 127,397 New policy $4,200,000 × 34/365 391,233 $263,836 Δ Opportunity cost on investment in accounts receivable at 10% Total incremental change

$60,500

(26,000)

(26,384) $ 8,116

Yes! Tobin should initiate the change.

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Block, Hirt, Danielsen, Short

7-31.

Happy Trails Adventure Products Δ Sales Present policy 400,000 × $24 = New policy $9,600,000 × 112%

$ 9,600,000 10,752,000 $ 1,152,000 Δ Contribution margin ($24 – $21)/ $24 = 12.5% Δ Discount expense Present policy 2% (75%) $9,600,000 New policy 2% (35%) $10,752,000

$144,000

144,000 75,264 68,736

68,736

Δ Bad debt expense Present policy 1.5% (90%) $9,600,000 129,600 New policy 2% (90%) $10,752,000 193,536 (63,936)

(63,936)

Δ Investment in accounts receivable Present policy 65% $9,600,000 × 10/365 25% $9,600,000 × 40/365 New policy 25% $10,752,000 × 10/365 65% $10,752,000 × 70/365 Δ Opportunity cost on investment in accounts receivable at 13% Total incremental change

$170,959 263,014 $433,973 $

73,644 1,340,318 1,413,962 $ 979,989 (127,399) $ 21,401

Yes! Happy Trail Adventure Products should initiate the change.

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

7-32.

Power Play, Inc. (Monthly analysis)

a. Δ Sales Present policy New policy

$ 450,000 400,000 $ (50,000)

Δ Contribution margin (1 – .78) = Δ Discount expense Present policy 3% (40%) $ 450,000 New policy no discount Δ Bad debt expense Present policy 2% ($450,000) New policy 1.75% ($400,000)

22%

$ (11,000)

$ 5,400 0 $ 5,400

5,400

$ 9,000 7,000 $ 2,000

2,000

Δ Investment in accounts receivable Present policy, average collection period 60% × 60 days 36 days 40% × 10days 4 days 40 days $450,000 × 12 × 40/365 = $591,781 New policy $400,000 × 12 × 30/365 = 394,521 $197,260 Δ Opportunity benefit on investment in accounts receivable at Total incremental change

11%/12

1,808 $ (1,792)

No! Power Play Inc. should not tighten its credit policy.

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

b. Since this problem is calculated on a monthly basis it is important to note the average balance of accounts receivable under both policies. Present policy New policy

$591,781 $394,521

c. The discount rate or opportunity cost of funds that is chosen is the rate charged by the bank. The bank is likely extending credit on the strength of the accounts receivable position and has chosen its interest rate accordingly. We are matching the risk of the asset (accounts receivable) with the expected rate of return for this investment.

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

7-33.

OB1 Sabres Ltd. Δ Sales Present policy (all cash *) New policy Δ Contribution margin (1 – .75) = Δ Discount expense Present policy no discount (all cash *) New policy 2% (75%) $5,500,000

$4,300,000 5,500,000 $1,200,000 25%

$300,000

$ 0 82,500 $82,500

(82,500)

$ 0 41,250 $41,250

(41,250)

Δ Bad debt expense Present policy (all cash *) New policy 0.75% ($5,500,000) Δ Marketing expense Present policy 4% ($4,300,000) New policy 4% ($5,500,000)

$172,000 220,000 $ 48,000 Δ Administrative expense (related to credit department) Present policy $ 0 New policy $50,000 + 2 ($35,000) $120,000 $120,000 Δ Investment in accounts receivable Present policy (all cash *) $ 0 New policy $5,500,000 (75%) × 10/365 $113,014 $5,500,000 (25%) × 30/365 113,014 $226,028 Δ Opportunity benefit on investment in A/R 11% Δ Investment in inventory Present policy (75%) $4,300,000 / 15 $215,000 New policy (75%) $5,500,000 / 15 275,000 $ 60,000 Δ Opportunity benefit on inv. investment 11% Total incremental change

(48,000)

(120,000)

$ (24,863)

(6,600) $(23,213)

No! OB1 Sabres should not adopt the proposed policy and the new credit department. Note: The inventory turnover ratio is calculated using Cost of goods sold.

7-34. a. Foundations of Fin. Mgt. 12Ce

First Picked Fruits, Inc. Policy #1

Policy #2 12 -

Policy #1

Policy #2

Block, Hirt, Danielsen, Short

Δ Sales Present policy $6,100,000 Policy one 6,900,000 $ 800,000 Policy two

$7,200,000 $1,100,000

Δ Contribution margin (1 – .94)= 6%

$48,000

$66,000

Δ Bad debt expense (on incremental sales only) Policy one 1.75% ($800,000) (14,000) New policy 2.0% ($1,100,000)

(22,000)

Δ Investment in accounts receivable (incremental sales only) Policy one $800,000 × 50/365 = $109,589 Policy two $1,100,000 x 65/365 = $195,890 Δ Opportunity benefit on investment in accounts receivable at 16% Policy one: $109,589 × 16% = Policy two: $195,840 × 16% = Total incremental change

(17,534) (31,342) $ 16,466

$ 12,658

Both policies are viable. Policy one is the best choice if a choice must be made.

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

b. Would the existing customers maintain an average collection period of 40 days, when new customers are allowed 50 days under policy one and 65 days under policy two? Notice the impact if existing customers stretch their payment patterns to correspond with the new customers. Δ Investment in accounts receivable (existing customers) Present policy $6,100,000 × 40/365 = Policy one $6,100,000 × 50/365 = Policy two $6,100,000 × 65/365

$ 668,493 $ 835,616 $1,086,301

Δ policy one ($835,616 – $668,493) = Δ policy two ($1,086,301 – $668,493) =

$167,123 $417,808

Δ Opportunity cost of investment in accounts receivable at 16% Δ policy one $167,123 × 16% = Δ policy two $417,808 × 16% =

$26,740 $66,849

This would render both policies unacceptable. c. The analysis presented assumes perpetuity for the cash flow changes. It ignores any impacts on machinery usage and accelerated wear and tear due to increased sales. This would bring forward in time capital investments. The analysis may also ignore competitive responses.

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Block, Hirt, Danielsen, Short

7-35.

Route Canal Shipping Company Age of Receivables April 30, 20XX

(1)

(2) Age of Month of sale account April 0-30 March 31-60 February 61-90 January 91-120 Total receivables

b. Average collection period 

(3)

(4) Percent of amount due 35% 20% 30% 15% 100%

Amounts $105,000 60,000 90,000 45,000 $300,000

Accounts receivable Average daily credit sales

$300,000 $300,000  $1,440,000 /120 $12,000  25 days 

c. Yes, the average collection period of 25 days is less than 30 days. d. No. The aging schedule provides additional insight that 65% of the accounts receivable are over 30 days old. e. It goes beyond showing how many days of credit sales accounts receivable represent, to indicating the distribution of accounts.

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Block, Hirt, Danielsen, Short

7-36.

Nowlin Pipe & Steel

a. EOQ 

2  72,000 $6 2SO   360,000  600 pipes $2.40 C

b. 72,000 pipes/ 600 pipes = 120 orders c. EOQ/ 2 = 600/ 2 = 300 pipes (average inventory) d. TC  SO  CQ Q 2 72,000 $6 $2.40  600  120 $6  $2.40  300   600 2  $720  $720  $1440 7-37.

Lokerup Alarms

a. C= $1.00 + $2.50 + $1.25 + $3.00 = $7.75 EOQ 

2 100,000$38.75 2SO   1,000,000  1,000 door locks C $7.75

b. 100,000 locks/ 1,000 locks = 100 orders c. EOQ/ 2 = 1,000/ 2 = 500 baskets (average inventory) d. 100 orders  $38.75 ordering cost = 500 inventory  $7.75 carrying cost per unit = Total costs =

Foundations of Fin. Mgt. 12Ce

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$ 3,875 3,875 $7,750

Block, Hirt, Danielsen, Short

7-38.

Friendly Home Services

a. Q= $125,000/$25 = 5000 EOQ 

2  5,000 $75 2SO   250,000  500 baskets C $3.00

b. 5,000 baskets/ 500 baskets = 10 orders c. EOQ/ 2 = 500/ 2 = 250 baskets (average inventory) d. 10 orders  $75 ordering cost = 250 inventory  $3.00 carrying cost per unit = Total costs =

7-39. a. EOQ 

$ 750 750 $1,500

Fisk Corporation 2  75,000$8 2SO   1,000,000  1,000 units C $1.20

b. 75,000 units/ 1,000 units = 75 orders c. EOQ/ 2 = 1,000 units/ 2 = 500 units (average inventory) d. 75 orders  $8 ordering cost = 500 inventory  $1.20 carrying cost per unit = Total costs =

Foundations of Fin. Mgt. 12Ce

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$ 600 600 $1,200

Block, Hirt, Danielsen, Short

7-40.

Fisk Corporation (Continued)

a. EOQ 

2  75,000$2 2SO   250,000  500 units C $1.20

75,000 units/ 500 units = 150 orders EOQ/ 2 = 500 units/ 2 = 250 units (average inventory) 150 orders  $2 ordering cost = 250 inventory  $1.20 carrying cost per unit = Total costs =

$300 300 $600

b. The number of units ordered declines 50%, while the number of orders doubles. The average inventory and total costs both decline by one-half. Notice that the total cost did not decline in equal percentage to the decline in ordering costs. This is because the change in EOQ and other variables (½) is proportional to the square root of the change in ordering costs (¼).

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7-41.

Higgins Athletic Wear

a. EOQ 

2  22,500 $3 2SO   90,000  300 units $1.50 C

b. EOQ/2 = 300/2 = 150 units (average inventory) 150 units  $1.50 carrying cost/unit = $225 total carrying cost

SO CQ  Q 2  22,500 $3  $1.50  300  75  $3  $1.5 150 300 2  $225  $225

TC  c.

 $450 Average inventory  

EOQ 2 300

 Safety stock

 30

2  180 180 inventory  $1.50 carrying cost per year = $270 total carrying cost

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Block, Hirt, Danielsen, Short

7-42.

Joseph Sports Equipment, Inc.

a. Inventory increases by  interest expense Increased costs Less: Savings Loss

$400,000 10.5% 42,000 35,000 ($ 7,000)

Don't switch to level production. Increased ROI is less than the interest cost of more inventory. b. If interest rates fall to 8.75% or less, the switch would be feasible. $35,000 savings  8.75% $400,000 increased inventory

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7-43.

Minty Airfresheners Ltd. The current situation:

EOQ 

2  81,600 $106.25 2SO   11,560,000  3,400 bottles C $1.50

81,600 packages per year /3,400 EOQ =

24 orders per year

Average inventory at EOQ= 3,400/2 =

1,700

TC at EOQ

= (24 orders x $106.25) + (1,700 average inventory × $1.50) = $2,550 + $2,550 = $5,100

The proposed quarterly ordering: Each order Average inventory

= 81,600/ 4 = 20,400 = 20,400/ 2 = 10,200

TC cost (with discount)

= (4 orders × $106.25) + (10,200 average inventory × $1.50) = $425 + $15,300 = $15,725

Inventory total cost increase Benefit of discount

= $15,725 ‒ $5,100 = $10,626 = $4.75 × 81,600 × .10 = $38,760

Yes! Do change the present ordering policy. Benefit exceeds cost by $28,135 ($38,760 – $10,626)

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7-44.

Downey Disks

Number of annual units = $200,000/ $5 = 40,000 At EOQ: 



  2  40,000 $125 2SO EOQ    4,000,000  2,000 units $2.50 C

TC  SO  CQ  40,000  $125  $2.50  2,000  $2,500  $2,500  $5,000 Q 2 2,000 2

However currently:

At 4×/ year orders = 40,000/4 = 10,000

TC  SO  CQ  40,000  $125  $2.50 10,000  $500  $12,500  $13,000 Q 2 10,000 2

Opportunity cost of not ordering at EOQ = $13,000 –$5,000 = $8,000

7-45.

Bonsay Dance

Current inventory investment = $10,000,000/8 = Previous inventory investment = $10,000,000/12 = Increased inventory investment = Opportunity cost of increased investment in inventory at 5% =

Foundations of Fin. Mgt. 12Ce

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$1,250,000 833,333 $ 416,667 ($20,833)

Block, Hirt, Danielsen, Short

7-46.

Baktoo Basics Ltd.

Existing inventory investment = $6,000,000/10 = New system inventory investment = $6,000,000/15 = Reduced inventory investment = Opportunity benefit (cost) of reduced investment in inventory at 11% = Cost of new control system = Benefit =

$600,000 400,000 $200,000 $22,000 17,500 $ 4,500

Yes! The new system is worth it.

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Comprehensive Problem Bailey Distributing Company Receivables and Inventory Policy

7-47.

a. Accounts receivable  Average collection period  average daily sales Before: Average collection period .40  10 = 4 .60  30 = 18 22 days Average daily sales Credit sales – discount 365 days

Accounts receivable After:

Average collection period .50  10 = 5 .50  50 = 25 30 days

Average daily sales Credit sales – discount 365 days

Accounts receivable

Foundations of Fin. Mgt. 12Ce

= $200,000 – (.01) (.40) ($200,000) 365 days = $200,000 – $800 365 days = $199,200 = $545.75 365 days = 22 days  $545.75 = $12,007

= $250,000 – (.03) (.50) ($250,000) 365 days = $250,000 – $3,750 365 days = $246,250 = $674.66 365 days = 30 days  $674.66 = $20,240

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Block, Hirt, Danielsen, Short

b. EOQ Before EOQ  

  2  20,000 $100 2SO   4,000,000  2,000 appliances C $1.00

After EOQ 

2SO 2  25,000 $100   5,000,000  2,236 appliances C $1.00

Average inventory: Before: 2,000/ 2 = 1,000 units

1,000 × $6.50 = $6,500

After:

1,118 × $6.50 = $7,267

2,236/ 2 = 1,118 units

Net sales (sales - cash discount) Cost of goods sold (65%) Gross Profit General and admin. expense (10%) Operating profit *Interest on increase in accounts receivable and inventory (12%) Income before taxes Taxes (25%) Income after taxes * 12%  AR

12%  INV

Before Policy Change

After Policy Change

$199,200 129,480 69,720 19,920 49,800

$246,250 160,063 86,187 24,625 61,562

49,800 12,450 $37,350

1,080 60,482 15,121 $45,361

= 12%  ($20,240 – $12,007) = 12%  $8,233 = = 12%  ($7,267 – $6,500) = 12%  $767 =

$988 $ 92 $1,080

d. Utilize new cash discount policy. Interest cost on the increased accounts receivable and inventory is small in comparison to the increased operating profit from the policy change. There would be a slight increase in ordering costs to 11.18 orders (25,000/ 2,236) from 10 orders per year (20,000/2,000). This will cost an additional $100 (1  $100). To the extent that carrying costs do not include the opportunity cost of funds tied up in inventory, carrying costs will increase up to $118 ($1  $118).

Chapter 8 Foundations of Fin. Mgt. 12Ce

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Discussion Questions 8-1.

It is advisable to borrow in order to take a cash discount when the cost of borrowing is less than the cost of forgoing the discount. If it cost us 36 percent to miss a discount, we would be much better off finding an alternate source of funds for 8 to 10 percent.

8-2.

Larger firms tend to be in a net creditor position because they have the financial resources to be suppliers to credit. The smaller firm must look to the larger manufacturer or wholesaler to help carry the firm's financing requirements.

8-3.

The prime rate is the rate that a bank charges its most creditworthy customers. The average customer can expect to pay one or two percent (or more) above prime rate. In competitive markets banks may actually charge preferred customers less than prime.

8-4.

The use of a compensating balance or minimum required account balance allows the banker to generate a higher return on a loan because not all funds are actually made available to the borrower. A $125,000 loan with a $25,000 compensating balance requirement means only $100,000 is being provided on a net basis. This benefit to the lender need not be a disadvantage to the borrower. The borrower may, in turn, receive a lower quoted interest rate and certain gratuitous services because of the compensating balance requirement. Bankers have tended towards eliminating both compensating balances and gratuitous services.

8-5.

The stated interest rate is the percentage rate unadjusted for time or method of repayment. The annual interest rate is the true rate and considers all these variables. A 5 percent stated rate for 90 days provides a 20 percent annual rate. The financial manager should recognize the annual rate as the true cost of borrowing. An effective rate would include any compounding effects over the relevant period.

8-6. Commercial paper can be either purchased or issued by a corporation. To the extent one corporation purchases another corporation's commercial paper as a short-term investment, it is a current asset. Conversely, if a corporation issues its own commercial paper, it is a current liability. 8-7. In comparison to bank borrowing, commercial paper can generally be issued at below the prime rate. Furthermore, there are no compensating balance requirements, though the firm is required to maintain approved credit lines at a bank. Finally, there is a certain degree of prestige associated with the issuance of commercial paper. The disadvantages are the possibility of default, the potential of a liquidity freeze and a lack of loyalty or ongoing commitment as opposed to a banking relationship 8-8.

A bankers‘ acceptance offers the guarantee of payment from a chartered bank.

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8-9.

Major types of collateralized short-term loans include: a. Pledging accounts receivable: borrowing with receivables as collateral. b. Factoring account receivables: selling accounts at a discount to a finance company. c. Borrowing with inventory as collateral through (1) Blanket inventory lien-general claim against inventory or collateral. No specific items are marked or designated. (2) Trust receipt-borrower holds the inventory in trust for the lender. Each item is marked and has a serial number. When the inventory is sold, the trust receipt is canceled and the funds go into the lender's account. (3) Warehousing-the inventory is physically identified, segregated, and stored under the direction of an independent warehouse company that controls the movement of the goods. If done on the premises of the warehousing firm, it is termed public warehousing. An alternate arrangement is field warehousing whereby the same procedures are conducted on the borrower's property.

8-10. A public offering backed by an asset (accounts receivable) as collateral. Essentially a firm sells its receivables into the securities markets. 8-11. Hedging means to engage in a transaction that partially or fully reduces a prior risk exposure. In selling a financial futures contract, if interest rates go up, one is able to buy back the contract at a profit. This will help to offset the higher interest charges to a corporation or other business entity. Hedging involves the matching of maturities of assets and liabilities to reduce risk. 8-12. Pledging receivables entails providing a lender with the ability to take over control of the receivables, if appropriate, in exchange for the lender providing a loan. In effect the receivables back up the loan. Factoring involves selling receivables to a lender or factor in exchange for immediate funds. When pledged the receivables stay on a firm‘s balance sheet along with a newly created loan and cash, whereas in factoring the receivables are replaced on the firm‘s balance sheet as cash, without the loan entry.

Internet Resources and Questions 1. http://www.m-x.ca/produits_taux_int_bax_en.php 2. http://www.globeinvestor.com/v5/data/rates/ http://www.financialpost.com/personal-finance/rates/loans-personal.html

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Problems 8-1.

Cost of forgoing the cash discount 𝑑%

365

𝐾DIS = 100%−𝑑% × 𝑓 (date)−𝑑 (date) a. 𝐾DIS = b. 𝐾DIS = c. 𝐾DIS = d. 𝐾

= DIS

1% 100%−1% 2% 100%−2% 2% 100%−2% 3% 100%−3%

8-2.

× × × ×

365 20−10 365 30−15 365 45−10

= .3687 = 36.87% = .4966 = 49.66% = .2128 = 21.28%

365

= .0664 = 6.64%

180−10

Arbutus Ltd.

a. Accounts payable forgoing discount: Annual purchases/365 × Final due date = $9,210,000/ 365 × 45 = Accounts payable taking discount: Annual purchases/365 × Discount period = $9,210,000/ 365 × 10 = Additional financing available =

$1,135,479

252,329 $ 883,150

b. Cost of forgoing the cash discount 2% 365   .2128  21.28% K DIS  100%  2% 45 10

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-3.

S. Pumpkins

a. COGS

= Average inventory × turnover rate = $630,000 × 8 = $5,040,000

Average accounts payable = COGS/ 365 × average payment period = $5,040,000/ 365 × 45 = $621,370 b. Annual sales

8-4.

= Average A/R × 365/Average collection period = $520,250 × 365/30 = $6,329,708

Paul Promptly K DIS 

3%  365   .2258  22.58% 100%  3% 60 10

In this problem, Mr. Promptly has the use of funds for only 50 extra days (60 – 10), instead of 60 extra days (70 – 10). Mr. Promptly‘s suppliers are offering terms of 3/10, net 70. Mr. Promptly is actually accepting terms of 3/10, net 60. 8-5.

Little Kimi Clothiers K DIS 

2%  365   .0993  9.93% 100%  2% 90 15

Little Kimi should accept the bank‘s terms and borrow at 6% to take the cash discount. The cost of forgoing the discount is 9.93%.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-6.

Chris Angle K DIS 

365 1%    .0737  7.37% 100%  1% f 60  d10

Chris should not accept the bank‘s terms and borrow at 8%. He should take the cash discount. The cost of forgoing the discount is 7.37%.

8-7.

Treasury Bills

100  98.671 365 100  P 365    0.0540  5.40%  r P d 98.671 91

8-8.

Treasury Bills 100  98.097 365 100  P 365    0.0389  3.89%  r P d 98.097 182

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-9.

McGriff Dog Food Company

a. Accounts receivable = Average daily credit sales × average collection period = $10,000 × 25 = $250,000 Accounts payable = Average daily credit purchases × average payment period = $9,000 × 20 = $180,000 Net credit position Net credit position

= Accounts receivable – Account payable = $250,000 – $180,000 = $70,000

b. Accounts receivable will remain at Accounts payable = $9,000 × 32 Net credit position

$250,000 288,000 ($38,000)

McGriff has improved its cash position and cash flow. Instead of extending $70,000 more in credit (funds) than it is receiving, it has reversed the position and is the net recipient of $38,000 in credit.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-10.

Sampson Orange Juice Company

a. Accounts receivable = Average daily credit sales × average collection period = $9,000 × 34 = $306,000 Accounts payable = Average daily credit purchases × average payment period = $7,500 × 30 = $225,000 Net credit position Net credit position

= Accounts receivable – Account payable = $306,000 – $225,000 = $81,000

b. Accounts receivable will remain at Accounts payable = $7,500 × 45 Net credit position

$306,000 337,500 ($31,500)

The firm has improved its cash position and cash flow. Instead of extending $81,000 more in credit (funds) than it is receiving, it has reversed the position and is the net recipient of $31,500 in credit.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-11.

Your Bank I 365  $25  365  0.1014  10.14%   R ANNUAL = P d $2,000 45 365   $25 45  1  0.1060  10.60% r  1  EFF   $2,000 

  8-12.

A Pawnshop I 365  $45  365  0.1095  10.95%   R ANNUAL = P d $3,000 50   r  1  $45 50 1  0.1148  11.48% EFF  $3,000  365

 8-13.

Dr. Painkiller One year‘s interest = $3,000 ×0.08 = $240 R DIS

365 I $240 365    0.0870  8.70% =   P-I d $3,000  $240 365

8-14.

Marty Not

R DIS =

365 I $215 365    0.0840  8.40%   P-I d $8,000  $215 120

8-15.

Talmud Book Company $16,000 × .09 × 30/365 = $118.36

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-16.

Dr. Ruth Prime Rate Loan (6%) LIBOR Rate Loan

Annual rate 

Interest Days per year (365)  Principal Days loan is outstandin g

Effective interest = (4.5% × $5,000) + $40 = $225 + $40 = $265

$265 365   5.3% 1  5.3% $5,000 365 LIBOR is cheaper than prime (5.3% vs. 6%)

8-17.

Gulliver Travel Agencies

9% Interest 14% Decline in the dollar (increased cost in euros) 23% Total effective cost

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-18.

Maxim Air Filters Inc. Annual rate of interest with 20% compensating balance = R COMP =

365 I $30,000 365    0.125  12.5%   PB d $300,000  $60,000 365

or: Interest rate 10%  10%  12.5%  (1 c) (1 .20) 0.80

8-19.

Computer Graphics Company

a. 𝐴𝑚𝑜𝑢𝑛𝑡 𝑡𝑜 𝑏𝑒 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 = =

$250,000 (1 − .20)

𝐴𝑚𝑜𝑢𝑛𝑡 𝑛𝑒𝑒𝑑𝑒𝑑 (1−𝑐)

$250,000 . 80

= $312,500

b. Interest to be paid: $312,500 × .10 = $31,250 𝑅COMP =

𝐼

365

𝑃− B 𝑑 = 12.5%

Foundations of Fin. Mgt. 12Ce

$31,250 $312,500 − $62,500

12 -

365 365

= 0.125

Block, Hirt, Danielsen, Short

8-20.

Carey Company

Annual rate of interest with 20% compensating balance: 365 I $24,000 365    0.15  15%   R COMP = PB d $200,000  $40,000 365 OR: I  12%  R COMP =  0.15  15% 1 .20  (1  c)

Installment loan with compensating balance: R INSTALL =

2  Annual number of payments  I (Total number of payments  1)  P

RINSTALL =

2 12  $24,000

(12  1)  $200,000  $40,000 $576,000  $2,080,000  0.2769  27.69%

8-21.



$576,000

13 $160,000

Randall Corporation Annual rate of interest: I $16,000 365  365    R COMP = PB d $200,000  $30,000* 365  0.0941  9.41% *Compensating balance = 20% × $200,000 = Normal funds = Restricted compensating balance =

Foundations of Fin. Mgt. 12Ce

12 -

$40,000 10,000 $30,000

Block, Hirt, Danielsen, Short

8-22.

Brandon Blue Sox Annual rate of interest: I $986 * 365  365    R COMP = PB d $20,000  $1,500 ** 180  0.1081  10.81% * (10% × $20,000) × 180/365 = **Compensating balance = 15% × $20,000 = Normal funds = Restricted compensating balance =

8-23.

$986 $3,000 1,500 $1,500

Tucker Drilling Corp. Annual rate of interest with 20% compensating balance: Interest = $200,000 × (0.08 + 0.005) = $17,000: Administration fee: $200,000 × 0.02 = $4,000 $17,000 / ($200,000 – $40,000 - $4,000) = $17,000/ $156,000 = 0.1090 = 10.90%

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-24.

Your Company

a. simple interest with a 10% compensating balance: I $400,000* 365  365    PB d $5,000,000  $500,000 ** 365  0.0889  8.89%

R COMP =

* $5,000,000 × 0.08 = ** $5,000,000 × 0.10 =

$400,000 $500,000

b. discounted interest: I $400,000 365  365    d P-I $5,000,000  $400,000 365  0.0870  8.70%

R DIS =

c. an instalment loan with 12 payments: 2 12  $400,000  $9,600,000  (12  1)  $5,000,000 13 $5,000,000 $9,600,000  $65,000,000  0.1477  14.77%

R INSTALL =

d. discounted interest with a 1% administrative fee: $400,000/ ($5,000,000 – $400,000 – $50,000) = $400,000/ $4,550,000 = 0.0879 = 8.79%

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-25.

Your borrowing

a. $500/ 4,000 = 12.5% Use formula 8–6 for b, c, and d. b. RINSTALL =

2  2  $500  $2,000   0.1667  16.67% (3)  $4,000 $12,000

c. RINSTALL =

2  4  $500  $4,000   0.2000  20.00% (5)  $4,000 $20,000

d. RINSTALL =

2 12  $500  $12,000  0.2308  23.08%  (13)  $4,000 $52,000

8-26.

Vroom Motorcycle Company R INSTALL =

2  Annual number of payments  I (Total number of payments  1)  P

R INSTALL =

2 12  $9,000  $216,000   0.1946  19.46% (36  1)  $30,000 $1,110,000

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-27.

Morrisette Records Annualized yield on discounted paper: 100−𝑃 𝑃

365 𝑑

=𝑟=

100−98.512 98.512

365 = 0.0735 = 7.35% 75

Effective annual yield = 7.57%  100  98.512  75 1  0.0757  7.57% rEFF  1   98.512   365

8-28.

CO2 Coal Annualized yield on discounted paper: 100−𝑃 𝑃

365 𝑑

=𝑟=

100−99.123 99.123

365 = 0.0633 = 6.33% 51

Effective annual yield = 7.57% 365

100−99.123 51 = (1 + ) − 1 = 0.0651 = 6.51% 𝑟EFF 99.123

Bankers’ Acceptance

8-29.

100  P 365 100,000  97,915 365  r   0.0864  8.64% P d 97,915 90

Effective annual yield = 8.92% FV = 100,000 PV = 97,915 (neg.) CPT % I/Y =?

Foundations of Fin. Mgt. 12Ce

12 -

PMT = 0

N = 90/ 365

Block, Hirt, Danielsen, Short

8-30.

Blue Grass Filters

a. Cost of forgoing the cash discount: d%  365  K DIS  100%  d % f date  d date K DIS 

2%  365   .1241  12.41% 100%  2% 75 15

Effective annual yield = 13.08% Choose the bank at 11%. b. No security requirements More convenient and more readily available No life story required

8-31.

Reynolds Corporation Cost of forgoing the cash discount: d%  365 K DIS   100%  d % f date  d date K DIS 

2%  365   .1655  16.55% 100%  2% 55 10

We use 55 days instead of 40 days as the final due date because Reynolds‘ suppliers have effectively made this the due date even though the stated due date is 40 days. Annual rate of interest; 20% compensating balance requirement:

R COMP =

I  14%  0.1750  17.50%  (1  c) 1  0.20 

The annual cost of the loan, 17.5%, is more than the cost of passing up the discount, 16.55%. Reynolds Corporation should continue to pay in 55 days and pass up the discount.

8-32.

Reynolds Corporation (Continued)

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Annual rate of interest; 10% compensating balance requirement: I  14%  0.1556  15.56%  R COMP = (1  c) 1  0.10  The answer now changes. The annual cost of the loan, 15.56%, is less than the cost of passing up the discount, 16.55%. Reynolds Corporation should borrow the funds and take the discount.

Burt’s Department Store

8-33.

a. Annual rate on bank loan: I 365  $8,100  365  0.1643  16.43% =   R ANNUAL P d $300,000 60 b. Cost of forgoing cash discount 3%  365   .1881 18.81% K DIS  100%  3% 70 10 c. Yes, because the cost of borrowing is less than the cost of losing the discount. Amount to be borrowed = d.



$300,000  $300,000  $375,000  (1  .20) .80 I $10,125 365  365    PB d $375,000  $75,000 60  0.2053  20.53%

R e.

Amount needed (1  c)

COMP

No, do not borrow with a compensating balance of 20 percent since the annual rate is greater than the cost of forgoing the cash discount.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-34.

Neveready Flashlights, Inc.

a. Annual rate on bank loan: I 365  $5,500  365  0.1115  11.15%  R ANNUAL =  $300,000 60 P d b. Cost of forgoing cash discount 2%  365   .1241 12.41% K DIS  100%  2% 70 10 c. Yes, because the cost of borrowing is less than the cost of losing the discount.

Amount to be borrowed = d. 

Amount needed (1  c)

$300,000 $300,000   $352,941.18 (1 .15) .85

I 365  $6,850 365    $300,000 60 PB d  0.1389  13.89%

R COMP =

No, do not borrow with a compensating balance of 15 percent since the annual rate is greater than the cost of forgoing the cash discount.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-35.

Rockford Filing Ltd.

a. Annual commitment fee

Interest expense

= 0.01 × $1,000,000 = $10,000 = $1,000,000 × 10% × 45/365 = $12,328.77

Annual rate of interest: I 365 $10,000  $12,328.77 * 365 R =    ANNUAL P d $1,000,000 45  0.1811  18.11% *Note: The interest cost also includes the commitment fee.

b. Cost of forgoing the cash discount: 2%  365   .1655  16.55% K DIS  100%  2% 60 15 c. Discounted commercial paper 100  P 365  1.25  365  0.1027  10.27%  r P d 100  1.25 45 



P = price = 100 – 1.25 = 98.75 Choose the commercial paper. It is the cheapest alternative.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Bernie’s Macs

8-36.

a. Annual commitment fee Interest expense

= $4,750 = $600,000 × 7% × 60/365 = $6,904.11

Annual rate of interest: I 365 $4,750  $6,904.11* 365 R =    ANNUAL P d $600,000 60  0.1182  11.82% *Note: The interest cost also includes the commitment fee.

b. Cost of forgoing the cash discount: 365 2%   K DIS   .1241  12.41% 100%  2% f 90  d 30

c. Discounted commercial paper 100  P 365  1.91  365  0.1185  11.85%  r P d 100  1.91 60 



Choose the bank loan. It is the cheapest alternative.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-37.

Rapier Fencing

a. Interest = $750,000 × 0.06 × 60/365 = $7,397.26 R DIS =

365 I $7,397.26 365    0.0606  6.06%   PI d $750,000  $7,397.26 60

or: Interest rate 0.06  0.06  0.0706  7.06%  (1 c) (1 .15) 0.85

b. Cost of forgoing the cash discount: K DIS 

365 0.015    .0926  9.26% 1  0.015 f 70 d10

c. Discounted commercial paper 100  P 365  1.20  365  0.0739  7.39%  r P d 98.80 60

Choose the bank loan. It is the cheapest alternative.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-38.

Macco Bakers

a. Annual commitment fee Interest expense

= $5,000 = $500,000 × 8% × 90/365 = $9,863.01

Annual rate of interest: I

365  $5,000  $9,863.01* 365   P d $500,000 90  0.1206  12.06%

= ANNUAL



*Note: The interest cost also includes the commitment fee.

b. Cost of forgoing the cash discount: K DIS 

2% 365   .0827  8.27% 100%  2% 100 10

c. Discounted commercial paper 100  P 365  2.05  365  0.0849  8.49%  r P d 100  2.05 90 



Choose forgoing the cash discount.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-39.

Ajax Box Company

a. Midland Bank Annual interest rate

2  4  $8,000 (4  1) $100,000  $20,000  $8,000   0.1778  17.78%

R INSTALL =

Central Bank Annual interest rate R INSTALL =

2 12  $8,000

(12  1)  $100,000  $10,000

 0.1641  16.41% Choose Central Bank since it has the lowest annual interest rate. b. The numerators stay the same as in part (a) but the denominator increases to reflect the use of more money because compensating balances are already maintained at both banks. Midland Bank Annual interest rate 2  4  $8,000 R INSTALL = (4  1)  $100,000  $8,000  0.1391  13.91% Central Bank Annual interest rate 2 12  $8,000 R INSTALL = (12  1)  $100,000  0.1477  14.77% c. The compensating balance assumption changed interest rates as follows: Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Interest rate Midland With compensating balance 17.78% Without compensating balance 13.91 Difference in cost 3.87%

Central 16.41% 14.77 1.64%

Yes. If compensating balances are maintained at both banks in the normal course of business, then Midland should be chosen over Central Bank. The annual cost of its loan will be less.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

8-40.

Marla Maple Sugar Company

0 - 30 days A C G K Total loan % loan

Amount $ 60,000 70,000 30,000 210,000 370,000 90% $333,000

Total loan % loan

Amount $ 220,000 40,000 60,000 320,000 80% $256,000

Total loan % loan

Amount $ 120,000 50,000 170,000 70% $119,000

31 - 40 days F I L

41-45 days B E

Maximum Loan = $333,000 + $256,000 + $119,000 = $708,000 b. Loan balances Interest, 15% annual One month's interest

Foundations of Fin. Mgt. 12Ce

$708,000 0.0125 per month $ 8,850

12 -

Block, Hirt, Danielsen, Short

8-41.

Towers Arcades Bank cost: Interest: $560,000 × 10% × 1/12 = Processing charge = $800,000 × .5% = Factor cost: Interest: $560,000 × 11% × 1/12 = Processing fee = $800,000 × 2% = Less credit department savings =

$ 4,667 4,000 $ 8,667 $ 5,133 16,000 (15,000) $ 6,133

Choose the factor. 8-42.

Thornton Pipe and Steel Company

a. Sales price: December Treasury bond contract (Sale takes place in July) Purchase price, December Treasury bond contract: .9  $105,000 = (10% price decline) Gain per contract Number of contracts Profit on futures contracts

$105,000 94,500 10,500 5 $ 52,500

b. Profit occurred because the bond value fell due to increasing rates. This meant the subsequent purchase price was less than the initial sales price. c. Increased interest cost $60,800 Profit from hedging 52,500 Net cost $ 8,300 $8,300 Net cost   0.1365  13.65% $60,800 The net cost is 13.65%. This means 86.35% of the increased interest cost was hedged away. d. If interest rates went down, there would be a loss on the futures contracts. The lower interest rates would lead to higher bond prices and a purchase price that exceeded the original sales price.

MINI CASE Fresh and Fruity Foods, Inc. Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

(Short-term Financing) Purpose: The student must focus on accounts receivable as an investment (use of funds) and the financial advantages of reducing the commitment to this asset. At the same time the firm is also considering reductions to its accounts payable balance in order to take cash discounts. This alternative will call for additional bank financing and comparative costs must be carefully assessed. The case utilizes many calculations that are covered in the text, but places them in a more complex, decision oriented framework. Suggested Questions: a. Using the data in the income statement and the balance sheet that follow, compute the company‘s average collection period (ACP) in days. Use a 365day year when calculating sales per day. b. Compute the cost, as a percent, that the company is paying for not taking the suppliers‘ discounts. (The suppliers‘ terms are 2/10, net 60; but note from the bottom of the balance sheet that Fresh & Fruity has been taking 67 days to pay its suppliers). c. Assume Alice Plummer‘s first initiative to offer a 10 percent discount was implemented, and the company‘s average collection period dropped to 32 days. If net sales per day remained the same, as Alice expects, what would be the new accounts receivable balance? How much cash was freed up by the reduction in accounts receivable? What is the new accounts payable balance if the money is used to pay off suppliers? d. As a result of Alice‘s first initiative described in part c, Fresh & Fruity is able to take advantage of the 2 percent discount on one-third of its purchases (see the income statement). What will be the cash discount figure on the income statement? What effect does this have on net income (after taxes)? The simplest way to get this figure is to multiply the cash discount figure by (1 – Tax rate) and add this figure to the net income after tax figure on the income statement. Also what is the effect on the return-on-sales ratio shown toward the bottom of the balance sheet? Consider the effect on the return-onequity ratio as well. e. Alice‘s second initiative calls for Fresh & Fruity to obtain a bank loan of a sufficient size to enable the company to take all suppliers‘ discounts. What is the minimum size of this loan? Hint: To take all suppliers‘ discounts, the average payment period must be 10 days, and net purchases will be Purchases – (Purchases from Figure 1 × .02). Assume all this happens, and solve the following formula for the new accounts payable balance, using: Accounts payable = Average payment period × Purchase per day* Now compare the accounts payable you just solved with the new accounts Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

payable balance you found in part c. The difference is the size of the loan that is required. f. Assume Fresh & Fruity obtains an 8 percent loan for one year in the amount you solved in part e, and it reduces its accounts payable balance accordingly. Now the company is taking 2 percent discounts on all purchases and paying 8 percent a year on the loan balance. What is the net gain from taking the discounts and paying the interest on a before-tax basis? (on an aftertax basis?) g. (Optional) Suppose the 8 percent loan that Fresh & Fruity obtained was a discount loan, and the bank further required a 20 percent compensating balance of the full loan amount. What is the annual rate of interest to Fresh & Fruity? How does this compare to your answer in question b for the cost of not taking a cash discount?

Answers

a. Average collection period = Accounts receivable/ Average daily credit sales Accounts receivable = $209,686 Average daily credit sales = $1,179,000/ 365 = $3,230 Average collection period = $209,686/ $3,230 = 64.92 days

b. Cost of forgoing the cash discount: 2%  365   .1307  13.07% K DIS  100%  2% 67 10 The formula tells us that Fresh and Fruity is effectively paying 13.07% interest to delay paying the discounted amount for 57 days (the 67 days on which they pay less the 10 day discount period).

c. Average collection period  Average daily credit sales = New accounts receivable 32  $3,230 = $103,360 Freed-up cash Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

= Old accounts receivable  New accounts receivable

$209,686 103,360 $106,326

Old accounts payable  Funds from accounts receivable New accounts payable

$180,633 106,326 $ 74,307

d. Purchases (Figure 1) 1/3 exposed to purchase discount 2% purchase discount savings

$969,000 $323,000 $ 6,460

With the firm in a 33 percent tax bracket, a savings of $6,460 will produce $4,328 in aftertax income. The answer is equal to the cost savings  (1 - T).

$6,460 (1  .33) = $6,460 (.67)

= $4,328

This means total income will now be: Old income New aftertax income Total aftertax income

$50,623 4,328 $54,951

Return on sales will be: Net income (aftertax)/ Sales

= $54,951/ $1,179,000 = 0.0466 = 4.66%

This, of course, represents an improvement over the old figure of 4.29%. Return on equity will be: Net income (aftertax)/ Equity

= $54,951/ $123,600 = 44.46%

This, also, represents an improvement over the old ratio of 40.96%. (Note: This firm has a particularly high return on equity because of rapid asset turnover and high current liabilities). If the added profit is included in equity, the return is 42.95% ($54,951/ $127,928).

e. Accounts payable = Average payment period  Purchases per day Average payment period = 10 days Purchases per day = [969,000  (.02  969,000)]/365 Foundations of Fin. Mgt. 12Ce

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= [969,000  $19,380]/ 365 = $2,602 Accounts payable = 10  $2,602 = $26,020 Accounts payable from question c $74,307 Accounts payable from question e 26,020 Size of loan required $48,287 This is the size of the loan required to take all cash discounts in 10 days. f. The cost is the 8 percent interest on the bank loan of $48,287 or $3,863. The gain is the cash discounts taken of $19,380. The net gain before tax is $15,517 ($19,380  $3,863). On an aftertax basis this translates to a gain of $10,396 ($15,517  0.67). g. First determine the amount of funds on which interest must be paid. $48,287  (.08  $48,287)  (.20  $48,287) = $48,287  $3,863  $9,657 = $34,767 Then divide the interest payment by this value. Interest/ Useable funds $3,863/ $34,767 = 0.1111 or 11.11% The cost goes up from 8% to 11.11%. However, this value is still less than the cost of forgoing the cash discount of 13.07%, computed in part (b). Thus, it is advantageous to borrow and take the cash discount. Note: Alert students may point out that Fresh & Fruity still needs $48,287 in cash no matter what kind of loan it is. Therefore if the interest is to be charged on a discounted basis, and a compensating balance is required, Fresh & Fruity must borrow a larger amount to make up for it. Solve for the larger amount using algebra where L is the larger amount.

L  (.08  L)  (.20  L) L  .08L  .20L Foundations of Fin. Mgt. 12Ce

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= $48,287 = $48,287 Block, Hirt, Danielsen, Short

L  .28L .72L L L

= $48,287 = $48,287 = $48,287/ .72 = $67,065

Chapter 9 Discussion Questions 9-1.

The future value represents the expected worth of a single amount, whereas the present value represents the current worth. Future value

FV = PV (1 + i) n

Present value PV  FV

1 

1  i

9-2. The present value of a single amount is the discounted value for one future payment, whereas the present value of an annuity represents the discounted value of a series of consecutive payments of equal amount. 9-3. Money has a time value because funds received today can be reinvested to reach a greater value in the future. A person would rather receive $1 today than $1 in ten years, because a dollar received today, invested at 6 percent, is worth $1.791 after ten years. 9-4. Inflation makes a dollar today worth more than a dollar in the future. Because inflation tends to erode the purchasing power of money, funds received today will be worth more than the same amount received in the future. The objective should be to place current funds in real assets (such as real estate or capital assets) that will go up in value with the rate of inflation. 9-5.

FV = PV  FVIF (Appendix A) i = 12%, n = 10 3.106 (Annual) i = 6%, n = 20 3.207 (Semiannual) The more frequent compounding under the semiannual compounding assumption increases the future value.

9-6. The greater the number of compounding periods, the larger the future value. The investor should choose daily compounding over monthly or quarterly. 9-7.

A deferred annuity is an annuity in which the equal payments will begin at some future point in time.

9-8.

Different financial applications of the time value of money: Equipment purchase or new product decision, Present value of a contract providing future payments, Future worth of an investment, Regular payment necessary to provide a future sum, Regular payment necessary to amortize a loan, Determination of return on an investment,

Foundations of Fin. Mgt. 12Ce

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Determination of the value of a bond 9-9.

Compounding of interest allows the accumulation of capital by earning interest on interest. If money (capital) is held outside a tax-sheltered plan there will be a depletion of the ‗interest‘ capital base each year as taxes are paid. Therefore, less capital will be accumulated over time.

Internet Resources and Questions 1. www.canada.ca/en/services/finance/tools.html rbcroyalbank.com/mortgages/index.html www.bmo.com/main/personal/mortgages/calculators/ 2. www.bankofamerica.com/mortgage/mortgage-calculator/

Problems [Calculator answers with steps carry extra decimal places throughout the calculation, although interim calculations are rounded]

9-1. Appendix B PV = FV PVIF a. $ 8,000  .558 = b. $16,000  .567 = c. $25,000  .315 = d. $ 1,000  .001 =

$4,464 $9,072 $7,875 $1

Calculator (N = 10, %I/Y = 6) $ 4,467 (N = 5, %I/Y = 12) 9,079 (N = 15, %I/Y = 8) 7,881 (N = 40, %I/Y = 20) 0.68

$6,181 $5,619 $5,108

Calculator (N = 1, %I/Y = 10) $ 6,182 (N = 1, %I/Y = 10) 5,620 (N = 1, %I/Y = 10) 5,109

9- 3. Appendix A FV = PV  FVIF a. $12,000  1.501 = $ 18,012 b. $12,000  5.474 = $ 65,688 c. $12,000 10.835 = $130,020 d. $12,000 11.467 = $137,604

Calculator (N = 6, %I/Y = 7) $ 18,009 (N = 15, %I/Y = 12) 65,683 (N = 25, %I/Y = 10) 130,016 (N = 50, %I/Y = 5) 137,609

9- 4. Appendix A FV = PV  FVIF a. $3,000  1.12 = $ 3,360 b. $3,360  1.12 = $ 3,763 c. $3,763  1.12 = $ 4,215

Calculator (N = 1, %I/Y = 12) $ 3,360 (N = 1, %I/Y = 12) 3,763 (N = 1, %I/Y = 12) 4,215

9- 2. Appendix B PV = FV  PVIF a. $ 6,800  .909 = b. $ 6,181  .909 = c. $ 5,619  .909 =

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d. $3,000  1.405 = $4,215 (N = 3, %I/Y = 12) 4,215 9-5. Appendix B (a and b) PV = FV  PVIF Calculator a. $12,000  .517 = $6,084 (N = 6, %I/Y =12) $ 6,080 b. $15,000  .315 = $4,725 (N = 15, %I/Y =8) 4,729 Appendix D (c and d) PVA = A  PVIFA Calculator c. $5,000  6.710 = $33,550 (N = 10, %I/Y = 8) $ 33,550 d. $5,000  7.247 = $36,235 (N = 10, %I/Y = 8)(BGN) 36,234 e. $50,000  13.801 = $690,050 (N = 50, %I/Y = 7) 690,037 f. $50,000  14.767 = $738,350 (N = 50, %I/Y = 7)(BGN) 738,340 9-6. Appendix C FVA = A  FVIFA a. $8,000  12.578 = $100,624 b. $8,000  51.160 = $409,280 c. $8,000  341.590 = $2,732,720

Calculator (N = 10, %I/Y = 5) $ 100,623 (N = 20, %I/Y = 9) 409,281 (N = 35, %I/Y =11) 2,732,716

9-7. Appendix C (Annuity in advance) FVA = A  FVIFA BGN Calculator a. $8,000  13.207 = $105,656 (N = 10, %I/Y = 5) $ 105,654 b. $8,000  55.765 = $446,120 (N = 20, %I/Y = 9) 446,116 c. $8,000  379.164 = $3,033,312 (N = 35, %I/Y =11) 3,033,315

9-8.

9-9.

You Invest Appendix A FV = PV  FVIF 20,000 × 1.501 = $30,020

Calculator (N = 6, %I/Y = 7) $30,015

Appendix A FV = PV  FVIF $30,020 × 2.144 = $64,363

(N = 8, %I/Y = 10)

$64,339

Delia PV = FV  PVIF (Appendix B) (N= 50, %I/Y = 8) Calculator

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= $30,000  .021 = $630 Take the $650 today.

$640

9-10. ‘Red’ Herring a. PVA = A  PVIFA (Appendix D) (n = 18, %I/Y = 9)Calculator PVA = $11,000  8.756 = $96,316 $96,312 Yes, the present value of the annuity is not worth $100,000.

‘Red’ Herring (in advance - BGN) PVA = A  PVIFA (Appendix D) (n = 18, %I/Y = 9)Calculator PVA = $11,000  (8.544 + 1) = $104,984 $104,980 No, the present value of the annuity is worth more than $100,000.

9-11.

Phil Goode PV = FV  PVIF (Appendix B) (N= 50, %I/Y = 14)Calculator = $175,000  .001 = $175 $250

9-12. Carrie Tune a. PVA = A  PVIFA (Appendix D) (N = 20, %I/Y = 10) Calculator PVA = $18,000  8.514 = $153,252 $153,244 Yes, the present value of the annuity is not worth $160,000.

Carrie Tune (in advance - BGN) PVA = A  PVIFA (Appendix D) (N = 20, %I/Y = 10)Calculator PVA = $18,000  (8.365 + 1) = $168,570 $168,569 No, the present value of the annuity is worth more than $160,000.

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9-13. George Penny a. PVA = A  PVIFA (Appendix D) (N = 10, %I/Y = 6) Calculator PVA = $32,250  7.360 = $237,360 $237,363 Yes, the present value of the annuity is not worth $240,000.

George Penny (BGN) PVA = A  PVIFA (Appendix D) (N = 10, %I/Y = 6) Calculator PVA = $32,250  (6.802 + 1) = $251,615 (BGN) $251,605 No, the present value of the annuity is worth more than $240,000.

9-14.

Epic Contest (BGN) PVA = A × PVIFA (Appendix D) (n = 50, %I/Y = 9)Calculator PVA = $250,000 × 10.962 = $2,740,500 = $2,740,500 × (1.09) = $2,987,145 $2,987,059

9-15.

Joan Lucky PVA = A × PVIFA (Appendix D) (N=50, %I/Y = 12)Calculator PVA = $1,000,000 × 8.304 = $8,304,000 $8,304,498 PV = FV × PVIF (Appendix B) (N=50, %I/Y = 12%) PV = $30,000,000 × .003 = $90,000 $ 103,805 $8,304,000 + $90,000 = $8,394,000 $8,408,303

9-16.

Larry Doby FV = PV  FVIF (Appendix A) (n = 5, %I/Y = 8) Calculator = $50,000  1.469 = $73,450 $73,466

Foundations of Fin. Mgt. 12Ce

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9-17.

Dr. Sisters FVA = A  FVIFA (Appendix C) (N = 12, %I/Y = 6) Calculator = $10,500  16.870 = $177,135 $177,134

9-18.

Doubling, Tripling If the sum is doubling, then the tabular value must equal 2. In Appendix A, looking down the 8% column, we find the factor closest to 2 (1.999) on the 9-year row. The factor closest to 3 (2.937) is on the 14-year row. Calculator: PV = 1 FV = 2 %I/Y = 8% Compute N = 9.006

PMT = 0 N =?

Calculator: PV = 1 FV = 3 %I/Y = 8% Compute N = 14.275

PMT = 0 N =?

9-19.

Your Debt PV

= FV  PVIF (Appendix B) (N = 7, %I/Y = 11) Calculator = $30,000  .482 = $14,460 $14,450

9-20.

Jack Hammer PV = FV  PVIF (Appendix B) = $2.00  .901 = 1.80 = $2.20  .812 = 1.79 = $2.40  .731 = 1.75 = $33.00  .731 = 24.12 $29.46

Foundations of Fin. Mgt. 12Ce

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Calculator (N= 1, %I/Y = 11) $ 1.80 (N= 2, %I/Y = 11) 1.79 (N= 3, %I/Y = 11) 1.75 (N= 3, %I/Y = 11) 24.13 $29.47

Block, Hirt, Danielsen, Short

9-21.

S. Ken Flint

a. PVA = A  PVIFA (Appendix D) (N = 10, %I/Y = 10)Calculator = $45,000  6.145 = $276,525 $276,506 b. PV = FV  PVIF (Appendix B) (N Calculator = $276,525  .826 = $228,410

%I/Y

10%)

$228,517

Alternative Solution Deferred annuity-Appendix D PVA = $45,000(6.814 ─ 1.736) (where N=12; N=2 %I/Y=10) = $45,000 (5.078) = $228,510 (difference due to rounding in the tables)

and

c. PVA = A  PVIFA (Appendix D) (N = 10, %I/Y = 10)Calculator = $45,000  (5.759 + 1) = $304,155 BGN $304,156

9-22.

Cousin Berta

a. FV = PV  FVIF (Appendix A) (N =40, %I/Y = 3) Calculator FV = $100,000  3.262 = $326,200 $326,204 i .12    4 Effective annual interest rate  1  n  1  1  1     b. 4   n    0.1255  12.55%

Foundations of Fin. Mgt. 12Ce

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9-23. Appendix A FV = PV  FVIF a. $3,000  1.469 = $4,407 b. $3,000  1.480 = $4,440 c. $3,000  1.486 = $4,458

Calculator (N = 5, %I/Y = 8) $4,408 (N = 10, %I/Y = 4) $4,441 (N = 20, %I/Y = 2) $4,458

Effective annual interest rate a. (1 + 0.08)1 – 1 = 0.0800 = 8.00% b. (1 + 0.04)2 – 1 = 0.0816 = 8.16% c. (1 + 0.02)4 – 1 = 0.0824 = 8.24%

9-24.

Joe Macro

a. Effective annual interest rate: (1 + 0.025)4 – 1 = 0.1038 = 10.38% b. A

= FVA/ FVIFA (Appendix C) Calculator = $60,000/ 16.235 = $3,696 (Factor interpolated between 10 & 11%) (n = 10, %I/Y = 10.38) $3,697

c. PV = FVA/ FVIFA (Appendix C) Calculator = $60,000/ 17.922 = $3,348 (Factor interpolated between 10 & 11%, @ n=11, factor reduced by 1) (n = 10, %I/Y = 10.38) BGN $3,349

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9-25. Sally Gravita a. Effective annual interest rate: (1 + 0.04)2 – 1 = 0.0816 = 8.16% b. PVA = A × PVIFA (Appendix D) Calculator = $23,500 × 7.476 = $175,686 (Factor interpolated between 8 & 9%) (n = 12, %I/Y = 8.16) $175,639 c. PV = FV × PVIFA (Appendix D) Calculator = $23,500 × 8.086 = $190,021 (Factor interpolated between 8 & 9% for 11 + 1) (n = 12, %I/Y = 8.16) BGN $189,971 9-26.

Your Grandfather (1st alternative) PV of $5,000 received now:

$ 5,000

(2nd alternative) PV of annuity of $1,000 for eight years: PVA = A  PVIFA (Appendix D) Calculator = $1,000  5.146 = $5,146 (N = 8, %I/Y = 11) $5,146 (3rd alternative) PV of $12,000 received in eight years: PV = FV  PVIF (Appendix B) Calculator = $12,000  .434 = $5,208 (N = 8, %I/Y = 11) $5,207 Select $12,000 to be received in eight years.

Revised answers based on 12%. (1st alternative) PV of $5,000 received today:

$5,000

(2nd alternative) PV of annuity of $1,000 for eight years: PVA = A  PVIFA (Appendix D) Calculator = $1,000  4.968 = $4,968 (N = 8, %I/Y = 12) $4,968 (3rd alternative) PV of $12,000 received in eight years: PV = FV  PVIF (Appendix B) Calculator $12,000  .404 = $4,848 (N = 8, %I/Y = 12) $4,847 Select $5,000 now. 9-27. Your Need a. PV = FV  PVIF (Appendix B) Foundations of Fin. Mgt. 12Ce

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Calculator Block, Hirt, Danielsen, Short

b. A

= $23,000  .547 = $12,581

(N = 7, %I/Y = 9) $12,582

= FVA/FVIFA (Appendix C) = $23,000/9.200 = $ 2,500

(N = 7, %I/Y = 9)

$2,500

9-28.

Carol Travis FVA = A  FVIFA (Appendix C) Calculator = $500  17.258 = $8,629 (n = 16, %I/Y =1) $8,629 FV = PV  FVIF (Appendix A) = $8,629  1.295 = $11,175 (9%, 3 periods) $11,175

9-29.

Charley Dow PV 3 periods  $12  0.667 PV IF  FV $18 Return is between 14% & 15% for 3 years (Appendix B) PVIF @ 14% .675 PFIF at 14% .675 PVIF @ 15% –.658 PVIF computed –.667 .017 .008 14% + (.008/ .017) (1%) Calculator 14% + .471 (1%) = 14.47% (N = 3, PV = –12, FV = 18) 14.47%

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9-30.

April Wine PV 4 periods  $5.50  0.262 PV IF  FV $21 Return is between 35% & 40% for 4 years (Appendix B) PVIF @ 35% .301 PFIF at 35% .301 PVIF @ 40% –.260 PVIF computed –.262 .041 .039 35% + (.039/ .041) (5%) Calculator 35% + .951 (5%) = 39.76% (N = 3, PV = –12, FV = 18) 39.79%

9-31. Al Counsel PV $5 a. PV  1 periods   0.833 IF FV $6 Return is 20% for 1 year (Appendix B) Calculator (n = 1, PV =–5, FV = 6) 20.0%

b. PVIF 

3.5 periods  $5.00  0.458

FV $10.92 Return is 25% for 3.5 years (Appendix B)

Calculator (n = 3.5, PV = 5, FV = 10.92) 25.0% c. PV 

6 periods 

$5.00

 0.596

FV $8.39 Return is 9% for 6 years (Appendix B) Calculator (n = 6, PV = 5, FV = 8.39) 9.01%

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9-32.

John Foresight PV $8,370  0.093 PVIF  17 periods  FV $90,000 Rate of return = 15% (Appendix B)

9-33.

Ester Seals 

Calculator 14.99%`

IFA

PVA

12 periods 

$56,521

 7.536 BGN 11 periods  7.536  1  6.536

$7,500

7.536 is exactly 8% for 12 periods PVIFA @ 8%

6.536 is between 9% and 10% for 11 periods (Appendix D) PVIFA @ 9% 6.805 PVIFA @ 10% – 6.495 0.310

7.536

PVIFA @ 9% PVIFA @ computed

a. b.

6.805 – 6.536 0.269 9% + (0.269/ 0.310) (1%) 9% + (0.868) (1%) = 9.87% Calculator (N = 12, PV = –56,521, PMT = 7,500) 8.00% BGN (N = 12, PV = –56,521, PMT = 7,500) 9.86%

9-34.

Mr. G. Day PV = FV × PVIF (Appendix B) Calculator = $30,000 × 0.772 = $23,160 (n = 3, %I/Y = 9) $23,165.5 PV = FV × PVIF (Appendix B) = $85,000 × 0.763 = $64,855 (n = 4, %I/Y =7) $64,846 PV = FV × PVIF (Appendix B) = $64,855 × 0.650 = $42,156 (n = 5, %I/Y =9) $42,145.5 Loan amount can be $65,316 $65,311.0

9-35.

Ms. R. Emm PV = FV × PVIF (Appendix B)

Foundations of Fin. Mgt. 12Ce

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Calculator Block, Hirt, Danielsen, Short

= $45,000 × .731 = $32,895 (n = 4 × 2 = 8, %I/Y = 8/ 2 = 4) Value of land = $32,895 + $90,000 = $122,895

9-36.

$122,881

Count Crow PV = FV × PVIF (Appendix B) Calculator = $150,000 × (.582 + .540)/ 2 = $84,150 (n = 8, %I/Y = 7.5) $84,105 A = PVA/ PVIFA (Appendix D) = [$625,000 – $84,150] / [(5.389 + 5.206)/ 2] + 1 = $540,850/ 6.2975 = $85,883 (n = 8, %I/Y =7.5) BGN $85,903

9-37. A

9-38.

$32,881

Graham Bell = PVA/ PVIFA (Appendix D) = $300,000/ 9.447 = $31,756 (N = 16, %I/Y = 7)

Calculator $31,757

River Babylon FV = PV  FVIF (Appendix A) Calculator = $65,000  1.469 = $95,485 (N = 5, %I/Y = 8) $95,506 A = PVA / PVIFA (Appendix D) = $95,485/ 7.161 = $13,334 (N = 12, %I/Y = 9) $13,338

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9-39.

Una Day Determine the present value of an annuity during retirement:

PVA = A  PVIFA (Appendix D) Calculator = $12,000  9.077 = $108,924 (N = 25, %I/Y = 10, PMT = –12,000) $108,924 Determine the annual deposit into an account earning 8% that is necessary to accumulate $108,924 after 20 years:

= FVA/ FVIFA (Appendix C) = $108,924/ 45.762 = $2,380 (N = 20, %I/Y = 8, FV = –108,924)

9-40.

Calculator $2,380

Louisa and Bart a. Louisa FVA = A  FVIFA (Appendix C) Calculator $5,000  31.772 = $158,860 (N = 15, %I/Y = 10) $ 158,862 FV = PV  FVIF (Appendix A) $158,860  17.449 = $2,771,948 (N = 30, %I/Y = 10) $2,772,054 Bart FVA = A  FVIFA (Appendix C) Calculator $5,000  164.49 = $822,450 (N = 30, %I/Y = 10) $ 822,470 b. Louisa FVA = A  FVIFA (Appendix C) Calculator $5,000  18.599 = $92,995 (N = 15, %I/Y = 3) $ 92,995 FV = PV  FVIF (Appendix A) $92,995  2.427 = $225,699 (N = 30, %I/Y = 3) $225,722

Bart FVA = A  FVIFA (Appendix C) Calculator $5,000  164.49 = $822,450 (N = 30, %I/Y = 3) $ 237,877 9-41. Your Retirement a. PVA = A × PVIFA (Appendix D) Calculator = $55,000 × 10.059 = $553,245 Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

(n = 18, %I/Y = 7) A = FVA/ FVIFA (Appendix C) = $553,245/ 136.31 = $4,059 (n = 30, %I/Y = 9) b. ABGN = FVA/ FVIFA (Appendix C) = $553,245/ 148.58 = $3,724 (n = 30, %I/Y = 9) $3,724

9-42.

$553,250

$4,059

BGN

Retirement Planning FV = PV × FVIF (Appendix A) = $57,000 × 3.946 = $224,922 (n = 35, %I/Y = 4)

PVA (BGN) = A × PVIFA (n =29) + A (Appendix D) = $224,922 × 11.158 + $224,922 = $2,734,602 (n = 30, %I/Y = 8) A

= FVA/ FVIFA (Appendix C) = $2,734,602/ 138.237 = $19,782 (n = 35, %I/Y = 7)

Foundations of Fin. Mgt. 12Ce

12 -

Calculator $224,927

$2,734,755

$19,783

Block, Hirt, Danielsen, Short

9-43.

Your Retirement (#2) FV = PV × FVIF (Appendix A) Calculator = $75,000 × 2.259 = $169,425 (n = 33, %I/Y = 2.5) $169,414

PVA (BGN) = A × PVIFA (n =24) + A (Appendix D) = $169,425 × 13.799 + $169,425 = $2,507,321 (n = 25, %I/Y = 5) $2,507,097 FV = PV × FVIF (Appendix A) = $125,000 × 2.952 = $369,000 (n = 16, %I/Y = 7) A

= FVA/ FVIFA (Appendix C) = [$2,507,321 + $369,000]/ 118.93 = $24,185 (n = 33, %I/Y = 7)

9-44.

Calculator $369,020

$24,183

Del Monty PV = FV  PVIF (%I/Y = 9) 2,000  0.917 = $1,834 3,500  0.842 = 2,947 4,500  0.772 = 3,474 $8,255

Calculator $1,835 2,946 3,475 $8,256

(N = 1) (N = 2) (N = 3)

PVA = A  PVIFA (Appendix D) (N = 7, %I/Y = 9) = $5,000  5.033 = $25,165 (PMT = –5,000) PV = FV  PVIF (N = 3, %I/Y = 9) = $25,165  0.772 = $19,427 (FV = –25,165) Total= $8,255 + $19,427 = $27,682 ($27,687.38)

Foundations of Fin. Mgt. 12Ce

12 -

$25,165

$19,432 $27,688

Block, Hirt, Danielsen, Short

9-45.

Bridget Jones PV = FV  PVIF (%I/Y = 14) 1,000  0.877 = $ 877 (N = 1) 2,000  0.769 = 1,538 (N = 2) 3,000  0.675 = 2,025 (N = 3) 4,000  0.592 = 2,368 (N = 4) 5,000  0.519 = 2,595 (N = 5) $9,403

Calculator $ 877 1,539 2,025 2,368 2,597 $9,406

PVA = A  PVIFA (Appendix D) (N = 10, %I/Y = 14) = $8,500  5.216 = $44,336 (PMT = –8,500) PV = FV  PVIF (N = 5, %I/Y = 14) = $44,336  0.519 = $23,010 (FV = –44,337) Total= $9,403 + $23,010 = $32,413 ($27,687.38) 9-46.

$44,337

$23,027 $32,433

Darla White The value of the annuity at the beginning of the year it starts (2024) is (assuming first payment at end of 2024):

PVA = A  PVIFA (Appendix D) Calculator = $12,000  5.146 (N = 8, %I/Y = 11)$61,753(2024 Begin) = $61,752 (BGN) $68,546 (2024 End) To find the present value at the beginning of 2021 we discount from: the beginning of 2024 for 3 periods: (2021, 2022, 2023) the end of 2024 for 4 periods: (2021, 2022, 2023, 2024)

PV = FV  PVIF (11%, 3 periods) Calculator = $61,752  0.731 = $45,141 $45,154 The maximum that should be paid for the annuity is $45,154.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

9-47.

Emphatically Square A $1,000  $14,286 PV   i .07

9-48.

Forever College A $7,500  $125,000 PV   i .06

9-49.

Emphatically Square (2nd thought) PV 

A $1,000   $25,000 i  g .07  .03

Forever College (2nd thought)

9-50.

PV 

A $7,500   $187,500 i .06  .02

Emphatically Square (3rd thought) n 25 1 1   1  .03  A1  1 1   1  g   $1,000 PV  ig 1 i  .07  .03 1  .07    $15,356 n          

9-51.

 Forever College (3rd thought)

9-52.

n 30  1   1  g   1    1  .02   1   PVn  A1     $7,500 .06  .02 1   1  .06    $128,367 ig 1 i          

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

9-53.

Your retirement (Growing annuity) FV = PV × FVIF (Appendix A) = $90,000 × 3.262 = $293,580n (N = 40, %I/Y = 3) 30

Calculator $293,583

 1   1  g   1    1  .03   1   PVn  A1     $293,583 .04  .03 1   1  .04    $7,387,419 ig 1 i          

By tables and formula: $7,387,344 FV = PV × FVIF (Appendix A) = $250,000 × 4.322 = $1,080,500 (N = 30, %I/Y = 5) Required (expressed at time 40) = $7,387,344 + $1,080,500 = $8,467,844 A

$1,080,486

$8,467,905

= FVA/ FVIFA (Appendix C) = $8,467,844/ 120.800 = $70,098 (N = 40, %I/Y = 5)

9-54.

Calculator

$70,099

Your Interest Rate PVIFA

= PVA/A (Appendix D) (N = 5) = $9,725/ $2,500 = 3.890

Interest rate = 9 percent

Foundations of Fin. Mgt. 12Ce

Calculator

%i = 9%

12 -

Block, Hirt, Danielsen, Short

9-55.

Sarah Adia FV = PV  FVIF (Appendix A) = $15,000  1.260 = $18,900 (N = 3, %I/Y = 8) A

= PVA/PVIFA (Appendix D) = $18,900/3.890 = $4,859 (N = 5, %I/Y = 9)

9-56.

Calculator $18,896

$4,858

Your Uncle A

= PVA/PVIFA (Appendix D) Calculator = $50,000/5.335 = $9,372 (N = 8, %I/Y = 10) $9,372

First payment: $50,000  .10 = $9,372 – $5,000 =

$5,000 interest $4,372 to principal

$4,372

Second payment: First determine remaining principal $50,000 – $4,372 = $45,628

$45,628

$45,628  .10 = $9,372 – $4,563 =

Foundations of Fin. Mgt. 12Ce

$4,563 interest $4,809 to principal

12 -

$4,563 $4,809

Block, Hirt, Danielsen, Short

9-57.

Jim Thomas

a. A = PVA/PVIFA (Appendix D) = $70,000/8.055 = $8,690 b.

8,690  30 $ 260,700 – 70,000 $ 190,700

Calculator (N = 30, %I/Y = 12%) $8,690

annual payments years total payment repayment of principal $190,702

c. New payments at 10% A = PVA/PVIFA (Appendix D) = $70,000/ 9.427 = $7,425 (N = 30, %I/Y = 10)

$7,426

Difference between old and new payments $8,690 old 7,425 new $ 1,265 difference

$ 8,690 7,426 $ 1,264

P.V. of difference: Amount that could be paid to refinance. PVA = A  PVIFA (Appendix D) = $1,265  9.427 = $11,925 (N = 30 %I/Y = 10)

Foundations of Fin. Mgt. 12Ce

12 -

$11,916

Block, Hirt, Danielsen, Short

9-58.

Larry Davis

a. A = PVA/PVIFA (Appendix D) = $80,000/6.873 = $11,640 b.

11,640  25 $ 291,000 – 80,000 $ 211,000

Calculator (N = 25, %I/Y = 14%) $11,640

annual payments years total payment repayment of principal $210,997

c. New payments at 10% A = PVA/PVIFA (Appendix D) = $80,000/ 9.077 = $8,813 (N = 25, %I/Y = 10)

$8,813

Difference between old and new payments $11,640 old 8,813 new $ 2,827 difference

$11,640 8,813 $ 2,827

P.V. of difference: Amount that could be paid to refinance. PVA = A  PVIFA (Appendix D) = $2,827  9.077 = $25,661 (N = 25 %I/Y = 10)

Foundations of Fin. Mgt. 12Ce

12 -

$25,661

Block, Hirt, Danielsen, Short

9-59.

Peter Piper

a. Determine the monthly effective interest rate. PV = 1 FV = –1.0425 (8.5/ 2) PMT = 0 N=6 Compute %I/Y = 0.696106% Determine monthly payment PV = $120,000 FV = 0 %I/Y = 0.696106% N = 240 (20 × 12) Compute PMT=

$1,030.27

b. Determine the weekly effective interest rate. PV = 1 FV = 1.0425 (8.5/ 2) PMT = 0 N = 26 Compute %I/Y = 0.16021156% Determine weekly payment PV = $120,000 FV = 0 %I/Y = 0.16021156% N = 1,040 (20 × 52) Compute PMT=

$237.12

c. Determine the bi-weekly effective interest rate. PV = 1 FV = 1.0425 (8.5/ 2) PMT = 0 N = 13 Compute %I/Y = 0.3206798% Determine bi-weekly payment PV = $120,000 FV = 0 %I/Y = 0.3206798% N = 520 (20 × 26) Compute PMT=

Foundations of Fin. Mgt. 12Ce

12 -

$474.62

Block, Hirt, Danielsen, Short

9-60.

Ocean Spray

a. Determine the monthly effective interest rate. PV = 1 FV = 1.0225 (4.5/ 2) PMT = 0 N=6 Compute %I/Y = 0.37153196% Determine monthly payment PV = $200,000 FV = 0 %I/Y = 0.37153196% N = 300 (25 × 12) Compute PMT=

$1,106.95

b. Determine the weekly effective interest rate. PV = 1 FV = 1.0225 (4.5/ 2) PMT = 0 N = 26 Compute %I/Y = 0.08561589% Determine weekly payment PV = $200,000 FV = 0 %I/Y = 0.08561589% N = 1,300 (25 × 52) Compute PMT=

$255.08

c. Determine the bi-weekly effective interest rate. PV = 1 FV = 1.0225 (4.5/ 2) PMT = 0 N = 13 Compute %I/Y = 0.1713051% Determine bi-weekly payment PV = $200,000 FV = 0 %I/Y = 0.1713051% N = 650 (25 × 26) Compute PMT=

Foundations of Fin. Mgt. 12Ce

12 -

$510.39

Block, Hirt, Danielsen, Short

9-61.

Bing and Monica Cherrie Determine the monthly effective interest rate. PV = 1 PMT = 0 FV = 1.020 (4.0/ 2) N=6 Compute %I/Y = 0.33058903% Determine monthly payment PV = $145,000 FV = 0 %I/Y = 0.33058903% PMT = $1,150 Compute N= Or

9-62.

163.4 13.6 years

Deidre Hall

Determine the monthly effective interest rate. PV = 1 FV = 1.0175 (3.5/ 2) PMT = 0 N=6 Compute %I/Y = 0.28956239% Determine monthly payment FV = 0 N = 300 %I/Y = 0.28956239% PMT = $690 Compute PV=

Foundations of Fin. Mgt. 12Ce

12 -

$138,202

Block, Hirt, Danielsen, Short

9-63.

Barbara Present value of college costs PVA = A  PVIFA (Appendix D) = $15,000  3.170 = $47,550 (N = 4, %I/Y =10)

Calculator $47,548

Accumulation based on investing $2,000 per year for 10 years. FVA = A  FVIFA (Appendix C) = $2,000  15.937 = $31,874 (N = 10, %I/Y = 10) $31,875

Additional funds required 5 years from now. $47,550 PV of college costs Calculator 31,874 Accumulation based on $2,000 per year $15,676 Additional funds required $15,673 Added contribution for the next 5 years A = FVA/FVIFA (Appendix C) = $15,676/6.105 = $ 2,568 (N = 5, %I/Y = 10)

Foundations of Fin. Mgt. 12Ce

12 -

$2,567

Block, Hirt, Danielsen, Short

Barbara’s Wedding

9-64.

Funds available after the wedding $47,550 Funding available before the wedding – 7,000 Wedding $40,550 Funds available after the wedding Less present value of vacation PVA = A  PVIFA (Appendix D) = $4,000  2.487 = $9,948 $40,550 – 9,948 $30,602

Calculator $47,548 ─ 7,000 $40,548

(N = 3, %I/Y = 10)

Remaining funds for graduate school

$9,947 $40,548 — 9,947 $30,601

Value of funds 3 years later for graduate school:

FV = PV  FVIF (Appendix A) = $30,602  1.331 = $40,731 (N = 3, %I/Y =10)

Calculator $40,730

Number of years of graduate education:

PV IFA 

PVA

10%  $40,731  3.170

$12,850 A With i = 10%, N = 4 for 3.170. The answer is 4 years.

Foundations of Fin. Mgt. 12Ce

12 -

Appendix D

Calculator:

3.9996 years

Block, Hirt, Danielsen, Short

9-65.

Middle Hockey League

a. A

= FVA/ FVIFA (Appendix C) = $250,000/60.402 = $4,139 (N = 40, %I/Y = 2)

Calculator $4,139

b. Determine how much the old payments are equal to after 16 periods:

FVA = A  FVIFA (Appendix C) = $4,139  18.639 = $77,147 (N = 16, %I/Y = 2)

$77,147

Determine how much this value will grow to after 24 periods at 3%.

FV = PV  FVIF (Appendix A) = $77,147  2.033 = $156,840 (N = 24, %I/Y = 3) $156,824 Determine how much has to accumulate on the next 24 payments.

$250,000 – 156,840 $ 93,160

$250,000 – 156,824 $ 93,176

Determine revised payment to accumulate this sum after 24 periods at

3%. A = FVA/ FVIFA (Appendix C) Calculator = $93,160/ 34.426 = $2,706 (N = 24, %I/Y = 3) $2,707

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

9-66. Medical Research Corporation (Comprehensive Problem) Offer I Annuity of 200,000 (years 6 thru 15): PVA = A  PVIFA (Appendix D) = $200,000  6.145 = $1,229,000 (n = 10, %I/Y = 10) PV = FV  PVIFA (Appendix B) = $1,229,000  .621 = $763,209 (n = 5, %I/Y= 10) th Possible payment in 15 year: PV = FV  PVIFA (Appendix B) = 0.70  $3,000,000 .239 = $501,900 (n = 15, %I/Y= 10) Payment now: $1,000,000 $(763,209 + 501,900 + 1,000,000) = $2,265,109

Calculator $1,228,913

$ 763,059

502,723 1,000,000 $2,265,782

Offer II Year 1 2 3 4

Sales $2,000,000 2,800,000 3,920,000 5,488,000

Gross profit (60% of sales) $1,200,000 1,680,000 2,352,000 3,292,800

Payment (30% of Gross) $360,000 504,000 705,600 987,600

PVfactor .909 .826 .751 .683

PV $327,240 416,304 529,906 674,531 $1,947,981 Calculator $1,948,473

Offer III Trust fund value after 8 years (16 periods): FVA = A  FVIFA (Appendix C) (n = 17 ─ 1, %I/Y= 5) Calculator = $200,000  (25.840 ─ 1) = $4,968,000 (BGN) $4,968,073 Present value of trust fund: PV = FV  PVIFA (Appendix B) = $4,968,000 .467 = $2,320,056 (n = 8, %I/Y= 10) $2,317,643 Or: (n = 16, %I/Y= 5) $2,275,931 Offer #3 is the best

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

MINI CASE Allison Boone The case brings the time value of money into a legal settlement context, where present value concepts are frequently utilized. Many professors may also be able to draw on their own personal expertise to enhance the discussion of the case. The case deals with a high earning medical doctor and the loss to her family as a result of an accident. Select a current long-term interest rate as discount rate. This may vary. We will select 6%, close to the long-term Government of Canada bond in 2017 plus 3.5%. a. @ 6% Proposal Number One: $300,000 a year for the next 20 years PVA = A  PVIFA (Appendix D) Calculator = $300,000  11.470 = $3,441,000 (N = 20, %I/Y = 6) $3,440,976 Plus: $500,000 a year for the remaining 20 years Step 1 PVA = A  PVIFA (Appendix D) Calculator =$500,000  11.470 = $5,735,000 (N = 20, %I/Y =6) $5,734,961 Step 2 PV = FV  PVIF (Appendix B) = $5,735,000  .312 = $1,789,320 (N = 20, %I/Y= 6) $1,788,188 Total present value: = $3,441,000 + $1,789,320 = $5,230,320 $5,229,164

Proposal Number Two: $5,000,000

Proposal Number Three $50,000 a year for the next 40 years PVA = A  PVIFA (Appendix D) = $50,000  15.046 = $752,300 Plus: $75 million at the end of 40 years Foundations of Fin. Mgt. 12Ce

12 -

Calculator (N = 40, %I/Y = 6) $752,315

Block, Hirt, Danielsen, Short

= FV  PVIF (Appendix B) = $75,000,000  .097 = $7,275,000 Total present value: = $752,300 + $7,275,000 = $8,027,300 PV

(N = 40, %I/Y = 6) $7,291,664 $8,043,979

At a discount rate of 6 percent, proposal three has the highest net present value of $8,043,979. b. @ 11% Proposal Number One: $300,000 a year for the next 20 years PVA = A  PVIFA (Appendix D) Calculator = $300,000  7.963 = $2,388,900 (N = 20, %I/Y =11)$2,388,998 Plus: $500,000 a year for the remaining 20 years Step 1 PVA = A  PVIFA (Appendix D) Calculator = $500,000  7.963 =$3,981,500 (N = 20, %I/Y =11)$3,981,664 Step 2 PV = FV  PVIF (Appendix B) = $5,735,000  .124 = $493,706 (N = 20, %I/Y =11) $493,861 Total present value: = $2,388,900 + $493,706 = $2,882,606 $2,882,860 Proposal Number Two: $5,000,000 Proposal Number Three $50,000 a year for the next 40 years PVA = A  PVIFA (Appendix D) = $50,000  8.951 = $447,550 Plus: $75 million at the end of 40 years PV = FV  PVIF (Appendix B) = $75,000,000  .015 = $1,125,000 Total present value: = $447,550 + $1,125,000 = $1,572,550

Calculator (N = 40, %I/Y =11) $447,553

(N = 40, %I/Y =11)$1,153,831 $1,601,383

At a discount rate of 11 percent, proposal two has the highest net present value of $5,000,000.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

c. At a relatively high discount rate of 11 percent in question 2, the later payments lose much of their value. For example, the $75 million payment as part of proposal three only has a present value of $1,125,000 at a discount rate of 11 percent as compared to $7,275,000 at six percent. For this reason, the $5 million (immediate) payment in proposal two is the most favorable at the higher discount rate. d. Punitive damages are added on to the economic damages. With the likelihood of $4 million in punitive damages, Sloan Whitaker may well want to take the case before a jury. However, we should keep in mind that offers for the out-of-court settlements have likely been influenced by the potential for punitive damages. Also, a jury verdict may be appealed and actual payment may be deferred many years into the future. Because attorneys in cases such as this often get 1/3rd of the out-of-court settlement (or the jury determined value) as their fee, Sloan Whitaker is likely to consider this matter quite seriously. Of course, the final decision will rest with the Boone family, but Samuel Boone will be strongly influenced by the attorney‘s recommendation. Although this question is not a financial one, it has financial implications for the student doing the case. Chapter 10 Discussion Questions 10-1. The valuation of financial assets is based on the required rate of return to security holders. This, in turn, becomes the cost of financing (capital) to the corporation. 10-2. The valuation of a financial asset is equal to the present value of future cash flows. 10-3. Because BCE, Inc. has less risk and a stronger market position than Air Canada, BCE, Inc. provides a lower return; Air Canada has stiff competition and has had financial difficulties. 10-4. The three factors that influence the demanded rate of return are: a. The real rate of return b. The inflation premium c. The risk premium 10-5. The real rate of return is the financial rent received by investors for giving up use of their funds, above inflation and without a risk premium.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-6. If inflationary expectations increase, the yield to maturity (required rate of return) will increase. This will mean a lower bond price. 10-7. The longer the time period remaining to maturity, the greater the impact of a difference between the rate the bond is paying and the current yield to maturity (required rate of return). For example, a two percent ($20) differential is not very significant for one year, but very significant for 20 years. In the latter case, it will have a much greater effect on the bond price. 10-8. The valuation models represent the complex real world in a simplified manner. As such they are incomplete. If we can keep the other components of the model constant, then the model will hinge on the investor‘s required or expected rate of return. Three components of an investor‘s required rate of return have been suggested. If a change in an investor‘s required return can be fully captured, the model will work. For practical purposes holding other factors constant and fully capturing changes in investor expectations and psychology proves difficult. 10-9. The three adjustments in going from annual to semiannual bond analysis are: 1. Divide the annual interest rate by two. 2. Multiply the number of years by two. 3. Divide the annual yield to maturity by two. 10-10. The longer the life of an investment, the greater the impact of a change in the required rate of return. Since preferred stock has a perpetual life, the impact is likely to be at a maximum. 10-11. The no-growth pattern for common stock is similar to the dividend on preferred stock. 10-12. To go from Formula (10-7) to Formula (10-8): The firm must have a constant growth rate (g). The discount rate (ke) must exceed the growth rate (g). 10-13. The two components that make up the required return on common stock are: D a. Dividend yield  1 P0 b. The growth rate (g). This actually represents the anticipated growth in dividends, earnings, and stock price over the long term. 10-14. The price-earnings ratio is influenced by the earnings and sales growth of the firm, the risk (or volatility in performance), the debt-equity structure of the firm, the dividend policy, the quality of management, and a number of other factors. Firms that have bright expectations for the future tend to trade at high P/E ratios while the opposite is true of low P/E firms. 10-15. The higher the firm‘s Ke, the lower will be the price-earnings ratio, assuming all other things remain equal. This makes sense because a relatively high Ke implies a higher level of risk. The greater the estimate of dividend growth (g), the higher the price-earnings ratio because of buoyancy of future expectations. Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-16. A supernormal growth pattern is represented by very rapid growth in the early years of a company or industry that eventually levels off to more normal growth. The supernormal growth pattern is often experienced by firms in emerging industries, such as in the early days of electronics or microcomputers. 10-17. In valuing a firm with no cash dividend, one approach is to assume that at some point in the future a cash dividend will be paid, perhaps a liquidating dividend. You can then take the present value of future cash dividends. A second approach is to take the present value of future earnings as well as a future anticipated stock price. The discount rate applied to future earnings is generally higher than the discount rate applied to future dividends.

Internet Resources and Questions 1. www.bankofcanada.ca/rates/interest-rates/ www.pfin.ca/ 2. www.tmx.com www.reuters.com/finance/markets

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Problems 10-1.

Wild Rose Company

a. 6 percent yield to maturity Present value of interest payments PVA = A  PVIFA (n = 20, %I/Y = 6) (Appendix D) PVA = 90  11.470 = $1,032.30 Present value of principal payment at maturity PV = FV  PVIF (n = 20, %I/Y = 6) (Appendix B) PV = $1,000  0.312 = $312 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

PV =? FV = $1,000 n = 20 %I/Y = 6% PV = $1,344.10

$1,032.30 312.00 $1,344.30 PMT = $90

b. 8 percent yield to maturity PVA = A  PVIFA (n = 20, %I/Y = 8) (Appendix D) PVA = $90  9.818 = $883.62 PV = FV  PVIF (n = 20, %I/Y = 8) (Appendix B) PV = $1,000  0.215 = $215 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 n = 20 %I/Y = 8% PV = $1,098.18

12 -

$ 883.62 215.00 $1,098.62 PMT = $90

Block, Hirt, Danielsen, Short

c. 12 percent yield to maturity PVA = A  PVIFA (n = 20, %I/Y = 12) (Appendix D) PVA = $90  7.469 = $672.21 PV = FV  PVIF (n = 20, %I/Y = 12) (Appendix B) PV = $1,000  0.104 = $104.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

10-2.

PV =? FV = $1,000 n = 20 %I/Y = 12% PV = $775.92

$672.21 104.00 $776.21 PMT = $90

Midland Oil

a. 7 percent yield to maturity Present value of interest payments PVA = A  PVIFA (n = 25, %I/Y = 7) (Appendix D) PVA = $80  11.654 = $932.32 Present value of principal payment at maturity PV = FV  PVIF (n = 25, %I/Y = 7) (Appendix B) PV = $1,000  0.184 = $184.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 n = 25 %I/Y = 7% PV = $1,116.54

12 -

$ 932.32 184.00 $1,116.32 PMT = $80

Block, Hirt, Danielsen, Short

b. 10 percent yield to maturity PVA = A  PVIFA (n = 25, %I/Y = 10) (Appendix D) PVA = $80  9.077 = $726.16 PV = FV  PVIF (n = 25, %I/Y = 10) (Appendix B) PV = $1,000  0.092 = $92.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond

$726.16 92.00 $818.16

Calculator:

PMT = $80

Compute:

PV =? FV = $1,000 n = 25 %I/Y = 10% PV = $818.46

c. 13 percent yield to maturity PVA = A  PVIFA (N = 25, %I/Y = 13) (Appendix D) PVA = $80  7.330 = $586.40 PV = FV  PVIF (N = 25, %I/Y = 13) (Appendix B) PV = $1,000  0.47 = $47.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond

Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 N = 25 %I/Y = 13% PV = $633.50

12 -

$586.40 47.00 $633.40

PMT = $80

Block, Hirt, Danielsen, Short

10-3.

Exodus Limousine Company

a. 5 percent yield to maturity Present value of interest payments PVA = A  PVIFA (N = 50, %I/Y = 5) (Appendix D) PVA = $100  18.256 = $1,825.60 Present value of principal payment at maturity PV = FV  PVIF (N = 50, %I/Y = 5) (Appendix B) PV = $1,000  0.087 = $87.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond

$1,825.60 87.00 $1,912.60

Calculator:

PMT = $100

Compute:

PV =? FV = $1,000 N = 50 %I/Y = 5% PV = $1,912.80

b. 15 percent yield to maturity Present value of interest payments PVA = A  PVIFA (N = 50, %I/Y = 15) (Appendix D) PVA = $100  6.661 = $666.10 Present value of principal payment at maturity PV = FV  PVIF (N = 50, %I/Y = 15) (Appendix B) PV = $1,000  0.001 = $1.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 N = 50 %I/Y = 15% PV = $666.97

12 -

$666.10 1.00 $667.10 PMT = $100

Block, Hirt, Danielsen, Short

10-4.

Exodus Limousine Company (Continued) The principal payment of $1.00 represents: $1 $666.97

= 0.0015 = 0.15%

of the bond value.

10-5.

Applied Software

a. 30 years to maturity Present value of interest payments PVA = A  PVIFA (N = 30, %I/Y = 7) (Appendix D) PVA = $120  12.409 = $1,489.08 Present value of principal payment at maturity PV = FV  PVIF (N = 30, %I/Y = 7) (Appendix B) PV = $1,000  0.131 = $131.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 N = 30 %I/Y = 7% PV = $1,620.45

12 -

$1,489.08 131.00 $1,620.08 PMT = $120

Block, Hirt, Danielsen, Short

b. 15 years to maturity PVA = A  PVIFA (N = 15, %I/Y = 7) (Appendix D) PVA = $120  9.108 = $1,092.96 PV = FV  PVIF (N = 15, %I/Y = 7) (Appendix B) PV = $1,000  0.362 = $362.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

PV =? FV = $1,000 N = 15 %I/Y = 7% PV = $1,455.40

$1,092.96 362.00 $1,454.96 PMT = $120

c. 1 year to maturity PVA = A  PVIFA (N = 1, %I/Y = 7) (Appendix D) PVA = $120  0.935 = $112.20 PV = FV  PVIF (N = 1, %I/Y = 7) (Appendix B) PV = $1,000  0.935 = $935.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond

$ 112.20 935.00 $1,047.20

Calculator:

PMT = $120

PV =? FV = $1,000 N=1 %I/Y = 7% Compute: PV = $1,046.73

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-6.

Victoria Telephone Company

a. 30 years to maturity Present value of interest payments PVA = A  PVIFA (N = 30, %I/Y = 8) (Appendix D) PVA = $50  11.258 = $562.90 Present value of principal payment at maturity PV = FV  PVIF (N = 30, %I/Y = 8) (Appendix B) PV = $1,000  0.099 = $99.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

PV =? FV = $1,000 N = 30 %I/Y = 8% PV = $662.27

$562.90 99.00 $661.90 PMT = $50

b. 15 years to maturity PVA = A  PVIFA (N = 15, %I/Y = 8) (Appendix D) PVA = $50  8.559 = $427.95 PV = FV  PVIF (N = 15, %I/Y = 8) (Appendix B) PV = $1,000  0.315 = $315.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 N = 15 %I/Y = 8% PV = $743.22

12 -

$427.95 315.00 $742.95 PMT = $50

Block, Hirt, Danielsen, Short

c. 1 year to maturity PVA = A  PVIFA (N = 1, %I/Y = 8) (Appendix D) PVA = $50  0.926 = $46.30 PV = FV  PVIF (N = 1, %I/Y = 8) (Appendix B) PV = $1,000  0.926 = $926.00 Total present value: Present value of interest payments Present value of principal payments Total present value or price of the bond PV =? N=1 Compute: PV = $972.22 Calculator:

Foundations of Fin. Mgt. 12Ce

FV = $1,000 %I/Y = 8%

12 -

$ 46.30 926.00 $972.30 PMT = $50

Block, Hirt, Danielsen, Short

10-7.

Victoria Telephone Company (continued) 5% bond, $1,000 par (maturity) value

Bond value $1,000

$900

$800

$700

Assumes 8% yield to maturity (YTM)

$600

$500 30

Time to maturity

As the time to maturity becomes less and less, the importance of the difference between the interest rate the bond pays and the yield to maturity becomes less significant. Therefore, the bond trades closer to par value.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-8.

Sunfish Bond (rates decrease) a. PVA = A  PVIFA (N = 20 × 2 = 40, %I/Y = 12/ 2 = 6) (Appendix D) PVA = $50  15.046 = $752.30 PV = FV  PVIF (N = 40, %I/Y = 6) (Appendix B) PV = $1,000  0.097 = $97.00 Total present value: Present value of interest payments $752.30 Present value of principal payments 97.00 Total present value or price of the bond $849.30

Calculator: Compute:

PV =? FV = $1,000 N = 20 × 2 = 40 PV = $849.54

PMT = $50 (100/ 2) %I/Y = 12/ 2 = 6%

b. PVA = A  PVIFA (N = 20 × 2 = 40, %I/Y = 8/ 2 = 4) (Appendix D) PVA = $50  19.793 = $989.65 PV = FV  PVIF (N = 40, %I/Y = 4) (Appendix B) PV = $1,000  0.208 = $208.00 Total present value: Present value of interest payments $989.65 Present value of principal payments 208.00 Total present value or price of the bond $1,197.65

Calculator: Compute: c.

PV =? FV = $1,000 N = 20 × 2 = 40 PV = $1,197.93

PMT = $50 (100/ 2) %I/Y = 8/ 2 = 4%

Sales price (8%) .............................$1,197.93 Purchase price (12%) ..................... 849.54 Profit ..............................................$ 348.39 𝐺𝑎𝑖𝑛 =

Foundations of Fin. Mgt. 12Ce

348.39 = 0.41 = 41% 849.54

12 -

Block, Hirt, Danielsen, Short

10-9.

Sunfish Bond (rates increase) a. PVA = A  PVIFA (N = 20 × 2 = 40, %I/Y = 6/ 2 = 3) (Appendix D) PVA = $50  23.115 = $1,155.75 PV = FV  PVIF (N = 40, %I/Y = 3) (Appendix B) PV = $1,000  0.307 = $307.00 Total present value: Present value of interest payments $1,155.75 Present value of principal payments 307.00 Total present value or price of the bond $1,462.75

Calculator:

PV =? FV = $1,000 N = 20 × 2 = 40 PV = $1,462.30

Compute:

PMT = $50 (100/ 2) %I/Y = 6/ 2 = 3%

b. PVA = A  PVIFA (N = 20 × 2 = 40, %I/Y = 14/ 2 = 7) (Appendix D) PVA = $50  13.332 = $666.60 PV = FV  PVIF (N = 40, %I/Y = 7) (Appendix B) PV = $1,000  0.067 = $67.00 Total present value: Present value of interest payments $666.60 Present value of principal payments 67.00 Total present value or price of the bond $733.60

Calculator:

PV =? FV = $1,000 N = 20 × 2 = 40 PV = $733.37

Compute:

PMT = $50 (100/ 2) %I/Y = 14/ 2 = 7%

c. Sales price (14%) .......................... $ 733.37 Purchase price (6%) ....................... 1,462.30 Profit ...............................................($ 728.93) 𝐿𝑜𝑠𝑠 =

Foundations of Fin. Mgt. 12Ce

728.93 = 0.50 = 50% 1,462.30

12 -

Block, Hirt, Danielsen, Short

10-10.

Ron Rhodes-Golden Years Recreation Corporation

PVA = A  PVIFA (N = 18 × 2 = 36, %I/Y = 11/ 2 = 5.5) (Appendix D) PVA = $65  15.536 = $1,009.84 PV = FV  PVIF (N = 36, %I/Y = 5.5) (Appendix B) PV = $1,000  0.146 = $146.00 Total present value: Present value of interest payments $1,009.84 Present value of principal payments 146.00 Total present value or price of the bond $1,155.84

Calculator: Compute:

PV =? FV = $1,000 N = 18 × 2 = 36 PV = $1,155.36

PMT = $65 (130/ 2) %I/Y = 11/ 2 = 5.5%

Broker‘s price is at $1,170 is too high compared to $1,155.36 value.

10-11.

Vinny Cartier Company

First compute the new required rate of return (yield to maturity). Real rate of return Inflation premium Risk premium Total return

3% 3 2 8%

Then use this value to find the price of the bond: Present value of interest payments

PVA = A  PVIFA (N = 15 × 2 = 30, %I/Y = 8/ 2 = 4%) (App. D) PVA = $60  17.292 = $1,037.52 Present value of principal payment at maturity

PV = FV  PVIF (N = 30, %I/Y = 4%) (Appendix B) PV = $1,000  0.308 = $308.00 $1,037.52 308.00 $1,345.52 Calculator: Compute: 10-12.

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 PMT = $60 ($120/ 2) N = 15 × 2 = 30 %I/Y = 8/ 2 = 4% PV = $1,345.84 Martin Shipping Lines

12 -

Block, Hirt, Danielsen, Short

First compute the new required rate of return (yield to maturity). Real rate of return Inflation premium Risk premium Total return

2% 2 4 8%

Then use this value to find the price of the bond. Present value of interest payments PVA = A  PVIFA (N = 20 × 2 = 40, %I/Y = 8/ 2 = 4%) (App. D) PVA = $50  19.793 = $989.65 Present value of principal payment at maturity PV = FV  PVIF (N = 40, %I/Y = 4%) (Appendix B) PV = $1,000  0.208 = $208.00 $ 989.65 208.00 $1,197.65 Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 N = 20 × 2 = 40 PV = $1,197.93

12 -

PMT = $50 ($100/ 2) %I/Y = 8/ 2 = 4%

Block, Hirt, Danielsen, Short

10-13.

Lance Whittingham IV-Leisure Time Corporation

a. Current price of the bonds PVA = A  PVIFA (N = 16 × 2 = 32, %I/Y = 10/ 2 = 5%) (Appendix D) PVA = $20  15.803 = $316.06 PV = FV  PVIF (N = 32, %I/Y = 5%) (Appendix B) PV = $1,000  0.210 = $210.00 $316.06 + 210.00 $526.06 Calculator: Compute:

PV =? FV = $1,000 N = 16 × 2 = 32 PV = $525.92

PMT = $20 ($40/ 2) %I/Y = 10/ 2 = 5%

b. Percent increase at maturity Maturity value $1,000.00 Current price – 525.92 Dollar increase $ 474.08 $474.08 increase   0.9014  90.14% Percentage $525.92 c. Compound rate of growth The bond will grow by 90.14 percent over 16 years. Using Appendix A, the future value of $1, we see the growth rate is between 4 and 5 percent (4.02 percent based on interpolation).

Compute:

PV = $525.92 FV = $1,000 N = 16 %I/Y =? %I/Y = 4.10%

Foundations of Fin. Mgt. 12Ce

12 -

Calculator:

PMT = 0

Block, Hirt, Danielsen, Short

10-14.

Coleman Manufacturing Company

10-15.

PV = $850 FV = $1,000 PMT = $45 ($90/2) n = 10 × 2 = 20 %I/Y =? %I/Y = 5.785 × 2 = 11.57%

Tyler Food Chain

Approximate yield to maturity is represented by Y'. Annual interest payment  Principal payment - Price of the bond Number of years to maturity Y 1  0.6 Price of the bond  0.4 Principal payment $1,000  $1,080 $125  $125  $4 20   0.1155  11.55%     0.4  $1,000 $648  $400 0.6 $1,080  Calculator: PV = $1,080 FV = $1,000 PMT = $62.50 ($125/2) N = 20 × 2 = 40 %I/Y =? Compute: %I/Y = 5.736 × 2 = 11.47%

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-16.

Ann Nichols: Southwest Technology

8%/2 = 4% semiannual interest rate 4%  $1,000 = $40 semiannual interest 25  2 = 50 number of periods (n) 10%/ 2 = 5% yield to maturity expressed on a semiannual basis PVA = A  PVIFA (n = 50, %I/Y = 5%) (Appendix D) PVA = $40  18.256 = $730.24 PV = FV  PVIF (n = 50, %I/Y = 5%) (Appendix B) PV = $1,000  0.087 = $87 Present value of interest payments Present value of principal payment Total present value or price of the bond Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 N = 25 × 2 = 50 PV = $817.44

12 -

$ 730.24 87.00 $817.24 PMT = $40 ($80/2) %i = 10/ 2 = 5%

Block, Hirt, Danielsen, Short

10-17.

Holtz Corporation

a. Present Value of Interest Payments PVA = A  PVIFA (n = 30, %i = 6%) (Appendix D) PVA = $70  13.765 = $963.55 Present Value of Principal Payment at Maturity PV = FV  PVIF (n = 30, %i = 6%) (Appendix B) PV = $1,000  0.174 = $174.00 $ 963.55 174.00 $1,137.55 Calculator: Compute:

PV =? FV = $1,000 N = 15 × 2 = 30 PV = $1,137.65

PMT = $70 ($140/2) %i = 12/ 2 = 6%

b. PVA = A  PVIFA (n = 20, %i = 4%) (Appendix D) PVA = $70  13.590 = $951.30 PV = FV  PVIF (n = 20, %i = 4%) (Appendix B) PV = $1,000  0.456 = $456 $ 951.30 456.00 $1,407.30 Calculator: Compute:

PV =? FV = $1,000 N = 10 × 2 = 20 PV = $1,407.71

PMT = $70 ($140/2) %I/Y = 8/ 2 = 4%

c. Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =$858 FV = $1,000 PMT = $70 ($140/2) N = 10 × 2 = 20 %I/Y =? I/Y = 8.50%; I/Y% = 8.50 × 2 = 17.0%

12 -

Block, Hirt, Danielsen, Short

10-18.

Douglas Bonds

Approximate yield to maturity is represented by Y'. Annual interest payment  Principal payment - Price of the bond Number of years to maturity Y 1  0.6 Price of the bond  0.4 Principal payment $1,000  $1,105 $105  $105  $10.50 10    0.0889  8.89% 0.6 $1,105  0.4 $1,000  $663  $400 Calculator: PV = $1,105 FV = $1,000 PMT = $52.50 ($105/2) N = 10 × 2 = 20 %i =? Compute: %i = 4.45 × 2 = 8.89% 10-19. a. Calculator: Compute: Calculator: Compute: Calculator: Compute: Calculator: Compute:

Bond Relationships PV =? FV = $1,000 N=1×2=2 PV = $1,019.42

PMT = $30 ($60/2) %i = 4/ 2 = 2%

PV =? FV = $1,000 N=1×2=2 PV = $981.14

PMT = $30 ($60/2) %i = 8/ 2 = 4%

PV =? FV = $1,000 N = 20 × 2 = 40 PV = $802.07

PMT = $30 ($60/2) %i = 8/ 2 = 4%

PV =? FV = $1,000 N = 20 × 2 = 40 PV = $1,273.55

PMT = $30 ($60/2) %i = 4/ 2 = 2%

b. Price and yield are inversely related. c. Bond prices change more for longer terms, for a given yield change.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-20.

Hilton Chocolate Company p P  D  $6.00  $75 p Kp 0.08

10-21.

Airdrie Lanes Pp 

Dp Kp

or : 10-22.



$1.20  $40 0.03



$0.30  $40 0.0075

X-Tech

a. Original price $5.00 p P D   $100 p Kp 0.05 b. Current value $5.00 p P D   $41.67 p Kp 0.12 c. The price of preferred stock will increase as yields decline. Since preferred stock is a fixed income security, its price is inversely related to yields as would be true with bond prices. The present value of an income stream has a higher present value as the discount rate declines, and a lower present value as the discount rate increases.

10-23.

Quaid Brothers Corporation K p 

Foundations of Fin. Mgt. 12Ce

Dp Pp



$12  0.1111 11.11% $108

12 -

Block, Hirt, Danielsen, Short

10-24.

B2Y Solutions K p  or :

10-25.

$3  0.0400  4.00% $75 Pp $0.75   0.0100 4  0.04  4% $75 

Stagnant Iron and Steel Co. P0 

10-26.

D1 $4.20   $35.00 K e  g 0.12  0.0 Allied Coal

D1 $3.40  $3.40  $56.67  P0  K e  g 0.14  0.08 .06 10-27. P  0

Husky Kennels D

$0.20  $0.20  4  $0.80  $16.00 or   $16.00 .05 0.02  0.0075 K e  g 0.08  0.03 1

10-28.

Friedman Steel Company D1 $1.50  $1.50  $30.00 a. P0   K e  g 0.10  0.05 .05 b. P0 

D1 $1.50  $1.50  $21.43  K e  g 0.12  0.05 .07

c. P0 

$1.50 D1 $1.50   $50.00  K e  g 0.10  0.07 .03

d. P0 

D1 $2.00  $2.00  $40.00  K e  g 0.10  0.05 .05

10-29. Foundations of Fin. Mgt. 12Ce

Fleming Corporation 12 -

Block, Hirt, Danielsen, Short

= D0 (1 + g) = $4.00(1.08) = $4.32 P0 

D1 $4.32  $4.32  $86.40  K e  g 0.13  0.08 .05

Rick’s Department Store

10-30.

a. Earnings have been growing at a rate of 5 percent per year. (Actual 4.99%) 20XU (Base Period) 20XV $4.20/ 4.00 20XW $4.41/ 4.20 20XX $4.63/ 4.41 20XY $4.86/ 4.63

5% growth 5% growth 5% growth 5% growth

The projected EPS for 20XZ is $5.10 ($4.86  1.05) Dividend for 20XZ represent 40% of earnings or $2.04 ($5.10  40%) This is the value for D1. b. Ke (required rate of return) is 13% and the growth rate is 5%. $2.04  $2.04  $25.50  .08 Ke  g 0.13  0.05

D P 20XZ  

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-31.

Just Tin Coatings

a. Earnings have been grown from $2.00 to $2.62 over four (4) years. A longer-term trend is best as the pattern from one year to the next varies. Calculator: Compute:

PV = –2.00 FV = 2.62 PMT = 0 N=4 %I/Y = growth = ? %I/Y = 7%

20XU (Base Period) 20XV $2.18/ 2.00 20XW $2.28/ 2.18 20XX $2.42/ 2.28 20XY $2.62/ 2.42

9.0% growth 4.6% growth 6.0% growth 8.3% growth

The projected EPS for 20XZ is $2.80 ($2.62  1.07) Dividend for 20XZ represent 30% of earnings or $0.84 ($2.80  30%) This is the value for D1. b. Ke (required rate of return) is 12% and the growth rate is 7%. D1 $0.84  $0.84  $16.80  20XZ    P0 .05 K e  g 0.12  0.07 10-32.

Freudian Slips

The current dividend of $2.12 must be increased by the growth rate to get D1. $2.12 ×1.06 = $2.2472 𝐾 = 𝑒

𝐷1 𝑃0

+𝑔 =

$2.2472

+ 0.06 = 0.0412 + 0.06 = 0.1012 = 10.12%

$54.50

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-33.

A Firm

K e 

D1 $4.00 g  0.05  0.08  0.05  0.1300  13.00% $50.00 P0

10-34. Ke 

Triple Peaks Playhouse D1 P0

 g 

$0.40  4  0.04  0.05  0.04  0.0900  9.00% $32

10-35. a. K e 

Still Another Firm D1 $1.50  g   0.09  0.0250  0.09  0.1150  11.50% $60.00 P0

b. If the dividend payment increases, the dividend yield (D1/Po) will go up, and the required rate of return (Ke) will also go up. c. If the expected growth rate (g) increases, the required rate of return (Ke) will go up. d. If the stock price increases, the dividend yield (D1/Po) will go down, and the required rate of return (Ke) will also go down.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-36. a. D1 D2 D3

Hunter Petroleum Corporation = $2.00 × (1.05) = = $2.10 × (1.05) = = $2.205 × (1.05) =

b. Dividends D1 D2 D3

$2.10 $2.205 $2.315

PV of Dividends @ 12%

= $2.10 = $2.205 = $2.315

$1.875 1.757 1.648 $5.280

c. D4 = $2.315 × (1.05) = $2.430 P3 

D4 $2.43  $2.43  $34.71  K e  g 0.12  0.05 .07

d. PV of P3 for n = 3, %I/Y = 12%

Calculator: PV = $24.71

PV = $34.71  .712 = $24.716

e. answer to part b (PV of dividends) answer to part d (PV of P3) current value of the stock f. P0 

$ 5.28 24.72 $30.00

D1 $2.10  $2.10  $30.00  K e  g 0.12  0.05 .07

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-37.

P/E Ratio Valuation

a. Graham appears to be the best value based on the P/E ratio. An investor would be paying less for [current] earnings than the other firms.

b. Ted probably has the highest P/E ratio based on expected future earnings to the company. This could indicate higher risk and might be the result of lower earnings in the latest period, that is not reflected in the earnings of the other firms.

10-38.

A Common Share

If a $2.25 dividend has just been paid this is D0. D1 = $2.25 (1.05) = $2.3625 $2.3625  $19.69 P  D1  $2.3625  0 .12 K e  g 0.17  0.05

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-39.

A Bond

PVA = A × PVIFA (N = 9 × 2 =18, %I/Y = 8/ 2 = 4%) (Appendix D) = $120/2 × 12.659 = $759.54 PV = FV × PVIF (N = 18, %I/Y = 4%) (Appendix B) = $1,000 × .494 = $494.00 $ 759.54 494.00 $1,253.54 Calculator: Compute:

10-40.

PV =? FV = $1,000 N = 18 (9 × 2) PV = $1,253.19

PMT = $60 ($120/2) %I/Y = 4% (8%/2)

Tahitian Lottery

This is a perpetuity. The annual stipend can be considered Dp. $75,000 p P D   $1,250,000 p 0.06 Kp

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-41.

A Bond PVA = A × PVIFA (n = 7, i% = 8.5%) (Appendix D) = $2,500 × (5.206 + 5.033)/2 = $2,500 × 5.1195 = $12,799 PV = FV × PVIF (n = 7, %i = 8.5%) (Appendix B) = $25,000 × (.583 + .547)/2 = $25,000 × 0.565 = $14,125 $12,799 14,125 $26,924

Calculator: Compute: 10-42.

PV =? FV = $25,000 N=7 %i = 8.5% PV = $26,919.44

PMT = $2,500

Burrito Bell PVA = A × PVIFA (n = 12, i% = 6%) (Appendix D) = $100 × 8.384 = $838.40 PV = FV × PVIF (n = 12, %i = 6%) (Appendix B) = $1,000 × 0.497 = $497.00 $ 838.40 497.00 $1,335.40

Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 N = 12 %i = 6% PV = $1,335.35

12 -

PMT = $100

Block, Hirt, Danielsen, Short

10-43.

A Preferred Share $6.00 p P D   $66.67 p Kp 0.09

10-44.

A Common Share $1.20  $10.91 P  D1  $1.20  0 .11 K e  g 0.19  0.08 

10-45.

Annual Annuity A

= PVA/ PVIFA (n = 12, i% = 8%) (Appendix D) = $175,000/ 7.536 = $23,221.87

Calculator: Compute:

PV = $175,000 FV =0 N = 12 %i = 8% PMT = $23,221.63

PMT =?

10-46.

A Preferred Share $3.00 p P D   $21.43 p Kp 0.14

10-47.

Waterman Company $0.75  $6.82 P  D1  $0.75  0 .11 K e  g 0.17  0.06 

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-48.

Lou Spence PVIF 

PV $15   0.3539 FV $42.39

Appendix B, n = 7, IFPV = .3539 We find %i = 16% Calculator: Compute:

10-49.

PV = $15 n=7 %i = 16%

FV = $42.39 %i =?

PMT = 0

Strip Bond PV = FV × PVIF (n = 12, %i = 8%) (Appendix B) = $10,000 × 0.397 = $3,970

Calculator: Compute:

10-50.

PV =? FV = $10,000 n = 12 %i = 8% PV = $3,971.14

PMT = 0

A Life Payment Current market yield

2% 3% 2% 7%

Perpetuity formula  P  D  p Kp p

Foundations of Fin. Mgt. 12Ce

12 -

inflation real rate of return risk premium $50,000

 $714,286

0.07

Block, Hirt, Danielsen, Short

10-51.

Thunderbay Ltd.

PVA = A × PVIFA [n = 28 (14 × 2), i% = 4.5% (9%/2)] (Appendix D) = $55 ($110/ 2) × 15.743 = $865.87 PV = FV × PVIF (n = 28, %i = 4.5%) (Appendix B) = $1,000 × 0.292 = $292 $ 865.87 292.00 $1,157.87 Calculator: Compute:

10-52.

PV =? FV = $1,000 N = 28 (14 × 2) PV = $1,157.43

PMT = $55 ($110/2) %i = 4.5% (9%/ 2)

Royal Blue Bonds

FVA = A × FVIFA (n = 9, %i = 9) (Appendix C) = $130 × 13.021 = $1,692.73 Calculator: Compute:

PV = 0 FV =? N=9 %i = 9% FV = $1,692.73

Amount now available:

Calculator: Compute:

PMT = $130

$1,692.73 1,000.00 2,692.73

PV = $1,000 N=9 %i = 11.63%

FV = $2,692.73 %i =?

PMT = 0

With tables: Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

PV $1,000   0.3714 FV $2,692.73 Appendix B, n = 9, PVIF = .3714; between 11% and 12% PV IF 

PVIF at 11% = PVIF at 12% = Difference =

.391 .361 .030

PVIF at 11% = PVIF designated = Difference =

.391 .371 .020

.020  % i  0.11 0.01  .030  0.11 0.01.67  0.1167  11.67%   10-53.

Baffin College

$7,500 p  $75,000 a. Perpetuity formula  P  D  p Kp 0.10 b. If the endowment won‘t commence for five years, $75,000 is required at the beginning of the fifth year or four years from now. PV = FV × PVIF (n = 4, i = 10%) (Appendix B) = $75,000 × 0.683 = $51,225 Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $75,000 N=4 %i = 10% PV = $51,226

12 -

PMT = 0

Block, Hirt, Danielsen, Short

10-54.

Clear Waters Records 𝐷𝑝 $1.55 = = 0.0500 = 5.00% 𝐾𝑝 = 𝑃𝑝 $31 $0.3875 𝑜𝑟∶ = = 0.0125 × 4 = 0.05 = 5% $31

10-55.

Kris P. Bacon

Calculator: PV = ‒$1,203.67 FV = $1,000 PMT = $35 ($70/2) N = 8 × 2 = 16 %I/Y =? Compute: %I/Y = 2.000 × 2 = 4.00%

10-56.

𝐾 = 𝑒

Miller Timepieces 𝐷1

+𝑔 =

𝑃0

$0.35×4

+ 0.05 = 0.03 + 0.05 = 0.0800 =

$46.67

8.00%

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

10-57. a.

Healthy Products, Inc. Comprehensive Problem

D1 $1.20 1.20    $40.00 Ke  g 0.13  0.10 .03

P0 

b. Future Value of Dividends D1 D2 D3

$1.20 (1.10) = $1.32 (1.10) =

$1.20 $1.32 $1.452

Present Value of Dividends Dividends $1.20 1.32 1.452

D1 D2 D3

PV (13%) .885 .783 .693

(PV of Dividends) $1.06 1.03 1.01 $3.10

Value of Share Price at the End of Year 3

P3 

D4 Ke g

P3 

D4  D3 1  g  $1.452

1.10  $1.597

$1.597 $1.597   $53.23 0.03 0.13  0.10

Present Value of Future Share Price PV3 = $53.23, n = 3, I = 13% (Appendix B PV = $53.23 × .693 = $36.89 Total Share Price PV of Dividends 3.10 PV of Share Prices 36.89 $39.99 (or $40, slight rounding difference)) c. Average P/E of Five Food Industry Companies Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Del Monte General Mills Heinz Kellogg Kraft

12 15 14 22 17 80 80

 16 Average P/E

5 Share Price = P/E × EPS 16 × $2.45 = $39.20

The share price using the P/E ratio approach is slightly lower than the value using the dividend valuation model approach. ($39.20 versus $40.00).

d. P/E of Industry Companies (Kellogg weighted 40%) Del Monte 12 × 0.15 = 1.80 General Mills 15 × 0.15 = 2.25 Heinz 14 × 0.15 = 2.10 Kellogg 22 × 0.40 = 8.80 Kraft 17 × 0.15 = 2.55 17.50 Share price = P/E × EPS = 17.50 × $2.45 = $42.88 e.

Share price increases by $42.88−$39.20 = 0.0939 = 9.39%

Foundations of Fin. Mgt. 12Ce

$39.20

12 -

Block, Hirt, Danielsen, Short

MINI CASE Gilbert Enterprises This case examines valuation concepts from both a theoretical dividend valuation model approach and a price-earnings ratio approach. Because an initial period of supernormal growth is assumed, a review of Appendix 10B is necessary for the case. The case also makes strong use of ratios as part of the comparative P/E ratio analysis and shows how ratios influence valuation. Determine the share price using the valuation of a supernormal growth firm.

Discount rate = 10% P.V. of Dividends D0 = $1.20 D1 = 1.20(1.15) = $1.38 D2 = 1.38(1.15) = 1.59 D3 = 1.59(1.15) = 1.83 D4 to D = 𝐷 P3 $1.83 (1.06) 𝑃 = 4 = = $48.50 3

𝐾𝑒−g

$1.25 1.31 1.37 36.42

0.10−0.06

$40.35

Because the stock is only selling in the market for $35.25, it appears to be undervalued. Gilbert Enterprises has the second lowest P/E ratio of the four firms. Based on the financial information provided in Figure 1, this does not appear to be appropriate. First of all, Gilbert Enterprises has the fastest growth rate in earnings per share of any of the four firms. Furthermore, the growth is expected to accelerate to 15 percent over the next three years (as explained earlier in the case). Gilbert Enterprises also has the second highest return on shareholder‘s equity. Only Reliance Parts has a higher return, but its return is achieved solely as a result of its high debt ratio of 68 percent. As we learned in Chapter 3, it is possible to generate a high return on equity using debt, but still have relatively low profitability. In fact, Reliance Parts has the lowest return on total assets of any firm in the industry. In evaluating debt utilization as a separate item, Gilbert Enterprises once again looks attractive with a debt to total assets ratio of 33 Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

percent. Only Standard Auto has a lower ratio. We get further insight by evaluating market value to book value as well as market value to replacement value. In terms of market value to book value, Gilbert Enterprises appears to be overvalued relative to other firms in the industry. Its‘ market value to book value ratio is 2.15 ($35.25/ $16.40). For the other three firms, the ratios are more conservative.

Gilbert Enterprises Reliance Parts Standard Auto Allied Motors

Market Value $35.25 70.50 24.25 46.75

Book Value $16.40 50.25 19.50 50.75

Market Value to Book Value 2.15 1.40 1.24 0.92

But keep in mind that book value is a relatively meaningless concept because it is based on historical cost. A more meaningful analysis relates market value to replacement value. In this instance, we see that Gilbert Enterprises is the most conservatively valued of the four firms.

Gilbert Enterprises Reliance Parts Standard Auto Allied Motors

Market Value

Replacement Value

$35.25

$43.50

Market Value to Replacement Value 0.81

70.50 24.25 46.75

68.75 26.00 37.50

1.03 0.93 1.25

What about dividends? In terms of dividend yield, only Standard Auto provides a higher return to its shareholders. In summarizing the variables under consideration, it appears that Gilbert Enterprises may be undervalued relative to its competitors. While it has the second lowest P/E ratio, it has the fastest growth rate in earnings per share, the highest return on assets, and the lowest ratio Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

of market value to replacement value. The average P/E ratio for the four firms in the industry is 18.3. A strong case can be made that Gilbert Enterprises belongs at least at that level. Our analysis reveals that the firm may undervalued. Albert Roth should seriously consider recommending that the firm repurchase part of its shares in the marketplace. There are two possible caveats. One is that the market tends to be efficient in the pricing of securities so that one could possibly argue that there is some missing information that justifies Gilbert Enterprises‘ relatively low valuation. While an extended discussion of this point goes beyond the scope of this case, it probably should be brought up. Second is even if the stock is undervalued in the marketplace, the management of Gilbert Enterprises must make sure this is the best possible use of its funds. While the justification for a repurchase decision is not covered until Chapter 18 of the text, the instructor should at least make mention of the alternative uses of funds that must be considered in a stock repurchase decision.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Appendix 10A Problems 10A-1.

Peabody Corporation

Since the bond is trading below par value at $890, we can assume the yield to maturity must be above the quoted interest rate of 8 percent. (The yield to maturity would be 8 percent at a bond value of $1,000.) As a first approximation, we will try 9 percent.

Present value of interest payments PVA = A  PVIFA (N = 18, %I/Y = 9%) (Appendix D) PVA = $80  8.756 = $700.48 Present value of principal payment at maturity PV = FV  PVIF (N = 18, %I/Y = 9%) (Appendix B) = $1,000  0.212 = $212.00 $700.48 212.00 $912.48 The discount rate of 9 percent gives us too high a present value in comparison to the bond price of $890. So we next use a higher discount rate of 10 percent. Present value of interest payments PVA = A  PVIFA (N = 9, %I/Y = 7%) (Appendix D) = $80  8.201 = $656.08 Present value of principal payment at maturity PV = FV  PVIF (N = 9, %I/Y = 7%) (Appendix B) = $1,000  0.180 = $180.00 $ 656.08 180.00 $836.08

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

The discount rate of 10 percent provides a value lower than the price of the bond. The actual value for the bond must fall between 10% and 9%. Using interpolation, the answer is: $912.48 – 836.08 $ 76.04 9% 

PV at 9% PV at 10%

$22.48

$912.48 -890.00 $ 22.48

PV at 9% Bond price

1%  9%  0.29 1%  9.29%

$76.04

Calculator: Compute: 10A-2.

PV = $890 FV = $1,000 N = 18 %I/Y =? %I/Y = 9.28%

PMT = $80

Bullwinkle Corporation

Since the bond is trading above par value at $1,100, we can assume the yield to maturity must be below the quoted interest rate of 9 %. (The yield to maturity would be 9 % at a bond value of $1,000.) As a first approximation, we will try 7 % or 3.5 % semiannually. The semiannual payment is $45 ($90/ 2). Present value of interest payments PVA = A  PVIFA (n = 7 × 2 = 14, %i = 7/ 2 = 3.5%) (Appendix D) PVA = $45  10.921 = $491.45 Present value of principal payment at maturity PV = FV  PVIF (n = 14, %i = 3.5%) (Appendix B) = $1,000  0.618 = $618 $ 491.45 618.00 $1,109.45 The discount rate of 7 % gives us too high a present value in comparison to the bond price of $1,100. So we next use a higher discount rate of 8% or 4% semiannually. Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Present value of interest payments PVA = A  PVIFA (n = 14, %i = 4%) (Appendix D) = $45  10.563 = $475.34 Present value of principal payment at maturity PV = FV  PVIF (n = 14, %i = 4%) (Appendix B) = $1,000  0.577 = $577 $ 475.34 577.00 $1,052.34 The discount rate of 8 percent provides a value lower than the price of the bond. The actual value for the bond must fall between 7% and 8%. Using interpolation, the answer is: $1,109.45 – 1,052.34 $ 57.11

PV at 7% PV at 8%

$1,109.45 –1,100.00 $ 9.45

PV at 7% Bond price

$9.45 1%  5%  0.165 1%  7.165% 7%  $57.11

Calculator: Compute:

PV = $841 FV = $1,000 N = 22 %I/Y =? %I/Y = 3.58 × 2 = 7.16%

Foundations of Fin. Mgt. 12Ce

12 -

PMT = $20

Block, Hirt, Danielsen, Short

Appendix 10B Problems 10B-1. a. D1 D2 D3

Surgical Supplies Corporation $1.12(1.25) = $1.40(1.25) = $1.75(1.25) =

b. Supernormal dividends

$1.40 $1.75 $2.19 Present value of dividends during the supernormal growth period at Ke = 12% (Appendix B)

D1 = $1.40 D2 = $1.75 D3 = $2.19

$1.25 1.40 1.56 $4.21

c. D4 = D3 (1.07) = $2.19 (1.07) = $2.34 $2.34  $46.80 P  D4  $2.34  3 .05 K e  g 0.12  0.07 d. PV of P3 for n = 3, %i = 12% $46.80 PV = $33.31 e. Answer to part b (PV of dividends) Answer to part d (PV of P3) Current value of the stock

Foundations of Fin. Mgt. 12Ce

12 -

$ 4.21 33.31 $37.52

Block, Hirt, Danielsen, Short

10B-2.

Black Tie Co. Discount rate = 22% P.V. of Dividends D1 = $2.00 $1.64 D2 = 2.00(1.12) = $2.24 1.50 D3 = 2.24(1.12) = 2.51 1.38 D4 = 2.51(1.12) = 2.81 1.27 D5 to D = P4 $2.811.05 D5   $17.36 7.83 P4  K e  g 0.22  0.05 P0 $13.63

10B-3.

Ninja Co. Discount rate = 16% P.V. of Dividends D1 = $5.00 $4.31 D2 = 5.00(1.09) = $5.45 4.05 D3 = 5.45(1.09) = 5.94 3.81 D4 = 5.94(1.09) = 6.48 At this point growth becomes constant to infinity at 6%, so D4 can be used in the formula. D4 to D = 𝐷 𝑃4 = 5 = 𝐾𝑒−g

P3 $6.48

= $64.80

Foundations of Fin. Mgt. 12Ce

41.51

0.16−0.06

$53.68

12 -

Block, Hirt, Danielsen, Short

10B-4.

Sleepy Ltd. Discount rate = 16% P.V. of Dividends D0 = $1.25 – D1 = 1.25(1.20) = $1.50 1.29 D2 = 1.50(1.20) = 1.80 1.34 D3 = 1.80(1.20) = 2.16 1.38 D4 to D = P3 P  D4  $2.16  $13.50 8.65 3 K e  g 0.16  0.00 P0 $12.66

10B-5.

Clarinett, Inc. Discount rate = 18% P.V. of Dividends D1 = $1.10 $0.93 D2 = 1.10 0.79 D3 = 1.10 0.67 D4 = 1.10 0.57 D5 to D = P4 D5 $1.10 1.07   $10.70 5.52 P4  0.18  0.07 Ke  g P0 $ 8.48

Foundations of Fin. Mgt. 12Ce

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Block, Hirt, Danielsen, Short

10B-6.

March Hair Ltd. Discount rate = 14% P.V. of Dividends D0 = $1.80 – D1 = 2.90 2.54 D2 = 4.00 3.08 D3 to D = P2 D3 P   $4.00 1   0.05 $20.00 15.39 2

Ke  g

0.14   0.05



$21.01

Chapter 11 Discussion Questions 11-1. Though an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm. 11-2. The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation. 11-3. In computing the cost of capital, we use the current costs for the various sources of financing rather than the historical costs. We must consider what these funds will cost us to finance projects in the future rather than their past costs. 11-4. Even though debt and preferred stock may be both priced to yield 10 percent in the market, the cost of debt is less because the interest on debt is a tax-deductible expense. A 10 percent market rate of interest on debt will only cost a firm in a 40 percent tax bracket an aftertax rate of 6 percent. The answer is the yield multiplied by the difference of (one minus the tax rate). 11-5. The two sources of equity capital are retained earnings and new common stock. 11-6. Retained earnings belong to the existing common shareholders. If the funds are paid out instead of reinvested, the shareholders could earn a return on them. Thus we say retaining funds for reinvestment carries an opportunity cost. 11-7. Because shareholders can earn a return at least equal to their present investment. For this reason, the firm's rate of return (Ke) serves as a means of approximating the opportunities for alternate investments.

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11-8. In issuing new common stock, we must earn a slightly higher return than the normal cost of common equity in order to cover the distribution costs of the new security. In the case of the Baker Corporation, the cost of new common stock was six percent higher. 11-9. The weights are determined by examining different capital structures and using that mix which gives the minimum cost of capital. We must solve a multidimensional problem to determine the proper weights. 11-10. The logic of the U-shaped approach to cost of capital can be explained through Figure 11-1. It is assumed that as we initially increase the debt-to-equity mix the cost of capital will go down. After we reach an optimum point, the increase use of debt will increase the overall cost of financing to the firm. Thus we say the weighted average cost of capital curve is U-shaped.

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11-11. Other possible ratios influencing the cost of capital might be:  times interest earned  fixed charge coverage and indirectly  net income / sales  net income / total assets  net income / shareholders‘ equity 11-12. If the firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on the firm's operations and will lower the overall wealth of the shareholders. Clearly, it is undesirable to invest in a project yielding 8 percent if the financing cost is 10 percent. 11-13. Inflation can only have a negative impact on a firm's cost of capital-forcing it to go up. This is true because inflation tends to increase interest rates and lower stock prices, thus raising the cost of debt and equity directly and the cost of preferred stock indirectly. Note, however, that a proper cost of capital calculation requires marginal and current market costs. As such the component costs reflect market participants‘ inflationary expectations. 11-14. The marginal cost of capital is the cost of incremental funds. After a firm reaches a given level of financing, capital costs will go up because the firm must tap more expensive sources. For example, new common stock may be needed to replace retained earnings as a source of equity capital. 11-15. The dividend valuation model suggests that investors‘ required rates of return are based on future dividends. Does this fully reflect investors required returns? Furthermore future dividends that must be projected are difficult to determine, and the growth model assumes growth at a constant rate forever. The growth rate must also be translated into dividends flowing through to shareholders. The model must also assume that the share price is efficiently determined. 11-16. Investors base their expected returns on their market value investment, not on how much they had invested at some time in the past. The costs of financing in an efficient market are based on the market value capital structure and not on how the books report that structure.

Internet Resources and Questions 1. www.sedar.com 2. www.pfin.ca www.dbrs.com 3. www.reuters.com/finance/markets

www.standardandpoors.com

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Discussion Questions: Appendix 11-A 11A-1. The capital asset pricing model explains the relationship between risk and return, and the price adjustment of capital assets to changes in risk and return. As investors react to their economic environment and their willingness to take risk, they change the prices of financial assets like common stock, bonds, and preferred stock. As the prices of these securities adjust to investors' required returns, the company's cost of capital is adjusted accordingly. 11A-2. K e = D1 / P0 + g, while K j = R f + β j (R m – R f) K j and K e are equal when the market is in equilibrium because the expected return K e will be equal to the required return K j. K e is the return expected by investors based on dividends and dividend growth, which will cause the stock price to grow accordingly. K j is the return required to be received, but K j is related to the minimum required return on a risk free security plus a risk premium relative to the market return. The beta in the K j equation expresses the individual company‘s return relationship to the risk premium required. 11A-3. The SML, Security Market Line, reflects the risk-return tradeoffs of securities. As interest rates increase, the SML moves up parallel to the old SML. Now investors require a higher minimum return on risk free assets and an equally higher rate for all levels of risk. A change in the rate of inflation has a similar impact. The risk free rate goes up to provide the appropriate inflation premium and there is an upward shift in the SML. In regard to changing investor expectations, as investors become more risk averse, the SML increases its slope. The more risk taken, the greater the return premium that is desired (see figure 11A-4). 11A-4. If an individual security lies above the SML, this could suggest market inefficiency. The expected return from investing in that security is higher than one should expect given the risk assumed. Therefore it is a good investment. As other investors realize the same abnormally high return they will invest causing the security‘s price to rise. This is good for the investor. As the security‘s price rises its return will drop until it reaches the SML. 11A-5. An efficient market assumes that all pertinent information is quickly and continuously impounded into asset prices. The result is that abnormal profits cannot be achieved consistently, and investors are properly compensated for the risk they assume from investment. The CAPM assumes a relationship that properly describes return as a function of market related risk. All securities lie on a linear line, the SML. If the market is inefficient because information is not included in prices, it is likely that securities will not lie along the SML. 11A-6. The CAPM is a good theoretical framework for describing a relationship between risk and return. Nevertheless several aspects of the model may not be appropriate for the financial manager. The parameters of the model are historical and difficult to determine in practice. The model is based on diversified holdings whereas a financial manager is likely not diversified and therefore the manager‘s concept of risk is somewhat broader. The CAPM is based on a one period time frame, but the financial manager should have a Foundations of Fin. Mgt. 12Ce

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longer focus in decision making. The CAPM assumes an efficient market as well. While that may be close to true in the capital markets, the financial manager operates in the markets for technology, machinery, and so on, which are far from efficient. The relationship between risk and return under these circumstances becomes less than clear. Additionally beta is not very stable for individual stocks. The ultimate test is if the model can predict well.

Discussion Questions: Appendix 11-B 11B-1. Under the net income (NI) approach, it is assumed that the firm can raise all the funds it desires at a constant cost of equity and debt. Since debt tends to have a lower cost than equity, the more debt utilized the lower the overall cost of capital and the higher the valuation of the firm. Under the net operating income (NOI) approach, the cost of capital and valuation do not change with the increased utilization of debt. Under this proposition, the low cost of debt is assumed to remain constant with greater debt utilization, but the cost of equity increases to such an extent that the cost of capital remains unchanged. The traditional approach falls somewhere between the net income (NI) approach and the net operating income (NOI) approach in which there are benefits from increased debt utilization, but only up to a point. After that point, the cost of capital begins to turn up and the valuation of the firm begins to turn down. 11B-2. Under the initial Modigliani and Miller approach, the use of debt does not change the cost of capital. This is because the added risk premium associated with the use of debt cancels out any lower cost benefits. Also, investors could use homemade leverage to arbitrage the difference between undervalued and overvalued securities. 11B-3. Corporate tax considerations tend to make the tax deductibility of interest on debt highly attractive and to lower the cost of capital at all levels. However, the potential threat of bankruptcy has the opposite effect and tends to make the cost of capital more expensive with greater debt utilization. The net effect is that these influences tend to offset each other and lead us back to the traditional, U-shaped approach.

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Problems 11-1.

Hertz Pain Relievers

No, each individual project should not be measured against the specific means of financing that project, but rather against the weighted average cost of financing all projects for the firm. This principle recognizes that the availability of one source of financing is dependent on other sources. Once a common overall cost is determined, the ―heating compound‖ yielding 14 percent is much more likely to be accepted than the ―massage machine‖ only yielding 8 percent.

11-2.

Royal Petroleum Co. a.

Cost Debt Common equity Weighted average cost of capital

6% 18%

Weighted Weights Cost 50% 50%

3.0% 9.0% 12%

b. Only the new machine with a return of 16 percent. The return exceeds the weighted average cost of capital of 12.0 percent.

11-3. Kd

Foundations of Fin. Mgt. 12Ce

Pogo Stick Co. = Yield (1 – T) = 9% (1 – .25) = 9% (.75) = 6.75%

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11-4.

Law Suit Settlement Calculator: Compute:

PV =? FV = 0 PMT = $240,000 N = 50 %I/Y = 4% PV = $5,155,724

Present Value at 4% Appendix D PVA = A × PVIFA (4%, 50 periods) PVA = $240,000 × 21.482 = $5,155,680

Calculator: Compute:

PV =? FV = 0 PMT = $240,000 N = 50 %I/Y = 8% PV = $2,936,036

Calculator Difference = $5,155,724 –$2,936,036 = $2,219,688 Present Value at 8% Appendix D PVA = A × PVIFA (8%, 50 periods) PVA = $240,000 × 12.233 = $2,935,920 PV at 4% rate PV at 8% rate Difference

11-5. Kd

$5,155,680 2,935,920 $2,219,760

Aftertax Debt Cost Yield (1 – T)

Yield a. 8.0% b. 14.0% c. 11.5%

Foundations of Fin. Mgt. 12Ce

(1 – T) (1 – .22) (1 – .36) (1 – .42)

12 -

Yield (1 – T) 6.24% 8.96% 6.67%

Block, Hirt, Danielsen, Short

11-6. Kd

Aftertax Debt Cost Yield (1 – T)

Yield d. 8.0% e. 12.0% f. 10.6%

11-7.

(1 – T) (1 – .18) (1 – .34) (1 – .15)

Yield (1 – T) 6.56% 7.92% 9.01%

Aftertax Debt Cost Kd

11-8.

= = =

[Yield / (1 – F)] (1 – T) [10%/ (1 – 1%)](1 – .34) 6.67%

Goodsmith Charitable Foundation a. Kd = Yield (1 – T) Yield = 9% × 1.25 = 11.25% Kd b. Kd

11-9.

= 11.25% (1 – 0) = 11.25% (1) = 11.25% = 11.25% (1 – .30) = 11.25% (.70) = 7.875%

Waste Disposal Systems Kd = Yield (1 – T) Kd Y  .06  .06  0.0895  8.95% 1 - T  1  0.33 0.67

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11-10. a.

Octopus Transit

Annual interest payment  Principal payment - Price of the bond Number of years to maturity Y 1  0.6 Price of the bond  0.4 Principal payment  $1,000  $1,092 $75  $75  $9.20 10   0.0624  6.24%  0.6 $1,092  0.4 $1,000  $655.20  $400

Calculator:

Compute: b.

PV = $1,092 FV = $1,000 PMT = 75/2 = $37.50 N = 10 × 2 = 20 %I/Y =? %I/Y = 3.124 × 2 = 6.25% Kd

11-11. a.

= = = =

Yield (1 – T) 6.25% (1 – .35) 6.25% (.65) 4.063%

Russell Container Company

Annual interest payment  Principal payment - Price of the bond Number of years to maturity Y 1  0.6 Price of the bond  0.4 Principal payment  $1,000  $920 $95  $4 20   0.1040  10.40%  0.6 $920 0.4 $1,000 $552  $400 $95 

Calculator: Compute: b.

PV = $920 FV = $1,000 PMT = $95 N = 20 %I/Y =? %I/Y = 10.47%

K d (approx) = 10.40% (1 – T) K d = 10.40% (1 – .25) = 10.40% (.75) = 7.80%

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= = = =

Yield (1 – T) 10.47% (1 – .25) 10.47% (.75) 7.85%

Block, Hirt, Danielsen, Short

11-12.

Russell Container Company (Continued)

= = = =

Yield (1 – T) 11.47% (1 –.34) 11.47% (.66) 7.57%

b. It has gone down. Although the before-tax yield is higher, the larger tax deduction (34 percent versus 25 percent) more than offsets the higher rate.

11-13.

Terrier Company a.

Kd = Yield (1 – T) = 10% (1 – .40) = 10% (.60) = 6.00%

Kd(new) = Yield (1 – T) = 9% (1 – .25) = 9% (.75) = 6.75%

It has gone up. The before-tax yield is lower, but the lower tax rate reduces the tax benefit. The reduced tax benefit more than offsets the lower rate.

11-14.

Suncor

a. 3.20% b. 3.20% + 0.15% = 3.35% c. K d = = = =

Yield (1 – T) 3.35% (1 – .25) 3.35% (.75) 2.5125%

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11-15. a. K p 

Schuss Inc. Dp $7  $7    0.1228  12.28% P  F $60  $3 $57 p

b. No tax adjustment is required. Preferred stock dividends are not a tax deductible expense for the issuing firm.

11-16.

Meredith Corporation $8 p K D   0.1067  10.67% p Pp $75

11-17.

Radio Gaga Dp  $1.50  0.06  6.0% (yield only) K p  Pp $25

(flotation expense adjutment) K p 

Foundations of Fin. Mgt. 12Ce

K p

1 F

12 -



.06  0.0632  6.32% 1 0.05

Block, Hirt, Danielsen, Short

11-18.

Sutton Security Systems Aftertax cost of debt Kd = Yield (1 – T) = 10.5% (1 – .34) = 10.5% (.66) = 6.93% Aftertax cost of preferred stock Dp $4.40  $4.40  0.0917  9.17% Kp   Pp $50  $2 $48

Yes, the treasurer is correct. The difference is 2.24% (6.93% versus 9.17%).

11-19.

Ellington Electronics

$1.50 D1   0.08  0.05  0.08  0.1300  13.00% a. K e   g P0 $30 D  P   $30  0 1 b. K n   P  g  P   0.1300 $30  $2   0.1393  13.93%    0  n 

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11-20.

Cost of Equity

a. K e 

$4.60 D1  0.06  0.0767  0.06  0.1367  13.67% g  P0 $60

D  P   $60  0  1 n     g K P P  0.1367 $60  $4   0.1465  14.65%    0  n   

$0.25 D1   0.10  0.0125  0.10  0.1125  11.25% b. K e   g P0 $20  D1  P0  $20   Kn   P  g  P   0.1125 $20  $1.50   0.1216  12.16%    0  n 

 c. D1

K e 

30%  E1 = 30%  $6.00 = $1.80

$1.80 D1  0.045  0.072  0.045  0.1170  11.70% g P0 $25

D  P  $25   0 1 K   P  g P   0.1170 $25  $2.00   0.1272  12.72%    0  n  n

 d. D1 =

Do (1 + g) = $3.00  (1.07) = $3.21

$3.21 D1   0.07  0.0764  0.07  0.1464  14.64% g K e  P0 $42 D  P  $42   0 1 K   P  g P   0.1464 $42  $3.00   0.1577  15.77%    0  n  n

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Sam’s Fine Garments

11-21. 

a. FV IF Appendix A  Calculator: Compute:

PV FV

$1.87

 1.87@ n  6 : %i  11%

$1.00

PV = $1.00 FV = $1.87 N=6 %I/Y =? %I/Y = 10.996%

b. E1

= = =

E o (1 + g) $1.87 (1.11) $2.08

c. D1

= = =

E1  40% $2.08  40% $0.83

d. K e 



PMT = 0

$0.83 D1  0.1100  0.0553  0.1100  0.1653  16.53% g  P0 $15

D  P  $15   1 0 e. K n   P  g P   0.1653 $15  $1.75   0.1871 18.71%    0  n 

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11-22.

Tyler Oil Company Cost (after tax)

Debt (K d) ................................. 7.0% Preferred stock (K p) ................. 10.0 Common equity (K e) (retained earnings) ............. 13.0 Weighted average cost of capital (Ka)

11-23.

Weighted Weights Cost 35% 15

2.45% 1.50

50 100

6.50 10.45%

Tyler Oil Company (Continued) Cost (after tax)

Debt (K d) .................................. 8.8% Preferred stock (K p) ................. 10.5 Common equity (K e) (retained earnings) ............. 15.5 Weighted average cost of capital (Ka)

Weighted Weights Cost 60% 5

5.28% 0.53

35 100

5.43 11.24%

The plan presented in the previous problem is the better alternative. Even though the second plan has more relatively cheap debt, the increased costs of all forms of financing more than offset this factor.

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11-24.

Genex Corporation

= = = =

Yield (1 – T) 11% (1 – 0.30) 11% (.70) 7.7%

The bond yield of 11% is used rather than the coupon rate of 13% because bonds are priced in the market according to competitive yields to maturity. The new bond is sold to reflect yield to maturity. $10.00  $10.00  0.1081  10.81%  K p  Pp  F $98  $5.50 $92.50 Dp

K e 

D1 $3 g  0.08  0.06  0.08  0.1400  14.00% P0 $50

Cost (after tax) Debt (K d) .................................. 7.70% Preferred stock (K p) ................. 10.81 Common equity (K e) (retained earnings) ............. 14.0 Weighted average cost of capital (Ka)

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Weighted Weights Cost 35% 10

2.70% 1.08

55 100

7.70 11.48%

Block, Hirt, Danielsen, Short

11-25. Kd

Hadley Corporation Yield (1 – T) 7% (1 – .34) 7% (.66) 4.62%

= = = =

Dp $9.00  $9.00 K p  P  F  $102  $3.20  $98.80  0.0911  9.11% p

K e 

D1  g  $3.50  0.06  0.05  0.06  0.1100  11.00% P0 $70

Cost (after tax) Debt (K d).................................. 4.62% Preferred stock (K p)................. 9.11 Common equity (K e) (retained earnings)............. 11.00 Weighted average cost of capital (Ka)

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Weighted Cost Weights 30% 10

1.39% 0.91

60 100

6.60 8.90%

Block, Hirt, Danielsen, Short

11-26. Puppet Corporation a. Internally Generated funds Kd  Kp 

Y 1  T  .071  .35 .0455    0.0464  4.64% 1 F 1  0.02 0.98 Dp / Pp



1F

.05  .05   0.0515  5.15% 1  .03 0.97

D1  g  $1.50  0.06  0.05  0.06  0.1100  11.00% K e  P0 $30

Cost (after tax) Debt (K d).................................. 4.64% Preferred stock (K p)................. 5.15 Common equity (K e) (retained earnings)............. 11.00 Weighted average cost of capital (Ka)

Weighted Weights Cost 55% 5

2.55% 0.26

40 100

4.40 7.21%

b. Externally generated funds D1 g P0

 0.11  0.1146  11.46% K   0.11  n 1 F 1  0.04 0.96 

Cost (after tax) Debt (K d).................................. 4.64% Preferred stock (K p)................. 5.15 Common equity (K e) (new share issue)................ 11.46 Weighted average cost of capital (Ka)

Weighted Weights Cost 55% 5

2.55% 0.26

40 100

4.58 7.39%

c. A new share issue incurs flotation costs (use of investment dealer, lawyers, etc.). Internally generated funds only come from shareholders claim on earnings (and amortization). All new funding for debt, preferred and new common shares requires access to capital markets and thus flotation costs are incurred.

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11-27. Kd

Valvano Publishing Company Yield (1 – T) 13% (1 – .34) 13% (.66) 8.58%

= = = =

Dp $5.50  $5.50 K p  P  F  $50  $1.50  $48.50  0.1134  11.34% p

$5.50 0.1100  0.1134  11.34% or : Pp  $50  1  F  1  0.03 0.97 



$50 × 0.03= $1.50 K e 

$2.52 D1  0.11  0.056  0.11  0.1660  16.60% g P0 $45

Cost (after tax) Debt (K d).................................. 8.58% Preferred stock (K p)................. 11.34 Common equity (K e) (retained earnings)............. 16.60 Weighted average cost of capital (Ka)

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Weighted Weights Cost 35% 10

3.00% 1.13

55 100

9.13 13.26%

Block, Hirt, Danielsen, Short

11-28.

McNabb Construction Company

Kd = Yield (1 – T) = 10.5%/ (1 – 30) = 10.5% (.70) = 7.355% Kp = Dp/(Pp – F) = ($8.50/$90.00) / (1 – .02)= .0944/0.98 = .0964 = 9.64% Ke = (D1/P0)+ g D1 = $3.15 P0 = $98.44 g = 12% (see below) $.24/2.00 = 12.0% .27/2.24 = 12.1% .30/2.51 = 12.0% g = Calculator: PV =$2.00 FV = $3.15 PMT = 0 N=4 %I/Y or g =? Compute: %I/Y = 12.03% Ke = (D1/P0)+ g $3.15/$98.44 + 12.03% = 3.2% + 12.03% = 15.23%

Cost Weighted (after tax) Weights Cost 7.355% 30% 2.21% 9.64 10% 0.96

Debt (Kd)......................... Preferred stock (Kp) ........ Common equity (Ke) (retained earnings) ........ 15.23 60% Weighted average cost of capital (Ka)...........................................................

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9.14 12.31%

Block, Hirt, Danielsen, Short

11-29.

Western Electric Utility Company

a. Realize that the cost of debt is related to the cost of debt for other debt issues of the same risk class. Although, in actuality, the rate Western Electric might pay will not be exactly equal to Epcor, it should be close enough to serve as an approximation. Both are utilities that are rated A. Yield (1 – T) 2.84% (1 – .25) 2.84% (.75) 2.13%

Kd = = = =

b. K p 

c. Ke 

Dp Pp  F D1

g 



$9.00  $9.00   0.0914  9.14% $100  $1.50 $98.50

$4.50

 0.06  0.075  0.06  0.1350  13.50%

$60

Cost (after tax)

Debt (K d).................................. 2.13% Preferred stock (K p)................. 9.14 Common equity (K e) (retained earnings)............. 13.50 Weighted average cost of capital (Ka)

Foundations of Fin. Mgt. 12Ce

12 -

Weighted Weights Cost 40% 10

0.852% 0.91

50 100

6.75 8.512%

Block, Hirt, Danielsen, Short

11-30. a.

Eaton International Corporation X

Retained Earnings % of retained earnings in the capital structure

= $19.5 million/.65 = $30 million

b. Z 

Amount of lower cost debt % of debt in the capital structure

= $14 million/.25 = $56 million 11-31.

Nolan Corporation

Cost (after tax) Weights Debt (K d).................................. 5.60% Preferred stock (K p)................. 9.00 Common equity (K e) (retained earnings)............. 12.00 Weighted average cost of capital (Ka)

b. X  X 

WACC

45% 15

2.52% 1.35

40 100

4.80 8.67%

Retained earnings % of retained earnings in capital structure $12 million  $30 million .40

Cost (after tax) Weights Debt (K d).................................. Preferred stock (K p)................. Common equity (K n)................ Marginal cost of capital (K mc)

Foundations of Fin. Mgt. 12Ce

12 -

5.60% 9.00 13.20

45% 15 40 100

WACC 2.52% 1.35 5.28 9.15%

Block, Hirt, Danielsen, Short

d. Z  Z

Amount of lower cost debt % of debt within the capital structure $18 million  $40 million .45

Cost (after tax) Weights Debt (K d).................................. Preferred stock (K p)................. Common equity (K n)................ Marginal cost of capital (K mc)

Foundations of Fin. Mgt. 12Ce

12 -

7.20% 9.00 13.20

45% 15 40 100

WACC 3.24% 1.35 5.28 9.87%

Block, Hirt, Danielsen, Short

11-32.

Evans Corporation

Cost (after tax) Weights Debt (K d) .................................. 6.20% Preferred stock (K p) ................. 9.40 Common equity (K e) (retained earnings) ............. 12.00 Weighted average cost of capital (Ka)

b. X  X

WACC

30% 10

1.86% 0.94

60 100

7.20 10.00%

Retained earnings % of retained earnings in capital structure

$20 million

 $33.33 million

.60

Cost (after tax) Weights Debt (K d) .................................. 6.20% Preferred stock (K p) ................. 9.40 Common equity (K n) ................ 13.40 Marginal cost of capital (K mc)

d. Z  Z

WACC

30% 10 60 100

1.86% 0.94 8.04 10.84%

Cost (after tax) Weights

WACC

Amount of lower cost debt % of debt within the capital structure $36 million  $120 million .30

Debt (K d) .................................. 7.80% Preferred stock (K p) ................. 9.40 Common equity (K n) ................ 13.40 Marginal cost of capital (K mc)

Foundations of Fin. Mgt. 12Ce

12 -

30% 10 60 100

2.34% 0.94 8.04 11.32%

Block, Hirt, Danielsen, Short

11-33.

Eaton Electronic Company

= Rf. + β(Rm – Rf) = 7% + 1.6 (10% – 7%) = 7% + 1.6 (3%) = 7% + 4.80% = 11.80%

Ke 

$0.70 D1  g   0.08  0.0368  0.08  0.1168  11.68% $19 P0

Although the values almost equal in this example, that is not always the case.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Comprehensive Problems 11-34.

Medical Research Corporation Marginal Cost of Capital and Investment Returns Yield (1 – T) 11% (1 – .30) 11% (.70) 7.70% $0.90 K  D1  g   0.11  0.036  0.11  0.1460  14.60% e $25 P0

a. K d = = = =

Cost (aftertax) Weights Debt (K d).................................. 7.70% Common equity (K e) (retained earnings)............. 14.60 Weighted average cost of capital (Ka) b. X  X 

WACC

40%

3.08%

8.76 11.84%

Retained earnings % of retained earnings in capital structure $15 million  $25 million .60

D  P   $25  0 1 c. K n   P  g P   0.1460 $25  $3   0.1659  16.59%    0  n  Cost (aftertax) Weights Debt (K d).................................. Common equity (K n)................ Marginal cost of capital (K mc)

Foundations of Fin. Mgt. 12Ce

12 -

7.70% 16.59

40% 60

WACC 3.08% 9.95 13.03%

Block, Hirt, Danielsen, Short

d. Z  Z

Amount of lower cost debt % of debt within the capital structure $20 million  $50 million .40

e. First compute the new value for K d Kd = Yield (1 - T) = 13% (1 – .30) = 13% (.70) = 9.10% Cost (aftertax) Weights Debt (K d).................................. Common equity (K n)................ Marginal cost of capital (K mc)

WACC

9.10% 16.59

40% 60

3.64% 9.95 13.59%

Return on Investment

Marginal Cost of Capital

f. The answer is $ 50 million.

1st $25 million $25 million – $50 million $50 million – $75 million $75 million – $100 million

Foundations of Fin. Mgt. 12Ce

18.0% 14.0% 11.8% 10.9%

12 -

> > < <

11.84% 13.03% 13.59% 13.59%

Block, Hirt, Danielsen, Short

Medical Research Corporation 20.00%

18.00%

16.00%

14.00%

Kmc 12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00% 25

100

Amount of capital required (millions)

Top of bar represents return on investment Dotted line represents marginal cost of capital (K mc) Invest up to $50 million

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

11-35.

Masco Oil and Gas Company Cost of Capital with Changing Financial Needs

a. The before tax cost of debt will be equal to the market rate of 12.1%. The student must realize that the historical cost of the three bonds does not influence the cost of debt. Yield (1 – T) 12.1% (1 – .4) 12.1% (.60) 7.26%

Kd = = = =

b. The fact that the preferred stock carries a coupon rate of 7.5% does not influence K p, which is dependent upon current prices and the dividend. Dp $7.80  $7.80 K p  P  F  $80  $2.50  $77.50  0.1006  10.06% p

$1.90 c. K  D1  g   0.08  0.0475  0.08  0.1275  12.75% e $40 P0  D  P  $40   0 1 d. K n   P  g P   0.1275 $40  $2.20   0.1349  13.49%    0  n  e. Only those sources of capital that are expected to be used as long-run optimum components of the capital structure should be included in the weighted average cost of capital. The firm states that all their funds can be supplied by retained earnings (50%); therefore, we do not need to include new common stock or preferred stock in our calculation of the weighted cost of capital.

Cost (aftertax) Weights Debt (K d).................................. 7.26% Common equity (K e)................ 12.75 Weighted average of capital (Ka)

Foundations of Fin. Mgt. 12Ce

12 -

50% 50

WACC 3.63% 6.37 10.00%

Block, Hirt, Danielsen, Short

11-36.

River Runs Ltd.

Debt: Market Value

PVA = A × PVIFA (N = 12, I/Y = 12%) (Appendix D) = 8% × $10,000,000 × 6.194 = $4,955,200 PV = FV × PVIF (N = 12, I/Y = 12%) (Appendix B) = $10,000,000 × 0.257 = $2,570,000 Total = $4,955,200 + $2,570,000 = $7,525,200

Calculator:

PV =? FV = $10,000,000 PMT = $800,000 N = 12 %I/Y = 12% PV = $7,522,250

Compute: Cost

= [Y × (1 – T)]/ (1 – F) = [12% × (1 – .40)]/ (1 – .035) =

7.46%

Preferreds: Market Value: P  D p  $2,000,000  0.06  $1,200,000 p Kp 0.10 .10  0.1042  10.42% Cost: K  Yield  .10  p 1  F  1  0.04 0.96

Equity:

Market Value:

= $11 × 1,000,000 shares outstanding = $11,000,000 Cost (new shares required) D  P   $0.75  .12 $11   0 1 n      $10.50  $10.50  .05      g $11 K P P    0  n   $11  .1882  0.2075  20.75% $9.975

Overall: Market Value Weighting Cost Debt $ 7,522,250 .3814 .0746 Preferreds 1,200,000 .0609 .1042 Equity 11,000,000 .5577 .2075 $19,722,250 1.0000 River Runs Cost of Capital = 15.05%

Foundations of Fin. Mgt. 12Ce

12 -

Overall .0285 .0063 .1157 .1505

Block, Hirt, Danielsen, Short

11-37.

Island Capital

Bonds: Market Value PVA = A × PVIFA (n = 18, %I/Y = 11%) (App. D) = 8% × $20,000,000 × 7.702 = $12,323,200 PV = FV × PVIF (n = 18,% I/Y = 11%) App. B = $20,000,000 × 0.153 = $3,060,000 Total = $12,323,200 + $3,060,000 = $15,383,200 Calculator: Compute: Cost

PV =? FV = $20,000,000 N = 18 %I/Y = 11% PV = $1 5,379,030 = = =

PMT = $1,600,000

[Y/ (1 – F)] (1 – T) [11% / (1 – .025)] (1 – .39) 6.88%

Perpetuals: Market Value: P  D p  $4,000,000 0.09  $4,500,000 p Kp 0.08 Dp $50  0.08  $4.00 K p  P  F  $50  $50  0.03  $48.50  0.0825  8.25% p

Cost:

$4.00 0.0800  0.0825  8.25% or : Pp  $50  1  F  1  0.03 0.97 



Equity:

Market Value: = $18 × 4,000,000 shares outstanding = $72,000,000 Cost: (internally generated funds sufficient)

D1  g  $1.75  0.07  0.0972  0.07  0.1672  16.72% Ke  P0 $18

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short



a. Overall: Market Value Debt $15,379,030 Preferreds 4,500,000 Equity 72,000,000 $91,879,030

Weighting .1674 .0490 .7836 1.0000

Island Capital’s Cost of Capital

Cost .0688 .0825 .1672

Overall .0115 .0040 .1310 .1465

= 14.65%

b. Cost: if new shares required are required flotation costs and a price under-pricing will occur for new shares, raising the cost to the firm. D  P  $18   0  1 n   K P  gP  0.1672 $17.50  $17.50  0.05   0.1810  18.10%    0  n 



Overall: Market Value Debt $15,379,030 Preferreds 4,500,000 Equity 72,000,000 $91,879,030

Weighting .1674 .0490 .7836 1.0000

Island Capital’s Cost of Capital

Foundations of Fin. Mgt. 12Ce

12 -

Cost .0688 .0825 .1810

Overall .0115 .0040 .1418 .1573

= 15.73%

Block, Hirt, Danielsen, Short

11-38.

Trois-Rivieres Manufacturing

Note:Semiannual payments; $10,000,000 × 0.10 × ½ Debt: Market Value PVA = A × PVIFA (n = 16, %I/Y = 6%) (App. D) = 5% × $10,000,000 × 10.106 = $5,053,000 PV = FV × PVIF (n = 16, %I/Y = 6%) (App. B) = $10,000,000 × 0.394 = $3,940,000 Total = $5,053,000 + $3,940,000 = $8,993,000

Calculator: Compute: Cost

PV =? FV = $10,000,000 PMT = $500,000 N = 8 × 2 = 16 %I/Y = 12%/ 2 = 6% PV = $8,989,410 = = =

Preferreds: Market Value

[Y/ (1 – F)] (1 – T) [12.36% / (1 – .04)] (1 – .38) 7.98% Pp = $26.50 × 100,000 shares o/s = $2,650,000

Cost: Dividend =$2,500,000 × .075 ÷ 100,000 shares = $1.875 Dp $2,500,000  0.075  $187,500 K p  P  F  $2,650,000  $2,650,000  0.05  $2,517,500  7.45% p

$1.875 0.0708  0.0745  7.45% or : Pp  $26.50  1  F  1  0.05 0.95 



Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Equity:

Market Value

= =

$15 × 600,000 shares o/s $9,000,000

Cost: (new shares required) g = Calculator: PV = –$0.80 FV = $1.23 PMT = 0 N=5 %I/Y or g =? Compute: %I/Y = 8.98% D  P   $1.231.0898  .0898 $15.00   0    1 n   $15.00  $15.00  .07     g $15 K P P    0  n   $15  0.1927  19.27%  0.0894  0.0898 $13.95

Overall: Market Value Debt $ 8,989,410 Preferreds 2,650,000 Equity 9,000,000 $20,639,410

Weighting .4355 .1284 .4361 1.0000

Cost .0798 .0745 .1927

Overall .0348 .0096 .0840 .1284

Trois Rivieres’ Cost of Capital = 12.84%

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Murchie’s

11-39. a. Debt: Market Value

= $10,000,000 × 1.15 = $11,500,000

Effective Yield: Calculator: PV = 115 FV = 100 PMT = 12/ 2 = 6 N = 15 × 2 = 30 %I/Y = ? Compute: %I/Y = 5.0218% (semiannual) Annual yield

= =

(1 + .050218)2 – 1 0.1030 or 10.30%

Cost:

= = =

[Y/ (1 – F)] (1 – T) [10.30%/ (1 – .03)] (1 – .43) 6.05%

Note: This a subtle difference between the semiannual yield and annual cost. Perpetual bonds: Market Value: P  D p  $2,000,000 0.09  $1,500,000 p 0.12 Kp Cost (if tax deductible): Yield .12 K p  1  T   1  0.43  0.12500.57  7.13% 1  F  1  0.04 Equity:

Market Value

= =

$4.50 × 750,000 shares o/s $3,375,000

Cost (new shares required) D  P   $0.10  $4.50  0 1 K n   P  g P    $4.50  .15 $4.10   0  n      0.0222  0.151.0976  0.1890  18.90%

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Overall: Market Value Debt $11,500,000 Perpetual Bonds 1,500,000 Equity 3,375,000 $16,375,000

Weighting .7023 .0916 .2061 1.0000

Cost .0605 .0713 .1890

Overall .0425 .0065 .0390 .0880

Cost .1062 .1250 .1890

Overall .0746 .0115 .0390 .1251

Murchie’s Cost of Capital = 8.80% b. Overall: Market Value Debt $11,500,000 Perpetual Bonds 1,500,000 Equity 3,375,000 $16,375,000

Weighting .7023 .0916 .2061 1.0000

Murchie’s Cost of Capital (without tax savings on debt) = 12.51% K d = 10.30%/ (1 – .03) = 10.62% (Perpetual Bonds)K d = 12%/ (1 – .04) = 12.50% c. Murchie‘s is highly leveraged. It is taking a chance with lots of debt, particularly in a risky business. Murchie‘s however seems to be getting away with it as the suppliers of capital, primarily through debt, have not yet demanded higher yields. Tax savings from debt are being well utilized providing there is sufficient cash flow to service the debt and income to take advantage of the tax savings. However, the share price appears depressed. A firm with volatile earnings and cash flow should stay away from highly leveraged positions (unless the bankers haven‘t caught on).

d. The weighted average cost of capital can be used assuming new acquisitions will be financed in the same proportions as in the calculation, and the new acquisitions are of the same risk as the average of Murchie‘s present assets. The possibility of the new acquisitions being of the same risk seems highly unlikely given that diversification is the objective. Diversification by its nature requires a portfolio of different risk assets. Furthermore the cost of capital may be affected by the risk reduction of Murchie‘s through diversification.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Problems: Appendix 11-A 11A-1. a.

Kj = Rf + βj (Rm – Rf) = 4% + 0.7(8 % – 4%) = 4% + 0.7(4%) = 4% + 2.8% = 6.8%

Kj = 4% + 1.4(8% – 4%) = 4% + 1.4(4%) = 4% + 5.6% = 9.6%

Kj = 4% + 1.7(8% – 4%) = 4% + 1.7(4%) = 4% + 6.8% = 10.8%

Kj = 7% + 0.7(6.5%) = 7% + 4.55% = 11.55%

Kj = 7% + 1.4(6.5%) = 7% + 9.1% = 16.1%

Kj = 7% + 1.7(6.5%) = 7% + 11.05% = 18.05%

11A-2.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

11A-3.

Kj = Rf + βj (Rm – Rf) = 7% + 1.2(13% – 7%) = 7% + 1.2(6%) = 7% + 7.2% = 14.2% P1 = $15 + 14.2% × $15 (no dividends) = $17.13

11A-4.

Kj = Rf + βj (Rm – Rf) = 4.75% + 1.15(6.90%) = 4.75% + 7.935% = 12.685% With no capital appreciation g = 0. One period time frame P0 = D1/ Kj = $1.80/ 12.685% = $14.19

11A-5.

Therefore

Kj = Rf + βj (Rm – Rf) Rm Rm – Rf Rf

= 16% = 7% = Rm – 7% = 16% – 7% = 9%

Kj = 9% + 1.05(7%) = 9% + 7.35% = 16.35%

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

11A-6. a.

Cranberry Dreams Kj

= = = =

Rf + βj (Rm – Rf) 2.50% + 1.75(6%) 2.50% + 10.5% 13%

b. An expected return of 11% suggests that you will not be adequately compensated for the risk you are assuming (CAPM suggests 13% is adequate). Sell Cranberry Dreams. If the return is less than adequate the price of shares should fall until the return is appropriate given the risk assumed.

11A-7.

Austen Sensibles Ltd,

Debt: Cost

Kd = = =

Y (1 – T) 11.00% (1 – .44) 6.16%

Preferreds: Cost K p

= = =

Dp/ (Pp – F) 8% / (1 – .05) 8.42%

Equity: Cost

= = = = =

Rf + βj (Rm – Rf) 8.5% + 0.9 (16% – 8.5%) 8.5% + 0.9 (7.5%) 8.5% + 6.75% 15.25%

Overall: Market Value Debt n.a Preferreds n.a Equity n.a n.a

Weighting .3500 .1000 .5500 1.0000

Austen Sensible’s Cost of Capital

Foundations of Fin. Mgt. 12Ce

12 -

Cost .0616 .0842 .1525

Overall .0216 .0084 .0839 .1139

= 11.39%

Block, Hirt, Danielsen, Short

11A-8.

Huron Ltd.

Debt: Market Value D)

PVA = A × PVIFA (n = 14, %i = 9.5) (Appendix = 16% × $30,000,000 × 7.572 = $36,345,600 PV = FV × PVIF (n = 14, i = 9.5%) (Appendix

Total

Calculator:

= $30,000,000 × 0.281 = $8,430,000 = $36,345,600 + $8,430,000 = $44,775,600

Compute:

PV =? FV = $30,000,000 PMT = $4,800,000 N = 14 %i = 9.5% PV = $44,765,111

Cost:

= [Y / (1 – F)] (1 – T) = [9.5% / (1 – .04)] (1 – .40) = 5.94%

Preferreds: Market Value: P  D p  $3,000,000 0.08  $3,692,308 p 0.065 Kp

Equity:

Cost: K  Yield  .065  0.0684  6.84% p 1  F  1  0.05 Market Value = $15.50 × 3,600,000 shares o/s = $55,800,000 Cost: (internal funds) K j  R f  β j Rm - R f 

 0.05  1.25 0.08  0.05  0.10  0.15  15%

a. Overall:

Market Value

Foundations of Fin. Mgt. 12Ce

Weighting 12 -

Cost

Overall

Block, Hirt, Danielsen, Short

Debt $ 44,765,111 Preferreds 3,692,308 Equity 55,800,000 $104,257,419 Huron’s Cost of Capital

.4294 .0354 .5352 1.0000 = 10.82%

.0594 .0684 .1500

.0255 .0024 .0803 .1082

b. Prime plus 1 percent is 8% and would be an adequate return if all financing came from the bank and is short term. However the bank‘s lending rate is probably based on the conservatively financed capital structure of Huron. If the equity position was to be changed from over 50 percent in the future the bank would likely require a slightly higher rate on its loans. Furthermore the equity holders demand a return of 15 percent and projects that only return 8 percent will eventually disappoint the shareholders, despite the use of debt that lowers the cost of capital to 10.82 percent. The investor will be disappointed if projects returning less than 10.82 percent are accepted given the present capital structure.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

11A-9.

Orbit Corp.

Demand loans: Market Value: We assume that the market value is the same as the book value because these loans have interest rates that float with current market yields and are payable anytime.

= (Prime + 1%) (1 – T) = (9.5% + 1%) (1 – .23) = 10.5% (.77) = 8.09%

Cost:

Debt: Market Value: PVA = A × PVIFA (N = 12, %I/Y = 12) (App. D) = 8% × $12,000,000 × 6.194 = $5,946,240 PV = FV × PVIF (N = 12, %I/Y = 12) (App. B) = $12,000,000 × 0.257 = $3,084,000 Total = $5,946,240 + $3,084,000 = $9,030,240 Calculator: Compute: Cost

PV =? FV = $12,000,000 N = 12 %I/Y = 12% PV = $9,026,700

PMT = $960,000

[Y/ (1 – F)] (1 – T) [12% / (1 – .05)] (1 – .23) 12.63% (.77) 9.73%

= = = =

Preferreds: Market Value: P  D p  $7,000,000 0.06  $3,818,182 p Kp 0.11 Cost: K  Yield  .11  0.1170  11.70% p 1  F  1  0.06 Equity: Market Value:

= =

$25 × 5,000,000 shares o/s $125,000,000

Cost (new shares required):

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

P   $25 K  R  β R - R  0  0.085  1.7 0.09   f  P   $25  $25  0.08 j f j m  n  $25  0.085  0.153  0.2381.08696  0.2587  25.87% $23 R f  β j Rm - R f  0.238 0.238   .2587  25.87% or :  1  F  1  0.08 0.92

a. Overall: Market Value Loans $ 3,000,000 Debt 9,026,700 Preferreds 3,818,182 Equity 125,000,000 $140,844,882

Weighting .0213 .0641 .0271 .8875 1.0000

Orbit’s Cost of Capital

= 24.07%

Cost .0809 .0973 .1170 .2587

Overall .0017 .0062 .0032 .2296 .2407

b. No. A growth company with good prospects (lots of projects with NPV > 0) should maintain generated cash flow in the corporation. Based on projects which exceed investor expectations the corporation is likely to do better with the cash flow than the shareholder who would have to invest dividends elsewhere. A growth company will attract shareholders (clientele) expecting capital appreciation not dividends. Dividends might change their perceptions of the company.

c. Use more debt. Almost 90 percent of Orbit Corp. is financed with equity. This forces the cost of capital higher requiring investments to surpass the high cost of capital to be acceptable. Debt is cheaper and also has the advantage of tax savings because the interest can be expensed for tax purposes. Initial levels of lower priced debt will not greatly increase the corporation‘s risk or the costs of the components of the capital structure. Therefore through averaging, the cost of capital will be lowered which will prove beneficial to shareholders. Discussion Questions Foundations of Fin. Mgt. 12Ce

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14-1. The major competitors are the federal government, federal crown corporations, the provinces, provincial crown corporations, municipalities, and the private sector. 14-2. When the economy is healthy and growing, tax revenues increase causing the government deficit to shrink and therefore reduce the amount of funds the finance department must raise. However, when the economy is in a recession, tax revenues decline, and deficits increase. If the government tries to stimulate the economy by increasing spending, the likely effect will be to create larger deficits in the short run and a much greater need for financing. 14-3. The average maturity on the federal government debt by 2017 had increased to about 6 years from under 4 years in 1989. Shorter terms cause a regular rollover of the debt and may cause a certain amount of market instability. 14-4. As the federal government reduces its accumulated debt we had seen the corporate sector (and individuals) step into the vacuum and increase their debt loads. There also has been decreased pressure on interest rates and we have seen rates decline. For investors and corporate treasurers there has been a decreased supply of government obligations. This has caused some disruptions in the financial markets and caused investors to accept the greater risk of corporate securities. As governments returned to borrowing competition for funds increased but with limited inflation interest rates had only shown modest upward pressure in 2017. 14-5. On average bonds and stocks have been used in equal proportions to fund external debt of Canadian corporations although there has been a wide variance from year to year and more use of debt in the last few years (Figure 14-6). Preferreds although significant have been a less significant source of funds to corporations during this period. 14-6. On average internally generated funds have provided between 60 to 80 percent of corporate funding requirements. Borrowed funds for expansion have tended to be balanced between debt and equity although the last decade has seen more significant debt borrowings. 14-7. In a three-sector economy consisting of business, households, and government, financial intermediaries such as banks, trust companies, insurance companies, mutual funds, pension funds, and credit unions provide the mechanism for reallocating funds from one surplus sector to a deficit sector. These institutions indirectly invest excess funds in areas of the economy where funds are needed.

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14-8. First, they enable corporations to raise funds by selling new issues of securities rapidly and at fair competitive prices for reinvestment in real assets. Second, they allow the investor who purchases securities to sell them with relative ease and speed and thereby to turn a paper asset into cash (they provide liquidity). Third, the market allocates capital to the most efficient users (some would argue that governments get allocated capital regardless of efficiency) and as such provide a barometer as to which companies are managing their assets best. Price will reflect that judgment. 14-9. The organized exchanges have one central location and operate as auction markets. The over-the-counter markets have no central location; instead a network of dealers all over the country is linked by computer display terminals, telephones, and teletypes. 14-10. Listing requirements provide some assurance to the investor that corporations trading on a specific exchange can meet demonstrated requirements as to income, number of shareholders, total asset value, and number of shares outstanding. The TSX has the strictest listing requirements as identified on its‘ website www.tmx.com. 14-11. Markets that: (1) are liquid, (2) have prices that react quickly to new information and (3) have prices that to a great extent reflect all available information. (NPV = 0). Proper compensation for risk assumed. 14-12. The weak form of efficient markets simply states that past price information is unrelated to future prices and that since no trends are predictable, investors cannot take advantage of them. The semi-strong form states that prices reflect all public information, while the strong form states that all information, both public and private, is reflected in the stock prices. 14-13. By abnormal profits (losses) we describe returns above (below) what the market anticipates given the risk assumed in a financial investment. NPV is greater (or less than) zero. 14-14. Discussion could center on the number of buyers and sellers, liquidity, degree of analysis, newspaper reporting, securities regulation, minimal transaction costs, and perceptions of a fair game by investors. Anything that aids information flow and its reflection in share prices. 14-15. Any tests the student suggests that relate abnormal profits to a theory are worth discussing. Included could be insider trading, the January effect, corporate announcements such as share repurchases, the crash of 1987, the speculative bubbles of the late 1990s, 2008 and so on.

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14-16. The ‗four pillars of finance‘ structure was an attempt to reduce the possibility of conflict of interest when managing other people‘s money. However, changes in the rules governing the separation of functions have been made as a concession to the reality of a globalized market. Whether the historically feared conflicts can be avoided remains to be seen. 14-17. The implications of the changing financial structure are enormous, with large financial institutions in all facets of the capital, money and retail markets. There are smaller boutique investment dealers and foreign-based institutions with large capital backing. Investment dealers have merged to raise substantial amounts of new capital or have specialized. Banks for example are in all areas of what formerly were the ―four separate pillars‖. 14-18. This is a library or internet assignment. It is likely that the business pages of any current newspaper would have noteworthy information on the changing financial environment. The regulatory environment has been strengthened to deal with the accounting scandals of the last number of years.

Internet Resources and Questions www.tsx.com/listings/listing-with-us/listing-guides www.nyse.com https://listingcenter.nasdaqomx.com/Show_Doc.aspx?File=listing_information.html a.

b. c.

No. Discuss the changes that have occurred related to the consolidation of exchanges in Canada and the pressures brought to bear in the international markets. Listing requirements including costs are less onerous. Also perceived as a more ―with it‖ exchange, particularly in the hi-tech area. Greater liquidity and access to the broader capital market. Also, many Canadian firms do most of their business on the world stage and often their cash flows are in $U.S.

http://cipf.ca/Public/CIPFCoverage.aspx https://www.cdic.ca/your-coverage/

Discussion Questions 15-1. The investment dealer is a risk taker (underwriter) when it agrees to buy the securities from the corporation and resell them to other security dealers and the public. 15-2. Market stabilization activities are managed in an attempt to ensure that the market price will not fall below a desired level during the distribution process. Syndicate members committed to purchasing the stock at a given level could be in trouble if there is a rapid decline in the price of the stock. This sometimes occurs despite careful calculations by the investment dealer.

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15-3. By forming a syndicate of many underwriters rather than just one, the overall risk is diffused and the capabilities for widespread distribution are enhanced. In the British Petroleum example, Canadian and U.S. securities firms faced huge losses because they formed only small syndicates to serve their national markets. On the other hand, the British syndicate consisted of many hundred firms so that no one faced enormous losses. 15-4. Common stocks often carry a larger underwriting spread than bonds because the market reaction to stocks is more uncertain. Bonds also may be offered in larger units, and thus carry economies of scale. 15-5. The price is determined by the firm‘s industry, its financial characteristics, and the firm‘s anticipated earnings and dividend-paying capability. Based on appropriate valuation techniques, a price will be tentatively assigned and will be compared to that enjoyed by similar firms in a given industry. If the industry‘s price-earnings ratio is 12, the firm should not stray too far from the norm. Anticipated public demand will also be a major factor in pricing a new issue. 15-6. Due to underpricing by the investment dealer, there is often a positive excess return immediately after the offering. With the passage of time, the efficiency of the market begins to become evident and long-term sustainable performance is very much dependent on the quality of the issue and market conditions. 15-7. Unlike most other countries, in Canada the major investment dealers have vertically integrated for a long time. However, for firms which had weak representation in the retail end of the business, mergers with firms that were particularly strong in retail and weak in underwriting have made sense. Foreign subsidiaries, traditionally operating on the retail side of the business, are now poised to move into underwriting. The chartered banks have operations in retail and the lucrative area of investment underwriting.

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15-8. The benefits of having a publicly traded security are: a. Greater ability to raise capital. b. Additional prestige and visibility that can be helpful in bank negotiations, executive recruitment, and the marketing of products. c. Increased liquidity for existing shareholders. d. Ease in estate planning for existing shareholders. e. An increased capability to engage in the merger and acquisition process. 15-9. There are number of disadvantages to being public which cause corporations to remain privately held. These are: a. All information must be made available to the public through securities commission filings. This can be very expensive for a small company. b. The president must be a public relations representative to the investment community. c. Tremendous pressure is put on the firm for short-term performance. d. Large downside movement in the stock can take place in a bear market. e. The initial cost of going public can be very expensive for a small firm. 15-10. Funds for private placement can be found through insurance companies, pension funds, and wealthy individuals. 15-11. The use of a leveraged buyout implies that either management or some other investor group borrows the needed cash to repurchase all the shares of the company. After the repurchase, the company exists with a lot of debt and therefore heavy debt servicing charges. To reduce the debt load, assets may be sold off to generate cash. Also, returns from asset sales may be redeployed into higher return areas. 15-12. Because of the extremely heavy debt load associated with leveraged buyouts, management must initiate strategies aimed at generating cash flow quickly in order to pay down the debt before its economic sector goes into recession (by their nature leveraged buyouts happen in mature, recession prone sectors of the economy). Thus, the strategy is usually short-term, efficiency oriented. 15-13. There have been spectacular failures with wasted resources but there have been reorganizations for increased efficiencies and the removal of entrenched conservative management. Moreover, answers may vary according to students‘ viewpoint. The impact on the economy remains unresolved.

Internet Resources and Questions 1. www.tsx.com/news/new-company-listings www.sedar.com/new_docs/new_en.htm

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Problems 15-1.

Midas and Company a.

$15.60 15.00 $ 0.60 Return 

Monies received (spread)  $0.60   0.04  4.00% $15.00 Capital invested

$16.00 15.00 $ 1.00 Return 

Selected dealer group's price Managing investment dealer's price Differential

Broker's price Managing investment dealer's price Differential

Monies received (spread)  $1.00   0.0667  6.67% $15.00 Capital invested

$16.50 15.00 $ 1.50 Return 

Public price Managing investment dealer's price Differential

Monies received (spread)  $1.50   0.10  10.00% Capital invested $15.00

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Block, Hirt, Danielsen, Short

15-2.

Walton and Company a.

$18.80 18.00 $ 0.80 Return 

Monies received (spread)  $0.80   0.0444  4.44% Capital invested $18.00

$19.20 18.00 $ 1.20 Return 

Selected dealer group's price Managing investment dealer's price Differential

Broker's price Managing investment dealer's price Differential

Monies received (spread)  $1.20   0.0667  6.67% $18.00 Capital invested

$19.50 18.00 $ 1.50

Return 

Public price Managing investment dealer's price Differential

Monies received (spread)  $1.50   0.0833  8.33% $18.00 Capital invested

15-3.

Canadian Loonie Company a. Spread = $20.95 – $20.00 = $0.95 Spread cost 

$0.95  0.0453  4.53% $20.95

b. Spread = $1,001 – $998 = $3 $3.00 Spread cost = = 0.0030 = 0.3% $1,001

c. The shares have the larger spread which is normal given the greater risk to the underwriter inherent in an equity issue.

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15-4.

Solar Energy Corp. $5,000,000 Earnings per share (eps)   $2.50 2,000,000 eps × price earnings multiplier = suggested price to public $2.50 × 18 = $45 The underwriting spread does not alter the suggested price to the public, only what the firm nets. Public Price 5% Spread Net amount received

15-5.

$45.00 – 2.25 $42.75

Tiger Golf Supplies Earnings per share (eps) 

$15,000,000

 $3.75

4,000,000

eps × price earnings multiplier = suggested price to public $3.75 × 22 = $82.50 The underwriting spread does not alter the suggested price to the public, only what the firm nets. Public Price 2.8% Spread Net amount received

Foundations of Fin. Mgt. 12Ce

$82.50 – 2.31 $80.19

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15-6.

Gum Shoe Detective Agency a. Spread = $40.00 – $35.80 = $4.20 Underwriting spread 

$4.20  0.105  10.50% $40.00

b. Spread = $40.00 – $36.90 = $3.10 Underwriting spread 

$3.10  0.0775  7.75% $40.00

c. Spread = $40.00 – $38.45 = $1.55 Underwriting spread 

$1.55  0.03875  3.875% $40.00

The principle demonstrated is the larger the offer size, the lower the underwriting spread.

15-7.

Power Temporaries a. Earnings per share (eps) 

$4,500,000

 $2.50

1,800,000

b. Earnings per share(eps) 

$4,500,000

 $2.05

2,200,000

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15-8.

New Brunswick Timber Company a. Earnings per share (eps) 

$9,000,000

 $1.80

5,000,000 Earnings per share (eps) 

$9,000,000

 $1.50

6,000,000

Dilution = $1.80 – $1.50 = $0.30 per share.

b. Net income

= $9,000,000 + 0.11 ($1,000,000  $40) = $9,000,000 + 0.11 ($40,000,000) = $9,000,000 + $4,400,000 = $13,400,000

Earnings per share after additional income: Earnings per share (eps) 

$13,440,000

 $2.24

6,000,000

Based on the current year‘s results, the public offering should be undertaken. E.P.S. will increase from $1.80 to $2.24. Of course, other variables may also be considered.

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15-9.

Hamilton Corporation $6,000,000 a. Earnings per share (eps)   $1.50 4,000,000 Earnings per share (eps) 

$6,000,000

 $1.20

5,000,000

Dilution = $1.50 – $1.20 = $0.30 per share. b. Net income

= $6,000,000 + 0.105 ($1,000,000  $30) = $6,000,000 + 0.105 ($30,000,000) = $6,000,000 + $3,150,000 = $9,150,000

Earnings per share after additional income: Earnings per share (eps) 

$9,150,000

 $1.83

5,000,000

Based on the current year‘s results, the public offering should be undertaken. E.P.S. will increase from $1.50 to $1.83. Of course, other variables may also be considered. 15-10.

Hamilton Corporation (Continued) Net income

= $6,000,000 + 0.06 ($1,000,000 × $23) = $6,000,000 + $1,380,000 = $7,380,000

Earnings per share after additional income $7,380,000 Earnings per share (eps)   $1.476 5,000,000 No, E.P.S. would decline by 2 cents from $1.50 to $1.48.

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15-11.

Carma S. Diego Travelers Corp.

a. Earnings per share before share issue: $18,000,000 Earnings per share(eps)   $1.80 10,000,000 Earnings per share after share issue: $18,000,000 Earnings per share(eps)   $1.64 11,000,000 Dilution = $1.80 – $1.64 = $0.16 per share.

b. Net income

= $18,000,000 + 0.12 (1,000,000 × $9) = $18,000,000 + 0.12 ($9,000,000) = $19,080,000

Earnings per share after additional income $19,080,000 Earnings per share(eps)   $1.73 11,000,000 Do not undertake the public offering as EPS decreases ($1.80 to $1.73).

c. Net income

= $18,000,000 + 0.12 (1,000,000 × $16) = $19,920,000 $19,920,000 Earnings per share(eps)   $1.81 11,000,000

Undertake the public offering as EPS increases ($1.80 to $1.81).

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15-12. a.

Macho Tool Company

Earnings per share before share issue $48,000,000/12,000,000 = $4.00 Earnings per share after share issue $48,000,000/$16,000,000 = $3.00

Note only four million new corporate shares were issued. The other two million belonged to founding shareholders and do not increase the number of shares outstanding.

EPS P/E Share price

$ 3.00 × 20 $60.00

The founding shareholders will probably not be pleased. They received a net price of $50 and the stock has a value of $60.00 immediately after the offering. They may wish the initial offering price had been higher.

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15-13.

Trump Card Company

a. $32 (Public price) –$29.20 (net proceeds) = $2.80 Underwriting spread 

$2.80  0.0875  8.75% $32.00

b. Spread established at $2.20 Underwriting spread  c.

$2.20  0.0688  6.88% $32.00

Public Price $32.00 2.5% Spread .80 Net Amount Received $31.20

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15-14.

Winston Sporting Goods

a. Spread = $18.00 – $16.50 = $1.50 Underwriting spread 

$1.50  0.0833  8.33% $18.00

b. Total expenses = ($1.50  600,000 shares) + $150,000 (out-ofpocket) = $900,000 + $150,000 = $1,050,000 = 600,000 shares  $18 = $10,800,000

Total value

Total spread  Total expenses  $1,050,000  0.0972  9.72% Price to public $10,800,000

c. Amount needed (net) = $18,000,000 $18,000,000  issue costs Net price per share $18,150,000   1,100,000 shares $16.50

Needed shares 

15-15.

DUR Semiconductors

a. Spread = $18.00 – $16.55 = $1.45 Spread 

$1.45  0.0806  8.06% $18.00

b. Spread 

$0.85  0.0472  4.72% $18.00

c. Public Price $18.00 3% Spread – 0.54 Net amount received $17.46 15-16. Becker Brothers

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Original Distribution: 10%  1,000,000 = 100,000 $ 1.40 $140,000

shares for Becker profit per share profit on original distribution

Market Stabilization: 40,000 $ 2.75 $110,000 Gain on original distribution Loss on market stabilization Net gain

15-17.

shares for Becker loss per share ($25.75 – $23.00) loss on market stabilization $140,000 110,000 $ 30,000

Ashley Homebuilding 80% of the S&P/TSX Composite Index = 80%  15 = 12 Industry Comparisons: Growth rate in earnings per share: superior Consistency of performance: superior Debt to total assets: inferior Turnover of product: inferior Quality of management: superior

+ 0.5 + 0.5 – 0.5 – 0.5 + 0.5 + 0.5

Initial P/E ratio = 12 + 0.5 = 12.5

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15-18.

A. Einstein & Co. D1 $1.44  $1.44  $36.00 a. P0   K e  g 0.12  0.08 .04 b. Public price Underwriting spread (6%) Net price to the corporation

$36.00 2.16 $33.84

c. Net price Necessary public price   1  underwriting spread  

$34.50 1  0.06

 $36.70

15-19.

Saskatchewan Cloud Inc. D1 $1.20  $1.20  $24.00 a. P0   K e  g 0.12  0.07 .05 b. Public price Underwriting spread (6%) Net price to the corporation

$24.00 1.44 $22.56

c. Net price Necessary public price   1  underwriting spread  

Foundations of Fin. Mgt. 12Ce

$23.50 1  0.06

12 -

 $25.00

Block, Hirt, Danielsen, Short

15-20.

The Landry Corporation Private Placement $1,000,000 – 30,000 $ 970,000

debt out-of-pocket costs net amount to Landry

interest payments (semiannually) = 11%/ 2 = interest payments = 5.5%  $1,000,000 = $55,000

5.5%

Present value of future interest payments PVA = A  PVIFA (N = 50, %I/Y = 6%) (Appendix D) PVA = $55,000  15.762 = $866,910 Present value of lump-sum payment at maturity PV = FV  PVIF (N = 50, %I/Y = 6%) (Appendix B) PV = $1,000,000  0.054 = $54,000 Total present value of interest and maturity payments: $866,910 + 54,000 $920,910 total present value Calculator: PV =? FV = $1,000,000 %I/Y = 6% N = 50 Compute PV = $921,191

PMT = $55,000

The net present value equals the net amount to Landry minus the present value of future payments. $ 970,000 – 921,191 $ 48,809

Foundations of Fin. Mgt. 12Ce

net amount to Landry present value of future payments net present value (private offering)

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Public Issue $1,000,000 – 40,000 – 100,000 $ 860,000

debt 4% spread out-of-pocket costs net amount to Landry

interest payments (semiannually) = 10%/ 2 = 5% interest payments = 5%  $1,000,000 = $50,000 Present value of future interest payments PVA = A  PVIFA (N = 50, %I/Y = 6%) (Appendix D) PVA = $50,000  15.762 = $788,100

Present value of lump-sum payment at maturity PV = FV  PVIF (N = 50, %I/Y = 6%) (Appendix B PV = $1,000,000  0.054 = $54,000

Total present value of interest and maturity payments: $788,100 + 54,000 $842,100 total present value Calculator: PV =? FV = $1,000,000 %I/Y = 6% Compute PV = $842,381

PMT = $50,000 N = 50

Net present value equals the net amount to Landry minus the present value of future payments. $ 860,000 – 842,381 $ 17,619

net amount to Landry present value of future payments net amount to Landry

The private placement has the higher net present value: ($48,809 vs. $17,619)

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15-21.

Midland Corporation

a. $21,660,000 net amount to be raised. Net price to the corporation:

Shares to be sold:

$38.00 – 1.90 $36.10

# shares 

public price 5% spread net price

$21,660,000

 600,000

$36.10

b. The new shares will increase the total number of shares outstanding and dilute EPS. This dilution effect may reduce the stock price in the market temporarily until income from the new assets becomes included in the price the market is willing to pay for the stock. By selling at below market value, the investment dealer is attempting to attract investors into this temporarily dilutive situation. The investment firm is also reducing its own underwriting risk by pricing the issue at the lower value.

c. Earnings per share (eps) 

$15,000,000

 $2.50

6,000,000 $40 Price earnings ratio (P/E)   16  $2.50 $15,000,000 Earnings per share (eps)   $2.27 6,600,000

Price = P/E  EPS = 16  $2.27 =

$36.32

d. Net income

= $15,000,000 + 15% ($21,660,000) = $15,000,000 + $3,249,000 =$18,249,000 $18,249,000 EPS after contribution   $2.77 6,600,000 Price = P/E  EPS = 16  $2.77 = $44.32

e. In the long run, it appears that the company is better off because of the additional investment. Earnings per share are $0.27 higher and the share price also increased. If the firm had used debt financing or a combination of debt and shares, they would have increased earnings per share even more, but would have created additional financial obligations in the process.

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15-22.

Presley Corporation

a. $20 price  95% = $19 net price $19 net price  600,000 new shares $11,400,000 proceeds before out-of-pocket costs – 200,000 out-of-pocket costs $11,200,000 net proceeds b. EPS before share issue  c. EPS after share issue 

$7,500,000  $3.00 2,500,000

$7,500,000  $2.42 3,100,000

d. There are now 3,100,000 shares outstanding. To maintain earnings of $3 per share, total earnings must be $9,300,000. This would imply an increase in earnings of $1,800,000 ($9,300,000 – $7,500,000).

incremental earnings  $1,800,000  0.1607  16.07%  net proceeds $11,200,000 16.07% must be earned on the net proceeds to produce EPS of $3.00.

e. $3.00 (1.05) = $3.15 (5% increase in EPS) Total earnings = $3.15  3,100,000 shares = $9,765,000 Incremental earnings = $9,765,000 – $7,500,000 = $2,265,000 incremental earnings  $2,265,000  0.2022  20.22%  net proceeds $11,200,000 20.22% would have to be earned to produce EPS of $3.15.

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15-23.

Tyson Works

a. $15 price  96% = $14.40 net price $14.40 net price  400,000 new shares $5,760,000 proceeds before out-of-pocket costs – 160,000 out-of-pocket costs $5,600,000 net proceeds $4,500,000 b. EPS after before share issue   $1.50 3,000,000 c. EPS after after share issue 

$4,500,000

 $1.32

3,400,000

d. There are now 3,400,000 shares outstanding. To maintain earnings of $1.50 per share, total earnings must be $5,100,000. This would imply an increase in earnings of $600,000 ($5,100,000 – $4,500,000).

incremental earnings  $600,000   0.1071  10.71% net proceeds $5,600,000 10.71% must be earned on the net proceeds to produce EPS of $1.50.

e. $1.50 (1.10) = $1.65 (10% increase in EPS) Total earnings = $1.65  3,400,000 shares = $5,610,000 Incremental earnings = $5,610,000 – $4,500,000 = $1,110,000 incremental earnings  $1,110,000   0.1982  19.82% $5,600,000 net proceeds 19.82% would have to be earned to produce EPS of $1.655.

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15-24.

Northern Airlines

a. $18 price  96% = $17.28 net price $17.28 net price  300,000 new shares $5,184,000 proceeds before out-of-pocket costs – 100,000 out-of-pocket costs $5,084,000 net proceeds b. EPS before share issue 

$6,000,000

 $1.50

4,000,000

c. EPS after share issue 

$6,000,000

 $1.40

4,300,000

d. There are now 4,300,000 shares outstanding. To maintain earnings of $1.50 per share, total earnings must be $6,450,000 (4,300,000 × $1.50). This would imply an increase in earnings of $450,000 ($6,450,000 – $6,000,000).

incremental earnings $450,000   0.0885%  8.85% net proceeds $5,084,000 8.85% must be earned on the net proceeds to produce EPS of $1.50.

e. $1.50 (1.10) = $1.65 (10% increase in EPS) Total earnings = $1.65  4,300,000 shares = $7,095,000 Incremental earnings = $7,095,000 – $6,000,000 = $1,095,000 incremental earnings $1,095,000   0.2154  21.54% net proceeds $5,084,000 21.54% would have to be earned to produce EPS of $1.65.

15-25.

I.B. Michaels – Hi-Tech Microcomputers

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a. Mr. Michael‘s purchase = 1.5%  15,000 shares = 225 shares Dollar profit or loss 1 week 225 shares  ($33 – $30) = $ 675.00 profit 1 month 225 shares  ($34.75 – $30) = $1,068.75 profit 1 year 225 shares  ($28.75 – $30) = $ 281.25 loss

b. Percentage profit or loss 1 week $3.00/ $30 = 1 month $4.75/ $30 = 1 year – $1.25/ $30 =

10.00% 15.83% – 4.17%

The results are in line with prior research. The shares went up one week and one month after issue, but actually provided a negative return for one year after issue. This is consistent with the research of Reilly (footnote 1), which showed excess returns of 10.9 percent, 11.6 percent and – 3.0 percent over comparable periods of study. Actually, the shares were a bit stronger than that indicated by the Reilly research for one month after issue.

c. A new public issue may be expected to have a strong aftermarket because investment dealers often underprice the issue to insure the success of the distribution.

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15-26.

Webster Labs

a. 3 million shares  $18.50 = $55.5 million (cost to go private)

b. Proceeds from sale of the divisions Petroleum research division Fiber technology division Synthetic products division

$16.0 million 9.5 million 20.0 million $45.5 million

Current value of the 3 million shares 3 million shares  (P/E  EPS) 3 million  (14  $1.50) 3 million  $21 Total value to the company

c. Total value to the company - Cost to go private Profit from restructuring

$63.0 million $108.5 million

$108.5 million 55.5 million $53.0 million

% profit  profit from restructuring  $53.0 million  0.9550  95.50% cost to go private $55.5 million

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Comprehensive Problem 15-27.

Anton Corporation New Public Offering

a. Earnings per share (eps) after 

$1,728,000  $1.02 1,200,000  500,000

Initial market price = P/E  EPS = 10  $1.02 = $10.20 b. 500,000 shares  $10.20 =

$5,100,000 gross proceeds – 357,000 7% spread – 150,000 out-of-pocket costs $ 4,593,000 net proceeds

c. Earnings per share (eps) before 

$1,728,000

 $1.44

1,200,000

In order to earn $1.44 after the offering, the return on $4,593,000 must produce new earnings equal to X. $1,728,000  X  $1.44 1,200,000  500,000 $1,728,000  X  $1.44 1,700,000 $1,728,000  X  $1.44 1,700,000 X  $2,448,000  $1,728,000 X  $720,000

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Proof: EPS  $1,728,000  $720,000  $2,448,000  $1.44 1,200,000  500,000 1,700,000

Thus:



Return 

New earnings $720,000   0.1568  15.68% New proceeds $4,593,000

The firm must earn 15.68% on net proceeds to equal earnings per share before the offering. This is greater than current return on assets of 13.50%. Return 

Net income $1,728,000   0.1350  13.50% New proceeds $12,800,000

d. Earnings per share(eps) after  Initial market price =

P/E  EPS = 10  $1.19 = $11.90

e. 250,000  $11.90 =

Foundations of Fin. Mgt. 12Ce

$1,728,000  $1.19 1,200,000  250,000

$2,975,000 – 208,250 – 150,000 $ 2,616,750

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gross proceeds 7% spread out-of-pocket costs net proceeds

Block, Hirt, Danielsen, Short

f. $1.44 represents earnings per share before the offering. In order to earn $1.44 after the offering, the return on $2,616,750 must produce new earnings equal to X. $1,728,000  X  $1.44 1,200,000  250,000 $1,728,000  X  $1.44 1,450,000 $1,728,000  X  $1.44 1,450,000 X  $2,088,000  $1,728,000 X  $360,000 Proof: EPS  $1,728,000  $360,000  $2,088,000  $1.44 1,200,000  250,000 1,450,000

Thus:



Return 

New earnings $360,000   0.1376  13.76% New proceeds $2,616,750

This is greater than the current return on assets of 13.50%. Return 

Net income $1,728,000   0.1350  13.50% New proceeds $12,800,000

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MINI CASES Robert Boyle and Associates, Inc. (Going Public and Investment Dealers) Purpose: The pros and cons of going public are considered in this case. Although the firm is a fictitious company, it is compared to a number of companies in the Real Estate Investment Trust (REIT) industry in order to establish the initial evaluation. The problem of capital shortage for the small private firm is the catalyst for considering the new offering. The potential dilution of new stock issues on earnings per share is carefully considered. In order to bring added interest to the case, there is a slightly nagging spouse who serves as a devil‘s advocate. a. Computation of Robert Boyle & Associates P / E ratio:

Return on Equity:

Return on assets:

Debt to assets:

Asset Turnover:

Net Profit Margin:

Boyle 35.5%

Industry P/E Industry 12.8%

14.0

Boyle 19.5%

Industry 8.7%

+.5

Boyle .45

Industry .31

–.5

Boyle .30

Industry .22

+.5

Boyle 64.1%

Industry 37.5%

+.5

5-Yr EPS growth:

Boyle Industry 9.7% 5.3% +.5 Net Additions and Subtractions: +2.0 Minus 1 to ensure a good sale: –1.0 Final P / E Ratio for Robert Boyle & Associates: 15.0

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b. Total size of the share issue necessary to yield $10 million in net proceeds: The size of the issue – the size times the spread percentage – out-of-pocket expenses = net proceeds X = the size of the issue X – .065(X) – $60,000 .935(X) X round to $10,800,000

= = =

$10,000,000 $10,060,000 $10,759,358.29

c. Required rate of return on net proceeds: Let X = the amount of income necessary to be earned: (Old Net Income + X) / Total number of shares outstanding = old EPS ($4,100,000 + X) / 4,699,029* = $1.03 $4,100,000 + X = $1.03 x 4,699,029 $4,100,000 + X = $4,840,000 X = $740,000 *4,00,000 old shares + 699,029 new shares = 4,699,029 Next compute the percent dollar return on the next proceeds. $740,000 / $10,800,000 = 6.85% Note that Robert Boyle & Associates earned a 19.5% return on assets in 20XX, so we would expect that the company should have no problems producing a 6.85% return on the new assets to be obtained. d. The total number of shares to be issued will be the two million from the existing shareholders plus the 699,029 originally planned. The decision by some of the existing shareholders to sell some of their shares makes no difference in this case—the company still needs to issue enough new shares to net $10,000,000. The two million shares from the existing shareholders are simply transferred from one set of people to another; the total number outstanding is not affected.

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e. Summary of the advantages of going public:  Provides access to capital, which, in this case, appears difficult to obtain in any other way.  Provides a method by which the existing shareholders may liquidate their holdings to raise cash or to buy other securities (in order to diversify their portfolios).  Establishes a market value for the firm. Summary of the disadvantages:  Relatively high cost (over $700,000 in this case to raise $10 million).  Additional paperwork and reporting requirements.  Necessity to deal with the public (Mr. Boyle will spend more of his time in public relations).  Pressure for short-term results.  Possible loss of control of the firm if enough shares are issued or if a hostile suitor attempts a takeover. S-1 Conclusion: Robert Boyle & Associates is doing perfectly well as it is, and could conceivably continue doing so without getting involved in the new shopping center on Salt Spring Island. However, the need to provide a market for the firm‘s shares and the need to provide a way for the existing shareholders to diversify their portfolios are strong arguments for going public (the shopping center development business is, after all, not without risk). Further, if the investors have any desire for growth, it appears they must go public to obtain the needed capital. From the limited information we have, the Salt Spring Center project appears to be attractive. Therefore, it is probable that Robert Boyle and Associates will not be able to take the conservative approach—save up for years until they have enough to build it—because another firm will step in and build it themselves. All in all, it appears that the time for Robert Boyle & Associates to go public may have arrived. Discussion Questions 17-1. Corporate management has become increasingly sensitive to the desires of large institutional investors because they fear these shareholders may side with corporate raiders in voting their shares in mergers or takeovers attempts. 17-2. There is no difference in dividend payments. The difference in trading values reflects a premium for being able to participate in electing a majority to the board of directors. 17-3. Usually corporations issue different classes of stock so that a controlling group can continue to control the board with a relatively small number of shares. Foundations of Fin. Mgt. 12Ce

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17-4. One disadvantage is that so-called non-voting shareholders generally contribute the bulk of the equity capital and get to elect only a minority of board members. Another is that in case of a takeover promising large premiums the non-voting shares can be ignored and therefore not get the same financial benefit as the voting shares. Student opinions will vary along continuum from rights of shareholders to interests of dominating/ founding shareholder. 17-5. The purpose of cumulative voting is to allow some minority representation on the board of directors. A possible disadvantage to management is that minority shareholders can challenge their actions. 17-6. Mainly because of the non-taxable nature of the dividends received by corporations and the dividend tax credit accorded individuals. 17-7. The preemptive right provides current shareholders with a first option to buy new shares. In this fashion, their voting right and claim to earnings cannot be diluted without their consent. 17-8. The actual owners have the last claim to any and all funds that remain. If the firm is profitable, this could represent a substantial amount. Thus, the residual claim may represent a privilege as well as a potential drawback. Generally, other providers of capital may only receive a fixed amount. 17-9. When a rights offering is announced, a stock initially trades rights-on, that is, if you buy the stock you will also acquire a right toward future purchase of the stock. After a certain period of time (say four weeks), the stock goes ex-rights; thus when you buy the stock you no longer get a right toward future purchase of stock. The significance to current and future shareholders is that they must decide if they wish to use or sell the right when the stock is trading rights-on. The stock will go down by the approximate value of the right when the stock moves to an ex-rights designation.

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17-10. A poison pill may help management defend itself against a potential takeover attempt. When another company attempts to acquire the firm, the poison pill allows current shareholders to acquire additional shares at a very low price. This increases the shares outstanding and makes it more difficult for the potential acquiring company to successfully complete the merger. 17-11. Preferred stock is a ‗hybrid‘ or intermediate form of security possessing some of the characteristics of debt and common stock. The fixed amount provision is similar to debt, but the non-contractual obligation is similar to common stock. Though the preferred shareholder does not have an ownership interest in the firm, the priority of claim is higher than that of the common shareholder. 17-12. Preferred stock may offer a slightly lower yield than bonds in spite of greater risk because corporate recipients of preferred stock dividends may receive them tax free while individuals can apply the dividend tax credit. 17-13. With the cumulative feature, if preferred stock dividends are not paid in any one year, they accumulate and must be paid in total before common shareholders can receive dividends. Even though preferred stock dividends are not a contractual obligation as is true of interest on debt, the cumulative feature tends to make corporations very aware of obligations to preferred shareholders. Preferred shareholders may even receive new securities for forgiveness of missed dividend payments. 17-14. The participation privileges of a few preferred stock issues mean that preferred shareholders may receive a payout over and above the quoted rate when the corporation enjoys a particularly good year. This is very similar to the situation with common stock and one can certainly say that common stock is a participation-type security. 17-15. There is less price volatility than with regular preferred stock. The corporation can issue floating-rate preferreds without trying to outguess the market in relation to future interest rates. 17-16. To the extent that shares on the NYSE are generally widely held while those on the TSX are more closely held, there should be more opportunities to buy control on the NYSE. Given the large size of many NYSE companies, however, many of those takeovers would require a great deal of capital. 17-17. Income trusts were once attractive investments because of favourable tax treatment and they generally provide a claim on the ―equity‖ cash flow from mature assets. Corporations set up trusts to provide additional capital funds for operations by providing an alternative investment for the marketplace. REITS survive and are well utilized by investors.

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17-18. Common Stock a) b) c) d) e) f) g) h)

Owners and control of the firm Obligation to provide return Claims to assets in bankruptcy Highest cost of distribution Highest return Highest risk Tax deductible of payment Payment to individual receives tax credit

Preferred Stock

Bonds

X X X X X X X X

Internet Resources and Questions 1. www.tmx.com http://www.globeinvestor.com/servlet/Page/document/v5/data/bonds/ 2. www.sedar.com/new_docs/new_en.htm

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Problems 17-1.

Folic Acid Inc. a. Earnings – Interest – Preferred stock dividends Common shareholders residual claim to earnings

(in millions) $20.00 2.75 1.80 $15.45

b. Common shareholders have no legal, enforceable claims to dividends.

17-2.

Diploma Mills a. Earnings – Interest – Preferred stock dividends Common shareholders residual claim to earnings

(in millions) $30.00 4.25 2.95 $22.80

b. Common shareholders have no legal, enforceable claims to dividends.

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17-3.

Rapid Employment Company a. Votes

= # of shares × # of directors to be elected = 21,000 × 11 = 231,000

b. Anita Job controls

= 507 × 11 = 5,577 votes

c. Anita‘s percentage of total votes

17-4.

= 5,577/ 231,000 = 0.0241 = 2.41%

Katie Homes and Gardens a. 10,640,000 25% 2,660,000

Total shares Trigger point Number of shares to trigger the poison pill

Current share price Reduction to current shareholders (30%) Price to existing shareholders

$52.00 15.60 $36.40

17-5.

Austin Power Company

# of directors desired  Shares required 



5 150,000 14  1

Foundations of Fin. Mgt. 12Ce

Total # of shares outstanding Total # of directors to be elected  1

1 

750,000

1

 1  50,001shares

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17-6.

Softdrinks, Inc.

Shares owned -1

directors  Total # of directors to be elected  1 that# of can be elected Total # of shares outstanding   



7,001 1 10  1  7,000 11  77,000  1 director 77,000

77,000

Yes, Mr. Cola can elect himself to the board.

17-7.

Boston Fishery a.

Shares owned - 1

of directors  Total # of directors to be elected  1 that# can be elected  Total # of shares outstanding   20,001 1 11  1  20,000 12  240,000  4 directors  60,000 60,000 60,000 Four directors can be elected by the dissident shareholders under cumulative voting. None would be elected by the dissidents under majority rule because the existing board controls over 50 percent of the shares. b. # of directors desired  Shares required 

Total # of shares outstanding 

Total # of directors to be elected  1 6  60,000 360,000  1   1  30,001 shares 11  1 12

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17-8.

Midland Corporation a.

Shares owned - 1

of directors  Total # of directors to be elected  1 that# can be elected   Total # of shares outstanding   40,001 1 11  1  40,000 12  480,000  4 directors  40,001 60,001 19,998 120,000 120,000 Mr. Pickens can be assured of electing 4 directors.

Shares owned - 1

 # of directors   Total # of directors to be elected  1 that can be elected  Total # of shares outstanding   60,001 1 11  1  60,000 12  720,000  6 directors  120,000 120,000 120,000 Ms. Ramsey and his friends can be assured of electing 6 directors. b. Shares owned = shares owned and proxies of other voters: Shares owned - 1 of directors  Total # of directors to be elected  1 that# can be elected   Total # of shares outstanding    40,001 19,998  1 11  1  59,99812  719,976  120,000 120,000 120,000  5.9998  5 directors rounded down Mr. Pickens can elect 5 directors. Ms. Ramsey will control the board.

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17-9.

Midland Corporation (Continued)

Shares owned - 1

of directors  Total # of directors to be elected  1 that# can be elected   Total # of shares outstanding   40,001 9,999  1 9  1  49,999 10  499,990  120,000 120,000 120,000  4.17  4 directors rounded down   17-10.

Express Frozen Foods, Inc. Mr. Frost controls 224,000 votes (32,000 × 7 directors) Mr. Cooke controls 196,000 votes (28,000 × 7) If Mr. Frost casts 90,000 votes for Jack, this will leave 44,667 votes (134,000/ 3) for each of the other three candidates he favours. Mr. Cooke could elect 4 of 7 directors (196,000/ 4 = 49,000), with less than one half of the votes because of Mr. Frost‘s error in voting.

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17-11.

Macho Iron Works

Founder's family votes

Class B votes

= Shares owned  10 = 62,635  10 = 626,350

= Total shares – founder's family shares = 1,500,000 – 62,635 = 1,437,365

Founders%  Founders family votes  626,350  0.4358  43.58% Class B votes 1,437,365

17-12.

Grantland Rice Co.

a. R  P0 - S  $55  $45  $10  $2.00 N 1 4 1 5 b. Pe – R = 55 – $2 = $53 The share price will decrease by the amount of the right's value.

17-13.

Redirect Energy Corporation

a. R  P0 - S  $30  $25  $5  $1.00 N 1 4 1 5 b. Po – R = $30.00 – $1.00 = $29.00 The share price will decrease by the amount of the right's value.

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17-14.

Prime Direct Corporation

a. R  P0 - S  $25  $20  $5  $1.25 N 1 3 1 4 b. Pe – R = $25.00 – $1.25 = $23.75 The share price will decrease by the amount of the right's value. 17-15.

Harmon Candy Company

a. R  P0 - S  $70  $62  $8  $1.33 N 1 5 1 6 b. Cindy owns 500 shares so she would receive 500 rights. 500 rights/ 5 rights per share = 100 shares 100 shares  $62 subscription price = $6,200 c. Neither exercising the rights nor selling them would have any effect on the shareholder's wealth (all things being equal). 17-16.

Skyway Airlines

a. R  P0 - S  $72  $60  $12  $2.40 N 1 4 1 5 b. Harold owns 800 shares so she would receive 800 rights. 800 rights/ 4 rights per share = 200 shares 200 shares  $60 subscription price = $12,000 c. Neither exercising the rights nor selling them would have any effect on the shareholder's wealth (all things being equal).

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17-17. Gallagher Tennis Clubs, Inc. (Todd Winningham IV) a. R 

Pe - S $50  $38   $2.00 N 6

$4,000 investment/ $2.00per right = 2,000 rights $4,000 investment/ $50 per share = 80 shares

b. R 

Pe - S $59  $38   $3.50 N 6

$3.50 per right value – $2.00 = $1.50  2,000 rights = c. ($59 – $50) = $9  80 shares =

d. R 

$1.50 profit per right $3,000 total profit (rights)

$9 profit per share $720 total dollar profit (shares)

Pe - S $30  $38   $1.33, value  $0 N 6

Todd would lose his entire $4,000 investment. e. ($30 – $50) = – $20  80 =

– $20 loss per share – $1,600

Todd would lose $1,600 on his $4,000 investment.

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17-18.

Magic Tricks Corp. (The Andersons)

a. R  P0 - S  $60  $48  $12  $2.00 N 1 5 1 6 b. Portfolio value: Stock 5  $60 = Cash Total Portfolio Value

$300 48 $348

c. First compute diluted value: Diluted value = Market value ex-rights Po – R = 60 – $2 = $58 OR: 5 old shares sold at $60 per share 1 new share will sell at $48 Total value of 6 shares

$300 48 $348

Average value of 1 share (Market value ex-rights) = $348/ 6 = $58 Portfolio value: Shares 6  $58 = Cash Total portfolio value

$348 0 $348

d. Portfolio value: Shares 5  $58 = $290 Proceeds from sale of 5 rights (5  $2) 10 Cash = 48 Total portfolio value $348

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17-19.

Smelly Kat Industries # of new share required to raise $25,000,000 = $25,000,000/ $25 = 1,000,000 new shares # of rights required to acquire 1 new share =5,000,000/ 1,000,000 = 5 rights R

P0 - S $30  $25 $5    $0.83 N 1 5 1 6

17-20.

Delovely Productions # of new share required to raise $42,000,000 = $42,000,000/ $14 = 3,000,000 new shares # of rights required to acquire 1 new share =6,000,000/ 3,000,000 = 2 rights R

P0 - S $17  $14 $3    $1.00 N 1 2 1 3

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17-21.

Walker Machine Tools $15 million  $3.00 per share 5 million shares $42 Market price   14  P/E ratio  Earnings per share $3

a. Earnings per share 

b. 5 million original shares + 500,000 new shares = 5,500,000 shares R

P0 - S $42  $36.50 $5.50    $0.50 N 1 10  1 11

Po – R = $42 – $0.50 = $41.50 Earnings per share 

P/E ratio 

$15 million  $2.73 per share 5,500,000 shares

$41.50 Market price   15.20  Earnings per share $2.73

17-22.

Shelton Corporation

a. Government bond 3%  (1 – .25) = 3.00%  .75 = 2.25% b. Corporate bond

6%  (1 – .25) = 6%  .75 = 4.5%

c. Preferred stock 5% Intercorporate dividends are tax free The preferred stock should be selected because it provides the highest aftertax return. It does however offer the greatest risk.

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17-23.

National Health Corporation

a. $9 per share  300,000 shares  5 years = $13,500,000 dividends in arrears. b. $13,500,000 original dividends in arrears + ($9  300,000) next year's preferred dividends – $11,000,000 profit paid out in dividends. $13,500,000 + $2,700,000 – $11,000,000 = $5,200,000 amount still in arrears. c. No common stock dividends can be paid until all the preferred dividends are paid to the cumulative preferred shareholders.

17-24.

Osmond Dental Products

a. $6.50 per share  850,000 shares  4 years = $22,100,000 dividends in arrears $22,100,000  90% = $19,890,000 compensation

b. Calculator: PV =? FV= 1,000 %i = 7% (14%/2) Compute: PV = $875.91

PMT = $60 ($120/ 2) N = 30 (15 × 2)

c. Compensation $19,890,000 Bond value ÷ 875.91 Number of bonds to provide compensation 22,708 (rounded)

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17-25.

Enterprise Storage Company

a. Enterprise is in arrears on the preferred shares 6 years × $4.75 × 400,000 shares = $11,400,000 b.

Common share value Value of dividends and future price D1 = $1.25 D2 = $1.50 D3 = $1.75 D4 = $2.00 P4 = $4.05 × 12 = $48.60

PV @ 10% $1.14 1.24 1.31 1.37 33.19 $38.25 c. To eliminate the deficit of $11,400,000 the number of common shares required for issue = $11,400,000  298,039 $38.25 This of course will not recover any of the original preferred share investment. 17-26.

Garcia Mexican Food Restaurants

a. Preferred Stock Dividend yield Dividends

$100,000 7.5% $ 7,500

b. Loan Interest expense Interest × (1 – T) Aftertax borrowing cost

$100,000 9.5% 9,500 75% $ 7,125

(Aftertax income)

c. Yes, the aftertax income exceeds the aftertax borrowing cost. Of course, other factors may be considered as well.

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d. The outcome could be quite unfavorable for two reasons. The increase in dividend yield would lower the value of the $100,000 portfolio. Also, interest rates generally are not fixed on a loan of this nature. Thus, the borrowing costs could go up. The dangers of these problems could be overcome by buying floating rate preferreds. The market value of the portfolio would be fixed and preferred share yields and interest rates would, in all likelihood, move up and down together.

17-27.

Garcia Mexican Food Restaurants (Continued) Dividend

$7,500

Interest × (1 – T) Aftertax borrowing cost

$9,500 80% $ 7,600

No, the aftertax income is now less than the aftertax borrowing cost.

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17-28.

Hailey Transmission

a. The floating rate preferred shares should be trading at very close to the par value of $100 since interest rates will adjust to current market conditions rather than price.

b. Based on formula 10-3, the price of the straight preferred share will be (assuming dividend rate and yield were equal at time of issuance): $8.00 p P D   $72.73 p

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Comprehensive Problems 17-29.

Crandall Corp. (Rights Offering and the Impact on Shareholders)

a. 10% discount-subscription price equals $45. # of new shares  Required funds  $900,000  20,000 Subscription price $45 # of rights to purchase1 share 

Old shares 100,000  5 New shares 20,000

20% discount-subscription price equals $40 # of new shares  Required funds  $900,000  22,500 Subscription price $40 # of rights to purchase1 share 

Old shares 100,000   4.4 New shares 22,500

40% discount-subscription price equals $30 # of new shares 

Required funds $900,000   30,000 Subscription price $30

# of rights to purchase 1share 

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Block, Hirt, Danielsen, Short

b. R 10%  P0 - S  $50  $45  $5  $0.83 N 1 5 1 6 R 20%  P0 - S  $50  $40  $10  $1.85 N 1 4.4  1 5.4 R 40%  P0 - S  $50  $30  $20  $4.65 N 1 3.3  1 4.3

c. EPS (before rights offering) 

EPS (after rights offering) 

$500,000  $5.00 per share 100,000 shares

$500,000  $4.17 per share 100,000  20,000 shares

d. 20% increase in shares outstanding (100,000 to 120,000)

e. Before After

100 shares  $5.00 = 120 shares  $4.17 =

$500 $500 (rounded)

f. No, he would expect greater earnings. He and others have put additional capital into the corporation so total claims to earnings should improve. Invested capital has increased from $5,000,000 to $5,900,000. He earned $500 before he put $900 more (20 shares  $45) of additional funds in the corporation. Over time, earnings should increase.

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

17-30.

Snyder Meat Packing Co. Cumulative Voting with Staggered Terms of Directors

a. Cumulative voting would make it easier for minority owners to obtain directors. b. Under majority vote, the majority could elect only one third of the directors each year so that staggered terms would make the takeover last for at least two years at which time the majority would have six of the nine positions. If cumulative voting along with staggered terms were used, Mr. Snyder could elect one out of three directors each time and so it would take the majority at least three years before they could control six of the nine directors. c. With majority vote, it doesn‘t matter how many directors there are: as long as you have a majority of votes, you control the whole company. If cumulative voting is used, the number of directors is possibly a concern. The fewer the number of directors, the greater the percentage of representation by minority interests.

Shares owned - 1

 # of directors   Total # of directors to be elected  1 that can be elcted  Total # of shares outstanding   1,050,000  1 9  1  1,049,999 10  10,499,990  3.5  3 directors  3,000,000 3,000,000 3,000,000 2   1,050,000 1 7  1 1,049,999 8  25%     2.8  2 directors   3,000,000 3,000,000 8    1,050,000 1 12  1 1,049,99913 4  33%      4.5  4 directors   3,000,000 3,000,000 12 

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17-31.

Electro Cardio Systems (ECS), Inc. Poison Pill Strategy

a. If Parker owns 25 percent of the shares outstanding of ECS, the poison pill will go into effect. Since there are 850,000 shares outstanding, the trigger point is at 212,500 shares. This means Parker would have to buy 112,500 additional shares to go with its current ownership of 100,000. The cost of 112,500 additional shares of ECS common stock at its current price of $42 per share would be $4,725,000. b. To get a 50% + 1 share interest in ECS, Parker would need to own 425,000 (1/2 of 850,000) + 1 shares. The number is 425,001. Since Parker has already acquired 212,500 shares of ECS, it would need to buy 212,501 more shares. At a stock price of $42 per share, this would represent an additional cost of $8,925,042. 212,501 $42 $8,925,042

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c. One more share than Parker would necessitate an ownership of 625,001 shares. Since ―friendly‖ interests to ECS already own 175,000 shares, they would need to acquire 450,001 additional shares. Because under the poison pill provision, they can buy at 80% of current market value, the total cost of the 450,001 shares would be $15,120,034. 450,001 $ 33.60 $15,120,034

additional shares cost per share* total cost

*$42  80% (poison pill provision) = $33.60 d. Yes, the poison pill is an effective deterrent in this case. With 850,000 shares outstanding and the ―friendly‖ interests already owning 175,000 shares, the most that Parker can acquire is 675,000. Since the poison pill provision allows up to 500,000 additional shares to be purchased by ―friendly‖ interests, the ―friendly‖ interests are assured of always owning more than 675,000 shares. Their total potential is 675,000 shares (175,000 shares currently owned plus 500,000 under the poison pill plan). Quite likely, the poison pill is not in the best interest of the general shareholders. Without the poison pill, ECS is more likely to be a merger takeover candidate. Often a price is offered well in excess of current market value for a takeover candidate. For example, ECS, with a current price of $42, might be offered $60 or $70 per share in a takeover tender offer. General shareholders would certainly benefit from such an offer.

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MINI CASE Alpha Biogenetics (Poison Pill) This case gives the student exposure to the poison pill and the entire issue of anti-takeover amendments. Through running the numbers in the case, the student is able to view how poison pills can protect the current position of management. There is also dialogue in the case in which the virtues and drawbacks of poison pills are discussed. The student begins to get a feel for the issues of management entrenchment versus shareholder rights. Because there is also a venture capital investment and an IPO, the student is exposed to other areas of corporate finance as well. a. Values for 20XT

Earnings per share 

Earnings



Shares Share price $9.60 P/E    30 EPS $0.32

$1,600,000  $0.32 5,000,000

Public price – Underwriting spread (5%) Net price × Shares (new shares sold) Total proceeds – Out-of-pocket expense Net proceeds

9.60 0.48 $ 9.12 2,000,000 $18,240,000 120,000 $18,120,000

Profit on sell of shares Sales price × Shares Total proceeds

– purchase price

9.60* 1,200,000 11,520,000 4,000,000

Profit

$ 7,520,000

*This assumes no underwriting spread on the secondary offerings of the venture capitalist shares. If the spread is included, the net sales price is $9.12 and the profit is $6,944,000. We are assuming the underwriter waives the spread.

Rate of return 

Profit $7,520,000   188% Investment $4,000,000

Given the risk that a venture capitalist takes in early stage financing, it is probably a reasonable return. Also, keep in mind that the venture capitalist had its funds tied up for a number of years to achieve the 188% total return. d. Values for 20XX Foundations of Fin. Mgt. 12Ce

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Earnings per share 

Earnings



Shares Share price $33.60 P/E    35 EPS $0.96

4,800,000  $0.96 5,000,000

Shares outstanding × Percent ownership Number of Shares × Price per share Total cost

5,000,000 25% 1,250,000 $33.60 $42,000,000

f. The inside control group owns 1.8 million shares. An unfriendly, outside party could acquire the remaining 3.2 million shares out of the 5 million shares outstanding. In order to maintain their majority position, the inside control group would need to buy 1,400,001 shares. This would give them a total of 3,200,001 shares. Old shares New shares

1,800,000 1,400,001 3,200,001

This represents one more share than the unfriendly, outside party owns. The total dollar cost would be: Share price $33.60 × Percent of price at which shares may be purchased 70% Net share price $23.52 × Number of shares 1,400,001 Total cost $32,928,024 g. In many cases, it appears that poison pills are intended to provide management with job security rather than maximize shareholder wealth. In fact, research indicates that poison pill announcements are often met with a slightly negative response in the stock market. Of course, the counter argument is that poison pills allow management to take a long-term perspective without fear of being ousted and also puts the firm in a strong bargaining position in the event of a potential tender offer. Although there is no one correct answer to this question and either side of the issue can be justified, most large institutional investors do not like poison pill provisions.

Discussion Questions 18-1. The marginal principle of retained earnings suggests that the corporation must do an analysis of whether the corporation or the shareholders can earn the most on funds associated with retained earnings. Thus, we must consider what the shareholders can earn on other investments. 18-2. A passive dividend policy suggests that dividends should be paid out if the corporation cannot make better use of the funds. We are looking more at alternate investment Foundations of Fin. Mgt. 12Ce

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opportunities than at preferences for dividends. If dividends are considered as an active decision variable, shareholder preference for cash dividends is considered very early in the decision process. 18-3. The shareholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the minds of investors and provide information content. Some shareholders may say that the dividends are relevant, but in a different sense. Perhaps they prefer to receive little or no dividends because of the income tax imposed on cash dividends. 18-4. The greater a company's growth possibilities, the more funds that can be justified for profitable internal reinvestment. This is very well illustrated in Table 18-1 in which we show growth rates for selected corporations and their associated dividend payout percentages. This is also discussed in the life cycle of the firm. 18-5. Factors influencing a firm‘s willingness and desire to pay dividends include: a. Internal investment opportunities: determined by corporate opportunities for investment and the life cycle of the firm. b. Shareholders‘ investment opportunities and tax position. c. Legal rules disallowing dividend payments from capital contributions to the firm. d. The cash position of the firm. e. The corporation‘s access to capital markets. f. Management‘s desire for control, which could imply that a closely held firm should avoid dividends to minimize the need for outside financing. For a larger firm, management may have to pay dividends in order to maintain their current position through keeping shareholders happy. 18-6. No, the old shareholder receives the upcoming quarterly dividend. Of course, if you continue to hold the stock, you will receive the next dividend. 18-7. The shareholder must pay a tax on dividends received, before funds can be reinvested. To the extent a shareholder is in a high tax bracket, he or she may prefer that the funds be reinvested in the corporation with the hope for future capital appreciation. 18-8. For a stock dividend, there is an accounting transfer between retained earnings and common stock (retained earnings is capitalized). The transfer takes place at the market value of the stock. Common stock

Retained earnings

–

For a stock split, there is no transfer of funds, but merely a proportionate increase in the number of shares outstanding. Before Common stock

After

(1,000,000 shares)

(2,000,000 shares)

18-9. The asset base remains the same and the shareholders' proportionate interest is unchanged (everyone got the same new share). Earnings per share will go down by the exact

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proportion that the number of shares increases. If the P/E ratio remains constant, the total value of each shareholder's portfolio will not increase. The only circumstances in which a stock dividend may be of some usefulness and perhaps increase value is when dividends per share remain constant and total dividends go up, or where substantial information is provided about a growth company. A stock split may have some functionality in placing the company into a lower ‗stock price‘ trading range. 18-10. A corporation can make a rational case for purchasing its own stock as an alternate to a cash dividend policy. Earnings per share will go up and if the price-earnings ratio remains the same, the shareholder will receive the same dollar benefit as through a cash dividend. Because the benefits are in the format of capital gains, the tax rate will be lower and the tax may be deferred until the stock is sold. A corporation also may justify the repurchase of its own stock because it is at a very low price, or to maintain constant demand for the shares. Reacquired shares may be used for employee options or as a part of a tender offer in a merger or acquisition. Firms may also reacquire part of their stock as protection against a hostile takeover. 18-11. The faster a firm grows, the more money it needs for investment and the less money it can pay out in dividends. In the early periods of growth, no dividends may be paid out because the firm needs all its earnings for reinvestment. In many cases there may be no earnings in the early periods of growth and alternative sources of external funds are not readily available. As the firm moves along the life cycle curve, growth slows, external funds become more available, earnings stabilize, and internal sources of funds are not all needed for reinvestment, resulting in an increasing payout ratio as the firm approaches maturity. 18-12. Currently 50% of capital gains are taxable when realized for an effective top marginal rate of around 22 to 27%. The dividend tax credit means that low income investors will pay very little tax on dividends with high income investors paying about 25 to 43 percent. 18-13. Dividend reinvestment plans allow corporations to raise funds continually from present shareholders. This reduces the need for some external funds. These plans allow shareholders to reinvest dividends at low costs and to buy fractional shares, neither of which can be easily accomplished in the market by an individual. The strategy of dividend reinvestment plans allows for the compounding of dividends and the accumulation of common stock over time. 18-14. Market efficiency suggests that all financial assets are bought and sold based on a proper return for the risk assumed. Prices have all information impounded into them to assure no abnormal returns and that the NPV of all financial transactions is zero. A corporation should be making investments in capital assets where it is likely that positive NPVs can be realized. By making purchases in a corporation‘s own shares, management is suggesting that share purchases are better investments than replenishing capital assets. The financial investment in a corporation‘s own shares has a positive NPV. This further suggests that the market has inefficiently priced the corporation‘s shares and that management knows better.

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18-15. A share repurchase will deplete cash resources and the equity in the firm. This will increase debt to equity ratios. There will be less shares outstanding but the assets (particularly cash) held by the firm will be decreased. In an efficient market (without taxes) the share price should be unaffected. There may however be a signaling effect that accompanies the repurchase announcement. 18-16. This question can require some research. It is suggested that Inco paid the dividend to recapitalize the corporation and make it less attractive as a takeover target. At the time Inco had enjoyed huge cash flows due to the high price of nickel and over $1/2 billion in cash sat on the balance sheet. This represented a valued prize of any takeover. By declaring the dividend Inco not only gave this cash to shareholders, but increased its debt to equity becoming a less attractive takeover target. Interestingly Inco had attempted to find a worthwhile acquisition before this decision but apparently was unsuccessful. This suggests that Inco could not find investments with a positive NPV and thus was returning money to the shareholders. Perhaps the shareholders could locate worthwhile investments. 18-17. Corporate executives believe a stable divided policy is important because the conventional wisdom says it should be stable. To alter that policy they believe would convey to shareholders that something has changed and shareholders may believe that as well. 18-18. It shouldn‘t matter unless the new dividend signals greater potential for the company‘s products. Is management conveying some new information about the future to the market?

Internet Resources and Questions 1. www.tmx.com 2. as above 3. as above

www.reuters.com/finance/markets

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Problems 18-1.

Omni Telecom $1.80  $30.00 a. P  D1  $1.80  0 .06 K e  g 0.10  0.04 $1.50  $37.50 b. P  D1  $1.50  0 .04 K e  g 0.10  0.06 c. Plan B produces the higher value because of the higher growth rate. Roget’s Search Engine Limited

18-2. Year

Dividends

PV@10%

1 2 3

$ 2.00 3.50 20.25

$ 1.82 2.89 15.21 $19.92

The suggested current value for Roget‘s is $19.92. Roget’s Revisited

18-3. a.

Year

Dividends

FV@8%

1 2 3

$ 2.00 3.50 20.25

$ 2.33 3.78 20.25 $26.36

Investor‘s require 10% PV (N = 3, %i = 10)

$19.80

The suggested current value for Roget‘s is $19.80.

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b. Year

Dividends

FV@10%

1 2 3

$ 2.00 3.50 20.25

$ 2.42 3.85 20.25 $26.52

Investor‘s require 10% PV (N = 3, %i = 10)

$19.92

The suggested current value for Roget‘s is $19.92. c. Year

Dividends

FV@12%

1 2 3

$ 2.00 3.50 20.25

$ 2.51 3.92 20.25 $26.68

Investor‘s require 10% PV (N = 3, %i = 10)

$20.05

The suggested current value for Roget‘s is $20.05.

18-4.

Gallagher Parades $0.75  0.250  25.0% Payout ratio  Dividend per share  Earnings per share $3.00

18-5.

Sewell Enterprises = (earnings – retained funds) = $160 million – $100 million = $60 million

Dividends

Payout ratio 

Dividends  $60 million   0.375  37.5% Earnings $160 million

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18-6.

Auction.com Payout ratio 

? Dividends    0.35  35.0% Earnings $420 million

Dividends  Earnings  payout ratio  $420 million  0.35  $147 million

Addition to retained earnings = earnings – dividends = $420 million – $147 million = $273 million

18-7.

Ronstadt Drum Company a.

 Dividends ?  Payout ratio   0.25  25.0% Earnings $710 million Dividends  Earnings  payout ratio  $710 million  0.25  $177.5 million

Addition to retained earnings = earnings – dividends = $710 million – $177.5 million = $532.5 million  b. Dividend per share  Dividends  $177.5 million  $2.09 # of shares 85 million Dividend per share  $2.09  0.0523  5.23% Dividend yield  Market share price $40

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18-8.

Springsteen Music Company b.

 ? Dividends   Payout ratio   0.20  20.0% Earnings $820 million Dividends  Earnings  payout ratio  $820 million  0.20  $164 million

Addition to retained earnings = earnings – dividends = $820 million – $164 million = $656 million  c. Dividend per share  Dividends  $164 million  $1.64 # of shares 100 million $1.64  0.0328  3.28% Dividend yield  Dividend per share  Market share price $50

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18-9.

Pills Berry Corporation $1.80  0.03  3% a. Dividend yield  Dividend per share  Market share price $60

b. Dividends per share  $1.80  0.50  50.0% Payout ratio  Earnings per share ? Dividends per share $1.80 Earnings per share    $3.60 Payout ratio 0.50 P/E ratio  Market share price  $60  16.67 Earnings per share $3.60

18-10.

Raptor BB Ranch

$1.25  0.05  5% a. Dividend yield  Dividend per share  Market share price $25

b. Dividends per share  $1.25  0.50  50.0% Payout ratio  Earnings per share ? Dividends per share $1.25 Earnings per share    $2.50 Payout ratio 0.50

P/E ratio  Market share price  $25  10.0 Earnings per share $2.50

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18-11.

Ynot Development Company

Market share price $22.50 = P/E ratio = = 15.0 Earnings per share ? Market share price $22.50 = Earnings per share = = $1.50 P/E ratio 15 ? Dividends per share = = 0.20 = 20% Earnings per share $1.50 Dividends per share = Earnings per share × Payout ratio = $1.50 × 0.22 = $0.30

Payout ratio =

Dividend yield = . 18-12.

$0.30 Dividend per share = = 0.013 = 1.3% Market share price $22.50

Chrétien Golf Links Limited $50  20.0 P/E ratio  Market share price  Earnings per share ? $50  $2.50 Earnings per share  Market share price  P/E ratio 20

Payout ratio 

Dividends per share ?   0.30  30.0% Earnings per share $2.50

Dividends per share  Earnings per share  Payout ratio  $2.50  0.30  $0.75 $0.75  0.0150  1.50% Dividend yield  Dividend per share  Market share price $50

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18-13.

Channel Weather News Annual dividend = Quarterly dividend =

$32 × 0.04 = $1.28 $1.28/ 4 = $0.32

The share should decline by approximately $0.32 to $31.68. Due to tax factors, the decline will be somewhat less than $0.32.

18-14.

Peabody Mining Company Annual dividend = Quarterly dividend =

$50 × 0.056 = $2.80 $2.80/ 4 = $0.70

The share should decline by approximately $0.70 to $49.30. Due to tax factors, the decline will be somewhat less than $0.70. 18-15.

Planetary Travel Co.

a. The legal limit is equal to retained earnings Retained earnings = Shareholder‘s equity – Common stock = $240,000,000 – 80,000,000 = $160,000,000 b. The practical limit based on liquidity is equal to the cash balance. Cash

c. Payout ratio

Foundations of Fin. Mgt. 12Ce

= Cash percentage × Total assets = 2% × $500,000,000 = $10,000,000 = Dividends/Earnings = $10,000,000/40,000,000 = 25%

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18-16.

Newell Labs, Inc. a. Plan A: ($2.50 + 2.55 + 2.50 + 2.65 + 2.65) = Plan B: ($0.80 + 3.30 + 0.35 + 2.80 + 6.60) =

$ 12.85 $ 13.85

b. Plan A 1 2 3 4 5

Dividend per share $2.50 2.55 2.50 2.65 2.65 Present value of future dividends

PV @ 10% $2.27 2.11 1.88 1.81 1.65 $9.72

Plan B Dividend per share PV @ 12% 1 $0.80 $0.71 2 3.30 2.63 3 0.35 0.25 4 2.80 1.78 5 6.60 3.75 Present value of future dividends $9.12 Plan A will provide the higher present value of future dividends.

18-17.

Turtle Co./ Hare Corp. Turtle is not growing very fast so it doesn‘t need cash for growth unless it desires to change its policies. Assuming it doesn‘t, Turtle should have a high payout ratio. Hare is growing very fast and needs its cash for reinvestment in assets. For this reason, Hare should have a low dividend payout.

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18-18.

Goren Bridge Construction Co.

a. Ms. Queen $3.80 31% $ 1.18

Cash dividend Marginal tax rate Taxes

b. Ace Corporation No tax on inter-corporate dividends. 18-19.

Alpha, Beta, Delta

a. Payout ratios Year Alpha 1 50% 2 50% 3 50% 4 50% 5 50%

Beta 50.0% 47.6% 41.7% 35.7% 38.3%

Delta 50.0% 35.7% 41.7% 53.6% 33.3%

b. Alpha has a constant payout ratio which could imply stability of earnings and sales, and steady growth patterns and financing needs. Alpha appears to have a planned dividend payout while Delta uses dividends as a residual. Beta seems to have a stepwise dividend policy in that they do not raise dividends until they are sure that even in a downturn they can be supported. (Note: They went to $2.30 in the last year).

c. Alpha has a constant payout ratio, a larger dividend stream over the period, and these may be considered desirable. The earnings of the companies are all the same so that a true investment decision would have to include an analysis of more than the dividend policy, including the shareholder‘s marginal tax rate. Other information that would be helpful in the decision would be corporate growth rates, ratio information, and a detailed analysis of the financial statements.

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18-20.

Interactive Technology

Earnings

Payout ratio

Dividends

$0.20 2.00 2.80 3.00

0 10% 40% 60%

0 $0.20 1.12 1.80

Stage 1 Stage II Stage III Stage IV b. Total dividends

= shares × dividends per share = 425 × $1.80 = $765.00

Dividend income = Taxes @ 31.33% = Aftertax income

$765.00 239.67 $525.33

c. Stock dividends or stock splits are most likely to be utilized during Stage II (growth) or Stage III (expansion).

18-21.

Squash Delight Inc. a. 2 for 1 stock split * Common stock (200,000 shares) Retained earnings * The only account affected

$300,000 500,000

b. 10% stock dividend * Common stock (110,000 shares) ** Retained earnings * $300,000 + 10,000 ($10) = $400,000 ** $500,000 – $100,000 = $400,000

$400,000 400,000

c. The stock dividend. Cash dividends cannot exceed the balance in retained earnings and the balance is lower with the stock dividend ($400,000 versus $500,000). 18-22. Foundations of Fin. Mgt. 12Ce

Sun Energy Company 12 -

Block, Hirt, Danielsen, Short

After 1st transaction Common stock (110,000 shares) Retained earnings

$250,000 150,000 $400,000

After 2nd transaction Common stock (110,000 shares) Retained earnings*

$250,000 117,000 $367,000 *The cash dividend of $0.30 per share causes retained earnings to be reduced by $33,000 (110,000  $0.30).

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18-23.

Philips Rock and Mud

a. From a legal viewpoint, the firm can pay cash dividends equal to retained earnings of $875,000. On a per share basis, this represents $3.50 per share. Dividend maximum 

Retained earnings $875,000   $3.50 250,000 Shares

This is not realistic as the cash available is only $312,500.

b. In terms of cash availability, maximum amount the firm can pay is $1.25 per share. To pay more would require borrowing. Dividend maximum 

c. Shareholder's equity $1,375,000

Cash $312,500   $1.25 250,000 Shares

= common stock + retained earnings = $500,000 + $875,000

Return on equity

= 16%  $1,375,000 = $220,000

Dividends

= 60%  return on equity = 60%  $220,000 = $132,000

Dividend per share  Total dividends  $132,000  $0.53 Shares 250,000

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18-24.

Adams Corporation Retain Incremental earnings

Earnings per share 

= 15%  $400,000 = $60,000

Earnings $750,000  $60,000   $2.70 Shares 300,000

Market price of share

= P/E ratio (earnings multiplier)  EPS = 8  $2.70 = $21.60

Payout New P/E

= 1.10  8 = 8.8

Earnings per share  Earnings  $750,000  $2.50 Shares 300,000

Market price of share

= P/E ratio (earnings multiplier)  EPS = 8.8  $2.50 = $22.00

The payout option provides the maximum market value.

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18-25.

Vinson Corporation Retain Incremental earnings

Earnings per share 

= 18%  $300,000 = $54,000

Earnings $500,000  $54,000   $2.216 Shares 250,000

Market price of share

= P/E ratio (earnings multiplier)  EPS = 20  $2.216 = $44.32

Payout New P/E Earnings per share 

= 1.10  20 = 22 Earnings Shares

Market price of share



$500,000  $2.00 250,000

= P/E ratio (earnings multiplier)  EPS = 22  $2.00 = $44.00

The retention option provides the maximum market value by a slight amount.

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18-26.

Omni Telecom a. Plan A – increase cash dividend immediately Po  D1 Ke  g First Compute D1 D1 =

= D0 (1 + g) $2.20 (1.05) = $2.31

Then Compute the share price D1 = $2.31, Ke = .10, g = .05 Po 

$2.31 $2.31   $46.20 .10  .05 .05

b. Plan B – increase growth rate First Compute D1 D1 = =

D0 (1 + g) $2.00 (1.06) = $2.12

Then Compute the share price D1 = $2.12, Ke = .10, g = .06 Po 

$2.12 $2.12   $53 .10  .06 .04

c. Plan B, which calls for using funds to increase the growth rate, will produce a higher value.

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

18-27.

Wilson Pharmaceuticals

a. Eight (8) million shares would be outstanding. Everything else will be the same.

b. Twelve (12) million shares would be outstanding. Everything else will be the same.

c. EPS before

= $14,000,000/ 4,000,000 shares = $3.50 e.p.s.

EPS after 2:1 split = $14,000,000/ 8,000,000 shares = $1.75 e.p.s EPS after 3-1 split =$14,000,000/ 12,000,000 shares = $1.17 e.p.s

d. Current P/E ratio 

Price $70   20  EPS $3.50

P/E  EPS = Price Price after 2-1 split Price after 3-1 split

= 20  $1.75 = $35.00 = 20  $1.17 = $23.40

e. Probably not. A stock split should not change the price-earnings ratio unless it is combined with a change in dividends to the shareholders. Generally speaking, nothing of real value has taken place. Only to the limited extent that new information content from this split increased investor's expectations would the stock split possibly have an impact on the P/E ratio.

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18-28.

Vegas Products

a. Common stock (220,000)* Retained earnings Net worth

$5,800,000 4,200,000 $10,000,000

*20,000 shares  $40 = $800,000 $5,000,000 + $800,000 = $5,800,000

b. EPS after stock dividend = $400,000/ 220,000 = $1.82 Price = P/E ratio  EPS = 20  $1.82 = $36.36 c. (100  1.10) = 110 shares after the stock dividend

Before 100  $40 = $4,000

After 110  $36.36 = $4,000

e. Generally speaking, nothing of real value has taken place. Only to the limited extent that total cash dividends might have increased or information been provided could small benefits have taken place. The investor‘s total investment after the stock dividend is the same as before.

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18-29.

Matrix Corp. Inc. a. Common stock (4,600,000 shares) ......................$64,000,000* Retained earnings ................................................ 36,000,000 Net worth ...........................................................$100,000,000 *4,000,000 × 15% = 600,000 600,000 shares × ($40 market price) = 600,000 × $40 = $24,000,000 ** $60,000,000 beginning Retained earnings account – 24,000,000 transfer to Common stock account $36,000,000 ending Retained earnings account

b. EPS after the stock dividend = $12,000,000/4,600,000 = $2.61 Price = P/E ratio × EPS = 13.33 × $2.61 = $34.79 c. 100 + (100 × 15%) = 115 shares after the stock dividend d. Before 100 × $40 = $4,000

After 115 × $34.79 = $4,000.85 ($0.85 rounding difference)

e. After 115 × $40 = $4,600 Yes. As a result of keeping the cash dividend constant, the shareholder not only received more cash dividends, but the portfolio value goes up by $600 as a result of having 15 more shares still worth $40 a share. f.

Dividend yield 

cash dividend market price

Foundations of Fin. Mgt. 12Ce

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

$1.05

 0.0263  2.6%

$40.00

Block, Hirt, Danielsen, Short

18-30.

Worst Buy a. Number of shares after reverse stock split = Original shares divided by the reverse split ratio = 140/5 = 28 shares

b. Anticipated share price = Original stock price x reverse split ratio = $2 × 5 = $10

c. Actual share price based on the 80% assumption $10 Anticipated stock price 80% Assumption $8.00 Actual stock price d. Dean Smith‘s total holdings Before reverse stock split 140 shares × $2 = $280 After reverse stock split 28 shares × $8.00 = $224 Dean‘s holdings have decreased by $56 ($280 - $224)

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18-31.

Belton Corporation

a. Price EPS Price

= P/E  EPS = $5 mil. / 1 mil. = $5 = 10  $5 = $50

b. $4 mil. / 1 mil.

= $4 dividends per share

c. $4,000,000/ $54

= 74,074 shares reacquired

d. Shares outstanding after repurchase 1,000,000 – 74,074 = 925,926 EPS = $5,000,000/ 925,926 = $5.40 e. Price = P/E  EPS = 10  $5.40 = $54 The stock price has increased by $4. f. No. With the cash dividend: Market value per share Cash dividend per share Total value With the repurchase of stock: Total value per share

$50 4 $54 $54

g. No. The effective tax rate on capital gains versus a cash dividend is lower for high income earners, although the effective rates are similar for mid range earners. (Each tax situation is different). As well capital gains can be deferred until realized.

h. The corporation may think its shares are underpriced in the market. The purchase may stave off further decline and perhaps even trigger a rally. Reacquired shares may also be used for employee stock options or as part of a tender offer in a merger or an acquisition. Firms may also reacquire part of their shares as a protective device against being taken over as a merger candidate.

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18-32.

Hill and Valley

a. and b. together Rudy Hill (mid bracket)

Grace Valley (top bracket)

Investment A Dividend income Marginal combined rate Taxes payable Net dividend after tax

$2,800.00 12.24% 342.72 $2,457.28

$2,800.00 39.34% 1,101.52 $1,698.48

Investment B Capital gain Marginal combined rate Taxes payable Net dividend after tax

$2,800.00 16.95% 474.60 $2,325.40

$2,800.00 26.76% 749.28 $2,050.72

c. Investment A:

$2,457.28 –$1,698.48 =

$758.80

d. Investment B:

$2,325.40 – $2,050.72 =

$274.68

e. The dividend tax credit has a more significant impact on the tax payer in a lower low tax brackets, while the capital gains savings are rate dependent.

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18-33.

Hasting Sugar Corporation

a. Dividends represent what is left over after profitable capital expenditures are undertaken. Profitable Capital Year Net Income Expenditures (millions) – (millions) 1 $10 – $ 7 2 15 – 11 3 9 – 6 4 12 – 7 5 14 – 8 Total cash dividends

Dividends (millions) $3 4 3 5 6 $21

b. Net income Year (millions) 1 $10 2 15 3 9 4 12 5 14

Foundations of Fin. Mgt. 12Ce

Dividends Payout ratio (millions)  .40 $ 4.0  .40 6.0  .40 3.6  .40 4.8  .40 5.6  Total cash dividends $24.0

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c. Year 1 2 3 4 5

Shares Dividends outstanding per share 2,000,000  $2.40 2.40 2,200,000  2.40 2,420,000  2.40 2,662,000  2.40 2,928,200  Total cash dividends

Dividends $4,800,000 5,280,000 5,808,000 6,388,800 7,027,680 $29,304,480

Year 1 2 3 4 5

Net Dividends income Payout Dividends Shares (millions) ratio (millions) (millions) per share $10 .30 $3.0 2.0000 $1.50 15 .30 4.5 2.4000 1.88 9 .30 2.7 2.8800 0.94 12 .30 3.6 3.4560 1.04 14 .30 4.2 4.1472 1.01

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Comprehensive Problem 18-34.

Lyle Communications Share price  $64  16.0  eps $4

P/E ratio 

$1.20  0.01875  1.875% Dividend yield  Dividend per share  Market share price $64

Dividends per share  $1.20  0.300  30.0% Payout ratio  Earnings per share $4.00

Portfolio value: Shares: 100 × $64 = Cash (from dividends): 100 × $1.20 =

$6,400 120 $6,520

Repurchase  Excess cash  $2.4 million  36,810 shares Share price $65.20

$8 million  $4.075 EPS  Total earnings  # of shares $2 million  36,810

Share price

= P/E × EPS = 16 × $4.075 = $65.20

Portfolio value: Shares:

Foundations of Fin. Mgt. 12Ce

100 × $65.20 =

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Block, Hirt, Danielsen, Short

MINI CASE Montgomery Corporation (Dividend policy) Purpose: The key issue is whether the firm's cash dividend should be considered an active or residual variable in setting the actual payment. There is enough bickering between the directors and officers of the firm to give the student plenty of insight into the issue. There is information on comparable industry dividend policies. The student is asked to use the dividend valuation model, to consider capital structure issues, and also to evaluate the suitability of a stock dividend versus a cash dividend.

a. From Figure 1, we note that dividends per share for the years 20XR – 20XX were:

20XR 20XS

20XT 20XU 20XV 20XW 20XX

$1.36

$1.48

$1.36

$1.70

$1.76

$1.96

The firm is following a constant dividend policy with increases as the company grows. Note that the total amount committed to common dividends has increased each year, but it's the dividend per share figure that counts. Given the increasing number of shares outstanding each year, the directors each year have ensured that DPS has remained constant or increased slightly.

b. In Figure 2, we see that all of Montgomery's competitors are either following the same policy that Montgomery is, or they are striving to increase the dividend every year. The Lake held to a $0.20 dividend in 20XX even though EPS decreased over 75% in 20XW! In 20XV The Lake actually increased the dividend by over 17% in spite of the decrease in EPS. Clearly, dividend stability and growth are perceived as important in the retailing industry. Even National Wheels, a growing company which might be expected to emphasize capital growth over dividends, follows the general trend. (It is interesting to note that Montgomery generally has the highest average payout ratio in the industry. That‘s to be expected of an old firm that has been paying, and increasing dividends for many years).

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c. Given that D1 = $2.10, g = 7.1%, and P0 = $35, ke, the expected return to the common shareholders is: D1 $2.10 g  0.071  0.06  0.071  0.1310  13.10% K e  P0 $35

d. If Don's proposal is adopted, and next year's dividend is zero, but g rises to 14%, the expected return to the shareholders is: D $0 K  1 g   0.14  0.00  0.14  0.1400  14.00% e $35 P0 It appears that if Montgomery adopted Don's suggestion, the shareholders would realize a 0.9% increase in their expected return. By this calculation alone, we might conclude that Don's idea is a good one: adopt a residual dividend policy. However, the shareholders would only realize Don's 14% gain if they sell their shares, while the firm's current dividend policy gives the shareholders 13.1%. Given that situation, and the fact that there is little advantage of a capital gain over dividends, one might well argue that the shareholders are better off under current policy. Further, note that the shareholders only appear to be better off under the new policy if g does, in fact, rise to 14%, which is speculative at best. If g turns out to be less than 13.1%, for example, the old policy will appear to be superior. It is reasonable to assume that if the dividend is retained and invested, g will increase, and intuitively we believe it should increase sufficiently to produce a total return greater than before, but there is no hard evidence that it will do so.

e. Don's argument rests on the principle that the capital budget, as well as the dividend, must be paid for solely out of net income for the current year, and, of course, this is not so. It is the amount of cash available that is the limiting factor. Referring to figure 1, we see that Montgomery's cash balance for 20XX is $3,235 million, so that is the maximum size that the capital budget plus dividend payment can be without selling off assets or seeking outside financing. (This is an excellent point). We often speak of financing the capital budget, or indeed, paying dividends out of retained earnings. We tend to speak of retained earnings as if they were cash. They are not, of course; only claims on assets, of which cash is but one. If retained earnings were to be entirely used up in financing the capital budget, then some of the firm's assets would have to be sold in the process.

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f. The cost of internal equity financing is, of course, 13.1%, which was computed in question (c), above. The cost of external equity financing would be slightly higher due to flotation costs.

g. Given that the firm can sell bonds priced to yield 13%, the aftertax cost of debt is 13% × (1 – .25) = 9.75%

h. This might throw the debt/equity mix out of proportion. Excessive use of debt might out only increase the cost of debt financing, but all other sources of financing as well.

i. Mr. Autry's comments strike at the heart of the residual dividend policy. That policy presumes that the shareholders have no preferences about the form of repayment they receive from their investment-only that the highest possible return be achieved. If, on the other hand the shareholders do have a preference, then the residual policy may not be the best. There is no hard and fast rule on establishing whether or not the shareholders have a preference, or how strong it might be. Strong cases can be argued for either point of view and the subject remains controversial. From Figure 2, it appears that managers of firms in the retailing business do believe that their shareholders have a preference for current income in the form of dividends.

j. The firm could pay a stock dividend in place of the cash dividend, and some shareholders might be satisfied with that. However, the majority would probably recognize that they had not received anything at all. A stock dividend is merely a paper entry creating more shares. It would only be perceived as beneficial if total shareholders‘ cash dividends increased as a result. (However this would defeat the proposed purpose of the stock dividend: to conserve funds).

k. As mentioned in (i), there is no universal agreement on this question, as some argue that dividends do not matter and some argue that they do. Most agree, however, that if the firm does pay taxes, if there are flotation costs associated with outside equity financing, and if there are costs associated with bankruptcy, then capital structure does matter, and dividend policy matters. Intuitively, and in the face of the obvious custom in the retailing industry, we would view a decision by a mature firm such Montgomery to go to a residual dividend policy with some misgivings. Such a policy is perhaps best left to a younger firm. Discussion Questions 20-1. In the 60s and 70s diversification seemed the order of the day, and in the 80s divestitures were in vogue. By the 90s refocusing was the motivation with the impetus found in low Foundations of Fin. Mgt. 12Ce

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interest rates, changing regulation, intense competition, evolving technology, and many other factors. The financial uncertainties of 21st century produced conservative management focused on value creation with strong balance sheets, low debt and record high liquidity. Economies of scale seemed also to be important in the new millennium. 20-2. The conglomerate type merger that is most likely to provide risk reduction is with firms that may be negatively correlated. 20-3. The firm can achieve this by acquiring a company at a lower P/E ratio than its own. The firm with lower P/E ratio may also have a lower growth rate. The combined growth rate for the surviving firm may be reduced and long-term earnings growth diminished. 20-4. Under a ‗purchase of assets‘, the difference between purchase price and adjusted book value (based on fair market value) is established on the balance sheet as goodwill and must be written off as the asset value is impaired, at the discretion of the firm and its accountants. Eligible capital expenditures have a CCA rate of 7% and 75% of expenditure is eligible. 20-5. a. Some combining of production facilities could reduce manufacturing expense. b. Some combining of marketing efforts could reduce expenses and improve effectiveness. c. There could be a sharing of engineering and other technological know-how. d. The combined larger size might increase financing capabilities. e. Need for only one corporate headquarters with reduction in corporate staff. 20-6. A cash buyout generally will not qualify as a tax-free exchange and there may be an immediate tax liability to the selling shareholder. For this reason the shareholder may demand a higher price. 20-7. (Primary answer) Low stock prices made potential acquisitions appear to be attractively priced to the acquiring company. Also, selling shareholders may have an opportunity to transfer out of underpriced issues into cash or the better recognized shares of other firms. It had happened in the wake of 2008-2009 financial recession when prices of stocks depressed and we saw historically low interest rates. 20-8. If earnings per share show an immediate appreciation, the acquiring firm may be buying a slower growth firm as reflected in relative P/E ratios. This immediate appreciation in earnings per share could be associated with a lower P/E ratio. The opposite effect could take place when there is an immediate dilution to earning per share. Obviously, a number of other factors will also come into play. 20-9. The unusually high premium may be attributed to the high replacement value of the assets and the high quality of the acquired companies. 20-10. An unfriendly takeover may be avoided by: a. turning to a second possible acquiring company: a "White Knight" b. establishing a shareholders‘ rights plans c. buying back outstanding corporate stock d. encouraging employees to buy stock e. staggering the election of directors f. increasing dividends to keep shareholders happy Foundations of Fin. Mgt. 12Ce

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g. buying up other companies to increase size and reduce vulnerability h. reducing the cash position to avoid a leveraged takeover 20-11. While management may wish to maintain their autonomy and perhaps keep their jobs, shareholders may wish the highest possible for their holdings. 20-12. Share prices are often bid upwards in a proposed merger. The individual may benefit if he or she gets in early. However, mergers may be called off with a subsequent decline in share price. An investor will lose if purchases were made at the height of the market. In some cases, Canadian Tire for example, not all shares were purchased in the takeover attempt. 20-13. The arbitrageur buys the stock of the merger candidate in hopes of exchanging it at a profit for the stock of the acquiring company or for cash. The arbitrageur may also shortsell the stock of the acquiring company; buy the stock of the merger candidate in anticipation of exchanging it for acquiring company stock and then covering the short position at a profit. The danger of being a merger arbitrageur is that the merger may be called off and the value of the merger candidate‘s stock may go down dramatically. 20-14. All three concepts are the same. The objective is to magnify results with a given level of capital or asset commitment, supported by a high degree of borrowing. So far there is no multiple taxation of a holding company‘s share dividend payment. 20-15. From the trusts of the 1890s, the U.S. has had huge companies with little concern for foreign competition. Many feared that these companies would corner their markets and exercise monopoly power. In Canada, without the history of mammoth manufacturing concerns we have had the problem of small companies of insufficient scale to be efficient. In the resource sector we have large companies but they have to be because they sell much of their product based on the pricing mechanisms of the international markets. On the foreign ownership front, our experience with failing to build the hoped-for efficiencies and scale in secondary manufacturing has been coupled with a high level of foreign ownership. In resource areas like oil and gas it is perceived that control over the pace and method of exploration is an issue of strategic national interest.

Internet Resources and Questions 1. Use the text suggested resources or perhaps your own to identify recent merger and acquisition activity.

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Problems 20-1.

Charles Corporation Cost (cash outflow): Purchase price $2,000,000 Less: tax shield benefit from tax loss carry-forward ($600,000  25%) – 150,000 Net cash outflow $1,850,000 Benefits (cash inflows): $260,000, N = 20, %I/Y = 12% (Appendix D)

Calculator:

PV =? FV = 0 %I/Y= 12%

Compute:

Benefit Cost Net present value

PMT = $260,000 N = 20 PV = $1,942,055

$1,942,055 1,850,000 $ 92,055

The positive net present value indicates the merger should be undertaken.

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20-2.

Wayne Corporation Cost: Purchase price $3,000,000 Less: tax shield benefit from tax loss carry-forward ($600,000  40%) – 240,000 Net cash outflow $2,760,000 Benefit: $380,000, n = 20, %i = 11% (Appendix D)

Calculator: Compute:

PV =? FV = 0 %i = 11% N = 20 PV = $3,026,065

Benefit Cost Net present value

PMT = $380,000

$3,026,065 2,760,000 $ 266,065

The positive net present value indicates the merger should be undertaken.

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20-3.

Arrow Corporation a. Reduction in taxes due to tax loss carry-forward = loss  tax rate = $400,000  25% = $100,000 b. Arrow Corporation (with merger and associated tax benefits)

20XX

20XY

20XZ

Total Value

Before tax income Tax loss carryforward

$160,000

$200,000

$320,000

$680,000

160,000

200,000

40,000

400,000

Net taxable income

280,000

70,000

Taxes (25%) 0 . Income available to shareholders (before tax income – taxes) $160,000

* **

$200,000

$250,000* $610,000**

Before-tax income – taxes ($320,000 – $70,000 = $250,000) Before-tax income – taxes ($680,000 – $70,000 = $610,000)

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20-4.

J & J Enterprises Cost (Purchase price) Years (1-5) Cash inflow Synergistic benefits Total benefit Calculator:

$4,000,000 $440,000 40,000 $480,000

FV = 0 PV =? %I/Y = 12%

Compute: Years (6-15) Cash inflow Synergistic benefits Total benefit

Calculator: Compute: Calculator:

PMT = $480,000 N=5 PV = $1,730,293

$600,000 60,000 $660,000

PV =? FV = 0 %I/Y= 12% PV = $3,729,147

PMT = $660,000 N = 10 PMT = 0

PV =? FV= $3,729,147 %I/Y = 12% N=5

Compute:

PV = $2,116,018

Years (16-20) Cash inflow Synergistic benefits Total benefit

Calculator: Compute: Calculator:

$800,000 70,000 $870,000

PV =? FV= 0 %I/Y= 12% PV= $3,136,155

PMT = $870,000 N=5 PMT = 0

PV =? FV= $3,136,155 %I/Y = 12% N = 15

Compute:

PV = $572,964

Total present value of benefits: Cost Net present value

$4,419,275 – 4,000,000 $ 419,275

The positive net present value indicates the merger should be undertaken.

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20-5.

Worldwide Scientific Equipment

Cost (Purchase price)

$1,600,000

Years (1-5) Cash inflow Synergistic benefits Total benefit Calculator:

$150,000 20,000 $170,000

PV =? FV = 0 %I/Y = 11%

Compute: Years (6-15) Cash inflow Synergistic benefits Total benefit

Calculator: Compute: Calculator:

PMT = $170,000 N=5 PV = $ 628,302

$170,000 30,000 $200,000

PV =? FV = 0 %I/Y= 11% PV = $1,177,846

PMT = $200,000 N = 10

PV =? FV= $1,177,846 %I/Y = 11% N=5

PMT = 0

Compute:

PV = $698,995

Years (16-20) Cash inflow Synergistic benefits Total benefit

Calculator: Compute: Calculator:

$210,000 50,000 $260,000

PV =? FV= 0 %I/Y= 11% PV= $1,531,200

PMT = $260,000 N = 10

PV =? FV= $1,531,200 %I/Y = 11% N = 15

PMT = 0

Compute:

PV = $ 320.028

Total present value of benefits: Cost Net present value

$1,647,329 – 1,600,000 $ 47,329

The positive net present value indicates the merger should be undertaken.

20-6.

McGraw Trucking Company Cost (Purchase price)

$3,000,000

Years (1-5) Foundations of Fin. Mgt. 12Ce

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Cash inflow Synergistic benefits Total benefit Calculator:

$200,000 30,000 $230,000

PV =? FV = 0 %I/Y = 9%

Compute: Years (6-15) Cash inflow Synergistic benefits Total benefit

Calculator: Compute: Calculator:

PMT = $230,000 N=5 PV = $ 894,620

$240,000 50,000 $290,000

PV =? FV = 0 %I/Y= 9% PV = $1,861,121

PMT = $290,000 N = 10

PV =? FV= $1,861,121 %I/Y = 9% N=5

Compute:

PV = $1,209,601

Years (16-20) Cash inflow Synergistic benefits Total benefit

Calculator: Compute: Calculator:

PMT = 0

$320,000 90,000 $410,000

PV =? FV= 0 %I/Y= 9% PV= $1,594,757

PMT = $410,000 N=5

PV =? FV= $1,594,757 %I/Y = 9% N = 15

Compute:

PMT = 0 PV = $ 437,821

Total present value of benefits: Cost Net present value

$2,542,042 – 3,000,000 $ (457,958)

The negative net present value indicates the merger should not be undertaken.

20-7.

Wolf Corporation and Lamb Enterprises (approach similar to Table 20-4) a. Total earnings:

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Lamb + Wolf

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$ 500,000 125,000 $625,000

Block, Hirt, Danielsen, Short

Shares outstanding (in surviving corporation):

New earnings per share 

Old + New

500,000 100,000 600,000

Net income $625,000   $1.04 600,000 Shares outstanding

b. Earnings per share of Lamb Enterprises increased because it has a higher P/E ratio than Wolf Corporation (20 × versus 16 ×). Any time a firm acquires another company at a lower P/E ratio than its own there is an immediate increase in post-merger earnings per share.

c. Although earnings per share for Lamb Enterprises went up, we cannot automatically assume the firm is better off. We need to know whether the Wolf Corporation will increase or decrease the future growth in earnings per share for the Lamb Enterprises and how it will influence its post-merger P/E ratio. The goal of financial management is not just immediate growth in earnings per share, but maximization of shareholder wealth over the long-term.

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20-8.

Jeter and A-Rod Corporations a.

$30 ×1.60 $48

current price 60% premium price paid

$48 × 400,000 $19,200,000

price paid shares total market value

Price $48   19.2 P/E ratio EPS $2.50

$19,200,000 total market value of A - Rod Corp.  640,000 new shares $30 Jeter Corp.'s share price

2,000,000 old shares + 640,000 new shares = 2,640,000 total shares

A-Rod Corp. earnings Jeter Corp. earnings Total earnings New postmerger EPS =

$1,000,000 4,000,000 $5,000,000

total earnings $5,000,000   $1.89 total shares 2,640,000

Jeter Corp. paid a higher P/E ratio (19.2) for A-Rod Corp. than its own (15). This will always cause a dilution in EPS.

Through more rapid future growth in earnings.

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20-9.

Surgical, Inc. a. Sales amount: 200,000 shares  $40 = Purchase amount: 200,000 shares  $1.00 = Capital gain Capital gains exemption Capital gain after exemption Taxable capital gain (50%) Taxes (28%) Aftertax profit (capital gain – tax) b. Sales amount: 200,000 shares  $72.50 = Purchase amount: 200,000 shares  $1.00 = Capital gain Capital gains exemption Capital gain after exemption Taxable capital gain (50%) Taxes (28%) Aftertax profit (capital gain – tax)

$8,000,000 200,000 7,800,000 500,000 7,300,000 3,650,000 1,022,000 $6,778,000 $14,500,000 200,000 14,300,000 500,000 13,800,000 6,900,000 1,932,000 $12,368,000

c. Discount back: $12,368,000 for 5 years at 11 percent Calculator: Compute:

PV =? FV= $12,368,000 %I/Y= 11% PV = $7,339,806

PMT = 0 N=5

This value of $7,339,806 exceeds the value in part (a) of $6,778,000. Deferring the sale (and the tax) appears to be the more desirable alternative.

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20-10. a.

Lindbergh Airlines Market price of Flight Simulators, Inc. + Premium of 60%

$30 18

Value offered per share

$48

Value offered per share

$48

Purchase price

Gain

$ 6 $6   $42

Percentage gain

Value after cancellation (original value)

$30

Purchase price

Loss

$12 $12   $42

Percentage loss

14.29%

28.57%

Return

Probability

Expected Value

+ 14.29%

.75

+ 10.72%

– 28.57%

.25

– 7.14

Expected value

3.58%

It appears to be a good investment

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20-11.

Minnie & Mickey Corporations

a. Total earnings Minnie ($800,000) + Mickey ($1,600,000) = $2,400,000 Shares outstanding in surviving company: The Mickey Corp. Old (800,000) + New (200,000) = 1,000,000 New earnings per share  b.

$40.00 × 1.25 $50.00 $50.00 × 200,000 $10,000,000

Shares issued 

Net income $2,400,000   $2.40 1,000,000 Shares outstanding market price of Minnie (25% premium) exchange value shares total price

Total price $10,000,000   250,000 (Mickey) Market share price $40

Also, 1.25 × 200,000 Minnie shares = 250,000 Mickey shares. This shortcut approach may also be used because the shares have an equal price before the merger. c. Total earnings Minnie ($800,000) + Mickey ($1,600,000) = $2,400,000 Shares outstanding in surviving company: The Mickey Corp. Old (800,000) + New (250,000) = 1,050,000 New earnings per share 

Foundations of Fin. Mgt. 12Ce

Net income $2,400,000   $2.29 1,050,000 Shares outstanding

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20-12.

Mickey-Minnie Corporations (continued) $40.00 × 2.00 $80.00 × 200,000 $16,000,000

Shares issued 

market price of Minnie (100% premium) exchange value shares total price

Total price $16,000,000   400,000 (Mickey) Market share price $40

Also, 2.00 × 200,000 Minnie shares = 400,000 Mickey shares. Total earnings: $2,400,000 × 1.25 = $3,000,000 Shares outstanding in surviving company: The Mickey Corp. Old (800,000) + New (400,000) = 1,200,000 New earnings per share 

Net income $3,000,000   $2.50 1,200,000 Shares outstanding

Earnings per share increase by $0.50 post-merger. ($2.00 to $2.50)

20-13. a.

Shelton Corporation Pre-merger

 $1.89 variation (V)    0.63 Coefficient of D $3.00

Post-merger $1.20  0.40 $3.00

b. Risk averse investors are being offered less risk and may assign a higher P/E ratio to post-merger earnings.

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20-14.

General Meter

a. Merger with A (answer in millions of dollars) D   DP

D 40 50 60

P .30 .40 .30

DP 12 20 18 50

= D

  D  D P 2



D 40 50 60

D 50 50 50

(D– D ) – 10 0 + 10

(D– D )2 100 0 100

P .30 .40 .30

(D– D )2P 30 0 30 60

  60  7.75

 7.75  0.155 variation  V    Coefficient of 50 D

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Merger with B (answer in millions of dollars) D   DP

D 10 50 90

P .25 .50 .25

DP 2.5 25.0 22.5 50.0

= D

  D  D P 2



D 10 50 90

D 50 50 50

(D– D ) – 40 0 + 40

(D– D )2 1,600 0 1,600



 28.28

P .25 .50 .25

(D– D )2P 400 0 400 800

 28.28  0.566 variation  V    Coefficient of 50 D b. Though both alternatives have an expected value of $50 (million), the lower coefficient of variation, and thus lower risk in merger A should call for a higher valuation by risk averse investors.

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20-15.

Wright Aerospace Corporation

a. Purchase price Book value Goodwill

$90,000,000 30,000,000 $60,000,000

Goodwill is now written off as the asset is impaired. Therefore, the write off will be based on market forces and management discretion.

b. Three quarters of the $60 million is eligible for a 7% per year, declining balance deduction as eligible capital property. This will create an annual tax saving equal to 7% times the tax rate times the remaining cumulative eligible capital (decreased by the amount of writ off taken each year).

c. By using a pooling of interest treatment, the recording of goodwill could have been avoided. However, it is generally not allowed. Under some circumstances assets may be written off.

20-16.

Ontario Corporation

a. Assets (in millions of $) Common Stock Holdings Eastern Corp. $ 301 Central Corp. $ 402 3 Western Corp. $ 10 Total $ 80

Liabilities Long term debt Preferred stock Common equity

$ 244 $ 165 $ 406 $ 80

25% × $120 = $30 2 20% × $200 = $40 3 10% × $100 = $10

30% × $80 = $24 20% × $80 = $16 6 50% × $80 = $40 5

b. Shareholders‘ equity/ Total holding company assets = $80× 50% / ($200 + $300 + $300) = 0.05 or 5%

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MINI CASE National Brands vs. A-1 Holdings (Merger analysis) This case features a surprise attack tender offer. The acquisition candidate decides to counter with a Pac Man defense in which they make an offer for the potential acquiring company. Both firms are considering various financing packages to establish their strategy including heavy leverage and the use of acquired assets as collateral. Consider the feasibility of the plans and the impact on shareholder wealth maximization. Consider social responsibility (good guy versus bad guy) issues related to the merger as well.

a. (1)

(2)

According to Figure 1, there are 113,640,000 shares of National Brands outstanding. But, A-1 already owns 5% of them, or 5,682,000, so it will only have to buy the remaining 107,958,000. A $55 each, the total price will be $5,937,690,000 (a little over $5.9 billion). The amount of liquid assets (i.e., cash and equivalents) on hand at National is $1,153,000,000. If A-1 can use this amount to offset the amount of borrowing required, the total amount it will have to borrow is: $5,937,690,000 – $1,153,000,000 = $4,784,690,000

(3)

After the purchase, A-1's total debt will consist of: A-1's old debt: National debt: Amount borrowed: Total

$1,899,500,000 2,110,300,000 4,784,690,000 $8,794,490,000

Since all the funds to make the purchase were borrowed, A-1's total equity remains $395,000,000 after the purchase. Its debt to equity ratio after the purchase, therefore, is: $8,794,490,000 / $395,000,000 = 22.26 to 1! This is astonishing. Such high debt to equity ratios are not normally encountered except in financial institutions, such as banks. (In fact, A1's balance sheet resembles that of a bank; over 75% of its assets are in cash and equivalents, lending credence to the charge that corporations such as A-1 aren't "real" corporations after all, merely shells, or deposit accounts used by their owners, to make acquisitions). Foundations of Fin. Mgt. 12Ce

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Given such a high debt to equity ratio, it is difficult to imagine how Mr. O'Brien could finance the purchase of National using debt sources.

(4)

In (2), above, we computed that $4,784,690,000 was needed to make the purchase. If A-1 issues stock at $13 a share to raise the funds, it will need to issue 368,053,077 new shares.

(5)

The total number of shares outstanding at A-1 after the purchase will be the 61,800,000 old shares plus 368,053,077 newly issued ones. Total expected earnings are the $192,000,000 A-1 originally expected plus $500,000,000 from National. So, A-1's EPS after the purchase will be: ($192,000,000 + $500,000,000)/ 61,800,000 + 368,053,077 = $692,000,000/ 429,853,077 = $1.61

(6)

b. (1) (2)

$1.61 represents a 48% decline from A-1's previous expected EPS of $3.11 (the decline, of course, was caused by the fact that National's P/E is much higher than A-1's). A-1's shareholders will be not be pleased, unless Mr. O'Brien can convince them that they will be better off in the long run (unlikely-National's growth rate is not high enough), or he has some other plan in mind, such as selling off pieces of National at a profit. National shareholders, on the other hand, will realize an immediate 15% capital gain. ($7.12 / $47.88) = 15 percent. They may be more satisfied, though 15 percent is a relatively small premium. Employing the Pac Man defense will cost National $17 a share times the 61,800,000 shares of A-1 outstanding, or $1,050,600,000. A-1 has $1,736,800 of liquid assets available. Using this amount to offset the amount of National stock to be issued brings the total amount of cash needed to be raised down to: $1,050,600,000 – $1,736,800,000 = -$686,200,000 It's a rather surprising result that National could buy A-1 without spending any of its own money at all! The Cash and Equivalents balance on hand at A-1 is more than enough to cover the cost of the company. Of course, National will have to assume all of A-1's debt too, which is rather substantial.

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(3)

National's total debt after the purchase will be its old debt plus A-1's debt: National's old debt: A-1's old debt: National‘s new debt:

$2,110,300,000 1,899,500,000 $4,009,800,000

National's total equity after the purchase will simply be its old equity, $3,050,000,000. Therefore, National's debt to equity ratio after the purchase will be: $4,009,800,000 / $3,050,000,000 = 1.31 to 1 The new ratio of 1.31 to 1 is nearly double National's old ratio of .69 to 1, so the company will probably want to use at least some of A-1's cash to reduce its debt load instead. This situation illustrates why companies with large cash balances (and little debt) are attractive takeover targets.

(4)

If National uses A-1's $1,736,800,000 cash and equivalents balance to pay down A-1's $1,899,500,000 debt balance, it will not have any left to apply to the stock issue. Therefore, National will have to issue enough of its own shares at $47.88 each to cover A-1's entire cost of $1,050,600,000 $1,050,600,000 / $47.88 = 21,942,356 shares

(5)

The total number of shares outstanding at National after the purchase will be the 113,640,000 old shares plus 21,942,356 newly issued ones. Total expected earnings are the $500,000,000 National originally expected plus $192,000,000 from A-1. So, National's EPS after the purchase will be: ($500,000,000 + $192,000,000)/ 113,640,000 + 21,942,356 = $692,000,000/ 135,582,356 = $5.10

(6)

Mr. Hall is correct. The A-1 purchase will not dilute National's earnings, at least in the coming year. They actually increase from $4.40 to $5.10.

c. If National's P/E remains at its previous value of 10.9, its stock price can be expected to rise to $5.10 × 10.9 = $55.59. Of course, it is highly unlikely that its P/E will remain at its previous value. A-1's old P/E was only 4.2, less than half that of National. It is likely, therefore, that investors will lower their expectations for National somewhat, despite its Foundations of Fin. Mgt. 12Ce

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higher earnings. If National's P/E drops only as far as 9.4, its stock price will remain at $47.88. Note-students may question why A-1 has a higher growth rate than National, yet its P/E is much lower. The answer lies in the fact that the P/E ratio does not depend on investors' growth expectations alone. In this case the P/E is inhibited by A-1's extremely high debt ratio.

d. (1)

As a result of A-1's offer to buy National, National's shareholders stand to realize a 15% capital gain, but National's management is against the move and will try to convince the shareholders to reject it. On the other hand, A-1's shareholders stand to realize a 31% capital gain ($13 to $17) if National buys A-1, and nothing in the case indicates that Mr. Kelly O'Brien would resist such a deal. Therefore, it seems likely that National's bid to purchase A-1 will prevail. It is tough to dismiss the suggestion that he may have engineered the entire situation merely to elicit the Pac Man response from National. In fact, this suggestion was reported in the press concerning the companies upon which this case is based.

(2)

It is difficult to say whether or not National's shareholders are better off as a result of their company's employment of the Pac Man defense. On the one hand, they have been denied the chance for a 15% capital gain. On the other, they have gained a set of assets which may or may not achieve an equal gain, even in the long term. Further, the assets were not purchased as a part of an integrated capital budgeting program, but were obtained under duress. On balance, it would appear that A-1's shareholders would be the big winners in this situation.

(3)

Those who take sides with the corporate "raiders" would say that they provide a valuable function in the economy; weeding out inefficiency. They do this by buying inefficiently managed companies and restructuring them into more effective units. In the long run, they say, the economy as a whole is strengthened. Opponents charge that the practice is unfair to employees who are uprooted and often lose their jobs in the restructurings, and they maintain that business ought to concentrate on making money by producing quality products rather than making it by trading companies. In the long run, they say, the economy as a whole is weakened. The issue goes far beyond a case in finance, essentially becoming one of ethics and point of view. The truth is probably a blend of the two views, or the classic ‗it depends‘.

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At the very least we can probably say that such decisions should not be made purely on the basis of the financial aspects of the situation. Discussion Questions 21-1. In addition to the normal risks that a domestic firm faces (such as the risk associated with maintaining sales and market share, the financial risk of too much leverage, etc.), the foreign affiliate of a multinational firm is exposed to foreign exchange risk and political risk. 21-2. Some countries have charged that foreign affiliates subverted their governments and caused instability for their currencies in international money and foreign exchange markets. The less developed countries (LDC's) have, at times, alleged that foreign business firms exploit their labour with low wages. The multinational companies are also under constant criticism in their home countries. The home country's labor unions charge the MNC's with exporting jobs, capital, and technology to foreign nations, while avoiding their fair share of taxes. In spite of all these criticisms, the multinational companies have managed to survive and prosper. 21-3. Factors affecting the value of a currency are: inflation, interest rates, balance of payments, and government policies. Other factors that have an influence include the stock market, gold prices, demand for oil, political turmoil, and labor strikes. All of the above factors will not affect each currency in the same way at any given point in time. 21-4. When a country sells (exports) more goods and services to foreign countries than it purchases (imports), it will have a surplus in its balance of trade. Since foreigners are expected to pay their bills for the exporter's goods in the exporter's currency, the demand for that currency and its value will go up. On the other hand, continuous deficits in balance of payments are expected to depress the value of the currency of a country because such deficits would increase the supply of that currency relative to the demand. Of course, a number of other factors may also influence these patterns. 21-5. The spot rate for a currency is the exchange rate at which the currency is traded for immediate delivery. An exchange rate established for future delivery is a forward rate. 21-6. The foreign-located assets and liabilities of a MNC, which are denominated in foreign currencies. Conversion by exchange rates to a home country is called accounting or translation exposure. The amount of loss or gain resulting from this form of exposure and the treatment of it in the parent company's books depends upon the accounting rules established by the parent company's government. 21-7. Factors that influence a Canadian business firm to go overseas are: avoidance of tariffs; lower production and labor costs; usage of superior Canadian technology abroad in such areas as oil exploration, mining, and manufacturing; tax advantages such as postponement of Canadian taxes until foreign income is repatriated, lower foreign taxes, and special tax incentives; defensive measures to keep up with competitors going overseas; and the achievement of international diversification. There also is the potential for higher returns.

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21-8. In studying exposure to political risk, a company may hire outside consultants or form their own advisory committee consisting of top level managers from headquarters and foreign subsidiaries. Strategic steps to guard against such risks include: a. Establish a joint venture with a local entrepreneur. b. Enter into a joint venture with firms from other countries. c. Purchase insurance. 21-9. An international financial feasibility study must go beyond domestic factors to also consider the treatment of foreign tax credits, foreign exchange risk, and remittance of cash flows. 21-10. A letter of credit is normally issued by the importer's bank; in which the bank promises to pay money for the merchandise when delivered. 21-11. In a parallel loan, the exchange rate markets are avoided entirely: that is, the funds do not enter the foreign exchange market at all. Also no financial institution is involved. In contrast, a fronting loan involves funds moving into foreign markets and the involvement of a financial institution to front for the loan. 21-12. LIBOR (London Interbank Offered Rate) is an interbank rate applicable for large deposits in the Eurodollar market. It is a bench mark rate just like the prime rate in Canada. Interest rates on Eurodollar loans are determined by adding premiums to this basic rate. Generally, LIBOR is lower than the Canadian bank‘s prime rate. 21-13. When a multinational firm borrows money through the Eurobond market (foreign currency denominated debt), it creates transaction exposure, a kind of foreign exchange risk. If the foreign currency appreciates in value during the bond's life, the cost of servicing the debt could be quite high. 21-14. ADRs (American Depositary Receipts) represent the ownership interest in a foreign company's common stock. The shares of the foreign company are put in trust in a New York bank. The bank, in turn, issues its depository receipts to the American shareholders of the foreign firm. Many ADRs are listed on the NYSE and many more are traded in the OTC market. 21-15. Debt ratios in many countries are higher than those in Canada. A foreign affiliate faces a dilemma in its financing decision. Should it follow the parent firm's norm or that of the host country? Furthermore, should this be decided at corporate headquarters or by the foreign affiliate? Dividend policy may represent another difficult question. Should the parent company dictate the dividends that the foreign affiliate must distribute or should it be left to the discretion of the foreign affiliate?

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Internet Resources and Questions 1. 2. 3. 4.

www.edc.ca www.ifc.org http://fx.sauder.ubc.ca/ www.cmegroup.com www.cmegroup.com

Problems 21-1.

Spot Rate Conversions (January 2020) Dollars required to buy a given amount of these currencies a. 10,000 10,000 b. 2,000 2,000 c. 100,000 100,000 d. 5,000 5,000 e. 20,000 20,000 f. 50,000 50,000



Euros 1/ 0.6772

$14,767



Rupees 1/ 53.996

$37.04



Yen 1/ 80.580

$1,241



Swiss francs 1/ 0.7199 =

$6,945



Swedish krona 1/ 7.2202 = $2,770



Thai baht 1/ 23.468

$2,131

21-2. The answer to this question depends on the time period in which the values are calculated.

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21-3.

Forward Premiums/ Discounts a. The euro was selling relative to the Canadian dollar, at a discount at 30 and 90 days, but a premium at 180-days, based on the spot rate.

b. Forward premium (discount) = =

1.4765 − 1.4767 1.4767

12 1

Forward-spot

Forward premium (discount) = =

1.4767

12 6

12 contract length (months)

= −0.000135437 × 12 = −0.001625245 = −0.16%

c. 1.4773 − 1.4767

spot

Forward-spot spot

12 contract length (months)

= 0.000406311 × 2 = +0.000812623 = +0.08%

d. Forward rate is 1.4761 ($/ euro) for 90 days: Therefore 100,000 Euros

= 100,000 × 1.4761 = $147,610 Canadian

e. Forward rate is 1.4773 ($/ Euro) for 180 days: Conversely the forward rate is 1/ 1.4773 = 0.67691 (Euro/ $) Therefore $100,000

Foundations of Fin. Mgt. 12Ce

= $100,000 × 0.67691 = 67,691 euros

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Block, Hirt, Danielsen, Short

21-4.

Cross Rates 1 Egyptian pound 1 Jordanian dinar

= $0.0719 Canadian = $1.8932 Canadian

$1 Canadian

= 1/0.0719 Egyptian pounds = 13.9082 Egyptian pounds

$1 Canadian

= 1/ 1.8932 Jordanian dinars = 0.5282 Jordanian dinars

13.9082 Egyptian pounds = 0.5282 Jordanian dinars 1 Egyptian pound = 0.5282/ 13.9082 Jordanian dinars (0.5282/ 13.9082) = 0.0380 Jordanian dinars OR: 1 Jordanian dinar = 13.9082/ 0.5282 Egyptian pounds (13.9082/ 0.5282) = 26.331 Egyptian pounds 21-5.

Cross Rates 1 Mexican peso 1 Brazilian real

= $0.0682 Canadian = $0.3017 Canadian

$1 Canadian

= 1/0.0682 Mexican pesos = 14.6628 Mexican pesos

$1 Canadian

= 1/ 0.3017 Brazilian reals = 3.3146 Brazilian reals

14.6628 Mexican pesos 1 Mexican n peso

= 3.3146 Brazilian reals = 3.3146/ 14.6628 Brazilian reals = 0.2261 Brazilian reals

OR: 1 Brazilian reals (14.6628/ 3.3146)

Foundations of Fin. Mgt. 12Ce

= 14.6628/ 3.3146 Mexican pesos = 4.4237 Mexican pesos

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Block, Hirt, Danielsen, Short

21-6.

Cross Rates 1 Thai Baht 1 Panamanian balboa

= $0.03280 Canadian = $1.3404 Canadian

$1 Canadian

= 1/0.03280 Thai Bahts = 30.4878 Thai Bahts

$1 Canadian

= 1/ 1.3404 Panamanian balboas = 0.74605 Panamanian balboas

30.4878 Thai Bahts 1 Thai Baht (0.7460/ 30.4878) OR: 1 Panamanian balboa (30.4878/ 0.74605)

= 0.7460 Panamanian balboas = 0.7460/ 30.4878 Panamanian balboas = 0.0245 Panamanian balboas

21-7.

= 30.4878/ 0.74605 Thai Bahts = 40.8656 Thai Bahts

Purchasing Power Parity $/ Swiss Franc (Sf) = $0.40/1Sf in 1974 Comparative inflation rate (to 2020) =

362 200

= 1.81

The value of the Swiss franc to the dollar will rise in proportion to the rate of inflation in Canada compared to the rate of inflation in Switzerland. $/Sf (2020) = $0.40/Sf  1.81 = $0.724 21-8.

Purchasing Power Parity Comparative inflation rate (to 2020) =

100 = 0.50 200

$/Sf (2020) = $0.40/Sf  0.50 = $0.20

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21-9.

Purchasing Power Parity (again) $/ ruble = $0.20/1ruble in 1996 Comparative inflation rate (to 2020) =

150 1500

= 0.1000

The value of the Russian ruble to the dollar will rise in proportion to the rate of inflation in Canada compared to the rate of inflation in Russia. $/ ruble (2020) = $0.20/ ruble  0.1000 = $0.020

21-10.

Interest Rate Parity Initial value  (1 + interest rate) 120,000  1.08 = 129,600 New Zealand dollars New Zealand dollars  0.8033 = Canadian dollars equivalent 129,600  0.8033 = 104,108 Canadian dollars $ 4,108/ $100,000

Foundations of Fin. Mgt. 12Ce

= 0.0411 = 4.11%

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Block, Hirt, Danielsen, Short

21-11.

French Investor = 300  $15 = $4,500

a. Initial investment

= 300  $17.75 = $5,325

Value after one year

Equivalent value to the French investor = $5,325  1.10 = $5,857.5 $5,875.5 − $4,500 Return = = 0.3017 = 30.17% $4,500 = 300  $15 = $4,500

b. Initial investment

= 300  $18.50 = $5,550

Value after one year

Equivalent value to the French investor = $5,550  0.90 = $4,995 4,995 − $4,500 Return = = 0.1100 = 11.0% $4,500

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21-12.

Canadian Investor = 200  $61 = $12,200

a. Initial investment

= 200  $58 = $11,600

Value after one year

Equivalent value to the Canadian investor = $11,600  1.04 = $12,064 Return 

$12,064  $12,200

 0.0111  1.11%

$12,200

= 200  $61 = $12,200

b. Initial investment

= 200  $55 = $11,000

Value after one year

Equivalent value to the Canadian investor = $11,000  (1 ‒ 0.02) = $10,780 Return 

$10,780  $12,200

 0.1164  11.64%

$12,200

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21-13.

Saturn Industries

a. Receipts in one year‘s time: 1. Take a chance on the spot rate (at the future date): 1,000,000 euros @ 1.3825 = $1,382,500 Canadian 2. Book a forward contract: 1,000,000 euros @ 1.3676 = $1,367,600 Canadian 3. Money market hedge: Borrow 1 year discounted: 1,000,000 euros Borrow 1,000,000/ 1.04 = 961,538 euros Convert to Canadian at the spot rate 961,538 euros @ 1.3805 = $1,327,403 Canadian Invest in Canada at the current interest rates $1,327,403 Canadian @ 1.03 = $1,367,225 Pay off the euro loan with the receipt of the 1,000,000 euros. b. Although the spot rate appears to produce the best return, it is uncertain and introduces risk. The forward contract provides the best result with minimal risk.

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21-14.

Royal Minty

a. Purchase in six months (180 days): 10,000 ounces @ $16.60 = $166,000 U.S. 1. Take a chance on the spot rate (at the future date): $166,000 @ 1/ £ 1.7915 = £ 92,660 2. Book a forward contract: $166,000 @ 1/ £ 1.7863 = £ 92,930 3. Money market hedge: Invest 180 day discounted: $166,000 (to meet contract) Invest $166,000/ 1+ (0.0115 × 180/ 365) = $165,064 Convert to £ (pounds) at the spot rate $165,064 @ 1/ 1.8127 = £ 91,060 Borrow in Britain at the current interest rates £ 91,060 @ 1 + (0.0470 × 180/ 365) = £ 93,171 owed in 180 days Pay off the pound (£) loan.

b. Although the spot rate appears to produce the lowest, it is uncertain and introduces risk. The forward contract provides the best result with minimal risk, although very similar to the money market hedge.

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21-15.

Nickel Plains of Canada

a. Purchase in three month‘s time (90 days): 500,000 pounds @ $6.96 = $3,480,000 U.S. 1. Take a chance on the spot rate (at the future date): $3,480,000 @ 1.3333 = $4,639,884 Canadian 2. Book a forward contract: $3,480,000 @ 1.3421 = $4,670,508 Canadian 3. Money market hedge: Invest 90 day discounted: $3,480,000 (to meet contract) Invest $3,480,000/ [1+ (0.0160 × 90/ 365)] = $3,466,325 Convert to $ Canadian at the spot rate $3,466,325 @ 1.3404 = $4,646,262 Canadian Borrow in Canada at the current interest rates $4,646,262 @ [1 + (0.020 × 90/ 365)] = $4,669,175 owed in 90 days Pay off the loan.

b. The money market contract provides the best result (slightly) for minimal risk.

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21-16.

Weese R. Grains of Canada

a. Receipts in one year‘s time: 5,000 tonnes of wheat @110 euros = 550,000 euros 1. Take a chance on the spot rate(at the future date): 550,000 euros @ 1.3485 = $741,675 Canadian 2. Book a forward contract: 550,000 euros @ 1.3676 = $752,180 Canadian 3. Money market hedge: Borrow 1 year discounted: 550,000 euros Borrow 550,000/ 1.0377 = 530,018 euros Convert to Canadian at the spot rate 530,018 euros @ 1.3805 = $731,690 Canadian Invest in Canada at the current interest rates $731,690 Canadian @ 1.0340 = $756,568 Pay off the euro loan with the receipt of the 550,000 euros.

b. The money market hedge provides the best result with minimal risk.

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21-17.

Exploratory Resources

a. The Calgary bank has extended a loan denominated in U.S. dollars and will be repaid in U.S. dollars. If the U.S. dollar increases in the future (a possibility implied by the futures contract price), the Calgary bank will be paid back in a currency that is worth more at the time it is repaid than it was at the time it was borrowed.

b. Basically the bank is buying U.S. dollars now for 0.9877 (1/$1.0125) and expecting to sell them in the future for 0.9894 (1/$1.0107), if the future rate is a reliable predictor of the future spot rate. The expectation is for $0.0017 on the $1,000,000 or $1,700 Canadian, to be made on the exchange rate.

c. By hedging the bank assures that the foreign exchange gain will be exactly $1,700. The extra $100 does not affect the decision much. Of course, the bank could also raise the funds in the United States market that it needs to fund the loan. It would then essentially have a natural hedge and would only face exchange risk on repatriation of the interest margin earned.

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21-18.

Campbell Electronics Corporation

a. Before tax earnings Foreign income tax @ 20% Earnings after foreign income taxes Dividends repatriated Gross Canadian taxes @ 25% of foreign earnings before taxes Foreign tax credit Net Canadian taxes payable

$5,000,000 -1,000,000 4,000,000 4,000,000 1,250,000 -1,000,000 $ 250,000

Aftertax cash flow from dividend: = ($4,000,000 – $250,000) = $3,750,000

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Problems: Appendix 21A 21A-1.

Office Automation Corporation

(values in millions of francs) Year 1 Year 2 Year 3 Year 4 Year 5 Revenue 20.00 20.00 20.00 20.00 20.00 – Operating expenses 10.00 10.00 10.00 10.00 10.00 – Amortization (20 M/5) 4.00 4.00 4.00 4.00 4.00 = Earnings before foreign taxes

– Foreign income tax (25%) = Earnings after foreign income taxes = Dividends repatriated Gross Canadian taxes (40% of foreign earnings before taxes) – Foreign tax credit = Net Can. taxes payable Aftertax dividend received Exchange rate (2 francs/$) Aftertax dividend (Can. $)

6.00 1.50

4.50 4.50

2.40

1.50 0.90 3.60

2.00 $1.80

PVIFA (%I/Y = 16%; N = 5) of dividends Calculator:

PV =? FV = 0 %I/Y = 16%

Compute:

Foundations of Fin. Mgt. 12Ce

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PMT = $1.8 million N=5 PV = $5.894 million

Block, Hirt, Danielsen, Short

Amortization equals 4.00 million per year: 4.00/ 2 francs/$ = $2.00 Calculator:

PV =? FV =0 %I/Y = 16%

Compute:

PMT = $2.0 m. N=5 PV = $6.549 million

The PV of all the cash inflows =$5.894 + $6.549 = Cost of project Net present value of the project

$12.443 million –10.000 million $ 2.443 million

The net present value of the project is positive; the firm should invest. b. The change in foreign exchange values must be applied to both aftertax dividends received (in francs) and depreciation (in francs).

Aftertax dividend received Amortization Total (in francs) Exchange rate (F/$1) Cash inflow (Can. $) PVIF (16%) PV (Can. $)

(in millions) Year 2 Year 3 Year 4 3.60 3.60 3.60 4.00 4.00 4.00 7.60 7.60 7.60 2.40 2.70 2.90 3.17 2.81 2.62 .743 .641 .552 + 2.36 + 1.80 + 1.45

Year 1 3.60 4.00 7.60 2.20 3.45 .862 +2.97

Year 5 3.60 4.00 7.60 3.20 2.38 .476 + 1.13

Total = 9.71 PV of all the inflows equals Cost of project Net present value of the project

$ 9.71 million 10.00 million ($0.29) million

On a purely economic basis, the investment should now be rejected. Discussion Questions

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12-1. Important administrative considerations relate to: the search for and discovery of investment opportunities, the collection of data, the evaluation of projects, the plan implementation, and the re-evaluation of prior decisions. 12-2. Cash flow rather than net income is used in capital budgeting analysis because the primary concern is with the amount of actual dollars generated. For example, amortization is subtracted out in arriving at net income, but this noncash deduction should be added back in to determine cash flow or actual dollars generated. 12-3. The weaknesses of the payback method are: a. There is no consideration of inflows after the cutoff period. b. The concept fails to consider the time value of money. The payback period has some features that help to explain its use by corporate management: a) Easy to understand. b) Heavy emphasis on liquidity (recoup initial investment quickly, in 3 to 5 years, or it will not qualify) c) Provides an initial view of an investment‘s risk.

12-4. The cost of capital as determined in Chapter 11, which capture the appropriate amount of risk for a project in which the firm normally engages. 12-5. The selection of one investment precludes the selection of other alternative investments. 12-6. From a purely economic viewpoint, a firm should not ration capital. The firm should be able to find additional funds and increase its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost. 12-7. The net present value profile allows for the graphic portrayal of the net present value of a project at different discount rates. Net present values are shown along the vertical axis and discount rates are shown along the horizontal axis. The points that must be determined to graph the profile are: a. The net present value at zero discount rate. b. The net present value as determined by a normal discount rate. c. The internal rate of return for the investment 12-8. In evaluating the forecast IRR and NPV, management must carefully review the assumptions that determined the timing and amount of estimated cash flows. In addition, it must carefully consider the particular project in relation to the firm‘s overall business. Although the overall effects may be impossible to quantify, they may be critically important in deciding whether or not to invest. 12-9. The capital cost allowance system generally makes CCA tax shields available earlier than would a straight-line system tied to the asset‘s economic life.

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Block, Hirt, Danielsen, Short

12-10. The investment tax credit represents direct dollar givebacks of a portion of an asset‘s capital cost regardless of whether or not the firm is taxable. It reduces the amount of capital the firm has to invest in a project. 12-11. The cost of a capital is calculated based on the current market yields for various components of the capital structure. Current market yields incorporate future expectations about interest rates and thus about inflation. Since inflation is incorporated in the evaluation tool to be used in capital budgeting analysis, it is important to be consistent and incorporate the same implied inflation into projected cash flows. 12-12. An efficient market implies that all financial transactions give a return just adequate for the risk assumed and abnormal profits do not exist. Therefore in an efficient market NPV = 0 for all investments. It is highly unlikely that the financial manager faces efficient markets in markets such as technology, machinery, and labour. 12-13. The modified internal rate of return calls for the determination of the interest rate that equates future inflows to the investment as does the traditional internal rate or return. However, it incorporates the reinvestment rate assumption of the net present value method. That is that inflows are reinvested at the cost of capital.

Internet Resources and Questions See Finance in Action boxes within chapter.

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Problems 12-1.

Primus Corporation cash flow Earnings before amortization and taxes Amortization Earnings before taxes Taxes @ 30% Earnings after taxes Amortization Cash flow

12-2.

$90,000 –40,000 50,000 –15,000 35,000 +40,000 $75,000

Corporate cash flow Earnings before amortization and taxes Amortization Earnings before taxes Taxes @ 34% Earnings after taxes Amortization Cash flow

$100,000 – 50,000 50,000 17,000 33,000 + 50,000 $ 83,000

Alternative cash flow calculation: $100,000 17,000 (taxes) $83,000 cash flow

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Block, Hirt, Danielsen, Short

12-3.

Corporate cash flow a. Earnings before amortization and taxes Amortization Earnings before taxes Taxes @ 34% Earnings after taxes Amortization Cash flow b. Cash flow (problem 1) $83,000 or Cash flow (problem 2a) 69,400 Difference in cash flow $13,600

12-4.

$100,000 – 10,000 90,000 30,600 59,400 + 10,000 $ 69,400

[$50,000 – $10,000](T) = 40,000 (.34) = $13,600

Blink 281 Corporation a. Average accounting return AAR 

Year EBAT 1 $35,000 2 37,000 3 41,000 4 45,000 5 50,000

Amortization $24,000 24,000 24,000 24,000 24,000

Average earnings aftertax

Average earnings aftertax Average book value

EBT Taxes (25%) EAT $11,000 $2,750 $ 8,250 13,000 3,250 9,750 17,000 4,250 12,750 21,000 5,250 15,750 26,000 6,500 19,500 66,000 $13,200

Average accounting return AAR  

$13,200  0.22  22% $120,000 / 2

b. Seems like a pretty good return, but we need a criteria for acceptance of projects. What AAR is enough? c. AAR does not use the time value of money, cash flows or the market value of assets.

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Block, Hirt, Danielsen, Short

12-5.

Secundus Corporation Earnings before amortization and taxes Amortization Earnings before taxes Taxes @ 35% Earnings after taxes Amortization Cash flow

$440,000 –140,000 300,000 –105,000 195,000 +140,000 $335,000

Earnings before amortization and taxes Amortization Earnings before taxes Taxes @ 20% Earnings after taxes Amortization Cash flow

$440,000 –140,000 300,000 –60,000 240,000 +140,000 $380,000

12-6.

A Firm

a. Earnings before amortization and taxes (cash flow)

Taxes (cash flow) 25% Earning after taxes Cash flow b. Earnings before amortization and taxes (cash flow)

Amortization (noncash expense) Earnings before taxes Taxes (cash flow) 25% Earning after tax Amortization Cash flow

$200,000 50,000 $150,000 $150,000 $200,000 200,000 0 0 $ 0 200,000 $200,000

c. The amortization provides the benefit of $50,000 in cash flow.

12-7.

Foundations of Fin. Mgt. 12Ce

Al Quick

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Block, Hirt, Danielsen, Short

Being short term oriented, he may make the mistake of turning down the project even though it will increase cash flow because of his fear of investors‘ negative reaction to the more widely reported quarterly decline in earnings per share. Even though this decline will be temporary, investors might interpret it as a negative signal.

12-8. Year EBAT 1 $110,000 2 120,000 3 150,000

Pluto Corporation Amortization $70,000 70,000 70,000

Average earnings aftertax

EBT Taxes (25%) EAT $40,000 $10,000 $30,000 50,000 12,500 37,500 80,000 20,000 60,000 127,500 $42,500

Average accounting return AAR  

Foundations of Fin. Mgt. 12Ce

$42,500  0.4048  40.48% ($210,000  0) / 2

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Block, Hirt, Danielsen, Short

12-9.

Payback Period Payback for Product X Payback for Product Y $250,000 – 90,000 1.0 year $250,000 – 50,000 1.0 year 160,000 – 90,000 2.0 years 200,000 – 80,000 2.0 years 70,000 – 60,000 3.0 years 120,000 – 60,000 3.0 years 10,000/ 20,000 0.5 years 60,000/ 70,000 0.86 years Payback Product X = 3.5 years Payback Product Y = 3.86 years Product X would be selected because of the faster payback.

12-10.

Payback Period

Payback for Investment A $50,000 – $10,000 40,000 – 11,000 29,000 – 13,000 16,000 – 16,000

Payback for Investment B $50,000 – $20,000 1 year 30,000 – 25,000 2 years 5,000/ 15,000 2.33 years

1 year 2 years 3 years 4 years

Payback: Investment A = 4.00 years Payback: Investment B = 2.33 years Investment B would be selected because of the faster payback.

12-11.

Payback Period Revisited

The $30,000,000 inflow would still leave the payback period for Investment A at 4 years. It would remain inferior to Investment B under the payback method.

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12-12.

Payback versus NPV

NPV for Investment A Year 1 2 3 4 5

Cash flow $ 10,000 11,000 13,000 16,000 30,000 Present value of inflows Initial investment NPV (net present value)

Present value @ 15% $ 8,696 8,318 8,548 9,148 14,915 $49,625 50,000 $ (375)

NPV for Investment B Year 1 2 3

Cash flow $20,000 25,000 15,000 Present value of inflows Initial investment NPV (net present value)

Present value @ 15% $17,391 18,904 9,863 $46,158 50,000 $(3,842)

Neither project is attractive, with investment B less attractive.

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12-13.

Short-Line Railroad

a. Payback for Electric Co.

Payback for Water Works

$100,000 – $70,000 30,000 – 15,000 15,000 – 15,000

$100,000 – $15,000 85,000 – 15,000 70,000 – 70,000

1 year 2 years 3 years

Both projects have equal payback = 3 years

b. The Electric Co. has a cash flow of $70,000 in the first year but because the time value of money is ignored, the $70,000 has the same value as the cash flow in year three for Water Works.

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12-14.

Britney Javelin Company

a. Payback for Project M $15,000 – $8,100 6,900 – 5,400 1,500/ 4,050

Payback for Project N

1 year 2 years 2.37 years

$15,000 – $6,750 8,250 – 4,050 4,200 / 10,800

1 year 2 years 2.39

years Based on payback the projects are virtually identical. b. NPV for Project M Year Cash flow 1 $8,100 2 5,400 3 4,050 Present value of inflows Initial investment NPV (net present value)

Present value @ 7% $7,570 4,717 3,306 $15,593 -15,000 $ 593

NPV for Project N Year Cash flow 1 $ 6,750 2 4,050 3 10,800 Present value of inflows Initial investment NPV (net present value)

Present value @ 7% $6,308 3,537 8,816 $18,661 -15,000 $ 3,661

Both projects are attractive, but project N adds the most value to the firm. It has the higher NPV. c. The NPV is preferred and gives more confidence because it incorporates the time value of money and considers all the cash flows.

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12-15.

A Firm

PV $24,907   5.535 ( Appendix D) A $4,500 For N = 8, we find 5.535 under the 9% column. Therefore IRR = 9% PV IFA 

Calculator: Compute:

12-16.

PV = $24,907 FV = 0 N=8 %I/Y =? %I/Y = 9.00%

PMT = $4,500

Hand Salsa

PV $11,778   5.889 ( Appendix D) A $2,000 For N = 10, we find 5.889 under the 11% column. Therefore IRR = 11% PV IFA 

Calculator: Compute: 12-17.

PV = $11,778 FV = 0 %I/Y =? N = 10 %I/Y = 11.00%

PMT = $2,000

King’s Department Store

PV $13,869   4.623 ( Appendix D) A $3,000 For N = 6, we find 4.623 under the 8% column. Therefore IRR = 8% PV IFA 

Calculator: Compute:

PV = $13,869 FV = 0 N=6 %I/Y =? %I/Y= 8.00%

PMT = $3,000

The machine should not be purchased since its return is less than 12%. 12-18.

Foundations of Fin. Mgt. 12Ce

Elgin Restaurant Supplies

12 -

Block, Hirt, Danielsen, Short

a. Year 1 2 3

Cash flow $10,000 9,000 6,500 Present value of inflows Initial investment NPV (net present value)

PV @ 14% @15% $ 8,772 $8,696 6,925 6,805 4,387 4,274 $20,084 $19,775 20,000 20,000 $ 84 $ (225)

IRR is the discount rate at which the NPV = 0. This is a trial and error process. In this case IRR is between 14% and 15% (14% + 84/ 309 × 1% = 14.27%)

b. Year 1 2 3

Cash flow $10,000 9,000 6,500 Present value of inflows Initial investment NPV (net present value)

Present value @ 12% $ 8,929 7,175 4,627 $20,731 20,000 $ 731

The manufacturing machine should be purchased as the NPV is positive.

c. Profitability index 

Foundations of Fin. Mgt. 12Ce

PV of inflows $20,731   1.037 PV of outflows $20,000

12 -

Block, Hirt, Danielsen, Short

12-19.

Altman Hydraulic Corporation

Year 1 2 3 4 5

Cash flow $54,000 66,000 (60,000) 57,000 120,000 Present value of inflows Present value of outflows NPV(net present value)

Present value @ 11% $48,649 53,567 (43,871) 37,548 71,214 $167,107 160,000 $ 7,107

The NPV is positive and the project should be undertaken.

12-20. Year 0 1 2 3 3

Hamilton Control Systems Cash flow Present value @ 10% $(90,000) $(90,000) 23,000 20,909 38,000 31,405 60,000 45,079 (15,000) (11,270) Net present value $(3,877)

The NPV is negative. The project should not be undertaken. Note, the $15,000 outflow could have been subtracted out of the $60,000 inflow in the third year and the same answer would result.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-21.

Twelve Inch Toes Corp.

Find the present value of a deferred annuity: PVA = A × PVIFA (n = 8, i = 11%) (Appendix D) PVA = $43,000 × 5.146 = $221,278 Calculator: Compute:

PV =? FV = 0 PMT = $43,000 N=8 %I/Y = 11% PV = $221,283

Discount this value to PV from the beginning of the third period (end of 2nd).

PV = FV × PVIF (n = 2, i = 11%) (Appendix B) PV = $221,278 × .812 = $179,678 Calculator: Compute:

PV =? FV = $221,283 N=2 %I/Y = 11% PV = $179,598

Present value of inflows Present value of outflows NPV (net present value)

PMT = 0

$179,598 175,000 $ 4,598

The project should be undertaken.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-22.

Helmsdale Excursions

Find the present value of a deferred annuity: PVA = A × PVIFA (n = 9, I/Y = 8%) (Appendix D) PVA = $50,000 × 6.247 = $312,350 Calculator: Compute:

PV =? FV = 0 PMT = $50,000 N=9 %I/Y = 8% PV = $312,344

Discount this value to PV from the beginning of the third period (end of 2nd).

PV = FV × PVIF (n = 3, I/Y = 8%) (Appendix B) PV = $312,500 × .794 = $248,125 Calculator: Compute:

PV =? FV = $312,344 N=3 %I/Y = 8% PV = $247,949

Present value of inflows Present value of outflows NPV (net present value)

PMT = 0

$247,949 250,000 $ (2,051)

The project should not be undertaken.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-23. a. NPV Year 1 2 3 4 5

DeBarry Corporation Cash flow Present value @ 9% $ 10,000 $ 9,174 10,000 8,417 16,000 12,355 18,000 12,752 20,000 12,999 Present value of inflows $55,697 Present value of outflows (cost) 50,000 NPV (net present value) $ 5,697

b. IRR Since we have a positive net present value, the internal rate of return must be larger than 9%. Because of uneven cash flows, we need to use trial and error. Counting the net present value calculation as the first trial, we now try 11% for our second trial.

Year 1 2 3 4 5

Cash flow $ 10,000 10,000 16,000 18,000 20,000 Present value of inflows

Present value @ 11% $ 9,009 8,116 11,699 11,857 11,869 $52,550

A two percent increase in the discount rate has eliminated over one-half of the net present value so another two percent should be close to the answer.

Year 1 2 3 4 5

Cash flow $ 10,000 10,000 16,000 18,000 20,000 Present value of inflows

Foundations of Fin. Mgt. 12Ce

Present value @13% $ 8,850 7,831 11,089 11,040 10,855 $49,665

12 -

Block, Hirt, Danielsen, Short

The correct answer must fall between 11% and 13%. We interpolate. $52,550 49,665 $ 2,885

PV @ 11% PV @ 13%

IRR interpolate  0.11

$2,550

$52,550 50,000 $ 2,550

PV @ 11% (Cost)

0.02  0.11 0.88390.02

$2,885  0.11 .0177  0.1277  12.77% Calculator:

Compute:

CF = – 50,000; 10,000; 10,000; 16,000; 18,000; 20,000 %I/Y =? IRR = 12.76%

c. The project should be accepted because the NPV is positive and the IRR exceeds the cost of capital. 12-24. a. NPV Year 1 2 3 4 5

Green Goddess Salad Oil Company Cash flow Present value @ 10% $15,000 $13,636 20,000 16,529 25,000 18,783 10,000 6,830 5,000 3,105 Present value of inflows $58,883 Present value of outflows (cost) 45,000 NPV (net present value) $13,883

b. IRR Since we have a positive net present value, the IRR must be larger than 10%. With uneven cash flows, we need to use trial and error. Counting the net present value calculation as the first trial, we now try 20% for our second trial.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Year 1 2 3 4 5

Cash flow $15,000 20,000 25,000 10,000 5,000 Present value of inflows

Present value @ 20% $12,500 13,889 14,468 4,823 2,009 $47,689

Since 20% is not high enough, we try a higher rate, say 25%.

Year 1 2 3 4 5

Cash flow $15,000 20,000 25,000 10,000 5,000 Present value of inflows

Present value @ 25% $12,000 12,800 12,800 4,096 1,638 $43,334

The correct answer must fall between 20% and 25%. We interpolate.

$47,689 43,334 $ 4,355

PV @ 20% PV @ 25%

IRR interpolation  0.20 

$2,689

$47,689 45,000 $ 2,689

PV @ 20% (Cost)

0.05  0.20  0.61750.05

$4,355  0.20  .0309  0.2309  23.09% Interpolation is more accurate using a small difference between trials.

Calculator: CFi = – 45,000; 15,000; 20,000; 25,000; 10,000; 5,000 %I/Y =? Compute: IRR = 22.99% c. The project should be accepted because the net present value is positive and the IRR exceeds the cost of capital.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-25.

Boring Corporation

NPV for Project X (Weather Report DVDs) Year Cash flow Present value @ 10% 1 $5,000 $ 4,545 2 3,000 2,479 3 4,000 3,005 4 3,600 2,459 Present value of inflows 12,488 Present value of outflows (cost) 10,000 NPV (net present value) $ 2,488 PV of inflows  $12,488  1.2488 Profitability index  PV of outflows $10,000

NPV for Project Y (Slow-Mo Commercials) Year Cash flow Present value @ 10% 1 $15,000 $ 13,636 2 8,000 6,612 3 9,000 6,762 4 11,000 7,513 Present value of inflows $34,523 Present value of outflows (cost) 30,000 NPV (net present value) $ 4,523 PV of inflows  $34,523  1.1508 Profitability index  PV of outflows $30,000 You should select Project X because it has the higher profitability index. This is true in spite of the fact that it has a lower net present value. The profitability index may be appropriate when you have different size investments. What can be earned on the differential investment of $20,000 (between projects) is relevant. If there are no other investment opportunities Project Y with the higher NPV may be the preferred investment.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-26.

Turner Video

a. Reinvestment assumption of NPV Year

Inflows

Rate

No. of Periods

1 2 3 4 5

$10,000 12,000 16,000 20,000 24,000

9% 9% 9% 9% –

4 3 2 1 0

Future value $14,116 15,540 19,010 21,800 24,000 $94,466

b. Reinvestment assumption of IRR

Year

Inflows

Rate

No. of Periods

1 2 3 4 5

$10,000 12,000 16,000 20,000 24,000

14% 14% 14% 14% –

4 3 2 1 0

Future value $ 16,890 17,779 20,794 22,800 24,000 $102,263

c. No. However, for investments with a very high IRR, it may be unrealistic to assume that reinvestment can take place at an equally high rate. The net present value method makes the more conservative assumption of reinvestment at the cost of capital.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-27.

Last Century Corporation a.

Year

Inflows

Rate

# of Periods

Future value

1 2 3

$12,000 10,000 7,200

7% 7% 7%

2 1 0 Terminal value

$13,739 10,700 7,200 $31,639

PVIF 

PV $25,000   0.790 (Appendix B) FV $31,639

At 3 periods, appendix B suggests a modified IRR of 8%

Calculator: Compute:

PV = $25,000 FV = $31,639 N=3 %I/Y = ? %i = 8.17%

PMT = 0

Calculator: CF\ = – 25,000; 12,000; 10,000; 7,200 Compute: IRR = 8.96%

%i = ?

The difference occurs because the traditional IRR assumes reinvestment at the IRR whereas the modified IRR (MIRR) assumes reinvestment at the lower cost of capital.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-28.

Music Box Rentals a.

Year

Inflows

Rate

# of Periods

Future value

1 2 3

$16,000 12,300 15,100

10% 10% 10%

2 1 0 Terminal value

$19,360 13,530 15,100 $47,990

PVIF 

PV $39,000   0.813 (Appendix B) FV $47,990

At 3 periods, appendix B suggests a modified IRR of 7%

Calculator: Compute:

PV = $39,000 FV = $47,990 N=3 %I/Y = ? %I/Y = 7.16%

PMT = 0

Calculator: CF = – 39,000; 16,000; 12,300; 15,100 Compute: IRR = 5.6%

%I/Y = ?

The difference occurs because the traditional IRR assumes reinvestment at the IRR whereas the modified IRR (MIRR) assumes reinvestment at the higher cost of capital.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-29.

Tosca Spoons Company a.

Year

Inflows

Rate

# of Periods

Future value

1 2 3

$15,000 12,000 9,000

12% 12% 12%

2 1 0 Terminal value

$18,816 13,440 9,000 $41,256

PVIF 

PV $27,000   0.654 (Appendix B) FV $41,256

At 3 periods, appendix B suggests a modified IRR of 15%

Calculator: Compute:

PV = $27,000 FV = $41,256 N=3 %I/Y = ? %I/Y = 15.18%

PMT = 0

Calculator: CF = – 27,000; 15,000; 12,000; 9,000 Compute: IRR = 17.5%

%I/Y = ?

The difference occurs because the traditional IRR assumes reinvestment at the IRR whereas the modified IRR (MIRR) assumes reinvestment at the lower cost of capital.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-30.

Suboptimal Glass Company

You should rank the investments in terms of IRR. Project

IRR

Project Size

Total Budget

E D C G A B F

23% 17.0 16.5 16.0 15.0 14.0 11.0

$10,000 10,000 25,000 15,000 10,000 30,000 20,000

$ 10,000 20,000 45,000 60,000 70,000 100,000 120,000

a. Because of capital rationing, only $60,000 worth of projects can be accepted. The four projects to accept are E, D, C and G. Projects A and B provide positive benefits also, but cannot be undertaken under capital rationing.

b. If Projects D and E are mutually exclusive, you would select Project E in preference to D. In summary, you would accept E, C, G and A. The last project would replace D and is of the same $10,000 magnitude.

12-31.

Keller Construction

a. Zero discount rate Project E Inflows Outflow $8,000 = ($5,000 + $6,000 + $7,000 + $10,000) – $20,000 Project H Inflows $5,000 = ($16,000 + $5,000 + $4,000)

Foundations of Fin. Mgt. 12Ce

12 -

Outflow – $20,000

Block, Hirt, Danielsen, Short

b. 9% discount rate Project E Year 1 2 3 4

Cash Flow $ 5,000 6,000 7,000 10,000 Present value of inflows Present value of outflows (cost) NPV (net present value)

Present Value @ 9% $ 4,587 5,050 5,405 7,084 22,126 20,000 $ 2,126

Project H Year 1 2 3

Cash Flow Present Value @ 9% $16,000 $14,679 5,000 4,208 4,000 3,089 Present value of inflows 21,976 Present value of outflows (cost) 20,000 NPV (net present value) $ 1,976

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

c. Net Present Value Profile Net present value profile

NPV

8000

Project E 6000

4000

Project H Crossover point

2000

IRRH = 0 0

IRRE=

Discount rate (%)

d. Since the projects are not mutually exclusive, they both can be selected if they have a positive net present value. At a 10% rate, they should both be accepted. As a side note, we can see Project E is superior to Project H. e. With mutually exclusive projects, only one can be accepted. Of course, that project must still have a positive net present value. Based on the visual evidence, we see: (i) 6% cost of capital  select Project E (ii) 13% cost of capital  select Project H (iii) 18% cost of capital - Do not select either project

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-32.

Luft Watch Company

a. NPV @ 0% discount rate Inflows $4,000 = (8,000 + $7,000 + $4,000)

Outflow – $15,000

b. 10% discount rate Year 1 2 3

Cash Flow $8,000 7,000 4,000 Present value of inflows Present value of outflows NPV (net present value)

Present Value @ 10% $7,273 5,785 3,005 16,063 15,000 $ 1,063

c. 20% discount rate Year 1 2 3

Cash Flow $8,000 7,000 4,000 Present value of inflows Present value of outflows Net Present Value

Foundations of Fin. Mgt. 12Ce

12 -

Present Value @ 20% $ 6,667 4,861 2,315 13,843 15,000 $(1,157)

Block, Hirt, Danielsen, Short

d. Net present value profile Net present value

4,000

2,000

Discount rate (%)

e. Interpolate between 14% and 15%: Year 1 2 3

Cash Flow $8,000 7,000 4,000 Present value of inflows $15,104 14,880 $ 224

PV @ 14% PV @ 15%

IRR interpolatation  0.14 

$104

Present Value @ 14% @ 15% $ 7,018 $ 6,957 5,386 5,293 2,700 2,630 $15,104 $14,880 $15,104 15,000 $ 104

PV @ 14% (Cost)

0.01  0.14  0.46430.01

$224  0.14  .0046  0.1446  14.46% Calculator: CF = – 15,000; 8,000; 7,000; 4,000 Compute: IRR = 14.46%

Foundations of Fin. Mgt. 12Ce

12 -

%I/Y =?

Block, Hirt, Danielsen, Short

12-33.

XYZ Corporation

a. The original cost of the building would be deducted from the Class 3 pool as the lower of sale price or original cost is used when disposing of an asset. The Class 3 UCC is: $12,000,000 4,500,000 $ 7,500,000 The present value of the tax shield lost on disposal would be: Salvage × d Tc/ (d + r) = $4,500,000 × .05 × .25/ (.05 + .12) = $4,500,000 × .0735294 = $330,882 The $500,000 difference ($5,000,000 – $4,500,000) would be a capital gain for tax purposes. Fifty percent of a capital gain is taxable. XYZ‘s tax on the taxable capital gain is:

0.50 × capital gain × T × PVIF (n = 1, i = 12%) = 0.50 × $500,000 × .25 × PVIF (n = 1, i = 12%) = $55,804 The total present value of tax consequences = $330,882 + $55,804 = b. Class 3 UCC

$386,686

$4,000,000 4,500,000 $ (500,000)

The negative balance of $500,000 is recaptured amortization. This is added to income in the year of disposal thus increasing tax by:

Income increase × T × PVIF (n = 1, I/Y = 12%) = $500,000 × .25 × PVIF (n = 1, I/Y = 12%) = $111,607

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

The present value of the tax shield lost on disposal would be: Salvage × d Tc / (d + r) = $4,000,000 × .05 × .25 / (.05 + .12) = $4,000,000 × .0735294 = $294,118 Since there was only $4,000,000 in the pool, that is the basis for calculating the tax shield lost on disposal. The tax on the taxable capital gain is $55,804 (as in part a).

The total present value of tax consequences = $111,607 + $294,118 + $55,804 = c. Class 3 UCC

$461,529

$6,000,000 4,500,000 $1,500,000

The $1,500,000 left over in the Class 3 pool is a terminal loss and can be written off against income in the year of disposal. The tax savings is: Terminal loss × T × PVIF (n = 1, I/Y = 12%) = $1,500,000 × .25 × PVIF (n = 1, I/Y = 12%) = $334,821 The present value of the tax shield lost on disposal would be: Amount in pool × = $6,000,000 × = $6,000,000 × = $441,176

d Tc/ (d + r) .05 × .25 / (.05 + .12) .0735294

The tax on the taxable capital gain is $55,804 (as in part a). The total present value of tax consequences = $(334,821) + $441,176 + $55,804 =

Foundations of Fin. Mgt. 12Ce

12 -

$162,159

Block, Hirt, Danielsen, Short

12-34.

Capital Cost Allowance

a. The assets will fall under Class 10 (auto equipment) with an allowable CCA rate of 30%.

b. Year 1 Increase in pool‘s UCC Allowable CCA in 1st year Year 2 Remaining increase in UCC Additional CCA allowable

= $95,000 = 1/2 ($95,000 × .30) = $14,250 = $95,000 – $14,250 = $80,750 = $80,750 × .30 = $24,225

c. The assets would then fall under Class 8 (machinery): The allowable CCA rate would be 20%.

d. There would be no effects except to the extent of any dollar amounts realized on disposal.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-35.

Coastal Shipping Corporation

a. The original cost of the vessel would be deducted from the Class 7 pool as the lower of sale price or original cost is used when disposing of an asset. The Class 7 UCC is: $2,000,000 1,000,000 $1,000,000 The present value of the tax shield lost on disposal would be: Amount lost from pool (salvage)  dTc / (d + r) = $1,000,000  .15  .25 / (.15 + .10) = $1,000,000  .15 = $150,000 This is the extent of the tax consequences. b. Class 7 UCC

$ 800,000 1,000,000 $ (200,000)

The negative balance of $200,000 is recaptured amortization. This is added to income in the year of disposal increasing tax by: Income increase  T  PVIF (n = 1, I/Y = 10%) = $200,000  .25  PVIF (n = 1, I/Y = 10%) = $45,454 The present value of the tax shield lost on disposal would be: Amount lost from pool (salvage)  dTc / (d + r) = $800,000  .15  .25 / (.15 + .10) = $800,000  .15 = $120,000 Since there was only $800,000 in the pool, that is the basis for calculating the tax shield lost on disposal.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

The total present value of tax consequences = $45,454 + $120,000 = c.

Class 7 UCC

$165,454

$ 600,000 1,000,000 $(400,000)

The negative balance of $400,000 is recaptured amortization. This is added to income in the year of disposal thus increasing tax by: Income increase  T  PVIF (n = 1, I/Y = 10%) = $400,000  .25  PVIF (n = 1, I/Y = 10%) = $90,909 The present value of the tax shield lost on disposal would be: Amount lost from pool (salvage)  dTc / (d + r) = $600,000  .15  .25 / (.15 + .10) = $600,000  .15 = $90,000 Since there was only $600,000 in the pool, that is the basis for calculating the tax shield lost on disposal. The total present value of tax consequences = $90,909 + $90,000 = $180,909

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-36.

Nexus Corp.

a. The CCA class for aircraft is Class 9, with a CCA rate of 25%. b. CCA allowable in 1st year $1,500,000  25%  .5

$187,500

CCA allowable in 2nd year [$1,500,000  $187,500]  25% =

$328,125

c. The CCA class for hangars is class 6, with a CCA rate of 10%.

d. After 10 years the UCC of Class 9 will be(including CCA for the 10th year): $1,500,000[1  (.25/2) (1  .25)10 – 1] = $1,500,000 [(.875) (.75)9] = $1,500,000 [.0656991] = $98,549 If the plane is scrapped after the 10th year the consequences are: Recapture of

$200,000 98,549 $101,451

Thus $101,451 will be added to taxable income in the eleventh year. To determine the taxes payable: multiple by Nexus‘ tax rate.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short



12-37.

Thorpe Corporation Increased sales Increased costs Earnings before amortization and taxes Amortization ($50,000 × .20 × 1/2) Earnings before taxes Taxes @ 25% Earnings after tax Amortization Net cash flow

12-38.

$80,000 45,000 35,000 5,000 30,000 7,500 22,500 5,000 $27,500

Acme Auto Parts Ltd.

a. The investment qualifies for a 35% ITC. $1,700,000 × .35 = $595,000 b. The original cost base is: $1,700,000 – $595,000

= $1,105,000

c. The effects of ITC and CCA are realized at year-end. Therefore: PV (ITC) = ITC × PVIF (n = 1, I/Y = 10%) = $595,000 × PVIF (n = 1, I/Y = 10%) = $540,909  dT 1  .5r  PV CCA  C - S   Cd r  1 r  PV PV   .20 .22 1   .5 .10   $1,105,000    $154,700 .10  .20 1  .10     Total combined present value of tax benefits is: = $540,909 + $154,700 =

Foundations of Fin. Mgt. 12Ce

12 -

$695,609

Block, Hirt, Danielsen, Short

12-39. a.

Follett Enterprises

(Beginning) Year UCC Purchases Sales Rate 0 0 $300,000 – (.10)(.50) 1 $285,000 – – (.10) 2 256,500 – – (.10) 250,000 – (.10)(.50) 3 4

468,350 421,515

This year 759,363 Remaining UCC 259,363

– – 400,000

– – –

(.10) (.10) (.10)(.50)

Tax shield CCA @ 30% $15,000 $ 4,500 28,500 8,550 25,650 12,500 38,150 11,445 46,835 14,051 42,152 20,000 62,152 18,646

500,000 77,809

Terminal loss

b. As in (a) only no terminal loss. CCA lost from this year forward on $500,000, but $259,363 remains in the pool. Year Tax shield Present value @ 14% 1 $ 4,500 $ 3,947 2 8,550 6,579 3 11,445 7,725 4 14,051 8,319 5 18,646 9,684 Present value of tax shields $36,254 (without terminal loss)

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

c. With formula: PV of impacts on pool: Year Purchase/ sell 0 $300,000 2 250,000 4 400,000 5 (500,000)

PV @ 14% $300,000 192,367 236,832 (259,684) $469,515 PV CCA  C - S PV  dT    r  Cd 11.5r r      0.10  0.301  .5 .14   $469,515 0.14  0.10 1  .14      $469,5150.1250.938596

 $55,086

Difference between formula and year by year calculation: = $55,086 – $36,254 = $18,832 Without formula: $759,363 remains in the pool before $500,000 sale.  0.10  0.30   0.10  0.30 1  .5 .14  PV CCA  $759,363   $500,000   0.14  0.10  0.14  0.10  1  .14        $759,363.125  $500,000.11732456  $94,920  $58,662 PV = =

$36,258 × PVIF (n = 5, %I/Y = 14) $18,818 (rounding difference)

Calculator: Compute: Note:

 $36,258

PV =? FV = $36,258 N=5 %I/Y = 14% PV = $18,831

PMT = 0

The half year rule has already been applied to arrive at the $759,363.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-40.

Elite Car Rental Corporation

n=2

Year 0 0 1-2 1-2 2 2 0

T = 30%

Event

r = 12% Expected Cash Flow

Investment $(900,000) Working capital (10,000) Revenue $21,000 × 30 = 630,000 Expenses $0.20(40,000) × 30 = 240,000 Sale (.60) (900,000) = 540,000 WC recovery 10,000 CCA pool PV CCA  C - S

d = 40% (class 16) Aftertax Cash Flow

Present Value @ 12%

– –

$(900,000) ( 10,000)

441,000

745,313

168,000

(283,929)

– –

430,485 7,972

1  .5r   dT   1  r  C

rd    0.30  1  .5 .12   0.40  $900,000  $430,485   0.12  0.40 1  .12      102,545  $469,5150.2307690.9464286 PV

NPV = $92,386 Elite Car Rental Corporation should purchase the autos as the firm‘s value will increase by $92,386.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-41.

Albert I. Stein Ltd.

n=9

T = 15%

r = 13%

d = 20% (class 8) ITC = 20%

Expected Year Event Cash Flow 0 Investment $(75,000) 1 ITC .20($75,000) = 15,000 1-2 Costs (17,500) 2 Working capital .10(121,000) = (12,100) 3-9 Revenues 121,000 3-7 8-9 9 0

Expenses Expenses

(90,000) (105,000)

Aftertax Cash Flow –

Present Value @ 13% $(75,000)

– (14,875)

13,274 (24,813)

– 102,850 454,865 (76,500) (269,068) (89,250) (148,878) –

(9,476)

WC recovery 12,100 CCA pool PV CCA  C - S PV  dT 1  r  Cd  1.5rr     1  .5 .13   0.20  0.15  $75,000  0 0.13  0.20 1  .13    

356,226 (210,720) (63,282) 4,028

 6,426  $75,0000.0909090.94247788 1 ITC from CCA pool   0.20  0.15  PV CCA  - ITC  dT   $15,000  C PV  0.13  0.20  r  d        $15,0000.090909

 $1,364

1,206



NPV = $(4,543) Albert I. Stein should not purchase the new machine.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

12-42.

Pierce Labs

n=5

T = 30%

Year

Event

0 0 1

Investment Trade- in ITC

1 2 3 4 5 0

r = 12%

d = 20% (class 8) ITC = 15%

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 12%

$(390,000) 85,000 .15(390,000) = 58,500 99,000 88,000 77,000 66,000 55,000

– –

$(390,000) 85,000

– 69,300 61,600 53,900 46,200 38,500

52,232 61,875 49,107 38,365 29,361 21,846

Cost savings Cost savings Cost savings Cost savings Cost savings CCA pool PV CCA  C - S PV  dT 1  r  Cd  1.5rr    0.20   0.301  .5 .12   $390,000  $85,000   0.12  0.20 1  .12      54,124  $305,0000.18750.94642857 1 ITC from CCA pool   0.20  0.30  PV CCA  - ITC  dT   $58,500  C PV  0.12  0.20   rd       $58,5000.1875

 $10,969

9,794



NPV = $(7,884) Pierce Labs should not purchase the new machine.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Comprehensive Problems 12-43. Year 1 2 3 4 5 6-10

Ontario Corporation

EBIT $650,000 $700,000 $720,000 $720,000 $690,000 $700,000

- Interest = $93,750 $93,750 $93,750 $93,750 $93,750 $93,750

EBT $556,250 $606,250 $626,250 $626,250 $596,250 $606,250

Tax

Net

(30%) $166,875 $181,875 $187,875 $187,875 $178,875 $181,875

= Income $389,375 $424,375 $438,375 $438,375 $417,375 $424,375

Capital + Amort. $140,000 $140,000 $140,000 $140,000 $140,000 $140,000

- Investment $200,000 $200,000 $200,000 $200,000 $200,000 $ 80,000

Cash

*PV of

= Flow $329,375 $364,375 $378,375 $378,375 $357,375 $484,375

Cash Flow $ 291,482 $ 285,359 $ 262,233 $ 232,064 $ 193,969 $ 924,678 $2,189,785

*13% was used since this is an equity only investment. From the table we see that the present value of the cash flows estimates for the next ten years is $2,189,785. We must now calculate a value for the cash flows expected more than 10 years hence. To do this we will calculate a terminal value at the end of year 10 and discount that back to the present. Terminal value

Present value

= = = = =

Annual cash flow/ discount rate $484,375/ 0.13 $3,725,962 $3,725,962 x PVIF (n = 10, i = 13%) ($1,099,159 – tables) $1,097,625 (Calculator)

Therefore, the present value of all future cash flow estimates is $2,189,785 + $1,097,625 = $3,287,410 Since the market value of the firm‘s shares is $3,000,000 (2,000,000 × $1.50/share) Ontario might consider pursuing Target Firm if management is reasonably confident in the assumptions underlying the analysis and has examined qualitative factors.

Foundations of Fin. Mgt. 12Ce

12 -

Block, Hirt, Danielsen, Short

Chapter 1 12-44.

Signs For Fields Machinery Ltd.

n = 10 a. Year 0 0 1-10 10 0

T = 30%

Event

r = 15%

d = 20%

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 15%

Purchase machine $(72,000) – $(72,000) Installation (7,000) – ( 7,000) Cost savings 17,500 12,250 61,480 Salvage 11,500 – 2,843 CCA pool PV CCA  C - S PV  dT   r  Cd 11.5rr     0.20 0.30 1  .5 .15   $72,000  $7000  $2,843   0.15  0.20 1  .15      12,204  $76,1570.171428570.9347826 NPV = $( 2,473) Signs For Fields Machinery should not purchase the new machine.

b. Sell old machine $ 9,000 Remove from CCA pool: – 9,000 (.16024845) (1,442) Net increase in NPV 7,558 Overall the new NPV = $ 5,085 Signs For Fields Machinery should now purchase the new machine.

Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1 c. Year 0 0 1-10 10 0

Event

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 14%

Purchase machine $(72,000) – $(72,000) Installation (7,000) – ( 7,000) Cost savings 17,500 12,250 63,897 Salvage 11,500 – 3,102 CCA pool PV CCA  C - S PV  dT    r  Cd 11.5r r     0.20 0.30 1  .5 .14   $72,000  $7000  $3,102   0.14  0.20 1  .14      12,571  $75,8980.176470590.93859649 NPV = $ 570 $570 – (2,473) $3,043

PV @ 14% PV @ 15%

$ 570 0,000 $ 570

PV @ 14% (Cost)

$570 0.01  0.14  0.18730.01 $3,043  0.14  .0019  0.1419  14.19%

IRR interpolatation   0.14 

Profitability indexPI 

Foundations of Fin. Mgt. 12Ce

PV of inflows $76,527   0.969 PV of outflows $79,000

13 -

Block, Hirt, Danielsen, Short

Chapter 1 12-45.

M and C Hammer Machinery Ltd.

n = 10 a. Year

T = 30%

Event

r = 14%

d = 20%

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 14%

Purchase machine $(54,000) – $(54,000) Installation (5,000) – (5,000) Cost savings 15,000 10,500 54,769 Salvage 8,000 – 2,158 CCA pool dT 1+.5𝑟 PV (CCA) = [C-S ] ( 𝐶) ( ) PV 𝑟+𝑑 1+𝑟 0.20 × 0.30 1 + .5 × .14 )( ) = [$54,000 + $5000 − $2,158] ( 0.14 + 0.20 1 + .14 [$56,842](0.176470588) (0.938596491) = = 9,415 NPV = $ 7,342

0 0 1-10 10 0

M and C Hammer Machinery should purchase the new machine. b. Sell old machine $ 7,000 Remove from CCA pool: 7,000 (.165634675) (1,159) Net increase in NPV 5,841 Overall the new NPV = $13,183 The NPV improves.

Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1 c. Year

Expected Cash Flow

Event

Aftertax Cash Flow

Present Value @ 18%

Purchase machine $(54,000) – $(54,000) Installation (5,000) – ( 5,000) Cost savings 15,000 10,500 47,188 Salvage 8,000 – 1,529 CCA pool dT 1+.5𝑟 PV (CCA) = [C-S ] ( 𝐶) ( ) PV 𝑟+𝑑 1+𝑟 0.20 × 0.30 1 + .5 × .18 )( ) = [$54,000 + $5,000 − $1,529] ( 0.18 + 0.20 1 + .18 = [$57,471](0.157894737) (0.923728814) = 8,382 NPV = ($1,901)

0 0 1-10 10 0

$7,342 – (1,901) $9,243

PV @ 14% PV @ 18%

$7,342 000 $7,342

PV @ 14% (Cost)

$7,342 (0.04) = 0.14 + 0.79(0.04) $9,243 = 0.14 + .0318 = 0.1718 = 17.18%

IRR (interpolation) = 0.14 +

Profitability index(PI) =

Foundations of Fin. Mgt. 12Ce

$66,342 PV of inflows = = 1.124 PV of outflows $59,000

13 -

Block, Hirt, Danielsen, Short

Chapter 1 12-46.

Helmsdale Improvements Ltd. n=7

OuOu Year

Event

T = 25%

r = 14%

Expected Cash Flow

d = 30%

Aftertax Cash Flow

Present Value @ 14%

Purchase machine $(50,000) – $(50,000) Operating costs (19,500) (14,625) (62,716) Salvage 6,000 – 2,398  0.30  0.25 1  .5 .14  PV CCA  $50,000  $2,398   0.14  0.30 1  .14      7,616  $47,6020.1704545450.93859649 NPV = $(102,702) 0 1-7 7

Major OuOu Year Event

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 14%

Purchase machine $(69,000) – $(69,000) Operating costs (13,000) (9,750) (41,811) Salvage 8,000 – 3,197  0.30  0.25 1  .5 .14  PV CCA  $69,000  $3,197   0.14  0.30 1  .14      10,528  $65,8030.1704545450.93859649 NPV = $(97,086) 0 1-7 7

The salvage value of $4,500 for the old machine would be deducted from the CCA pool, but since it is common to both alternatives it is ignored for the analysis and decision making purposes. The Major OuOu should be selected as its NPV is less costly. Our assumption is that the revenue stream is worthwhile and the least costly replacement is to be selected. Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1 12-47.

Jagged Pill Ltd. n=8

a. Year 0 1-8 4 8 0

Event

T = 25%

r = 13%

Expected Cash Flow

d = 20%

Aftertax Cash Flow

Present Value @ 13%

Purchase machine $(525,000) – $(525,000) Cash flow 165,000 123,750 593,848 Capital upgrade (105,000) – (64,398) Salvage 30,000 – 11,285 CCA pool (PV of tax savings) 0.20  0.25 1  .5 .13     $525,000  $64,398  $11,285   0.13  0.20 1  .13      82,554  $578,1130.151515150.9424779 NPV = $ 98,289 Note: The $60,000 deposit is a sunk cost and is irrelevant for this decision.

b. Year 0 1-8 4 8 0

Event

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 19%

Purchase machine $(525,000) – $(525,000) Cash flow 165,000 123,750 489,352 Capital upgrade (105,000) – (52,360) Salvage 30,000 – 7,460 CCA pool (PV of tax savings)  0.20  0.25 1  .5 .19   $525,000  $52,360  $7,460   0.19  0.20 1  .19      67,231  $569,9000.1282051280.920168067 NPV = ($13,317)

Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1

$98,289 – (13,317) $111,606

PV @ 13% PV @ 19%

$98,289 0,0000 $98,289

PV @ 13% (Cost)

$98,289 0.06  0.13  0.8806780.06 $111,606  0.13  .0528407  0.1828407  18.28%

IRR interpolatation   0.13 

This is an approximation.

Profitability indexPI 

PV of inflows $687,687   1.167 PV of outflows $589,398

This is calculated @13%.

d. Jagged Pill should purchase the new machine. Value will increase by $98,289 (the NPV), the IRR exceeds the cost of capital and the PI exceeds 1.

Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1 12-48.

Good T. n = 12

a. Year

Event

T = 39%

r = 14%

Expected Cash Flow

d = 30%

Aftertax Cash Flow

Present Value @ 14%

0 Capital expenditure($2,000,000) – ($2,000,000) 0 Previously purchased equipment (opportunity cost of forgoing sale) (525,000) (525,000) – 0 Working capital (75,000) – (75,000) 1-6 Cash flow 650,000 396,500 1,541,857 7-12 Cash flow 750,000 457,500 810,518 1-12 Rent forgone (100,000) (61,000) (345,278) (opportunity cost) 12 Salvage 50,000 – 10,378 12 WC Recovery 75,000 – 15,567 0 CCA pool PV CCA  0.30  0.39 1  .5 .14   $2,000,000  $525,000  $10,378   0.14  0.30 1  .14      627,603  $2,514,6220.265909090.93859649 NPV = $ 60,645 Good T should proceed. Value will be added to the firm.

b. A changing cost of capital can be handled by discounting with multiple discount rates appropriate to each year.

Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1 12-49.

Torch Concerts Ltd. n=7

T = 25%

r = 15%

d = 20%

Expected Present Value Year Event

Cash Flow

0 Purchase land $(325,000) 0 Working capital (60,000) 1-7 Cash flow 50,000 7 Sell land 700,000 7 WC recovery 60,000 8 Tax on taxable capital gain [700,000 – 325,000] × 0.50 × .25 = $46,875

Aftertax

Cash Flow

@ 15%

– – 37,500 – –

$(325,000) (60,000) 156,016 263,156 22,556 (15,324) NPV = $41,388

Note:The tax is paid one year after the realization of the capital gain (year 8). This assumption is consistent with other treatments for analysis purposes. Torch Concerts Ltd. should purchase the vacant lot. Its purchase will increase the value of the firm by $41,388. If the tax on the capital gain is taken at year 7 its PV is negative $17,622 and the overall present value is a positive $39,090 and the project is still acceptable.

Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1 12-50.

Clueless Company n = 15

Year

T = 30% r = 12% + (0.50)12% = 18% d = 30%

Event

Expected Cash Flow

Aftertax Cash Flow

Investment $(375,000) – Working capital 200,000 × 60/ 365 = (32,877) – 1-15 Revenues 200,000 140,000 1-15 Expenses (85,000) (59,500) 15 Salvage 15,000 – 15 WC Recovery 32,877 – 0 CCA pool PV CCA  0.30  0.30 1  .5 .18   $375,000  $1,253   0.18  0.30 1  .18      $373,7470.18750.9237288 0 0

Present Value @ 18% $(375,000) (32,877) 712,821 (302,949) 1,253 2,746

 64,733 NPV =$ 70,727

Clueless should proceed. Value will be added to the firm. This analysis has used an adjusted discount rate to account for the higher risk that would be assumed if the project were undertaken.

Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1 12-51.

Quixotic Enterprises N = 10

T = 25%

r = 20%

d = 5%

a. Expected Cash Flow

Aftertax Cash Flow

Present Value @ 20%

0 Construct windmills$(400,000) 0 Working capital (10,000) 1-10 Revenues 150,000 1-10 Big wind tax (7,500) 1-10 Rent forgone (opportunity cost) (5,000) 5 Capital upgrade (100,000) 10 Salvage 25,000 10 WC Recovery 10,000 0 CCA pool

– – 112,500 (5,625)

$(400,000) (10,000) 471,653 (23,583)

(3,750) – – –

(15,721) (40,188) 4,038 1,615

Year

Event

PV CCA  0.05 0.25 1  .5 .20   $400,000  $40,188  $4,038   0.20  0.05 1  .20      19,990  $436,1500.050.9166667 NPV = $ 7,804

Foundations of Fin. Mgt. 12Ce

13 -

Block, Hirt, Danielsen, Short

Chapter 1 b. IRR Year Event

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 21%

– – 112,500 (5,625)

$(400,000) (10,000) 456,084 (22,804)

(3,750) – – –

(15,202) (38,554) 3,716 1,486

PV CCA  0.05  0.25 1  .5  .21  $400,000  $38,554  $3,716   0.21  0.05 1  .21      $434,8340.0480769230.91322314

 19,091

NPV = ($6,183) $ 7,804 – (6,183) $13,987

PV @ 20% PV @ 21%

$7,804 0,000 $7,804

PV @ 20% (Cost)

$7,804 0.01  0.20  0.55790.01 $13,987  0.20  .0056  0.2056  20.56%

IRR interpolatation  0.20 

PV of inflows $497,296   1.016 PV of outflows $489,492 Just above 1 indicating profitability. (Info from part (a))

c. Profitability indexPI 

d. Dream the impossible dream as it will add value to Quixotic Enterprises.

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Chapter 1 12-52.

J. Letterman Ltd. n = 10

T = 28%

r = 12%

Aftertax Cash Flow

Present Value @ 12%

0 Purchase machine $(210,000) – 0 Sell old machine 32,500 – 0 Deinvest WC 10,000 – 1-10 Incremental annual(75,000 – 42,500) 23,400 cost savings 32,500 10 Incremental salvage(50,000 – 12,000) 38,000 – 10 Reinvest WC (10,000) – 0 CCA pool

$(210,000) 32,500 10,000

Year

Event

Expected Cash Flow

d = 30%

132,215 12,235 (3,220)

PV CCA  0.30  0.28 1  .5 .12   $210,000  $32,500  $12,235   0.12  0.30 1  .12      31,282  $165,2650.200.9464286 NPV = $ 5,012 J. Letterman should replace the older machine, as the NPV of the replacement, relative to the older machine is positive. Watch the complete differences between what essentially are two options.

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Chapter 1 12-53.

Midnight Oil and Gas N = 10

Year

Event

T = 30%

r = 14%

Expected Cash Flow

d (pipeline) = 20% d (buildings) = 4%

Aftertax Cash Flow

Present Value @ 14%

0 Construct pipeline$(1,000,000) – $(1,000,000) 0 Construct buildings (200,000) – (200,000) 0 Use land (opportunity cost) (2,000,000) – (2,000,000) 1-10 Cash flow 625,000 437,500 2,282,051 10 Enviro: cleanup (1,200,000) (840,000) (226,585) 10 Salvage 0 – 0 10 Sell land 4,500,000 – 1,213,847 11 Tax on capital gain (4,500,000 – 500,000) (600,000) (141,970) × .50 × .30 1 Tax on capital gain forgone (2,000,000 – 500,000) × .50 × .30 225,000 197,368 0 CCA pool building   $200,000 0.04  0.301  .5 .14  0.14  0.04 1  .14      12,515  $200,0000.0666666670.93859649 pipeline   $1,000,000 0.20  0.301  .5 .14  0.14  0.20 1  .14      $1,000,0000.1764705880.93859649

 165,635 NPV = $302,861

Build the pipeline. Value will be added to the firm.

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Chapter 1 12-54.

St. Bernard Venture n = 12

Year

Event

T = 30%

r = 15%

Expected Cash Flow

d (machinery) d (buildings)

Aftertax Cash Flow

= 30% = 4%

Present Value @ 15%

– $(600,000) – (956,522) – (132,325) 612,500 3,073,996 2,324,382 3-12 Expenses (325,000) (227,500) (1,141,770) (863,342) 12 Sell building 225,000 – 42,054 12 Sell machinery 50,000 – 9,345 12 12 Sell land 600,000 (1.09) 1,687,599 – 315,424 13 Tax on capital gain (1,687,599 – 600,000) × .50 × .30 (163,140) (26,515) 0 CCA pool building   $956,522  $42,054 0.04  0.301  .5 .15  0.15  0.04 1  .15      53,989  $914,4680.06315790.9347826 1  .5 .15  machinery  $132,325  $9,345 0.30  0.30   0.15  0.30 1  .15      22,992  $122,9800.2000.9347826 0 Acquire land $(600,000) 1 Payment building (1,100,000) 2 Purchase machinery (175,000) 3-12 Revenues 875,000

NPV = $189,482 St. Bernard should proceed with the venture. Value will be added to the firm.

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Chapter 1 12-55.

Marceline Enterprises N=9

Year 0 0 3 3 6 6 1-2 3-5 6-9 9 9 0

T = 25%

r = 11%

d = 15%

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 11%

Expansion $(1,000,000) Working capital (50,000) Additional capital (200,000) Additional WC (10,000) Additional capital (200,000) Additional WC (10,000) Revenues 250,000 Revenues 325,000 Revenues 375,000 Salvage 150,000

      187,500 243,750 281,250 

$(1,000,000) (50,000) (146,238) (7,312) (106,928) (5,346) 321,098 483,447 517,824 58,639

Event

WC Recovery CCA pool

70,000



27,365

1 .5.11 1,000,000  146,238  106,928  58,639.15.25  1,194,5270.144230770.9504505 



.11 .15



1  .11

  163,751

NPV = $256,300 Marceline Enterprises should proceed with the amusement park expansion, as the NPV is positive.

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Chapter 1 MINI CASES Aerocomp Corporation (Methods of Investment Evaluation) This case places emphasis on comparing the payback method, the internal rate of return, and the net present value approaches for a series of investments. As the student progresses through the calculations, the various advantages and disadvantages of the different approaches become evident. The reinvestment assumption of a high return project under the internal rate of return can be highlighted and evaluated. Capital rationing is also introduced into the case and plays a part in the analysis. Finally, the issue of reported earnings to shareholders versus sophisticated capital budgeting techniques is brought up and makes for interesting classroom discussion. Are shareholders more concerned with next quarter‘s earnings or long-term benefits? a. Total Reported Earnings increases for each projects: Project A

Project B

Project C

Project D

Year 1:

$(13,250)

$ 29,313

$(60,000)

$ 192,206

Year 2:

(450)

$ 87,938

$(16,000)

$ 129,846

Year 3:

$ 25,494

$146,563

$ 61,640 $ (43,350)

Year 4:

$101,003

$234,500

$162,140 $ (62,475)

Year 5: Total:

$ 63,315 $176,112

$322,438 $820,752

$262,640 $ (94,350) $410,420 $ 121,877

We are told in the case that Kay Marsh is sensitive to Aerocomp‘s level of earnings. Therefore, Project B, with over $820,000 in reported earnings increases (twice as much as any of the other projects), will be the one that attracts Kay‘s attention. (She may initially be swayed by the $192,206 that Project D brings in during the first year, but the losses in years three through five will probably cause her to reject that alternative quickly.) Note: Projects A and C both produce earnings decreases for the first two years. We would suspect that if Emily thinks that either of these two should be selected (on the basis of some other ranking method, such as NPV), she had better have some convincing arguments prepared! Foundations of Fin. Mgt. 12Ce

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Chapter 1

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Chapter 1 b. Payback Period, IRR, and NPV of each alternative: Project A

Project B

Project C

Project D

Payback Period:

4 years

5 Years

2 Years

IRR: NPV @ 10%:

14.08% $39,971

7.18% ($63,848)

11.95% $52,192

12.48% $20,609

(Students may get slightly different values due to rounding.) Note: A few students may question the fact that Project B‘s cost has not been completely recovered in the five-year period shown, as the cost of the other projects has been. Therefore, they will claim, we are not using the proper time frame for our comparison of the projects. Of course, they are correct, and deserve extra points for their astute observation. In the case, Project B‘s amortization, or depreciation, was limited on purpose to highlight the effect of amortization on reported income and cash flows.

c. 1. According to the Payback period, Project D should be selected. The initial investment of $510,000 is recovered in the second year.

2. The chief disadvantage of the Payback Period is obvious at once: the method ignores cash flows occurring after the payback period. In this case such an omission is disastrous, since Project D‘s reported earnings and cash flows fall off significantly after the payback period and never recover. Another disadvantage of the Payback Period is that it does not consider the timing of cash flows during the payback period.

3. In general, the Payback Period should not be used. However, it is used from time to time because it is easy to understand, and because it favors projects that pay off quickly. This can be an important factor in some fast-paced industries where a quick return is important. The Payback Period may have some justification as a backup method, but not as the primary analytical tool.

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Chapter 1 d. 1. According to the IRR method, Project A should be chosen. It returns nearly two percent more than the closest competing project.

2. Remember, that to achieve the IRR during a project‘s life, the project‘s cash inflows must be reinvested at the IRR rate. This may be difficult or impossible to accomplish when high IRR‘s are involved. (Suppose you were Aerocomp‘s financial manager, and you were getting the cash flows from Project A. What would you do with them: Pay dividends? Put them in a money market account at? You might encounter a great deal of difficulty locating an investment that would pay you back the IRR rate of 14.08%). As a matter of interest (no pun intended) if Project A‘s cash flows were reinvested at 7% annually instead of the IRR rate of 14.08%, the project‘s total return for the five-year period would drop to 11.84%.

3. Another disadvantage of the IRR method is that it does not give any consideration to project size. For example, the IRR method would select a project that returned $10 on a $1 investment over any of the projects in this case, even though the dollar return to the firm was only $9. This is not a problem when all projects with IRRs over the cost of capital can be selected, but when the projects are mutually exclusive, or when capital rationing is in effect (as it is in this case), the IRR method may lead the firm to make an incorrect choice. (Note: It is important to avoid confusion on this point. The IRR and NPV methods will both accept and reject the same investments, but they will not give them the same ranking. In this case, projects A, C, and D are all acceptable per IRR and NPV. However, the IRR method would choose projects A, D, and C, in that order, while the NPV method would choose C, A, and D.)

4. If the size of Aerocomp‘s capital budget were not limited, the IRR method would accept projects A, C, and D. Project B, with an IRR of 7.18%, almost 3% less than the cost of capital, would be rejected.

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Chapter 1 e. 1. According to the NPV method, Project C, with an NPV of over $52,000, will be chosen. It will add to the present value of the firm over $12,000 more than the next best project. Of course, under the IRR, Project A will be selected. Actually Project C is only a third place finisher under the IRR method.

2. If the size of Aerocomp‘s capital budget were not limited, the NPV method would accept projects A, C, and D. Project B, with an NPV of negative $63,848, would be rejected anyway. Note that both the NPV and IRR methods rejected project B. The return is less than the cost of capital.

3. The likely selection is Project C because of its high net present value. This is partly attributable to the fact that only one project can be selected. Had there not been capital limitations, one might put more emphasis on the IRR or use a profitability index approach. Of course, some instructors might select Project A as being preferable using other criteria, and that is fine. There may be some interesting opportunities for a classroom debate or discussion on these points.

f. 1. Profitability index = Project A Project B Project C Project D

[39,971 + 300,000]/ 300,000 = 1.133 [- 63,848 + 700,000]/ 700,000 = 0.909 [52,192 + 800,000]/ 800,000 = 1.065 [20,609 + 510,000]/ 510,000 = 1.040

2. The profitability index suggests project A with the highest relative profitability. However, project A adds the most value to the firm. Notice that projects A and D together, at roughly the same initial investment as C, provide a higher combined NPV.

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Chapter 1 Galaxy Systems, Inc. (Divisional Cost of Capital) Purpose: The case combines risk analysis with discount rate considerations. To emphasize how many multidivisional corporations operate, the case actually gets into the topic of divisional hurdle rates. The student is able to see how different divisions in a corporation might have different required rates of return based on their risk exposure. In this particular case, a key risk measure for the consideration is beta. (Only observe how they might be used). Calculations related to net present value and internal rate of return are purposely simple to emphasize more conceptual items. Emphasis can be made on how financial decisions are made in a corporate culture. This case draws on material from many of the capital budgeting chapters. Proposal A

NPV

(10% discount rate for the auto airbags production division)

N = 10

Year

Event

0 1-10

Airbag model Revenue

T = 40% r = 10% Expected Cash Flow

d = 20%

Aftertax Cash Flow

Present Value @ 10%

$(3,050,000) –  0.40 1  .5 432,000 .10   0.20720,000

$(3,050,000) 2,654,453

PV CCA  $3,050,000 

0.10  0.20





1  .10

 $3,050,000.2666666670.954545455 

  

776,363

NPV = $380,816 IRR (approximate) N = 10 Year

Event

0 1-10

Airbag model Revenue

T = 40% r = 13%

Expected Cash Flow

d = 20%

Aftertax Cash Flow

Present Value @ 13%

$(3,050,000) –  0.40 1  .5 432,000 .13   0.20720,000

$(3,050,000) 2,344,137

PV CCA  $3,050,000 

0.13  0.20





1  .13

 $3,050,000.242424240.942477876 

  

696,862

NPV = $(9,001) Foundations of Fin. Mgt. 12Ce

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Chapter 1 Proposal B

NPV

(15% discount rate for the aerospace division)

N = 10

Year

Event

0 1-10

Radar Revenue

T = 40% r = 15% Expected Cash Flow

d = 20%

Aftertax Cash Flow

Present Value @ 15%

$(3,100,000) –  0.40 1  .5  450,000 .15   0.20750,000

$(3,100,000) 2,258,446

PV CCA  $3,100,000 

0.15  0.20





1  .15

  

 $3,100,000.2285714290.934782609 

662,360

NPV = $(179,194) IRR (approximate) N = 10

T = 40% r = 13.5% d = 20%

Year

Event

Expected Cash Flow

0 1-10

Radar Revenue

$(3,100,000) 750,000 

Aftertax Cash Flow

Present Value @ 13.5%

– 450,000

$(3,100,000) 2,393,783

PV CCA   $3,100,000  0.20  0.40  1  .5  .135  0.135  0.20 1  .135      $3,100,000.238805970.940528634 

696,271

NPV = $(9,946)

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Chapter 1 Proposal C

NPV Year 0 1-15

(10% discount rate for the auto airbags production division)

N = 15

T = 40% r = 10% Expected Cash Flow

d = 20%

Aftertax Cash Flow

Present Value @ 10%

Airbag model $(225,000) – Cost savings  0.20  0.40 30,000 1  .5  .1018,000 

$(225,000) 136,909

Event

PV CCA   $225,000 

0.10  0.20



1  .10



  

[225,000].2666666670.954545455 

57,273

NPV = $(30,818) IRR (approximate) N = 15 Year 0 1-15

T = 40% r = 7%

Expected Cash Flow

d = 20%

Aftertax Cash Flow

Present Value @ 7%

Airbag model $(225,000) – Revenue 30,000  0.20  0.40 1  .5  .0718,000 

$(225,000) 163,942

Event

PV CCA   $225,000 

0.07  0.20





1  .07

 $225,000.2962962960.966183575 

  

64,486

NPV = $3,428

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Chapter 1 Proposal D

NPV

(15% discount rate for the aerospace division)

N=8

T = 40% r = 15%

Year

Event

Expected Cash Flow

0 1-8

Radar Revenue

d = 20%

Aftertax Cash Flow

Present Value @ 15%

$(1,700,000) –  0.40 1  .5  300,000 .15   0.20500,000

$(1,700,000) 1,346,196

PV CCA  $1,700,000 

0.15  0.20





1  .15

  

 $1,700,000.2285714290.934782609 

363,230

NPV = $9,426 IRR (approximate) slightly over 15% a. Proposal A should be accepted IRR > discount rate (13% > 10%) NPV is positive $380,186 Proposal B should be rejected IRR < discount rate (13.5% < 15%) NPV is negative ($179,194) Proposal C should be rejected IRR < discount rate (7% < 10%) NPV is negative ($30,818) Proposal D should be accepted IRR > discount rate (slightly over15% > 15%) NPV is positive $9,426 b. While the decisions related to Proposals A and B appear to be straightforward, Proposals C and D require further discussion. Proposal C has a negative net present value and the internal rate of return of 7% is well below the required rate of return of 10%. Nevertheless, it calls for the development of special equipment to be used in the disposal of environmentally harmful waste material created in the manufacturing process. Given tougher environmental laws, the project may have to be accepted. We are not told Foundations of Fin. Mgt. 12Ce

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Chapter 1 whether the installation is mandatory under the law, but there probably is adequate motivation to move forward with the project. Of course, if the installment of the equipment is required by law, then Galaxy must move forward regardless of the numbers. Proposal D has a positive net present value and the internal rate of return of slightly over 15 percent above the required rate of return of 15 percent for the division. However, the proposal appears to have even greater risk than projects normally undertaken in the aerospace division. While the high required rate of return for this division is supposed to cover the risk exposure of dealing in U.S. government contracts, Project D calls for the development of a microelectric control system for fighter jets that are still in the design stage. Even if the microelectric systems are successfully developed, there may not be a need for them if the other aerospace company cannot successfully develop fighter jets. Furthermore, the target market for the jets is in underdeveloped countries, which increases the uncertainty associated with this project. In the final analysis, top management might require an anticipated return of 20 percent or more to take on this highly speculative project. c. The $300,000 that has already been spent on the initial research for Proposal B (radar surveillance equipment) is a sunk cost. The money has already been spent and should have no influence on subsequent decisions. Sometimes in the real world, egos get in the way of corporate decisions, and division heads (or other executives) push hard for the continuance of projects that they spent funds on to explore; but that is not justification to continue on. This is somewhat like buying stock in an underperforming company in the stock market. Sometimes, you just have to take your losses. Of course, even if we considered the $300,000 that had already been spent, it would raise the total cost of the project and make it even less economical. Further overall comments: Companies that use divisional required rates of return often do have difficulties in finding betas for firms that produce products comparable to a division. That is, finding a ―pure play‖ comparison is difficult. Therefore, using the average beta for an entire industry may be the next best alternative. For example, if a division produces machine tools, its beta may be inferred from the entire machine tool industry rather than from a given firm in the industry. Discussion Questions

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Chapter 1 13-1. Risk-averse corporate managers are not unwilling to take risks, but will require a higher return from risky investments. There must be a premium or additional compensation for risk taking. 13-2. Risk may be defined in terms of the variability of outcomes from a given investment. The greater the variability, the greater the risk. Risk may be measured in terms of the coefficient of variation, in which we divide the standard deviation (or measure of dispersion) by the mean. We also may measure risk in terms of beta, in which we determine the volatility of returns on an individual stock relative to a stock market index. 13-3. The standard deviation is an absolute measure of dispersion, while the coefficient of variation is a relative measure that allows us to relate the standard deviation to the mean. The coefficient of variation is a better measure of dispersion when we wish to consider the relative size of the standard deviation or compare two or more investments of different size. 13-4. Risk may be introduced into the capital budgeting process by requiring higher returns for risky investments. One method of achieving this is to use higher discount rates for riskier investments. This risk-adjusted discount rate approach specifies different discount rates for different risk categories as measured by the coefficient of variation or some other factor. Other methods, such as the certainty equivalent approach, may also be used. 13-5. Referring to Table 13-3, the following order would be correct:      

repair old machinery (c) new equipment (a) addition to normal product line (f) new product in related market (e) completely new market (b) new product in foreign market (d)

13-6. In order to minimize risk, the firm that is positively correlated with the economy should select the two projects that are negatively correlated with the economy. 13-7. A discount rate combines the effects of risk and time value of money in one evaluation tool. A certainty equivalent deals first with risk by converting uncertain cash flows to ‗certainty equivalents‘, and then discounts at the risk-free rate to consider the time value of money.

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Chapter 1 13-8. Simulation is one way of dealing with the uncertainty involved in forecasting the outcomes of capital budgeting projects or other types of decisions. A Monte Carlo simulation model uses random variables for inputs. By programming the computer to randomly select inputs from probability distributions, the outcomes generated by a simulation are distributed about a mean and instead of generating one return or net present value, a range of outcomes with standard deviations are provided. 13-9. Sensitivity analysis only adjusts one variable at a time. In all likelihood variables are interdependent and if one changes the others will likely change as well. Sensitivity analysis misses this dynamism. As well sensitivity analysis does not assess risk, it only points out possible outcomes and we are left to assign probabilities. With today‘s ease of spreadsheet production on the PC one can turn out endless analysis, which, without a plan will become meaningless. 13-10. Decision trees help lay out the sequence of decisions that are to be made and present a tabular or graphical comparison resembling the branches of a tree which highlights the difference between investment choices. 13-11. The firm should attempt to construct a chart showing the risk-return characteristics for every possible set of 20. By using a procedure similar to that indicated in Figure 13-11, the best risk-return trade-offs or efficient frontier can be determined. We then can decide where we wish to be along this line. 13-12. High profits alone will not necessarily lead to a high market value for common stock. To the extent large or unnecessary risks are taken, a higher discount rate and lower valuation may be assigned to shares. Only by attempting to match the appropriate levels for risk and return can we hope to maximize our overall value in the market. 13-13. It depends! If the firm is well diversified beta risk would probably be more important. However if the firm is not well diversified or if a project is particularly significant in size to the firm then total risk (unique and systematic) would be more appropriate, as measured by the standard deviation of the project.

Internet Resources and Questions 1. www.standardandpoors.com/en_US/web/guest/home www.bankofcanada.ca http://pages.stern.nyu.edu/~adamodar/New_Home_Page/data.html

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Chapter 1 Problems 13-1.

Coefficient of Variation A B C

$900/ $1,800 = 0.50 $1,400/ $2,000 = 0.70 $500/ $1,500 = 0.33

Project C has the least risk.

13-2.

Pabst Dental Supplies

D   DP

D 20 40 65 80

P .10 .20 .40 .30

DP 2 8 26 24 60

= D

  D  D P 2

b. 

D 20 40 65 80

D 60 60 60 60

(D– D ) – 40 – 20 + 5 + 20

(D– D )2 1,600 400 25 400

P .10 .20 .40 .30

(D– D )2P 160 80 10 120 370

  370  19.24

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Chapter 1 13-3.

Northern Wind Power

D   DP

D 50 70 90 140

P .10 .40 .20 .30

DP 5 28 18 42 93

= D

  D  D P 2

b. 

D 50 70 90 140

D 93 93 93 93

(D– D ) – 43 – 23 – 3 + 47

(D– D )2 1,849 529 9 2,209

P .10 .40 .20 .30

(D– D )2P 184.9 211.6 1.8 662.7 1,061.0

  1,061  32.57

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Chapter 1 13-4.

Monarch King Size Beds Ltd.

D   DP

D 20 30 70

P .20 .50 .30

DP 4 15 21 40

= D

  D  D P 2

b. 

D 20 30 70

D 40 40 40

(D– D ) – 20 – 10 + 30

(D– D )2 400 100 900

P .20 .50 .30

(D– D )2P 80 50 270 400

  400  20  20  0.5 variation  V    Coefficient of D 40

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Chapter 1 13-5.

Sam Sung

D   DP

D 80 124 340

P .30 .50 .20

DP 24 62 68 154

  D  D P 2

b. 

D 80 124 340

D 154 154 154

(D– D ) (D– D )2 – 74 5,476 – 30 900 + 186 34,596

P .30 .50 .20

(D– D )2P 1,642.8 450.0 6,919.2 9,012.0

  9,012  94.93  94.93  0.616 Coefficient of variation V    D 154 13-6.

Five alternatives



A B C D E

Coefficient of variation V    D Ranking from lowest to highest $200/ $1,000 = .20 E (.09) $300/ $3,000 = .10 B (.10) $400/ $3,000 = .13 C (.13) $700/ $5,000 = .14 D (.14) $900/ $10,000 = .09 A (.20)

13-7. No, because the expected value is the same (investment scale). Foundations of Fin. Mgt. 12Ce

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Chapter 1

13-8.

Another five alternatives



Coefficient of variation V    D Ranking from lowest to highest A $300/ $1,200 = .25 C (.09) B $600/ $800 = .75 E (.22) C $450/ $5,000 = .09 A (.25) D $430/ $1,000 = .43 D (.43) E $13,200/ $60,000 = .22 B (.75)

13-9.

Digital Technology a. Year

Profits: Expected Value

Standard Deviation

Coefficient of Variation

1 3 6 9

180 240 300 400

54 104 166 260

.30 .43 .55 .65

b. Yes, the risk appears to be increasing over time. This may be related to the inability to make forecasts far into the future. There is more uncertainty.

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Chapter 1 13-10.

Ted Fears and Sonny Outlook Coefficient of variation Stocks $4,000/ $7,000 0.57 Bonds $1,560/ $5,000 0.31 Commodities $15,100/ $12,000 1.26 Options $8,850/ $8,000 1.11

a. Tom should select bonds, which have the least risk. b. Sonny should select commodities, which have the greatest risk.

13-11.

Tim Trepid and Mike Macho Coefficient of variation $6,140/ $9,140 0.67 $2,560/ $7,680 0.33 $26,700/ $19,100 1.40 $18,200/ $17,700 1.03

Shares Bonds Futures Real estate

a. Tim should select bonds, which have the least risk. b. Mike should select futures, which have the greatest risk.

13-12. Project A B C D

Tomcat Oil and HiC Construction $96,600/ $183,400 $282,100/ $471,800 $75,600/ $61,600 $144,900/ $87,500

Coefficient of variation 0.53 0.60 1.23 1.66

a. Tomcat Oil should select project D, which has the greatest risk. b. HiC Construction should select project A, which has the least risk.

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Chapter 1 13-13. Alternative 1 D × P = DP $50 .2 $10 80 .4 32 120 .4 48 D = $90

Foundations of Fin. Mgt. 12Ce

Three Investment Alternatives Alternative 2 D × P = DP $90 .3 $27 160 .5 80 200 .2 40 D = $147

Alternative 3 D × P = DP $80 .4 $32 200 .5 100 400 .1 40 D = $172

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Chapter 1 Standard Deviation: Alternative 1: D D $50 90 80 90 120 90

(D– D ) – 40 – 10 + 30

(D– D )2 1,600 100 900

P .20 .4 .4

(D– D )2P $320 40 360 $720

P .3 .5 .2

(D– D )2P $974.70 84.50 561.80 $1,621.00

P .4 .5 .1

(D– D )2P $3,385.60 392.00 5,198.40 $8,976.00

  720  26.83 Alternative 2: D D $90 $147 160 147 200 147

(D– D ) – 57 + 13 + 53

(D– D )2 3,249 169 2,809

  1,621  40.26 Alternative 3: D D $80 $172 200 172 400 172

(D– D ) $-92 +28 +228

(D– D )2 $8,464 784 51,984

  8,976  94.74 Rank by Coefficient of Variation: least risk to most Alternative 2

V     40.26  0.274

Alternative1

V    

Alternative 3

V    

Foundations of Fin. Mgt. 12Ce

D D D

147 26.83 90 94.74

 0.298  0.551

172

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Chapter 1 13-14.

Mary Beth Clothes Standard Deviations of Sites A and B

Site A D $50 100 110 135

D $100 100 100 100

(D– D ) ─ $50 0 +10 +35

(D– D )2 $2,500 0 100 1,225

P .20 .30 .30 .20

(D– D )2P $ 500 0 30 245 $ 775

P .10 .20 .40 .20 .10

(D– D )2P $ 640 500 0 500 640 $2,280

  775  $27.84 Site B D $20 50 100 150 180

D $100 100 100 100 100

(D– D ) ─ $80 ─ 50 0 +50 +80

(D– D )2 $6,400 2,500 0 2,500 6,400

  2,280  $47.75

VA VB

= =

$27.84/$100 $47.75/$100

= =

.2784 .4775

Site A is the preferred site since it has the smaller coefficient of variation. Because both alternatives have the same expected value, the standard deviation alone would have been enough for a decision. A will be just as profitable as B but with less risk.

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Chapter 1 13-15.

Waste Industries

The coefficient of variation suggests a discount rate of 14%. Year 1 2 3 4 5

Cash flow $11,000 16,000 21,000 24,000 30,000 PV of cash flows Investment NPV

PV@14% $ 9,649 12,311 14,174 14,210 15,581 65,925 70,000 — $4,075

Based on a negative NPV, the project should not be undertaken.

13-16.

Western Dynamite Co. Method 1

Year Cash flow 1 $25,000 2 30,000 3 38,000 4 31,000 5 19,000 PV of Inflows Investment NPV

Method 2 PV@10% $22,727 24,793 28,550 21,173 11,798 $109,041 100,000 $ 9,041

Year 1 2 3 4 5

Cash flow $28,000 32,000 39,000 33,000 25,000

PV@15% $24,348 24,197 25,643 18,868 12,429 $105,485 100,000 $ 5,485

Select Method 1 The instructor may wish to point out that Method 2 has higher undiscounted total cash flows than Method 1 (the numbers are $157,000 versus $143,000), but has a lower NPV because of the higher discount rate.

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Chapter 1 Debby’s Dance Studios

13-17.

a. Expected Cash Flow Cash Flow $4,570 5,550 7,400 9,930

P × × × ×

.1 .3 .4 .2

b. Net Present Value

$ 457 1,665 2,960 1,986 $7,068

(Appendix D)

$ 7,068 $23,693

(%I/Y = 15%, n = 5) =

$23,693 20,900 $ 2,793

Present Value of Inflows Present Value of Outflows Net Present Value

c. Debby should buy this new equipment because the net present value is positive.

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Chapter 1 Larry’s Athletic Lounge

13-18.

a. Expected Cash Flow Cash Flow $2,400 4,800 6,000 7,200

× × × ×

P .2 .4 .3 .1

$ 480 1,920 1,800 720 $4,920

b. NPV (Net Present Value) $4,920 (%I/Y = 14%, n = 5) = $16,891 $ 16,891 20,000 $(3,109)

Present value of inflows Present value of outflows Net present value

IRR (Internal Rate of Return) Calculator: Compute:

PV = $20,000 %I/Y =? %I/Y = 7.32%

FV = 0 N=5

PMT = $4,920

c. Larry should not buy this new equipment because the net present value is negative and the internal rate of return is less than the cost of capital. The answer assumes that Larry‘s probability distribution of the possible outcomes is accurate.

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Chapter 1 13-19.

Silverado Mining Company

a. Calculate the net present value for each project. The Yukon Mine Years Cash Flow 5-15 $400,000 (2 steps) 16-25 $800,000 (2 steps) Present value of inflows Present value of outflows NPV (Net present value)

Present Value @ 10% $1,774,486 $1,176,768 $2,951,254 $2,000,000 $ 951,254

The Labrador Mine Years Cash Flow 1-25 $300,000 Present value of inflows Present value of outflows NPV (Net present value)

Present Value @ 10% $2,723,112 $2,723,112 $2,400,000 $ 323,112

Both projects are attractive based on positive NPVs. Select the Yukon Mine if projects are mutually exclusive. b. Recalculate the NPV of the Yukon Mine at a 15% discount rate. The Yukon Mine Years Cash Flow 5-15 $400,000 (2 steps) 16-25 $800,000 (2 steps) Present value of inflows Present value of outflows NPV (Net Present Value)

Present Value @ 15% $1,196,957 $ 493,423 $1,690,380 $2,000,000 $ (309,620)

Reject the Yukon Mine. Purchase the Labrador Mine.

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Chapter 1 13-20.

John Backster

D   DP

Windy Acres

Hillcrest

D P 10 .10 15 .20 30 .40 45 .20 50 .10 Expected cash flow (thousands)

DP $1 3 12 9 5 $30

D P 15 .20 25 .30 35 .40 45 .10 Expected cash flow (thousands)

DP $ 3.0 7.5 14.0 4.5 $29.0

b. Find the standard deviation. Then the coefficient of variation. D $10 15 30 45 50

D $30 30 30 30 30

Windy Acres (D– D ) (D– D )2 ─ $20 $400 ─ 15 225 0 0 +15 225 +20 400

P .10 .20 .40 .20 .10

(D– D )2P $ 40 45 0 45 40 $170

  170  13.04 thousands  $13.04  0.4347 Coefficient of variation V     $30 D

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Chapter 1

D $15 25 35 45

Hillcrest (D– D ) (D– D )2 $-14 196 -4 16 +6 36 +16 256

D $29 29 29 29

(D– D )2P $39.2 4.8 14.4 25.6 $84.0

P .20 .30 .40 .10

  84  9.17 thousands  $9.17  0.3162 Coefficient of variation V     $29 D c. Based on the coefficient of variation, Windy Acres has more risk (0.4347 vs. 0.3162). 13-21.

John Backster (Continued)

a. Risk-adjusted net present value

Expected cash flow IFPVA (n = 10) Present value of inflows Present value of outflows Net present value

Windy Acres Hillcrest With V = 0.4347, With V = 0.3162, discount rate = 16% discount rate = 12% $30,000 $29,000 $144,997 100,000 $ 44,997

$163,856 100,000 $ 63,856

b. If these two investments are mutually exclusive, he should accept Hillcrest because it has a higher net present value. If the investments are non-mutually exclusive and no capital rationing is involved, they both should be undertaken.

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Chapter 1 13-22. a.

(1)

Wardrobe Clothing Manufacturers (2) (3) (4) Present Value of cash flows Probability Initial cost from sales .40 $240,000 $100,000

(5) (3) – (4) $140,000

(6) Expected NPV (2) × (5) $56,000

Enter

Expected Sales Fantastic

New Coat

Moderate

.20

180,000

100,000

80,000

16,000

Market

Dismal

.40

100,000

(100,000)

(40,000)

Expected NPV

$32,000

Enter

Fantastic

.20

$120,000

$60,000

$12,000

Blazer

Moderate

.60

75,000

60,000

15,000

9,000

Market

Dismal

.20

55,000

60,000

(5,000)

(1,000)

Expected NPV

$20,000

b. The indicated investment, based on the expected NPV, is in the new coat market. However, there is more risk in this alternative so further analysis may be necessary. It is not an automatic decision.

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Chapter 1 13-23.

Probability calculations Expected value = $30,000, σ = $6,000

a. $24,000 to $36,000 expected value + 1 σ 0.6826 = 68.26% b. $21,000 to $39,000 expected value + 1.5 σ 0.8664 = 86.64% c. greater than $18,000

$18,000 Compare to expected value: $18,000  $30,000   $12,000  2  $6,000 $6,000 This represents 0.4772 or 48%

Total distribution under the curve: .4772 .5000 .9772 = 97.72%

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Chapter 1 d. Less than $41,760

$41,760 Compare to expected value: $41,760  $30,000 $11,760   1.96 (Represents 0.4750 or 48%) $6,000 $6,000

Total distribution under the curve: .4750 .5000 .9750 = 97.50% e. Less than $27,000 or greater than $39,000

$27,000

$39,000

Compare to expected value: $27,000  $30,000   $3,000  .5 (Represents 0.1915 or 19%)  $6,000 $6,000 $39,000  $30,000 $9,000   1.5 (Represents 0.4332 or 43%) $6,000 $6,000

Total distribution under the curve, in the tails: 0.5000 – 0.1915 = 0.3085 + 0.5000 – 0.4332 = 0.0668 = 0.3753 = 37.53% Foundations of Fin. Mgt. 12Ce

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Chapter 1 13-24.

Caribou Pipeline Company

a. Standard deviation: year 1 D 65 80 95

D 80 80 80

(D– D ) – 15 0 + 15

(D– D )2 225 0 225

P .20 .60 .20

(D– D )2P 45 0 45 90

P .25 .50 .25

(D– D )2P 225 0 225 450

P .30 .40 .30

(D– D )2P 480 0 480 960

  90  9.49 Standard deviation: year 5 D 50 80 110

D 80 80 80

(D– D ) –30 0 + 30

(D– D )2 900 0 900

  450  21.21 Standard deviation: year 10 D 40 80 120

D 80 80 80

(D– D ) – 40 0 + 40

(D– D )2 1,600 0 1,600

  960  30.98

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Chapter 1 b. Risk over time

Dollars

Expected Cash flow ($80)

$80

1 yr.

5 yr.

10 yr.

Time

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Chapter 1 c. Table: (1) PVIF

(2) PVIF

(3) PVIF

12%

Difference

.943

.893

.050

.747

.567

.180

.558

.322

.236

Year

d. Yes. The larger risk over time is consistent with the larger differences in the present value interest factors (PVIFs) over time. In effect, future uncertainty is being penalized by a lower present value interest factor (PVIF). This is one of the consequences of using progressively higher discount rates to penalize for risk.

e. NPV Year

Inflow

PV @ 12%

$80

$ 71.4

45.4

25.8 PV of inflows

$142.6

Investment NPV Accept the investment.

Foundations of Fin. Mgt. 12Ce

135.0 $ 7.6

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Chapter 1 13-25.

Gifford Western Wear

a. Purchase of the Toy Company would provide some reduction in risk because of the low correlation with Gifford Western Wear, while purchase of Boot Company would do very little to reduce portfolio risk because of the high correlation coefficient. A combination with the Jewellery Company would provide a fairly large degree of risk reduction. b. Students may or may not calculate the coefficient of variation to get some idea about the riskiness of each project. If they do, they will find the following: VGWW = $3/ $10 = 0.3 VToy = $6/ $10 = 0.6

VBC = $5/ $10 = 0.5 VJC = $7/ $10 = 0.7

Although the Jewellery Company has the highest risk as measured by the coefficient of variation, its negative correlation coefficient of – 0.6 should provide the best risk reduction for Gifford Western Wear. This is an example of a risky company being added to a portfolio but reducing total risk. Buy the Jewellery Company. c. Since the Boot Company is most like Gifford Western Wear, its selection would provide the least amount of risk reduction. Therefore, add the Toy Company to the Jewelry Company selected in part (b). The Toy Company offers the next best risk reduction after the Jewelry Company because of its low positive correlation coefficient. You might also want to know more about the relationship of the other companies to each other.

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Chapter 1 13-26.

Treynor Pie Company a.

Coefficient of variation (V ) 

Standard deviation Expected value

(millions) Treynor Pie Company $ 4/$10 Gourmet Restaurant $1.4/$9 Baby Food $1.6/$5 Nutritional Products $3.2/$7

= .40 = .16 = .32 = .46

The Gourmet Restaurant chain is the least risky with a coefficient of variation of .16, while the nutritional products firm has the highest risk with a coefficient of variation of .46 b. Because the nutritional products firm is highly negatively correlated (–.7) with Treynor Pie Company, it is most likely to reduce risk. It would appear that the demand for highcalorie snack foods moves in the opposite direction as the demand for nutritional items. Thus, Treynor Pie Company would reduce its risk to the largest extent by acquiring the company with the highest coefficient of variation (.46) as computed in part a. This would appear to represent a paradox, but it is not. It simply reflects the fact that the interaction between two companies is much more important than the individual risk of the companies.

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Chapter 1 13-27.

Transoceanic Airlines

a. Before acquisition: D $30 50 70

D   DP

P DP .30 9 .40 20 .30 21 $50($millions)

  D  D P 2

D $30 50 70

D 50 50 50

(D– D ) – 20 0 + 20

(D– D )2 400 0 400

P .30 .40 .30

(D– D )2P 120 0 120 240

  240  15.49  15.49  0.310  V    Coefficient of variation D

After the acquisition:

Expected value 53.0 ($ millions) Standard deviation 34.9 ($ millions) Coefficient of variation 0.658

b. Not desirable. Although the expected value is $3 million higher, the coefficient of variation is more than twice as high (.658 vs. 310). The slightly added return probably does not adequately compensate for the added risk.

c. Probably not. There may be a higher discount rate applied to the firm's earnings to compensate for the additional risk. The share price may actually go down.

d. The oil company may provide the best diversification benefits. The performance of oil companies and airlines tend to go in opposite directions. If oil prices are high, oil companies‘ benefit, but airlines are hurt. The opposite effect is true when oil prices are low. A major travel agency or gambling

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Chapter 1 casino would probably not provide much in the way of risk reduction benefits. They are both closely associated with entertainment and travel.

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Chapter 1 13-28.

Jimmy

Investment D is riskier by itself with the higher standard deviation (5.2% vs. 4.1%), and D is also riskier in a portfolio context as its beta is higher (1.25 vs. 0.94).

ii.

D  0.4  0.18  0.60  0.14  0.072  0.084  .156  15.6%

iii.

DE  0.42  0.0522  0.62  0.0412  2  0.55 0.052 0.041 0.4  0.6 DE  0.0400081 4.0%

iv.

Β = 0.4 × 1.25 + 0.6 × 0.94 = 1.064

The standard deviation of the portfolio is less than either investment individually. The key variable in determining the portfolio standard deviation is the correlation coefficient (how the two investments move together). The portfolio beta is an easier calculation of risk than the portfolio standard deviation.

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Chapter 1 13-29.

Astrid

Investment N is riskier by itself with the higher standard deviation (3.9% vs. 3.1%). However M is also riskier in a portfolio context as its beta is higher (1.40 vs. 0.85).

ii.

D  0.55 0.12  0.45 0.19  0.066  0.0855  .1515  15.15%

iii.

DE  0.552  0.0312  0.452  0.0392  2  0.30  0.031 0.039 0.55 0.45 DE  0.027897  2.79%

iv.

Β = 0.55 × 1.40+ 0.45 × 0.85 = 1.1525

The standard deviation of the portfolio is less than either investment individually. The key variable in determining the portfolio standard deviation is the correlation coefficient (how the two investments move together). Beta is an easier calculation of risk than the portfolio standard deviation.

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Chapter 1 13-30.

Goodman Software Products a.

Adjusted Inflows

Year 1 2 3 4 5 b.

Inflow $32,200 59,500 79,900 59,200 65,600

Coefficient of Variation .12 .28 .45 .79 1.15

Adjustment Adjusted Factor Inflow .90 $28,980 .80 47,600 .80 63,920 .60 35,520 .50 32,800

Net Present Value

Adjusted Year Inflow 1 $28,980 2 47,600 3 63,920 4 35,520 5 32,800 Present Value of Adjusted Inflows Present Value of Outflows Net Present Value

Present Value @ 5% $ 27,600 43,175 55,216 29,222 25,700 $180,913 184,000 $ (3,087)

Based on the net present value of –$3,087, the project should not be accepted.

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Chapter 1 13-31.

Mr. Boone

a. b. 18

Mr. Boone

Return (percent)

16 15

G E

F C

12 11

B 10

9 0

Risk (percent)

c. Achieve the highest possible return for a given risk level. Allow the lowest possible risk at a given return level. d. No. Each investor must assess his or her own preferences about their risk and return trade-off.

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Chapter 1 Comprehensive Problems 13-32.

Roaring River Utility Company Portfolio Effect of a Merger

a. Computer Whiz Company D $6 10 16 25

P .30 .30 .20 .20

DP $ 1.8 3.0 3.2 5.0

Atlantic Micro-Technology D P $(1.0) .20 3 .20 10 .20 25 .30 31 .10 Expected cash flow (millions)

Expected cash flow $13.0 (millions)

DP (.2) 0.6 2.0 7.5 3.1 $13.0

b. Expected coefficient of variation for Computer Whiz Company D $6 10 16 25

D $13 13 13 13

(D– D ) $–7 –3 +3 + 12

(D– D )2 $ 49 9 9 144

P .3 .3 .2 .2

(D– D )2P $14.7 2.7 1.8 28.8 $48.0

  48  $6.93 million  $6.93  0.533  V    Coefficient of variation $13 D

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Chapter 1 Coefficient of variation for Atlantic Micro-Technology D $– 1 3 10 25 31

D $13 13 13 13 13

(D– D ) $– 14 – 10 –3 +12 +18

(D– D )2 $196 100 9 144 324

P .2 .2 .2 .3 .1

(D– D )2P $39.2 20.0 1.8 43.2 32.4 $136.6

  136.6  $11.69 million  $11.69  0.899  V    Coefficient of variation $13 D Computer Whiz has a lower coefficient of variation, 0.533 < 0.899. c. For both companies the annual expected value is $13million for 10 years. The cost is $75 million for either company. Roaring River Utility Company has a cost of capital of 10%. $13 million(n = 10, %i = 10%) = $79.879 PV of inflows 75.000 PV of outflows $ 4.879 Net present value (million) d. Based on present values, you could pick either company. e. The only way one will win out over the other is if risk factors are considered. Since Atlantic Micro-Technology has the higher coefficient of variation, we would select the lower risk company - Computer Whiz. If Roaring River Utility Company uses risk-adjusted cost of capital concepts, it would use a higher cost of capital for the cash flows generated by AMT and this would reduce its NPV.

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13 -

Blo

Chapter 1 f. Since Roaring River Utility has a correlation coefficient with the economy of +.3, the selection of AMT would offer the most risk reduction because its correlation coefficient with the economy is – .1.

g. Because Roaring River Utility is a stable billion-dollar company, this investment of $75 million would probably not have a great impact on the stock price in the short run. There could be some positive movement in the stock price if investors perceive less risk from portfolio diversification. This would be particularly true for a merger with AMT. You can use this question to discuss risk-return trade-offs and market reactions.

13-33.

Ace Trucking Company

a. Assumption One: Yr. 1 Yr. 2 Yr. 3 Probability D DP D DP D DP .1 $0.68 .068 $0.81 .081 $0.95 .095 .2 .81 .162 .95 .190 1.08 .216 .3 .95 .285 1.08 .324 1.22 .366 .2 1.08 .216 1.22 .244 1.35 .270 .2 1.22 .244 1.35 .270 1.49 .298 Expected value $0.975/litre $1.109/litre $1.245/litre Assumption Two: Yr. 1 Yr. 2 Yr. 3 Probability D DP D DP D DP .1 $1.22 .122 $1.35 .135 $1.76 .176 .3 1.35 .405 1.49 .447 2.03 .609 .4 1.76 .704 2.03 .812 2.43 .972 .2 2.03 .406 2.30 .460 2.70 .540 Expected value $1.637/litre $1.854/litre $2.297/litre

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Chapter 1 b. Assumption One: #of litres % savings Expected without with Year cost/ gal. efficiency = Cost efficiency 1 $0.975 30 million $29,250,000 15% 2 1.109 33,270,000 3 1.245 37,350,000

Total $ saved $4,387,500 4,990,500 5,602,500

Assumption Two: #of litres % savings Expected without with Year cost/ gal. efficiency = Cost efficiency 1 $1.637 30 million $49,110,000 15% 2 1.854 55,620,000 3 2.297 68,910,000 c. Compute annual CCA analysis. Year 1 30% (1/2) Year 2 30% Year 3 30%

Total $ saved $7,366,500 8,343,000 10,336,500

(amortization): Then proceed to the × 13.25 mil. × 11.2625 mil. × 7.88375 mil.

= = =

1.9875 mil. 3.37875 mil. 2.365125 mil.

Total saved equals increase in EBAT (earnings before amortization or CCA and taxes) Assumption One

Year 1

Year 2

Year 3

Increase in EBAT – CCA Increase in EBT – Taxes (30%) Increase in EAT + CCA Increased cash flow

$4,387,500 1,987,500 2,400,000 720,000 1,680,000 1,987,500 $3,667,500

$4,990,500 3,378,750 1,611,750 483,525 1,128,225 3,378,750 $4,506,975

$5,602,500 2,365,125 3,237,375 971,213 2,266,162 2,365,125 $4,631,288

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Chapter 1 Assumption Two

Year 1

Year 2

Year 3

Increase in EBDT – CCA Increase in EBT – Taxes (30%) Increase in EAT + CCA Increased Cash Flow

$7,366,500 1,987,500 5,379,000 1,613,700 3,765,300 1,987,500 $5,752,800

$8,343,000 3,378,750 4,964,250 1,489,275 3,474,975 3,378,750 $6,853,725

$10,336,500 2,365,125 7,971,375 2,391,413 5,579,962 2,365,125 $7,945,088

d. #1

Year 1 2 3

Cash Flow $3,667,500 4,506,975 4,631,288 PV of inflows PV of outflows NPV

Present Value @ 11% $ 3,304,054 3,657,962 3,386,358 $ 10,348,374 13,250,000 $(2,901,626)

Year 1 2 3

Cash Flow $5,752,800 6,853,725 7,945,088 PV of inflows PV of outflows NPV

Present Value @ 11% $5,182,703 5,562,637 5,809,380 $16,554,720 13,250,000 $3,304,720

Combined NPV: Outcome NPV Assumption One (2,901,626) Assumption Two 3,304,720 Expected Outcome

Probability .5 (1,450,813) .5 1,652,360 $201,547

e. Yes: The combined expected value of the outcomes is positive. f. Quite sensitive when that many litres are used per year.

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Chapter 1 13-34.

Indigo Ltd.

a. Cost of capital the same for all three projects @ 10% Project A Cash flow per year $37,000 Number of years 10 Present value = Cost NPV

$227,349 200,000 $ 27,349

Project B Cash flow per year Number of years

$27,500 10

Present value = Cost NPV

$168,976 160,000 $ 8,976

Project C Cash flow per year Number of years

$27,000 10

Present value = Cost NPV

$165,903 180,000 $(14,097)

Projects A and B have a positive NPV, when using the cost of capital as the evaluation criteria.

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Chapter 1 b. The CAPM [ K j = Rf + j (Rm – Rf) ]attempts to match the risk of a project with its required return. Project A

Kj = 3% + 1.6 (11% – 3%) = 3% + 12.8% = 15.8%

Present value = Cost NPV Project B

Kj = 3% +1.1 (11% – 3%) = 3% + 8.8% = 11.8%

Present value = Cost NPV Project C

$180,169 200,000 $(19,831)

$156,662 160,000 $(3,338)

Kj = 3% + .5 (11% – 3%) = 3% + 4.0% = 7.0%

Present value = Cost NPV

$189,637 180,000 $ 9,637

Based on the risk-return criteria of the CAPM, project A and B are no longer acceptable. Project C now has the highest positive NPV.

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Chapter 1 13-35.

Fine Winehouse

a. Cost of capital = 0.50  .08 (1  .28) + 0.50  .15 = .50  0.0576 + .075 = 0.0288 +0.075 = 0.1038 = 10.38% CAPM

= Rf + j (Rm – Rf) = 0.029 + 1.3 (0.07) = 0.12 = 12.00%

b. The Fine Winehouse could use one of two discount rates, depending on the perceived risk of the project. If the risk is the same as current projects the cost of capital based on current market values is appropriate. If the risk is different the CAPM is probably justified, in an attempt to match risk and required return. In this case the analysis suggests that the project is ‗quite unlike‘ any of its existing projects. Therefore, the CAPM rate of 12% is probably justified for use as the discount rate.

n=6

T = 28%

r = 12%

d = 30%

Year

Event

Expected Cash Flow

Aftertax Cash Flow

Present Value @ 12%

0 0 1-6 6 6

Investment $(500,000) Current liabilities 30,000 Revenues 150,000 Salvage 55,000 Current lia. reversed 30,000

  108,000 

$(500,000) 30,000 444,032 27,865 (15,199)

.30.28 1 .5.12 500,000  27,865 .12  .30 1  .12    472,135.20.946428571 

 89,368



NPV =



$76,066

Proceed!

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Chapter 1 13-36.

Sam McGee and the Midnight Sun Project

a. Cost of capital = .44  0.0953 (1  .38) + 56%  0.15 = .44  0.059086 + 0.084 = 0.026 +0.084 = 0.110 = 11% CAPM

= Rf + j (Rm – Rf) = 0.03 + 1.5 (0.08) = 0.150 = 15%

b. Sam McGee could use one of two discount rates, depending on the perceived risk of the project. If the risk is the same as current projects the cost of capital based on current market values is appropriate. If the risk is different the CAPM is probably justified, in an attempt to match risk and required return. In this case the analysis suggests that the project is ‗quite unlike‘ any of its existing projects. Therefore the CAPM rate of 15% is probably justified for use as the discount rate.

n=7

Year

Event

0 0 1-3 4-7 7 7

The M. Sun W. C. @15% Revenues Revenues Salvage WC recovery

T = 38% r = 15% Expected Cash Flow

d = 30% Aftertax Cash Flow   55,800 71,300 

$(320,000) (48,000) 90,000 115,000 25,000 48,000

Present Value @ 15% $(320,000) (48,000) 127,404 133,844 9,398 18,045

.30.38 1 .5.15 320,000  9,398 .15  .30 1  .15    310,602.2533.9347826 

 73,554

 NPV =



$(5,755)

Do not take on the Midnight Sun.

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Chapter 1 d. If instead of a firm beta we have an equity beta we will have to calculate the cost of capital based on a weighting of debt and equity. The cost of equity capital: CAPM K j = Rf + j (Rm – Rf) = 0.03 + 2.0 (0.08) = 0.190 = 19% Overall cost of capital = .44  0.0953 (1  .38) + 56%  0.19 = .44  0.059086 + 0.1064 = 0.026 +0.1064 = 0.1324 = 13.24% n=7 Year

Event

T = 38% r = 13.24% d = 30% Present Value Expected Aftertax @ 13.24% Cash Flow Cash Flow

 The M. Sun $(320,000)  W. C. @15% (48,000) Revenues 90,000 55,800 Revenues 115,000 71,300  Salvage 25,000  WC recovery 48,000 320,000 10,470 .30.38   1 .5.1324 .1324  .30 1  .1324     309,530.263645.94154  NPV = 0 0 1-3 4-7 7 7

$(320,000) (48,000) 131,217 145,324 10,470 20,102

76,835 $15,948

The Midnight Sun should be accepted.

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Chapter 1 MINI CASES Churchill's Muffins (Investment Decision with NPV and Risk Analysis) Standard (company-owned) P .30 .40 .30 D 1,450 630 – 200

× × × ×

NPV (in $ thousands) 1,450 = 435 630 = 252 (200) = (60) D = 627

D 627 627 627

(D– D ) (D– D )2 823 677,329 3 9 – 827 683,929

P .30 .40 .30

(D– D )2P 203,199 4 205,179 408,382

  408,382  639 Coefficient of variation

V     639  1.02 D

627

Expanded (company-owned) P .30 .40 .30 D 3,812 740 – 900

× × × ×

NPV (in $ thousands) 3,812 = 1,144 740 = 296 (900) = (270) D = 1,170

D 1,170 1,170 1,170

(D– D ) (D– D )2 2,642 6,980,164 − 430 184,900 – 2,070 4,284,900

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P .3 .4 .3

(D– D )2P 2,094,049 73,960 1,285,470 3,453,479

Block, Hirt, Danielsen, Short

Chapter 1

  3,453,479  1,858 Coefficient of variation

V     D

1,858

 1.59

1,170

The numeric analysis indicates that, on an expected values NPV basis, the expanded size alternative is far superior. The risk measure, on the other hand, certainly favors the standard size alternative. Note that the return advantage of the expanded alternative rests entirely with the enormous potential under the "very favorable" outcome. The downside risk is also very high under this alternative. The franchisee alternative offers lower potential returns but very little risk since the investment by the firm in case of poor franchisee performance will come mostly in the way of additional managerial troubleshooting efforts and the necessity to forgo royalties in order to ensure the survival of a franchisee under adverse conditions. In real life, Churchill's (disguised name) actually elected for the standard, franchised alternative. Under this one the franchisee still stood to make a reasonable return with lower risk to himself and also to the company (less investment for the company plus better experience historically under the franchisee option). Importantly, this allowed John's dad to begin withdrawing funds from the firm for the purpose of reducing the mortgage and thus removing his home from being at risk if the business failed.

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Chapter 1 Phillips Toy Company (Capital Budgeting and Cash Flow) Purpose: The case gives the student a good opportunity to do cash flow analysis. The use of variable discount rates based on project risk gives insight into how some corporations adjust for risk exposure. Also, the use of an appropriate time horizon for analysis is highlighted. Some students may take a special interest in the case because of the discussion of the profitable world of hockey card collecting. Though the case is closely related to Chapter 12, it should probably follow after Chapter 13 because of the risk dimensions in the discussion Given the case information, the expected value for sales in 2006 would be calculated as: P

Sales (in $ thousands)

.25 .40 .20 .15

× × × ×

1,100 2,000 3,750 4,500

= = = = =

275 800 750 675 2,500

The standard deviation and coefficient of variation of the estimated probable outcomes are: D $1,100 2,000 3,750 4,500

D $2,500 2,500 2,500 2,500

(D D ) $1,400 500 1,250 2,000

(D D )2 1,960,000 250,000 1,562,500 4,000,000

P .25 .40 .20 .15

(D D )2P $490,000 100,000 312,500 600,000 $1,502,500

  1,502,500  1,226 Coefficient of variation

= $1,226/ $2,500 = 0.49

Yet table 2 would indicate 14% as the appropriate discount rate. The 20XY timing for the first sales might be confusing for the students because they have to make an assumption about when in 20XX the equipment would be delivered and paid for. In actuality, the equipment, because of order lead times, will not be deliverable until late in 20XX and thus uncertainties Foundations of Fin. Mgt. 12Ce

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Chapter 1 will arise in any analysis on how soon it can be up and running smoothly and then how long it will take to produce an adequate starting inventory. A presales investment period would add to the initial investment. Note however that the standard analysis assumes the cash flows (earnings) occur at the end of each year, not throughout the year, which builds in a conservative bias. Barnes produced (the company's actual estimate for tax rate was 40 percent, not stated in the case) the following calculations:

Year 1 2 3 4 5 6

In thousands Operating Projected Expenses Sales (.70) = EBT $2,500 3,000 3,600 4,320 4,752 5,227

$1,750 2,100 2,520 3,024 3,326 3,659

PV of CCA tax shield

$ 750 900 1,080 1,296 1,426 1,568

(. 20)(. 40)

Present Value @ 14%

$450.0 540.0 648.0 777.6 855.6 940.8

$ 394.7 415.5 437.4 460.4 444.4 428.6 $2,581.0

1 + .5(. 14)

) . 14 + .20 1 + .14 2,800,000(0.235294)(. 938596) = 618,369 [2,800,000] (

)(

EAT × (1 — .40)

(assuming asset pool continues) and no salvage value Summary: PV of cash flows PV of CCA tax shields Initial working capital investment Initial investment Recovery of working capital (n=6) NPV =

$2,581.0 618.4 (200.0) (2,800.0) 91.1 $ 290.5

Based on the positive net present value NPV, the project appears to be feasible. The firm would be justified in going ahead with the investment. A six-year time horizon may be too short a time frame to fully assess the project. It assumes there will be no cash flows from the seventh year on. Foundations of Fin. Mgt. 12Ce

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Chapter 1 While many firms utilize a time frame of 5 to 10 years for conservative purposes, this may sometimes result in the rejection of a potentially profitable project that requires a longer time period for analysis. In this particular case, this was not a problem for the Phillips Toy Company as the project had a positive net present value over six years. Nevertheless, it could lead to an inappropriate decision for a long-life project in the future. Finally, there is the question of what discount rate to use for the calculations. Given the historical practice, we can take comfort that the coefficient of variation comes in right in the middle of one of the seemingly normal ranges. However, not knowing how or when those ranges were set up should make Barnes somewhat uncomfortable. Up until now estimates have resulted in a positive net present value for the new product. However, if a discount rate of 16 to 18 percent were really more appropriate that 14 percent, the investment would not be attractive. This may not be a concern given lower yields in the capital markets. Discussion Questions 16-1. In the 1970s the average Canadian industrial corporation had its interest covered over 4 times. In the early 90s it had slipped below 1, but by 2017 had rebounded to about 3.5 times. 16-2. The bond agreement specifies such basic items as the par value, the coupon rate, and the maturity date. 16-3. The bond agreement covers a limited number of items, whereas the bond indenture is a supplement that often contains over 100 pages of complicated legal wording and specifies every minute detail concerning the bond issue. The bond indenture covers such topics as pledged collateral, methods of repayment, restrictions on the corporation, and procedures for initiating claims against the corporation. 16-4. The greater the security provisions afforded to a given class of bondholders, the lower the coupon rate. 16-5. The priority of claims can be determined from Figure 16-2: 1. senior secured debt, 2. junior secured debt, 3. senior debenture, 4. subordinated debenture, 5. preferred stock, 6. common stock. The order is representing high-low priority in descending order. Senior secured debt represents the highest and common stock represents the lowest priority on claims. Foundations of Fin. Mgt. 12Ce

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Chapter 1 16-6. Bond conversion. 16-7. The purpose of serial and sinking fund payments is to provide an orderly procedure for the retirement of a debt obligation. To the extent bonds are paid off over their life, there is less risk to the security holder. 16-8. A call provision may be exercised when interest rates on new securities are considerably lower than those on previously issued debt. The purpose of a deferred call is to insure that the bondholder will not have to surrender the security due to a call for at least the first five or ten years. 16-9. Bond prices on outstanding issues and interest rates move in opposite directions. If interest rates go up, bond prices will go down and vice versa. Long-term bonds are particularly sensitive to interest rate changes because the bondholder is locked into the interest rate for an extended period of time. Table 16 – 2 demonstrates these facts.

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Chapter 1 16-10. The different bond yield terms may be defined as follows:   

Coupon rate: Stated interest payment divided by par value. Current yield: Stated interest payment divided by the current price of the bond. Yield to maturity: The interest rate that will equate future interest payments and a payment at maturity to the current market price.

16-11. The higher the rating on a bond, the lower the interest payment that will be required to satisfy the bondholder. 16-12. The spread in the yield between bonds in different risk classes is not always the same. The yield spread changes with the economy. If investors are pessimistic about the economy, they will accept as much as 3% less return to go into very high-quality securities-whereas, in more normal times the spread may only be 1 %. 16-13. a. The TransCanada Pipeline bond is rated higher at A (low) than the Telus bond rated at BBB (High) and both are investment grade. However, the TransCanada bond has a longer time to maturity (2046 versus 2029). Generally, a longer-term maturity requires a higher yield to compensate for liquidity risk. b. The Government of Canada medium-term bond yields (2029) 1.27% TransCanada Pipeline (2029) 2.65% (2.65 – 1.27) = 1.38 (or 138 basis points) The reason for the basis point spread can be attributed to greater risk of default (AAA versus A (low), as evidenced by the bond ratings). 16-14. The bond refunding problem is similar to a capital budgeting problem in that an initial investment must be made in the form of redemption and reissuing costs, and cash inflows will take place in the form of interest savings. We take the present value of the inflows to determine if they equal or exceed the outflow. 16-15. We use the aftertax cost of new debt as the discount rate rather than the more generalized cost of capital. Because the net cash benefits are known with certainty, the refunding decision represents a riskless investment. For this reason, we use a lower discount rate. 16-16. The primary advantages of debt are: a. b. c. d.

Interest payments are tax deductible. The financial obligation is clearly specified and of a fixed nature. In an inflationary economy, debt may be paid back with cheaper dollars. The use of debt, up to a prudent point, may lower the cost of capital to the firm.

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Chapter 1 The disadvantages are: a. Interest and principal payment obligations are set by contract and must be paid regardless of economic circumstances. b. Bond indenture agreements may place burdensome restrictions on the firm. c. Debt, utilized beyond a given point, may serve as a depressant on outstanding common stock. 16-17. The zero-coupon-rate bond is initially sold at a deep discount from par value. The return to the investor is the difference between the investor's cost and the face value received at the end of the life of the bond. The advantages to the corporation are that there is immediate cash inflow to the corporation, without any outflow until the bond matures. The zero coupon bond is no longer sold in Canada. A stripped bond is packaged by investment dealers to suit investor requirements. With no coupon payments until the bond or coupon‘s maturity the investor receives a true yield and does not have to worry about reinvesting the coupon payments. 16-18. Interest payments change with changing interest rates rather than with the market value of the bond. This means that the market value of a floating rate bond is almost fixed. The one exception is when interest rates dictated by the floating rate formula approach (or exceed) broadly defined limits. 16-19. A Eurobond is a bond payable in the borrower's currency but sold outside the borrower's country. It is usually sold by an international syndicate. 16-20. Capitalizing lease payments means computing the present value of future lease payments and showing them as an asset and liability on the balance sheet. 16-21. In both cases we create an asset and liability on the balance sheet. Furthermore, in both cases, for income statement purposes, we amortize the asset and write off interest (implied or actual) on the debt. 16-22. In the lease versus borrow to purchase decision most of the cash flows are relatively certain because they are fixed payment streams. This should be acknowledged in the analysis with a lower discount rate. We generally use the cost of capital to discount uncertain cash flows such as the salvage value or the revenue streams in capital budgeting projects. We are comparing the lease to a borrowing alternative so the choice of the aftertax borrowing rate, which has been objectively determined in the financial marketplace, seems a good choice. Finally aftertax cash flows should be analyzed with an aftertax rate.

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Chapter 1 Discussion Question: Appendix 16A 16A-1. Technical insolvency refers to the circumstance where a firm is unable to pay its bills as they come due. A firm may be technically insolvent even though it has a positive net worth. Bankruptcy, on the other hand, indicates that the market value of a firm's assets is less than its liabilities and the firm has a negative net worth. Under the law, either technical insolvency or bankruptcy may be adjudged as a financial failure of the business firm. 16A-2. Extension: Creditors agree to allow the firm more time to meet its financial obligations. Composition: Creditors agree to accept a fractional settlement on their original claims. Creditor committee: A creditor committee is set up to run the business because it is believed that management can no longer conduct the affairs of the firm. Assignment:

Liquidation of assets takes place without going through formal court action.

16A-3. An internal reorganization calls for an evaluation and restricting of the current affairs of the firm. Current management may be replaced and a redesign of the capital structure may be necessary. An external reorganization means that an actual merger partner will be found for the firm. 16A-4. (1) Cost of administering the bankruptcy procedures. (2) Wages due workers to a maximum of $2,000 per worker. (3) Outstanding source deductions.

Internet Resources and Questions Please refer to Finance in Action boxes.

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Chapter 1 Problems 16-1.

Garland Corporation a.

Coupon rate 

Annual interest $90   0.0900  9.0% Par (maturity) value $1,000

b. Current yield 

Annual interest $90   0.1098  10.98% Market (price) value $820

c. Approximate yield to maturity = (Y') Annual interest payment  Principal payment - Price of the bond Number of years to maturity Y 1  0.6 Price of the bond  0.4 Principal payment $1,000  $820 $90  $90  $18 10   0.1211  12.11%  0.6 $820   0.4 $1,000  $492  $400 Yield to maturity: Calculator: Compute:

PV = $820 FV = $1,000 PMT = $90/2 = $45 %I/Y =? N = 10 × 2 =20 %I/Y = 6.079 × 2 = 12.16%

d. Holding period return Calculator:

Compute: Calculator: Compute: 16-2.

Foundations of Fin. Mgt. 12Ce

PV = 0 FV =? %I/Y = 6%/2 = 3% N = 20 FV = $1,209.17

PMT = $45

PV = $820 FV = $2,209.17 PMT = 0 %I/Y =? N = 20 %I/Y = 5.08 × 2 = 10.16% (or 10.42% if N = 10, for effective return) Preston Corporation

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Chapter 1 a. Coupon rate 

Annual interest $70   0.070  7.0% Par (maturity) value $1,000

b. Current yield 

Annual interest $70   0.0655  6.55% Market (price) value $1,068

c. Approximate yield to maturity = (Y') Principal payment - Price of the bond Number of years to maturity 𝑌1 = 0.6 (Price of the bond) + 0.4 (Principal payment) $1,000 − $1,068 $70 + $70 − $9.71 7 = 0.0579 = 5.79% = = 0.6 ($1,068) + 0.4 ($1,000) $640.8 + $400 Annual interest payment +

Yield to maturity: Calculator: Compute:

PV = $1,068 FV = $1,000 PMT = $70/2 = $35 %I/Y =? N = 7 × 2 = 14 %I/Y = 2.90 × 2 = 5.80%

d. Holding period return Calculator: Compute: Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV = 0 FV =? PMT = $35 %I/Y = 9%/2 = 4.5% N = 14 FV = $662.62 PV = $1,068 FV = $1,662.62 PMT = 0 %I/Y =? N = 14 %I/Y = 3.21 × 2 = 6.42% (or 6.53% if N = 7, for effective return)

1 - 651

Block, Hirt, Danielsen, Short

Chapter 1 16-3.

Myra Breck a. Bond A

Annual interest  $100  0.1250  12.50% Current yield  Market (price) value $800

Bond B Annual interest  $100  0.1111  11.11% Current yield  Market (price) value $900

b. Bond A. It has a higher current yield.

c. Yield to maturity = (Y') Bond A: Calculator:

PV = $800

Compute:

%I/Y =? N = 10 × 2 = 20 %I/Y = 6.87% × 2 = 13.74%

Bond B: Calculator:

PV = $900

Compute

%I/Y =? N=2×2=4 %I/Y = 8.02% × 2 = 16.04%

FV = $1,000

PMT = $100/2 =

$50

FV = $1,000

PMT = $100/2 =

$50

d. Yes. Bond B has the higher yield to maturity. This is because the discount will be recovered over only two years. With Bond A there is a 10-year recovery period. Yield to maturity is a better measure of return.

Foundations of Fin. Mgt. 12Ce

1 - 652

Block, Hirt, Danielsen, Short

Chapter 1 16-4.

Bill Board a. Bond A

Current yield 

Annual interest $90   0.1059  10.59% Market (price) value $850

Bond B Current yield 

Annual interest $80   0.0889  8.89% Market (price) value $900

b. Bond A. It has a higher current yield. c. Yield to maturity = (Y') Bond A: Calculator: Compute: Bond B: Calculator: Compute

PV = $850 FV = $1,000 PMT = $90/2 = $45 %I/Y =? N = 10 × 2 = 20 %I/Y = 5.785 × 2 = 11.57% PV = $900 FV = $1,000 PMT = $80/2 = $40 %I/Y =? N=2×2=4 %I/Y = 6.95% × 2 = 13.90%

16-5.

Yield/ Security Matching Secured Debt Debenture Subordinated debenture

6.85% 7.76% 8.20%

With greater risk, a higher yield is expected.

Foundations of Fin. Mgt. 12Ce

1 - 653

Block, Hirt, Danielsen, Short

Chapter 1 16-6.

Milken Investment Fund a. Present value of interest payments PVA = A  PVIFA (N = 40, %I/Y = 7%) (Appendix D) PVA = $55  13.332 = $733.26 Present value of principal payment at maturity PV = FV  PVIF (N = 40, %I/Y = 7%) (Appendix B) PV = $1,000  0.067 = $67.00 Total present value Present value of interest payments $733.26 Present value of payment at maturity 67.00 Total present value or price of the bond $800.26

Calculator: Compute:

PV =? FV = $1,000 %I/Y = 7% (14%/2) PV = $800.02

PMT = $55 ($110/ 2) N = 40 (20 × 2)

b. Value of 90 bonds $800.02  90 $72,002.00

Foundations of Fin. Mgt. 12Ce

1 - 654

Block, Hirt, Danielsen, Short

Chapter 1 16-7.

Lee, Braun and James Company a. Present value of interest payments

PVA = A  PVIFA (N = 40, %I/Y = 5%) (Appendix D) PVA = $60  17.159 = $1,029.54 Present value of principal payment at maturity PV = FV  PVIF (N = 40, %I/Y = 5%) (Appendix B) PV = $1,000  0.142 = $142.00 Present value of interest payments $1,029.54 Present value of payment at maturity 142.00 PV or price of the bond $1,171.54

Calculator: Compute:

PV =? FV= 1,000 %I/Y = 5% (10%/2) PV = $1,171.59

PMT = $60 ($120/ 2) N = 40 (20 × 2)

b. No. The call price of $1,060 will keep the bonds from getting much over $1,060. Since the bonds are currently callable, investors will not want to buy the bonds at $1,172 and risk having them called away at $1,060.

16-8.

Falter Corporation An AA rating at issue gives a coupon rate is 6.6% annually (3.3% semiannually). With a downgrading to A, the new yield to maturity is 7% (3.5% semiannually). Present value of interest payments PVA = A  PVIFA (N = 30, %I/Y = 3.5%) (Appendix D) PVA = $33  18.392 = $606.94 Present value of principal payment at maturity PV = FV  PVIF (N = 30, %I/Y = 3.5%) (Appendix B) PV = $1,000  0.356 = $356.00 Present value of interest payments $606.94 Present value of payment at maturity 356.00 Present value of the bond $962.94

Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = $1,000 %I/Y = 3.5% (7%/2) PV = $963.22

1 - 655

PMT = $33 ($66/ 2) N = 30 (15 × 2)

Block, Hirt, Danielsen, Short

Chapter 1 16-9.

Polly Cracker Company 10% initial coupon rate, 8% current yield to maturity: Calculator: Compute:

16-10.

PV =? FV = $1,000 %I/Y = 4% (8%/2) PV = $1,172.92

PMT = $50 ($100/ 2) N = 30 (15 × 2)

A-rated public utility bond Interest rate on previously issued A-rated 20-year industrial bonds: 9%  1.25 =11.250% Additional return on previously issued

A-rated 20-year Public utility bonds Additional return on new issues Anticipated interest rate on newly issued A-rated public utility bonds 16-11. a. Calculator: Compute: b. Calculator: Compute: c. Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

+ 0.500% + 0.375% 12.125%

Strip Bond PV =? FV = $1,000 %I/Y = 8% PV = $463.19

PMT = 0 N = 10

PV =? FV = $1,000 %I/Y = 6% PV = $558.39

PMT = 0 N = 10

PV =? FV = $1,000 %I/Y = 10% PV = $385.54

PMT = 0 N = 10

1 - 656

Block, Hirt, Danielsen, Short

Chapter 1 16-12. Calculator: Compute:

16-13.

Strip Bond Yield PV = $376.89 FV = $1,000 %I/Y =? N = 20 %I/Y = 5.00%

PMT = 0

Millennium

Bonds with a floating rate covenant will have their coupon payment reset periodically to reflect current market yields. If the coupon rate and the current market rate are similar the bonds will sell at close to par value of $1,000.

16-14.

Rap Stars

Although the calculation below would normally be correct, these bonds have a redeemable feature allowing the company to call the bonds at$1,050 (5% above the face value of $1,000). Therefore, the bonds will trade at about this price, $1,050. Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV = ? FV = $1,000 PMT = $30 %I/Y =3.5/2 = 1.75% N = 8 ×2 = 16 PV = $1,173.13

1 - 657

Block, Hirt, Danielsen, Short

Chapter 1 16-15.

Anchor Corporation

Loan amount a. 1  cumulative inflation  $6,000,000  $3,333,333 1.80

b. $6,000,000  1.80 =

$10,800,000

A $10,800,000 loan repayment in an 80% cumulative inflationary environment will provide $6,000,000 in purchasing power to the original lender. c. Charge a high enough interest rate to not only provide an adequate annual return on the borrowed funds, but also compensate for the loss of purchasing power.

Foundations of Fin. Mgt. 12Ce

1 - 658

Block, Hirt, Danielsen, Short

Chapter 1 16-16.

Igor Sharp

a. The original bond was issued at 14% Yield to maturity is now 8% 10 years remain to maturity Calculator: Compute:

PV =? FV= $1,000 %I/Y = 4% (8%/2) PV = $1,407.71

b. $1,407.71 1,025.00 $ 382.71

Current price Purchase price Dollar increase

c. Purchase Price  20% Margin

d. Return 

$1,025.00 $ 205.00

PMT = $70 ($140/ 2) N = 20 (10 × 2)

Purchase price paid in cash

Money gained  $382.71  1.8669  186.69% Original investment $205.00

e. Mr. Sharp has not only benefited from an increase in the price of the bond (due to lower interest rates), but he also has benefited from the use of leverage by buying on margin. He has controlled a $1,025 initial investment with only $205 in cash. The low cash investment tends to magnify gains (as well as losses).

Foundations of Fin. Mgt. 12Ce

1 - 659

Block, Hirt, Danielsen, Short

Chapter 1 16-17.

Bonds of Mitchell and Gordon

Calculator:

PV =? FV= $1,000 PMT = $40 ($80/ 2) N = 30 (15 × 2) %I/Y = 7% (14%/2) PV = $627.73 Compute: a. Present value of interest payments PVA = A × PVIFA N = 30*, I/Y = 7%) Appendix D PVA = $35 × 12.409 = $496.36 Present value of principal payment at maturity = FV × PVIF (N = 30*, I/Y = 7%) PV PV = $1,000 × 0.131 = $131.00 Appendix B Total present value Present value of interest payments Present value of payment at maturity Total present value or price of the bond b. Purchase price Current value Dollar loss

$496.36 131.00 $627.36

$1,000.00 627.73 $ 372.27

Dollar loss Investment

$ 372.27 = 37.23% $1,000.00

c. Maturity value Purchase price Dollar gain

$1,000.00 627.73 $ 372.27

Dollar gain $372.27 = 59.30% Investment $627.73 d. The percentage gain is larger than the percentage loss because the investment is smaller ($627.73 vs. $1,000). The gain/loss is the same ($372.27). 16-18. Foundations of Fin. Mgt. 12Ce

The Wagner Corporation 1 - 660

Block, Hirt, Danielsen, Short

Chapter 1 Discount rate Costs (Outflows)

r (%I/Y) = 7.5(1 – .30) = 5.25%

1. Payment of call premium: $20,000,000  8% = $1,600,000 2. Borrowing expenses of new issue: Underwriting cost = $525,000 Amortization of expenses ($525,000/ 5) (.30) = $105,000 (.30) $31,500 tax savings per year Actual expenditure PV of future tax savings $31,500 @ PVIFA (N = 5, %I/Y = 5.25%) Net cost of borrowing expenses of new issue 3. Duplicate interest during overlap period: 9% × 1/12 ×$20,000,000 × (1 – 0.30) = 3% × 1/12 ×$20,000,000 × (1 – 0.30) =

$525,000 135,441 $389,559 $105,000 35,000 $70,000

Benefits (Inflows) 4. Cost savings in lower interest rates: 9% (interest on old bond)  $20,000,000 = 7.5% (interest on new bond)  $20,000,000 = Savings per year = Aftertax savings per year $300,000  (1 – .30) = PV of annual aftertax interest savings $210,000/ year @ PVIFA (N = 16, %I/Y = 5.25%) = Summary Costs 1. $1,600,000 2. 389,559 3. 70,000 4. PV of outflows $2,059,559 PV of inflows

$1,800,000 1,500,000 $ 300,000 $ 210,000 $2,235,969 Benefits 2,235,969 $2,235,969

NPV (Net present value) $176,410 Wagner Corporation should refund the issue, as the NPV is positive at this time. The underwriting cost of the old issue is irrelevant as cash flow consequences are not changed by the refunding decision.

Foundations of Fin. Mgt. 12Ce

1 - 661

Block, Hirt, Danielsen, Short

Chapter 1 16-19. Discount rate Costs (Outflows)

Delta Corporation r (%I/Y) = 4.6(1 – .25) = 3.45%

5. Payment of call premium: $30,000,000  5% = $1,500,000 6. Borrowing expenses of new issue: Underwriting cost = $600,000 Amortization of expenses ($600,000/ 5) (.25) = $120,000 (.25) $30,000 tax savings per year Actual expenditure PV of future tax savings $30,000 @ PVIFA (N = 5, %I/Y = 3.45%) Net cost of borrowing expenses of new issue 7. Duplicate interest during overlap period: 7% × 1/12 ×$30,000,000 × (1 – 0.25) = 1% × 1/12 ×$30,000,000 × (1 – 0.25) =

$600,000 135,644 $464,356 $131,250 18,750 $112,500

Benefits (Inflows) 8. Cost savings in lower interest rates: 7% (interest on old bond)  $30,000,000 = $2,100,000 4.6% (interest on new bond)  $30,000,000 = 1,380,000 Savings per year = $ 720,000 Aftertax savings per year $720,000  (1-.25) = $ 540,000 PV of annual aftertax interest savings $540,000/ year @ PVIFA (N = 6, %I/Y = 3.45%) = $2,882,150 Summary Costs Benefits 4. $1,500,000 5. 464,356 6. 112,500 4. 2,882,150 PV of outflows $2,076,856 PV of inflows $2,882,150 NPV (Net present value) $ 805,294 Delta Corporation should refund the issue, as the NPV is positive at this time. The underwriting cost of the old issue is irrelevant as cash flow consequences are not changed by the refunding decision.

Foundations of Fin. Mgt. 12Ce

1 - 662

Block, Hirt, Danielsen, Short

Chapter 1 16-20.

Harding Corporation Discount rate

r (%I/Y) = 9% (1 – .25) = 6.75%

Costs (Outflows) 1. Payment of call premium: $50,000,000  7.5% = $3,750,000 2. Borrowing expenses of new issue: Underwriting cost = 1.8% × $50 million = $900,000 Amortization of expenses ($900,000/ 5) (.25) = $180,000 (.25) $45,000 tax savings per year Actual expenditure PV of future tax savings $45,000 @ PVIFA (N = 5, %I/Y = 6.75%) Net cost of borrowing expenses of new issue 3. No overlap period:

$900,000 185,751 $714,249

Benefits (Inflows) 4. Cost savings in lower interest rates: 10.25% (interest on old bond)  $50,000,000 = 9% (interest on new bond)  $50,000,000 = Savings per year = Aftertax savings per year $625,000  (1 – .25) = PV of annual aftertax interest savings $468,750/ year @ PVIFA (N = 18, %I/Y = 6.75%) = Summary 1. 2. 3. PV of outflows

Costs $3,750,000 714,249 0 $4,464,249

$5,125,000 4,500,000 $ 625,000 $ 468,750 $4,801,477 Benefits

4. PV of inflows

NPV (Net present value)

$4,801,477 $4,801,477

$ 337,228

The Harding Corporation should refund the issue, as the NPV is positive at this time.

Foundations of Fin. Mgt. 12Ce

1 - 663

Block, Hirt, Danielsen, Short

Chapter 1 16-21.

Harding Corporation (Continued) Call premium (aftertax cost: not tax deductible) 7 years of 1/2% deductions (7th through 13th year) = 3 1/2% 8 % – 3 1/2% 4 1/2%

Call premium Call premium at the end of the 13th year

$50,000,000  4 1/2% =

Foundations of Fin. Mgt. 12Ce

$2,250,000

1 - 664

Block, Hirt, Danielsen, Short

Chapter 1 16-22.

Providence Industries Discount rate

r (%I/Y) = 9(1 – .25) = 6.75%

a. Costs (Outflows) 1. Payment of call premium: $25,000,000  5% = $1,250,000 2. Borrowing expenses of new issue: Underwriting cost = $470,000 Other costs = 80,000 Total borrowing costs $550,000 Amortization of expenses ($550,000/ 5) (.25) = $110,000 (.25) $27,500 tax savings per year Actual expenditure PV of future tax savings $27,500 @ PVIFA (N = 5, %I/Y = 6.75%) Net cost of borrowing expenses of new issue 3. No overlap period.

$550,000 113,514 $436,486

Benefits (Inflows) 4. Cost savings in lower interest rates: 10% (interest on old bond)  $25,000,000 = 9% (interest on new bond)  $25,000,000 = Savings per year = Aftertax savings per year $250,000  (1 – .25) = PV of annual aftertax interest savings $187,500/ year @ PVIFA (N = 15, %I/Y = 6.75%) = Summary 4. 5. 6. PV of outflows

Costs $1,250,000 436,486 0 $1,686,486

4. PV of inflows

NPV (Net present value)

$ 48,544

$2,500,000 2,250,000 $ 250,000 $ 187,500 $1,735,030 Benefits

1,735,030 $1,735,030

Providence Industries should refund the issue, as the NPV is positive.

Foundations of Fin. Mgt. 12Ce

1 - 665

Block, Hirt, Danielsen, Short

Chapter 1 b. The cost of capital is too high a discount rate to be used in bond refunding analysis. Cash flows in a bond refunding are relatively certain and a lower discount rate matched to their risk is appropriate. The market borrowing rate is an objective measure of any risk inherent in the anticipated cash flows so it is a good choice. The cash flows are aftertax and the discount rate should also be aftertax.

c. To remove restrictive covenants. To alter Providence‘s capital structure.

Foundations of Fin. Mgt. 12Ce

1 - 666

Block, Hirt, Danielsen, Short

Chapter 1 16-23.

United Oui Stand Ltd. Discount rate

r (%I/Y) = 7.0(1 – .25) = 5.25%

Costs (Outflows) 1. Payment of call premium: $40,000,000  7% = $2,800,000 2. Borrowing expenses of new issue: Underwriting cost = $1,000,000 Amortization of expenses ($1,000,000/ 5) (.25) = $200,000 (.25) $50,000 tax savings per year Actual expenditure $1,000,000 PV of future tax savings $50,000 (N = 5, %I/Y = 5.25%) 214,986 Net cost of borrowing expenses of new issue $785,014 3. Duplicate interest during overlap period: 9% × 1/12 ×$40,000,000 × (1 – 0.25) = $225,000 3% × 1/12 ×$40,000,000 × (1 – 0.25) = 75,000 $150,000

Benefits (Inflows) 4. Cost savings in lower interest rates: 9% (interest on old bond)  $40,000,000 = 7% (interest on new bond)  $40,000,000 = Savings per year = Aftertax savings per year $800,000  (1 – .25) = PV of annual aftertax interest savings $600,000/ year @ PVIFA (n = 10, %I/Y = 5.25%) = Summary 1. 2. 3. PV of outflows

Costs $2,800,000 785,014 150,000 $3,735,014

$3,600,000 2,800,000 $ 800,000 $ 600,000 $4,577,304 Benefits

4. PV of inflows

NPV (Net present value)

$ 842,290

4,577,304 $4,577,304

Refund!

b. %I/Y = 7% N = 10 Calculator: PV = ? FV = $1,000 PMT = 90 Compute: PV = $1,140.47; exceeds $1,070 call price. This difference is why the refunding is economically valuable.

16-24. Foundations of Fin. Mgt. 12Ce

Daedulus Wings 1 - 667

Block, Hirt, Danielsen, Short

Chapter 1 Discount rate

r (%I/Y) = 7.5%/ 2 (1 – .35) = 2.4375% (semiannual) r (%I/Y) = (1.024375)2 – 1 = 4.9344% (annual effective)

Costs (Outflows) 1. Payment of call premium: $50,000,000  8% = $4,000,000 2. Borrowing expenses of new issue: Underwriting cost = $1,000,000 Amortization of expenses ($1,000,000/ 5) (.35) = $200,000 (.35) $70,000 tax savings per year Actual expenditure PV of future tax savings $70,000 @ PVIFA (N = 5, %I/Y = 4.9344%) Net cost of borrowing expenses of new issue 3. Duplicate interest during overlap period: 12% × 1/24 ×$50,000,000 × (1 – 0.35) = 3% × 1/24 ×$50,000,000 × (1 – 0.35) =

$1,000,000 303,614 $696,386 $162,500 40,625 $121,875

Benefits (Inflows) 4. Cost savings in lower interest rates (semiannual): 6% (interest on old bond)  $50,000,000 = $3,000,000 3.75% (interest on new bond)  $50,000,000 = 1,875,000 Savings per half year = $1,125,000 Aftertax savings per half year $1,125,000  (1 – 0.35) = $731,250 PV of aftertax interest savings $731,250/ half year @ PVIFA (N = 14, %I/Y = 2.4375%) =$8,586,105 Summary Costs Benefits 1. $4,000,000 2. 696,386 3. 121,875 4. 8,586,105 PV of outflows $4,818,261 PV of inflows $8,586,105

NPV (Net present value)

$3,767,844

Daedulus Wings should refund the issue, as the NPV is positive.

Foundations of Fin. Mgt. 12Ce

1 - 668

Block, Hirt, Danielsen, Short

Chapter 1 16-25.

Webber Musicals Corporation Discount rate r (%I/Y) = 7% (No tax savings on dividends) Costs (Outflows) 1. Payment of call premium: ($71.43 – $50.00) × ($2,000,000/ $50) = $857,200 2. Borrowing expenses of new issue: Underwriting cost = $160,000 Amortization of expenses ($160,000/ 5) (0.28) = $32,000 (0.28) $8,960 tax savings per year Actual expenditure $160,000 PV of future tax savings $8,960 @ PVIFA (N = 5, %I/Y = 7%) 36,738 Net cost of borrowing expenses of new issue $123,262 3. No overlap period.

Benefits (Inflows) 4. Cost savings in lower interest rates: 10% (dividend on old preferred)  $2,000,000 = $200,000 7% (dividend on new preferred)  $2,000,000 = 140,000 Savings per year = $ 60,000 Dividends already aftertax: PV of annual dividend savings D $60,000 P    $857,143 $857,143 p 0.07 Kp Summary 1. 2. 3. PV of outflows

Costs $857,200 123,262 0 $980,462

Benefits

4. PV of inflows

NPV (Net present value)

857,143 $857,143

$ (123,319)

Webber Musicals Corporation should not buyback. An efficient market is in evidence. The decline in interest rates has caused the value of the preferreds to rise to compensate for the lower interest rates. A lack of a call provision does not limit the rise in the preferred share value making a buyback (refunding) uneconomical.

P  p

Foundations of Fin. Mgt. 12Ce



$5.00

 $71.43

0.07

1 - 669

Block, Hirt, Danielsen, Short

Chapter 1 16-26.

The Richmond Corporation

Using criteria 3 and 4 The lease is less than 75% of the estimated life of the leased property. 144 months = 12/ 18 =

12 years 67%

However, the present value of the lease payments is greater than 90% of the fair value of the property. $ 36,000 7.536 $271,296 Calculator: Compute:

annual lease payments PV (n = 12, %I/Y = 8%) (Appendix D) present value of lease payments

PV =? FV = 0 %I/Y = 8% PV = $271,299

% of fair value 

$271,296

PMT = $36,000 N = 12

 0.936  93.6%

$290,000

Since one of the four criteria for compulsory treatment as a capital lease is indicated, the transaction must be treated as a capital lease.

Foundations of Fin. Mgt. 12Ce

1 - 670

Block, Hirt, Danielsen, Short

Chapter 1 16-27.

The Ellis Corporation

$10 million annual lease payments × 11.470 (PVIFA for N = 20, %I/Y = 6%) $114.700 million (round to $115 million) Calculator: PV =? FV = 0 PMT = $10 million N = 20 %I/Y = 6% PV = $114,699,212 Compute: b. Balance sheet ($ millions) Current assets $ 50 Current liabilities Capital assets 50 Long-term liabilities Leased property Obligations under under capital lease 115 capital lease Total liabilities Shareholders' equity Total liabilities and Total assets $215 shareholders' equity c. Total debt Total assets d. Total debt Equity

$ 10 30 115 155 60 $215

Original:

Revised:

$40 million  40.0% $100 million

$155 million  72.1% $215 million

Original:

Revised:

$40 million  66.7% $60 million

$155 million  258.3% $60 million

e. No, the information was already known by financial analysts before it was brought into the balance sheet.

f. Management is concerned about whether the market is as efficient as is generally believed. They feel that newly presented information may make their performance look questionable.

Foundations of Fin. Mgt. 12Ce

1 - 671

Block, Hirt, Danielsen, Short

Chapter 1 16-28.

Hegan Corporation

a. Determine 10-year annuity that will yield 10% A = PVA/PVIFA (%I/Y = 10%, N = 10) (Appendix D) $900,000  $146,461 6.145

Calculator: Compute: Compute:

PV = $900,000 FV = 0 %I/Y = 10% N = 10 PMT = $146,471 PMTBGN = $133,155

PMT =?

b. The $130,000 tax shield reduces the net cost to: Original cost Tax shield Net cost A

Calculator:

$900,000 130,000 $770,000

$770,000  $125,305 6.145

Compute: Compute:

PV = $770,000 FV = 0 %I/Y = 10% N = 10 PMT = $125,314 PMTBGN = $113,922

Foundations of Fin. Mgt. 12Ce

1 - 672

PMT =?

Block, Hirt, Danielsen, Short

Chapter 1 16-29.

Omni Enterprises

(1) Year 0 1 2 3 4

b. A 

Payment $2,600 2,600 4,600 4,600 0

Compute: c. (2) (1)

1 2 3 4

(3) Aftertax Cost $2,600 1,690 3,690 2,990 (1,610)

PVA $10,000   $3,293 (n  4,%i  12) (Appendix D) PV IFA 3.037

Calculator:

Year

(2) Tax Shield 35% of (1) 0 910 910 1,610 1,610

PV = $10,000 FV = 0 %I/Y = 12% N=4 PMT = $3,292.34

PMT =?

(4) (5) Annual Repaymen Beginning Annual Interest t on Balance Payment 12% of (2) Principal (3) – (4)

Ending Balance (2) – (5)

$10,000 7,908 5,565 2,941

$7,908 5,565 2,941 2

(3)

$3,292 3,292 3,292 3,292

$1,200 949 668 353

$2,092 2,343 2,624 2,939

(6)

d. r = 12%(11 – .5r .35) = 7.8%  PV CCA  CPV  dT  1  .5 .078    $10,000 0.25 0.35   r  Cd  1  r  0.078  0.25  1  .078         $10,0000.2667680.9638219

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 $2,571

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Chapter 1 e.

(Annual Interest × 35%)

Year

Payment

Interest Tax Shield

Aftertax cost of Borrow/Purchase

1 2 3 4

$3,292 3,292 3,292 3,292

$420 332 234 124

$2,872 2,960 3,058 3,168

f. Leasing Aftertax Cost 0 $2,600 1 1,690 2 3,690 3 2,990 4 (1,610) Present value

Present value @ 7.8% $2,600 1,568 3,175 2,387 (1,192) $8,538

Borrow/Purchase Aftertax Cost 1 2,872 2 2,960 3 3,058 4 3,168

Present value @ 7.8% 2,664 2,547 2,441 2,346 $9,998* 2,571 $7,427

PV of CCA tax shield Present value

Note that this is equal to the cost of the asset. This will always be true if the aftertax cost of borrowing is selected as the discount rate.

g. Borrow/ purchase as the present value (as a cost) is lower.

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Chapter 1 16-30.

Kumquot Farms Ltd.

N=7 T = 25% k = 16% d = 20% Discount rate (r or i) = 10% (1 – .25) = 7.5% Lease alternative Annual lease payment BGN (in advance) a $7,750 @ PVIFA (N = 7, %I/Y = 7.5%) Tax savings on annual lease payment (in arrears) $7,750 × 25% @ PVIFA (N = 7, %I/Y = 7.5%) PV cost of lease alternative

$(44,127) 10,262 $(33,865)

Borrowing alternative PV of annual loan payments and tax savings from interest expense (cost of machine) b $(45,000) c Salvage value $11,000 @ PVIF (N = 7, k = 16%) 3,892 PV (CCA) 1 + .5 × .075 = [$45,000 − $3,892] ( 0.20 × 0.25 ) ( ) 0.075 + 0.20 1 + .075 = [$41,108](0.181818) (0.965116) = 7.213 PV cost of borrowing/ purchase alternative $(33,895) NPV of lease alternative (relative to borrowing) $ 30 Kumquot Farms Ltd. should lease, although the NPV is only marginally positive (indicating an efficient market). a

In advance payment 1.0 for payment at time 0 and N – 1 factor for the rest of the payments when using tables. b This will always be the case when the aftertax cost of borrowing is used as the discount rate. c The salvage value is a more uncertain cash flow than the other cash flows of the analysis and requires a higher discount rate to account for this greater uncertainty (or risk).

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Chapter 1 16-31. N=5 T = 25% Discount rate (r or i) =

I2C Beams Ltd. k = 14% d = 30% 9 (1 – .25) = 6.75%

Lease alternative Annual lease payment BGN (in advance) $29,000 @ PVIFA (N = 5, I/Y = 6.75%) Tax savings on annual lease payment (in arrears) $29,000 × 25% = $7,250 @ PVIFA (N = 5, %I/Y = 6.75%) PV cost of lease alternative

$(127,786)

29,926 $(97,860)

Borrowing alternative PV of annual loan payments and tax savings from interest expense (cost of machine) $(140,000) Salvage value $35,000 @ PVIF (N = 5, %I/Y = 14%) 18,178 PV (CCA) 1 + .5 × .0675 = [$140,000 − $18,178] ( 0.30 × 0.25 ) ( ) 0.0675 + 0.30 1 + .0675 = [$121,822](0.20408163) (0.968384) = 24,076 PV cost of borrowing/ purchase alternative NPV of lease alternative (relative to borrowing)

$(97,748) $(112)

I2C Beams Ltd. should borrow as the NPV of leasing is negative 112. It is however close. In an efficient market for money the NPV of the alternatives should almost be equal.

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Chapter 1 16-32.

Orwell Futures

N=5 T = 25% k = 15% d = 30% Discount rate (r or i) = 9% (1 – .25) = 6.75% Lease alternative Annual lease payment BGN (in advance) $15,800 @ PVIFA (N = 5, %I/Y = 6.75%) Tax savings on annual lease payment (in arrears) $15,800 × 25% = $3,950 @ PVIFA (N = 5, %I/Y = 6.75%) PV cost of lease alternative

$(69,621)

16,305 $(53,316)

Borrowing alternative PV of annual loan payments and tax savings from interest expense (cost of machine) $(75,000) Salvage value $25,000 @ PVIF (N = 5, k = 15%) 12,429 PV of annual maintenance payments $750 × (1 – .25) @ PVIFA (N = 5, %I/Y = 6.75%) (2,322) PV (CCA) 0.30 × 0.25 1 + .5 × .0675 = [$75,000 − $12,429] ( )( ) 0.0675 + 0.30 1 + .0675 = [$62,571](0.204081633) (0.968384075) = 12,366 PV cost of borrowing/ purchase alternative $(52,527) NPV of lease alternative (relative to borrowing)

$ (789)

Orwell Futures should borrow as the NPV of leasing relative to borrowing is negative.

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Chapter 1 16-33.

Dan Teasin’s Furs and Coats Ltd.

N=5 T = 20% k = 15% d = 20% Discount rate (r or i) = 8% (1 – .20) = 6.4% Lease alternative Annual lease payment BGN (in advance) $10,000 @ PVIFA (N = 5, %I/Y = 6.4%) Tax savings on annual lease payment (in arrears) $10,000 × 20% @ PVIFA (N = 5, %I/Y = 6.4%) PV cost of lease alternative

$(44,336) 8,334 $(36,002)

Borrowing alternative PV of annual loan payments and tax savings from interest expense (cost of machine) $(50,000) Salvage value $15,000 @ PVIF (N = 5, k = 15%) 7,458 PV of annual maintenance payments $500 × (1 – .20) @ PVIFA (N = 5, %I/Y = 6.4%) (1,667) PV (CCA) 1 + .5 × .064 = [$50,000 − $7,458] ( 0.20 × 0.20 ) ( ) 0.064 + 0.20 1 + .064 = [$42,542](0.1612903) (0.9699) = 6,877 PV cost of borrowing/ purchase alternative $(37,332) NPV of lease alternative (relative to borrowing)

$ 1,330

Dan Teasin‘s Furs and Coats should lease as the NPV is positive.

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Chapter 1 16-34.

Koss Leasing

N=2 T = 25% k = 14% Discount rate (r or I/Y) =14%

d = 30%

Since Koss Leasing holds this lease as an asset this is really a capital budgeting decision (for an asset acquisition), which suggests the cost of capital as the appropriate discount rate.

To achieve the desired rate of return NPV = 0. Cost of truck $(60,000) Annual lease payment BGN (in advance) L @ PVIFA (N = 2, %I/Y = 14%) L (1.8772) Tax payments on annual lease payment (in arrears) L x 25% @ PVIFA (N = 2, %I/Y = 14%) – .25L (1.6466) Salvage value $17,000 @ PVIF (N = 2, %I/Y = 14%) 13,081 PV CCA  0.30  0.25 1  .5 .14   $60,000  $13,081   0.14  0.30 1  .14      $46,9190.170454550.9385965 NPV

L (1.8772) – .25L (1.6466) L (1.46555) L

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= = =

1 - 679

 7,506 $ 0

$60,000 – $13,081 – $7,506 $39,413 $26,893

Block, Hirt, Danielsen, Short

Chapter 1 MINI CASES Leland Industries (Debt financing) This case gives the student a chance to understand the many factors influencing bonds. Initially the student concentrates on the variables affecting a bond rating and actually makes a basic bond rating decision. The relationship of bond ratings to yield to maturity also is stressed through various computations. The case also covers such innovative debt products as floating rate and zero-coupon rate bonds. Finally the use of hedging to cover interest rate exposure is explored.

International Bakeries Calculator: PV = $1,100 FV= $1,000 PMT = $51.75 ($103.50/2) %I/Y =? N = 50 (25  2) = 4.66  2 = 9.31% Compute i% Gates Bakeries Calculator: PV = $920 FV= $1,000 PMT = $47.25 ($94.50/2) %I/Y =? N = 40 (20  2) = 5.20  2 = 10.41% Compute i% Prairie Products Calculator: PV = $1,150 FV= $1,000 PMT = $78.75 ($157.50/2) %I/Y =? N = 30 (15  2) = 6.70  2 = 13.40% Compute i% Dyer Pastries Calculator: PV = $1,060 FV= $1,000 PMT = $51.50 ($103.00/2) %I/Y =? N = 40 (20  2) = 4.81  2 = 9.62% Compute i% Nolan Bread Calculator: PV = $950 FV= $1,000 PMT = $51.50 ($103.00/2) %I/Y =? N = 50 (25  2) = 5.44  2 = 10.88% Compute i% Kd (cost of debt) = Y (Yield) (1 – T) International Bakeries Gates Bakeries Prairie Products Dyer Pastries Nolan Bread

9.31% (1 – .35) 10.41% (1 – .35) 13.40% (1 – .35) 9.62% (1 – .35) 10.88% (1 – .35)

= 9.31% (.65) = 10.41% (.65) = 13.40% (.65) = 9.62% (.65) = 10.88% (.65)

= 6.05% = 6.77% = 8.71% = 6.25% = 7.07%

b. A potential bond issue by Leland would definitely not qualify for the AA (high) rating that International Bakeries enjoys and would be well above the B (low) rating of Prairie Products. The bond would undoubtedly fall somewhere between AA (low) and A (medium).

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Chapter 1 A comparative analysis with the three most similar firms is presented below.

Rating Debt to Total Assets Times interest earned Fixed charge coverage Current ratio Return on equity

Dyer Pastries AA3 35% 6.0×

Gates Bakeries A1 42% 5.5×

Nolan Bread A2 47% 4.9×

Leland Industries ? 44% 5.7×

3.6×

4.2×

3.8×

3.7×

2.8× 19%

2.3× 17.1%

2.1X 15%

2.0× 16.8%

Leland generally falls below Dyer Pastries on all measures except fixed charge coverage, so it is unlikely to qualify for an AA (low) rating. The firm appears to fall between the A (high) and A (medium) categories. Its debt ratio, times earned and return on equity ratios indicate that it falls closer to the A (high) category than the A (medium). However, its fixed charge coverage and current ratio are more in line with an A (medium) rating. On balance, A (high) is probably the most appropriate answer. c. Debt Outstanding Year 1 $20,000,000 × .95 = $19,000,000 Year 2 $19,000,000 × .95 = $18,050,000 Year 3 $18,050,000 × .95 = $17,147,500 Interest Payment on Debt Debt outstanding Interest expense (10%) Aftertax cost (1 – .35) Aftertax interest expense

$17,147,500 1,714,750 .65 $ 1,114,588

d. Interest savings on $20 million debt outstanding Size of issue .................................................................. $20 million Interest savings (%) ...................................................... 1.25 Interest savings ($)........................................................ $250,000 Taxes (.35) .................................................................... 87,500 Aftertax benefit............................................................. $162,500

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Chapter 1 Since the aftertax cost of hedging is $120,000, there is a net aftertax benefit of $42,500 per year Aftertax interest savings ............................................... Aftertax cost of hedging ............................................... Net aftertax benefit .......................................................

$162,500 120,000 $ 42,500

e. Assuming the A (high) rating we get a current yield of 10.41%. Adding ¾ of 1% produces a yield of 11.16% 1. Present value of $1,000 zero-coupon rate bond. PV = FV  PVIF (Appendix B) FV = $1,000, N = 20, i = 11% PV = $1,000  .124 = $124 The bond price would be $124 Calculator: Compute PV

PV =? %I/Y = 11.16% = $120.51

FV= $1,000 N = 20

PMT = $0

2. The number of bonds to be issued is:

$20,000,000  165,961 $120.51 (Note: with $1,000 per value bonds, only 20,000 bonds would be issued)

3. The danger is that the corporation is not paying any interest on an annual basis, and for this reason, the repayment obligation expands beyond the initial capital received. Thus, the firm must be sure that it is accumulating adequate funds to meet its future obligations (or will be able to issue new securities to refund the debt when it comes due).

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Chapter 1 Warner Motor Oil Co. (Bond Refunding) This case gives the student a clear insight into the refunding process. The importance of the Call privilege is emphasized. Clearly, a refunding would not be feasible if the old issue had to be reacquired at market value. The case also provides an example of where a positive net present value may not be sufficient justification for taking action if the NPV is likely to be even larger in the future. There is also the option of comparing accounting implications with cash flow and net present value considerations. Normally, a refunding decision hurts accounting profits in the first year, and increases them in all subsequent years. Price of Previously Issued Bonds Present value of interest payments PVA = A × PVIFA (N = 30, %I/Y = 5%) (Appendix D) (A = 11.5%/ 2 × $1,000 = 5.75% × $1,000 = $57.50) PVA = $57.50 × 15.372 = $883.89 Present value of principal payment at maturity PV = FV × PVIF (N = 30, %I/Y = 5%) (Appendix B) PV = $1,000 × 0.231 = $231.00

Total present value Present value of interest payments .......................................................................... Present value of payment at maturity...................................................................... Total present value of price of the bond.................................................................. Calculator: PV =? FV= $1,000 PMT = $57.50 %I/Y = 5% N = 30 Compute PV = $1,115.29

$ 883.89 231.00 $1,114.89

Market price ............................................................................................................ Par + 8% call premium............................................................................................ Savings per $1,000 bond .........................................................................................

$1,115.29 1,080.00 $ 35.29

Added comment—On 30,000 bonds, this represents total savings of $1,058,700.

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Chapter 1 Refunding Analysis Discount rate = 10% (1-.3) = 7% Costs (Outflows) 1. Payment of call premium $30,000,000 × 8% =

$2,400,000

2. Underwriting cost on new issue $30,000,000 × 2.8% = $840,000 Amortization of cost ($840,000/5) (.3) = $168,000 (.3) = $50,400 tax savings per year Actual expenditure......................................................................................... $840,000 PV of future tax savings $50,400 (N =5, %I/Y = 7%.................................... 206,650 Net cost of underwriting expense on new issue ............................................ $633,350 3. There is no overlap period. Benefits (Inflows) 4. Cost savings in lower interest rates 11.5% (interest on old bond) × $30,000,000 10.0% (interest on new bond) × $30,000,000 Savings per year Savings per year $450,000 × (1 – 0.3) $ 315,000 (N = 15, %I/Y = 7%)

= $3,450,000/year =

3,000,000/year

$ 450,000 = $ 315,000 aftertax PVIFA = $2,868,993

Summary Costs 1. $2,400,000 2. 633,350 $3,033,350

3. 4.

Benefits $2,868,993 . $2,868,993

PV of inflows ............... PV of outflows ............. Net of present value .....

$2,868,993 3,033,350 $(164,357)

The potential refunding has a negative net present value.

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Chapter 1 Gina and Sam must consider whether interest rates will go even lower. If this is likely to be the case, they still may be able to refund the old issue. It would be unwise to refund an issue, and then attempt to refund it again shortly thereafter if rates go down even further because of the large costs involved. Furthermore, if there is a deferred call provision on the new bonds issued after refunding, it may not be feasible to refund the new issue in any event.

The accounting numbers for 20XX are very different from net present value figures. From an accounting viewpoint, the numbers for 20XX are as follows: Payment of call premium.................................................................................... Amortization of underwriting cost on new issue (annual) ................................. Interest savings ................................................................................................... Before tax loss .................................................................................................... Tax rate (not applied on call premium) .............................................................. Taxes paid ($450,000 – $168,000) × tax rate = Aftertax loss .......................................................................................................

– $2,400,000 – 168,000 + 450,000 – $2,118,000 .30 84,600 – $2,202,600

The large loss is due to the payment of the call premium which is not tax deductible and the write-off of underwriting costs in 20XX. In 20XY, the benefit of refunding begins to show up in terms of profitability. Amortization of underwriting cost on new issue (annual) ................................. Interest savings ................................................................................................... Before tax profit.................................................................................................. Tax rate ............................................................................................................... Aftertax profit (Before tax profit × (1 – tax rate)) ..............................................

– $168,000 + 450,000 $282,000 .30 $197,400

Although the firm‘s profitability suffers in 20XX due to one-time write-offs, the benefits begin in 20XY and take place for the remaining life of the new issue.

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Chapter 1 Problems: Appendix 16A 16A-1.

Immobile Homes a. Liquidation value of assets Liabilities Difference

$3,500,000 5,900,000 ($2,400,000)

b. Preferred and common stock will not participate in the distribution because the liquidation value of the assets does not cover creditor claims.

c. Asset values in liquidation Administrative costs, wages and taxes Remaining asset values

$3,500,000 – 400,000 $3,100,000

d. Remaining asset value Payment to secured creditors Amount available to unsatisfied secured claims and unsecured debt

$3,100,000 – 400,000 $2,700,000

e. Remaining claims of unsatisfied secured debt and unsecured debt holders Secured debt (unsatisfied first lien) Accounts payable Senior unsecured debt Subordinated debentures

$ 250,000 2,000,000 1,300,000 1,450,000 $5,000,000

f. Amount available to unsatisfied security claims and unsecured debt (part d) Remaining claims of unsatisfied secured

$2,700,000

debt and unsecured debt holders (part e) $5,000,000 $2,700,000 Allocation ratio   0.54  54% $5,000,000

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Chapter 1 g. Allocation procedures for unsatisfied secured claims and unsecured debt (1) (2) (3) (4) Amount of Initial Amount Category claim allocation received (54%) Secured debt (unsatisfied first lien) Accounts Payable Senior unsecured debt Subordinated debentures

$ 250,000

$ 135,000

2,000,000

1,080,000

1,300,000

702,000

1,300,000

1,450,000 $5,000,000

783,000 $2,700,000

185,000 $2,700,000

*The subordinated debenture holders must transfer $598,000 of their initial allocation to the senior unsecured debt holders to fully provide for their payment ($702,000 + $598,000 = $1,300,000). This will leave $185,000 for subordinated debentures.

h. Payments and percent of claims Total amount Amount Category of claim received Secured debt (first lien) Wages Accounts payable Senior unsecured debt Subordinated debentures

Percent of Claim satisfied

$ 650,000

$ 535,000

82.31%

50,000

100.00%

1,950,000

1,030,000

52.82%

1,300,000

100.00%

1,450,000

185,000

12.76%

Discussion Questions

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Chapter 1 19-1. These are all derivatives that have value based to a large extent on the value of an underlying asset. All are used to reduce risk (hedge) or to take on risk (speculate).  Forwards are customized contracts (as to the amount and future delivery (exercise) date) between two parties for the future delivery of any asset. These contracts almost always must be exercised.  Futures are standardized contracts (as to the amount and future delivery (exercise) date) bought and sold through an organized exchange for the future delivery of any asset. These contracts can be exercised, but are usually sold back to the exchange.  Options are standardized contracts (as to the amount and future delivery (exercise) date) bought and sold through an organized exchange for the future delivery of any asset. These contracts can be exercised, but are usually sold back to the exchange. The holder can also let them expire if they have no further use, unlike forwards or futures. 19-2. A firm may force conversion of a bond issue through the use of the call privilege. If a bond has had a substantial gain in value due to an increase in price of the underlying common stock, the bondholder may prefer to convert to common stock rather than trade in the bond at some small premium over par as stipulated in a call agreement. 19-3. The advantages to the corporation of a convertible security are: a. The interest rate is lower than on a straight issue. b. This type of security may be the only device for allowing a small firm access to the capital markets. c. The convertible allows the firm to effectively sell stock at a higher price than that possible when the bond was initially issued (but perhaps at a lower price than future price potential might provide). 19-4. Basic earnings per share considers none of the potentially dilutive effects of convertibles, warrants, and other securities that can generate new shares of common stock. Fully diluted earnings per share considers all dilutive effects regardless of their origin. Adjustment includes: a. Numerator adjustment includes dividends payable on convertible preferred shares, aftertax interest on convertible debt and inputed aftertax interest earned on cash that would have been received from rights, warrants, and options if they had been exercised. b. Denominator includes all common shares outstanding and equivalent shares of all convertible preferreds and bonds and common shares issued if rights, warrants and options exercised. 19-5. Investors are willing to pay a premium over the theoretical value for a convertible preferred share issue because of the future prospects for the associated common stock. Thus, if there are many years remaining for the conversion privilege, the investor will be able to receive a reasonably high dividend rate and still have the existing option of going to common stock if circumstances justify. 19-6. The floor price of a convertible is based on the pure bond value associated with the interest payments on the bond as shown in Figure 19-1. Regardless of how low the associated common stock might go, the semiannual interest payments will set a floor Foundations of Fin. Mgt. 12Ce

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Chapter 1 price for the bond. For convertible preferreds, the guaranteed dividend payment does the same thing. 19-7. a. The strength of the underlying securities that can be substituted for the convertible. b. A decrease in long-term yields would primarily affect convertible securities trading on the strength of the dividend or interest yield, compared to securities trading on the common share value. 19-8. A "step-up" in conversion price means the conversion price will increase with the passage of time and likewise the conversion ratio will decline. Before each step-up, there is an inducement for bondholders to convert to common at the more desirable price. 19-9. To determine fully diluted earnings per share when convertibles are present, we add aftertax savings from the reduced interest or dividend obligation on ‗assumed conversion‘ to normally computed earnings aftertaxes. For example, if $450,000 in interest could be saved on an assumed conversion of bonds to 100,000 common shares, we would add $270,000 to the numerator (assuming a 40 percent tax rate) and 100,000 into the denominator. For warrants, we must compute the number of new shares that could be created by the exercise of all outstanding warrants and compute the return expected on the proceeds received from the exercise of the warrants. 19-10. Convertible bonds and warrants are similar in that they give the security holder a future option on the common stock of the corporation. They are dissimilar in that a convertible bond represents a debt obligation of the firm as well. When it is converted to common stock, corporate debt will actually be reduced and the capitalization of the firm will not increase. A warrant is different in that it is not a valuable instrument on its own merits, and also its exercise will increase the overall capitalization of the firm. 19-11. Warrants may be used to sweeten a debt offering or as part of a merger offer or a bankruptcy proceeding. 19-12. Warrants may sell above their intrinsic value because the investor views the associated stock's prospects as being bright, or because there is a reasonable amount of time to run before the warrant expires. Warrants also allow for the use of leveraged investing. 19-13. The speculative premium will be larger the longer the time to maturity, the higher the time value of money (a warrant is more valuable as only a downpayment), the greater the volatility of the underlying security (a greater chance of gain) and the closer the exercise price is to the market price of the underlying security (the greatest leverage opportunity). Dividends on the underlying security will dampen the speculative premium. 19-14. Put warrants go up in value as the underlying security decreases in value. Financial intermediaries have at various times offered these securities.

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Chapter 1 Internet Resources and Questions 1. 2. 3. 4. 5.

http://fx.sauder.ubc.ca www.cmegroup.com (see problem #2 for format) www.cmegroup.com (see problem #3 for format) www.cmegroup.com (see problem # 3 for format) www.tmx.com www.m-x.ca/accueil_fr.php (see problem #4 for format) www.tmx.com www.m-x.ca/accueil_fr.php (see problem #4 for format

Problems 19-1.

Giffen Forest Products The forward rate will produce $ Canadian = £ 155,000  1.7083 = $264,786.50 No payment is required today, only at the forward date. Forwards are usually executed through financial institutions, usually banks. They may require a good faith deposit or appropriate security to insure the completion of the contract.

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Chapter 1 19-2.

Western Farmer a. In September Sell canola at: Cash (spot) rate Close out future: Future (Nov. expiry) Sold at (March) Purchase at (Nov.) Loss on future Total revenues with: Cash market and future

Canola price ($ Cdn. / tonne)

Cash received 1,000 tonnes

$450

$450,000

$436 475 $(39)

$436,000 475,000 $(39,000)

$436,000 ($475,000 –$39,000)

Canola price ($ Cdn. / tonne)

Cash received 1,000 tonnes

$450

$450,000

$436 400 $ 36

$436,000 400,000 $ 36,000

In September Sell canola at: Cash (spot) rate Close out future: Future (Nov. expiry) Sold at (March) Purchase at (Nov.) Gain on future Total revenues with: Cash market and future

$436,000 ($400000 + $36,000)

Regardless of price movement up or down you, the farmer, have locked in a price of $436,000 (November cash price – purchase, plus gain/loss on future). Your risk is reduced and you can plan based on this expected receipt for your canola. There will be some differences in practice as the future price and cash prices are rarely identical as in this example.

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Chapter 1 19-3.

Jewelry Manufacturer a. In April Purchase gold at: Cash (spot) rate Close out future: Future (August expiry) Sold at (April) Purchase at (August) Loss on future Total payment with: Cash market and future

b. In April Purchase gold at: Cash (spot) rate Close out future: Future (April expiry) Sold at (April) Purchase at (June) Gain on future Total payment with: Cash market and future

Foundations of Fin. Mgt. 12Ce

Gold price ($ U.S. / ounce)

Cash payment 500 ounces

$1,582

$791,000

$1,595 1,950 $ 355

$ 797,500 975,000 $ (177,500)

$797,500 ($975,000 ‒ $177,500)

Gold price ($ U.S. / ounce)

Cash payment 500 ounces

$1,582

$791,000

$1,595 1,225 $ 370

$797,500 612,500 $185,000

$797,500 ($612,500 + $185,000)

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Chapter 1 19-4.

July Options a. Calls

Abracadabra Cinder I-invest Tomato

Share Price

Strike Price

$58.85 45.10 8.01 39.87

$50.00 45.00 8.00 40.00

Intrinsic Value (1  2) $8.85 0.10 0.01 0.00

Call Option Price $13.30 2.40 1.70 2.85

Share Price

Strike Price

$58.85 45.10 8.01 39.87

$50.00 45.00 8.00 40.00

Intrinsic Value (2  1) $0.00 0.00 0.00 0.13

Put Option Price $2.95 2.30 1.50 2.70

5 Speculative Premium (4  3) $4.45 2.30 1.69 2.85

b. Puts

Abracadabra Cinder I-invest Tomato

c. Abracadabra

Share price = $70.00

Call option price

Put option price

d. Abracadabra

Put option price

Foundations of Fin. Mgt. 12Ce

Speculative Premium (4  3) $2.95 2.30 1.50 2.57

Strike price = $50.00

= Intrinsic value + speculative premium = ($70  $50) + $0.50 = $20.50 = Intrinsic value + speculative premium = ($50  $70) + $0.50 = $0.00 + $0.50 = $0.50

Share price = $45.00

Call option price

Strike price = $50.00

= Intrinsic value + speculative premium = ($45  $50) + $1.25 = $0.00 + $1.25 = $1.25 = Intrinsic value + speculative premium = ($50  $45) + $1.25 = $5.00 + $1.25 = $6.25

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Chapter 1 19-5.

DNA Labs, Inc. a. $26.75 stock price × 40 shares = $1,070.00 conversion value b. $1,118.50 bond price – $1,070.00 conversion value = $48.50 conversion premium c. $1,000 par value/ 40 conversion ratio = $25 conversion price

19-6.

Kepon Trucking Company a. $4.50 stock price × 200 shares = $900.00 conversion value b. $990.00 bond price – $900.00 conversion value = $90 conversion premium c. $1,000 par value/ 200 conversion ratio = $5 conversion price

19-7.

Stein Company First compute the conversion ratio. The conversion ratio is equal to the par value ÷ the conversion price:

Par value/ conversion price $1,000/ $20

= conversion ratio = 50 conversion ratio

Multiply the common stock price times the conversion ratio to get the conversion value:

Common stock price × conversion ratio = conversion value $18.50 × 50 shares = $925 conversion value Add the conversion premium to the conversion value to arrive at the convertible bond price:

Conversion Value + Conversion Premium = Convertible Bond Price = $925 + $35 = $960 convertible bond price

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Chapter 1 19-8.

Goniff Bank & Trust

First compute the conversion ratio. The conversion ratio is equal to the par value ÷ the conversion price:

Par value/ conversion price $1,000/ $12.50

= conversion ratio = 80 conversion ratio

Multiply the common stock price times the conversion ratio to get the conversion value:

Common stock price × conversion ratio = conversion value $10.25 × 80 shares = $820 conversion value Add the conversion premium to the conversion value to arrive at the convertible bond price:

Conversion Value + Conversion Premium = Convertible Bond Price = $820 + $90 = $910 convertible bond price

19-9.

Sherwood Forest Products a. $1,000 par value/ 25 conversion ratio = $40 conversion price $35 common stock price × 25 shares = $875 conversion value $950 bond price – $875 = $75 conversion premium

b. $950 bond price/ 25 shares = $38

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Chapter 1 19-10.

Hughes Technology

a. Par value/ conversion ratio $1,000/ 40

= conversion price = $25

40 shares × $21 common stock price = $840 conversion value b. Pure bond value: Calculator:

PV =? FV = 1,000 %I/Y = 3.0% (6%/ 2) PV = $902.00

Compute: 19-11.

PMT = $25 ($50/2) N = 30 (15 × 2)

Hamilton Steel Company

a. Par value/ conversion price $1,000/ $50

= conversion ratio = 20

20 shares × $44 common stock price = $880 conversion value b. Pure bond value: Calculator: PV =? FV = 1,000 %I/Y = 5% (10%/ 2) PV = $817.44 Compute:

PMT = $40 ($80/2) N = 50 (25 × 2)

c. Conversion premium = $930 -$880 = $50 19-12.

Hamilton Steel Company Revisited Pure bond value:

Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =? FV = 1,000 %I/Y = 6% (12%/ 2) PV = $684.76

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PMT = $40 ($80/2) N = 50 (25 × 2)

Block, Hirt, Danielsen, Short

Chapter 1 19-13.

Western Pipeline, Inc.

a. $43.50 stock price × 28 shares

= $1,218 conversion value + 10 conversion premium $1,228 Bond price

b. 5% × $1,000 = $50 Annual interest Current yield  Annual interest  $50  0.0407  4.07% Bond price $1,228

c. Calculator: Compute:

PV =$1,228 FV = 1,000 PMT = $25 ($50/2) %i =? N = 14 (7 × 2) %i = 0.775 × 2 = 1.55% (annual)

d. $22.50 stock price × 28 shares= $ 630 conversion value + 100 conversion premium $ 730 Bond price Calculator: Compute:

Foundations of Fin. Mgt. 12Ce

PV =$730 FV = 1,000 PMT = $25 ($50/2) %i =? N = 14 (7 × 2) %i = 5.276 × 2 = 10.55% (ann ual)

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Chapter 1 19-14.

Standard Olive Company of B.C.

a. $1,000 par value/ 25 conversion ratio = $40 conversion price b. $30.00 stock price × 25 conversion ratio = $750 conversion value c. Pure bond value: Calculator: Compute:

PV =? FV= 1,000 %I/Y = 5% (10%/2) PV = $923.14

PMT = $45 ($90/2) N = 30 (15 × 2)

d. 200

180

160

Conversion value

140

Pure bond value

120

$923.14

Bond values

100

Floor value

0 0

Price of common shares

e. Most likely, the price of the bond will be influenced by the floor price and changing interest rates. The stock price needs to rise from $30.00 per share closer to $36.93 ($923.14/ 25) before the bond price will react directly to stock price changes.

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Chapter 1 19-15.

Swift Shoe

a. They will probably convert the bonds to common shares. With a conversion ratio of 22 and a common stock price of $59.25, the value of the converted securities would be $1,303.50. This is substantially above the call value of $1,080. Thus, there is a strong inducement to convert.

b. Bond price

= share price × conversion ratio = $60 × 22 = $1,320

c. Bond price in two months

= stock price × conversion ratio = $63.50 × 20 = $1,270

You should convert now rather than hold on to the bonds for two more months. The overall value will be $50 less at that point in time.

19-16.

Vernon Glass Company Conversion value

Bond price (now)

= Share price × conversion ratio = $19 × 50 = $950 = Conversion value + premium = $950 + $70 = $1,020

Next year Conversion value

= Share price × conversion ratio = $25 × 50 = $1,250 Bond price (next year)= Conversion value + premium = $1,250 + $15 = $1,265 Rate of return 

$1,265  $1,020  $245   0.2402  24.02% $1,020 $1,020

Foundations of Fin. Mgt. 12Ce

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Chapter 1 19-17.

Tulsa Drilling a. First find the price of the convertible bond. The conversion value is $1,280 ($32 × 40). The conversion value, $1,280, plus the $70 premium, equals $1,350, the current market price of the convertible bond. Next, find the price of the convertible bond on this day next year. $42 stock price × 40 shares = $1,680 conversion value $1,680 conversion value + $20 premium = $1,700 market price of the convertible bond ($1,700 – $1,350)/$1,350 = $350/$1,350 = 25.93% annual return. b. Pure bond value after one year (nine years remaining). n = 18 and i = 4% Calculator: PV =? FV = 1,000 %I/Y = 4% (8%/ 2) Compute: PV = $1,189.89

PMT = $55 ($110/2) N = 18 (9 × 2)

$55 semiannually × 12.659 (PVIFA) = $ 696.24 $1,000 principal value × 0.494 (PVIF) = 494.00 $1,190.24 Because the pure bond value of $1,189.89 is still well below the conversion value of $1,680 and the market value of $1,700, it would not have a significant effect on valuation. The share price is the major factor determining the convertible bond price.

Foundations of Fin. Mgt. 12Ce

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Chapter 1 19-18.

Manpower Electric Company Manpower Electric Company has 7 percent convertible bonds outstanding. Each bond has a $1,000 par value. The conversion ratio is 25, the share price is $38, and the bonds mature in 16 years. a. What is the conversion value of a bond? 25 shares × $38 per share = $950 conversion value b. Assume after one year, the common stock price falls to $27.50. What is the conversion value of the bond? 25 shares × $27.50 per share =$687.50 conversion value c. After one year. Pure bond value Calculator: PV =? FV = 1,000 PMT = $35 ($70/2) %I/Y = 5% (10%/ 2) N = 30 (15 × 2) Compute: PV = $769.41 N = 30 (2 × 15) I/Y = 5% (10%/2) PV of annuity = $35 × 15.372 = $538.02 PV of principal payment = $1000 × 0.231 = $231.00

Pure Bond Value

= $769.02

d. For the time being, the pure bond value ($769.41) will have the stronger influence than the share price. The conversion value of $687.50 is $81.91 less than the pure bond value. As the share price gets closer to the parity point ($769.41/25 shares) of $30.78, the shares will start to exert more influence than the pure bond value. e.

$81.91 $687.91

19-19.

Foundations of Fin. Mgt. 12Ce

= 0.1191 = 11.91%

B.C. Fisheries Ltd.

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Chapter 1 a. Conversion value

= 1.25 shares × $24 share price = $30

b. Current preferred yield

= $2.00/ $31.00 = .065 or 6.5%

c. Dividend yield (common)

= $0.60/ $24.00 = .025 or 2.5%

d. The potential for capital gain from the conversion feature, if the common shares appreciate in value.

e. The dividend yield on the preferred is more attractive because it is higher, is paid before the common dividend and any capital appreciation in the common share price will be reflected in the preferred price.

19-20.

Hansen Toy Company

a. I = (M – E) × N I = Intrinsic value of a warrant M = Market value of common stock E = Exercise price of a warrant N = Number of shares each warrant entitles the holder to purchase I

= ($28 – $22) × 1.5 = $9.00

b. S = W – I S = Speculative premium S

W = Warrant price

= $12.25 – $9.00 = $3.25

c. The speculative premium should decrease and approach $0 as the expiration date nears.

Foundations of Fin. Mgt. 12Ce

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Chapter 1 19-21.

Spring Fields

I = (M – E) × N = ($21 – 17) × 1 = $4

S =W–I = $6 – $4 = $2

19-22.

a. I

Preston Toy Co. = (M – E) × N = ($28 – 22) × 1 = $6 S =W–I = $10.50 – $6 = $4.50

19-23.

Sleepless Night Ltd. I

= (M – E) × N = ($16.25 – $10.00) × 1 = $6.25

S $3.00 W

Foundations of Fin. Mgt. 12Ce

=W–I = W – $6.25 = $9.25

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Chapter 1 19-24.

A Warrant

= (M – E) × N = ($12.00 – $14.50) × 1 = – $2.50 or 0 value

=W–I = $4.00 – $0 = $4.00

= (M – E) × N = ($21.75 – $14.50) × 1 = $7.25

S $1.00 W

Rate of return (share) 

=W–I = W – $7.25 = $8.25

$21.75  $12.00

Rate of return (warrant) 

$12.00 $8.25  $4.00 $4.00

Foundations of Fin. Mgt. 12Ce

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 $9.75  0.8125  81.25% $12.00 

$4.25

 1.0625  106.25%

$4.00

Block, Hirt, Danielsen, Short

Chapter 1 19-25.

Slowbus Transportation Corp. = (M – E) × N = (? – $17.50) × 1 – $2.75 (purchase price) = $0 (Breakeven) M = $20.25 I

19-26.

Intregra Life Sciences I

Foundations of Fin. Mgt. 12Ce

= (M – E) × N = (? – $11.75) × 1 – $2.85 (purchase price) = $0 (Breakeven) M = $14.60

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Chapter 1 19-27.

Another Warrant

= (M – E) × N = ($18.00 – $15.00) × 1 = $3.00

=W–I = $5.00 – $3 = $2.00

= (M – E) × N = ($27.00 – $15.00) × 1 = $12.00

S $0.00 W

Rate of return (share) 

=W–I = W – $12.00 = $12.00

$27.00  $18.00

Rate of return (warrant) 

$18.00

 $9  0.500  50.0% $18

$12.00  $5.00 $5.00



 1.40  140.0%

The warrant is leveraged. A movement in the share price will cause the warrant to rise on a smaller initial investment and, therefore, the percentage gain is larger for the warrant than for the shares.

Foundations of Fin. Mgt. 12Ce

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Chapter 1 19-28.

Manning Investment Company

= (M – E) × N = ($60.00 – $36.00) × 2 = $48.00

$48 × 100 warrants $30 × 100 warrants

= $4,800 proceeds from sale = $3,000 purchase price

Profit

= Proceeds from sale – Purchase price = $4,800 – $3,000 = $1,800

Rate of return (warrant) 

19-29.

$1,800

 0.60  60.0%

$3,000

Manning Investment Company (continued)

= (M – E) × N = ($50.00 – $36.00) × 2 = $28.00

=W–I = $30.00 – $28.00 = $2.00

c. $3,000 investment/ $50 per share = 60 shares 60 shares × ($60 – $50) = $600 d. Rate of return (share) 

$60.00  $50.00 $50.00

Foundations of Fin. Mgt. 12Ce

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

$10

 0.20  20.0%

$50

Block, Hirt, Danielsen, Short

Chapter 1 19-30.

Mr. John Hailey

a. Warrants available 

$1,000

 200

$5 b.

$ 30 – 20 $ 10 × 50 $500

new price old price gain shares total dollar gain $10 $500  0.500  50.0% or Rate of return (shares)  $1,000 $20

= (M – E) × N = ($30.00 – $18.00) × 1 = $12.00 (0 speculative premium) $12 –5 $7 × 200 $1,400

new price of warrant old price of warrant gain warrants total dollar gain $1,400 $7 or  1.400  140.0% Rate of return (warrants)  $1,000 $5 d. With an $18 exercise price, at a share price of $14.50, the warrant would have a negative intrinsic value of $3.50 (or zero). With a speculative premium of only $3.50, the warrant would be worthless. Under the problem as described, the warrant would be worthless at stock values of $14.50 or less. Note however that if a speculative premium exists the warrant will have value.

Foundations of Fin. Mgt. 12Ce

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Chapter 1 19-31.

Hughes Technology

Earnings per share (basic) 

net income $450,000   $4.50 100,000 shares outstanding

For fully diluted earnings per share: 1,200 bonds × 20 shares per bond = 24,000 shares 24,000 shares from conversion + 100,000 original shares = 124,000 adjusted shares for computing fully diluted $1,200,000 × 0.06 coupon rate × [1 – 0.34 (tax rate)] = $47,520 aftertax interest savings upon conversion $450,000 reported earnings + $47,520 aftertax interest savings = $497,520 adjusted earnings for fully diluted e.p.s. EPS (fully diluted)  adjusted aftertax income  $497,520  $4.01 fully diluted shares 124,000

19-32.

Hughes Technology (continued)

a. The basic (unadjusted) earnings per share remains the same ($4.50) no matter what interest rate is paid on bonds generally in the marketplace. b. No effect. The answer is still $4.01.

Foundations of Fin. Mgt. 12Ce

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Chapter 1 19-33.

Meyers Business Systems

a. Earnings per share (basic) 

net income $4,000,000   $2.00 2,000,000 shares outstanding

For diluted earnings per share: Adjusted shares

= 2,000,000 + 300,000 + 400,000 = 2,700,000

Aftertax interest savings = ($12,000,000 × 0.09 + $15,000,000 × 0.10) × (1 – 0.50) = $1,290,000 Adjusted earnings aftertax

EPS (diluted) 

= $4,000,000 + $1,290,000 = $5,290,000

$5,290,000 adjusted aftertax income   $1.96 2,700,000 shares (outstanding  converted)

b. Adjusted shares = 2,700,000 + warrant adjustment = 2,700,000 + 100,000 – [($20 × 100,000)/ $40] = 2,750,000 Proceeds from exercise of warrants assumed used to repurchase shares at market price. EPS (diluted) 

$5,290,000 adjusted aftertax income   $1.92 2,750,000 shares (outstanding  converted)

Foundations of Fin. Mgt. 12Ce

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Chapter 1 Comprehensive Problems 19-34.

United Technology Corporation (UTC) Interest expense 11% × $40 million = $4,400,000 Shares from conversion = 30 × 40,000 bonds = 1,200,000 Conversion value = 30 shares × $41 per share = $1,230 Call price = $1,000 × 1.09 = $1,090

a. If the bond is called, it will be converted because the conversion value is greater than the call price ($1,230 > $1,090). (Basic) EPS before conversion: Earnings per share (basic) 

$38,000,000 net income   $6.33 shares outstanding 6,000,000

(Basic)EPS after conversion (diluted eps as well): EPS (diluted) 

new aftertax income shares (outstanding  converted) $38,000,000  $4,400,000  1  0.25   $5.74 6,000,000  1,200,000 There is a reduction in basic EPS from $6.33 to $5.74. Diluted EPS after conversion is the same as before conversion because the potential new shares and interest reduction would be already accounted for in diluted EPS.

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Chapter 1 b. With the elimination of the convertible bond, UTC has reduced its debt and increased its equity financing. This provides more flexibility in the way of debt issues for the future. With the current interest rate at 8 percent, UTC could sell a new issue of straight debt and repurchase shares of common stock in the open market. This would serve the purpose of a partial refunding which would result in a lower outlay for interest and dividends. Flexibility is improved. c. Aftertax dividend expense= 1,200,000 × $3.50 = $4,200,000 Aftertax interest expense = $4,400,000 (1 ─ .25) = $3,300,000 Aftertax net cash loss $ 900,000 d. The shareholders will take the 30 shares of common stock since the conversion value of $1,230 is greater than the call price of $1,090. The dividend will also be greater than the interest expense on the old bond or interest that can be earned in the market at current rates of 8 percent. The dividend yield is 8.54 percent ($3.50/$41.00). e. Bonds have a required payment while the dividend has greater risk. However, in this case the dividend yield has become more attractive before tax and tax treatment would further enhance the desirability of the shares. Whether holding the bonds or the shares, capital appreciation will be shared equally.

Foundations of Fin. Mgt. 12Ce

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Chapter 1 MINI CASE

Hamilton Products (Convertibles) This case encourages the student to more fully appreciate the financial characteristics of convertible bonds. It also allows the student to see that the pure bond value is not necessarily stable, but may change because of changing interest rates or business risk. The student not only views upside potential, but increasing downside exposure as well.

a. Conversion value

= conversion ratio  common share price = 27  $32.75 = $884.25

Conversion premium = convertible bond price – conversion value = $1,000.00 – $884.25 = $115.75 b. First determine the conversion value: Conversion value = conversion ratio  common share price = 27  $45.50 = $1,228.50 Then determine the conversion premium: Conversion premium = convertible bond price – conversion value = $1,250.00 – $1,228.50 = $21.50 c. First determine the conversion value: Conversion value = conversion ratio  common share price = 27  $29.75 = $803.25 Then add the conversion premium: Convertible bond price = Conversion value + conversion premium = $803.25 + $98 = $901.25

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Chapter 1 d. Pure Bond Value Present value of interest payments PVA = A  PVIFA (n = 17, %I/Y = 10%) = $65  8.022 = $521.43 Present value of principal payment (par value) at maturity PV = FV  PVIF (n = 17, %I/Y = 10%) = $1,000 x .198 = $198.00 Present value of interest payments Present value of principal payment Total present value of pure bond

$521.43 198.00 $719.43

PV =? FV = 1,000 %I/Y = 10% N = 17 PV = $719.25

PMT = $65

Calculator: Compute:

Andre should probably not take too much comfort in the pure bond price. The convertible bond is selling for $901.25 as indicated in question c and the pure bond value is $719.25. That indicates a potential loss of $182 or 20.2% ($182/$901.25). Furthermore, there is always the danger of interest rates on comparable bonds going even higher. Originally, the pure bond value was $853.17, which certainly would have provided more comfort.

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