Chapter1

TheRoleandObjectiveofFinancialManagement

CHAPTER1
THEROLEANDOBJECTIVE
OFFINANCIALMANAGEMENT
ANSWERSTOQUESTIONS:
1.Shareholderwealthisdefinedasthepresentvalueoftheexpectedfuturereturnstothe
owners(thatis,shareholders)ofthefirm.Thesereturnscantaketheformofperiodicdividend
paymentsand/orproceedsfromthesaleofthestock.Shareholderwealthismeasuredbythe
marketvalue(thatis,thepricethatthestocktradesinthemarketplace)ofthefirm'scommon
stock.
2.Profitmaximizationtypicallyisdefinedasamorestaticconceptthanshareholderwealth
maximization.Theprofitmaximizationobjectivefromeconomictheorydoesnotnormally
considerthetimedimensionortheriskdimensioninthemeasurementofprofits.Incontrast,
theshareholderwealthmaximizationobjectiveprovidesaconvenientframeworkforevaluating
boththetimingandtherisksassociatedwithvariousinvestmentandfinancingstrategies.
Themarginaldecisionrulesderivedfromeconomictheoryareextremelyusefultoawealth
maximizingfirm.Anydecision,eitherintheshortrunorthelongrun,thatresultsinmarginal
revenuesexceedingthemarginalcostsofthedecisionwillbeconsistentwithwealth
maximization.Whenadecisionhasconsequencesextendingbeyondayearintime,the
marginalbenefitsandmarginalcostsofthatdecisionmustbeevaluatedinapresentvalue
framework.
3.Acloselyheldfirmismorelikelytobeawealthmaximizerthanacorporationwithwide
ownership.Inthecloselyheldfirm,theownersandthemanagerswillsharethesame
objectivesbecausetheownersarethemanagers.Inawidelyheldcorporation,wherethe
ownershipandmanagementfunctionsareseparate,itislikelythatmanagersmaypursue
objectivesthataremoreselfservingthanownerserving.Examplesofalternativeobjectives
thatmightbepursuedinthissituationareextremeriskaversebehavior,sizemaximization,
satisficing,orpersonalutilityfunctionmaximization.Amorecompletediscussionof
alternativeobjectivesmaybefoundinMcGuigan,Moyer,andHarris,ManagerialEconomics,
10thedition(SouthWestern,20059),Chapterl.
4.Thegoalofshareholderwealthmaximizationisalongtermgoal.Shareholderwealthisa
functionofallthefuturereturnstotheshareholders.Hence,inmakingdecisionsthatmaximize
shareholderwealth,managementmustconsiderthelongrunimpactonthefirmandnotjust
focusonshortrun(i.e.,currentperiod)effects.Forexample,afirmcouldincreaseshortrun

11

Chapter1
TheRoleandObjectiveofFinancialManagement
earningsanddividendsbyeliminatingallresearchanddevelopmentexpenditures.However,
thisdecisionwouldreducelongrunearningsanddividends,andhenceshareholderwealth,
becausethefirmwouldbeunabletodevelopnewproductstoproduceandsell.
5.Engaginginsocialresponsibilityactivitiescanbejustifiedonthebasisthattheseactivities
helptocreateanenvironmentinwhichthegoalofshareholderwealthmaximizationmore
easilycanbepursued.
6.Theseparationofownershipandcontrolincorporationsmayresultinmanagement
pursuinggoalsotherthanshareholderwealthmaximization,suchasmaximizationoftheirown
personalwelfare(utility).Concernfortheirownselfinterestsmayleadmanagementtomake
decisionsthatpromotetheirlongrunsurvival(jobsecurity),suchasminimizing(orlimiting)
theamountofriskincurredbythefirm.
7.Anagencyrelationshipoccurswhenoneormoreindividuals(theprincipals)hireanother
individual(theagent)toperformaserviceonbehalfoftheprincipals.Twoofthemost
importantagencyrelationshipsinfinancearebetweenthestockholders(principals)and
management(agent),andbetweentheowners(agents)andcreditors(principals).Agencycosts
areincurredwhenattemptingtocontrolagencyproblems.Agencyproblemsarisewhenthe
agentmakesdecisionsconsistentwiththemaximizationofhisorherownutilityratherthanthe
maximizationoftheutilityoftheprincipals.
8.Examplesofagencycostsincurredbyshareholdersinclude

Expenditurestostructuretheorganizationinawaythatwillminimizetheincentivesfor
managementtotakeactionscontrarytoshareholderinterests,suchasprovidingaportion
ofcompensationintheformofthestockinthecompany.
Expenditurestomonitormanagement'sperformance,suchasinternalandexternalaudits.
Bondingexpenditurestoprotectagainstmanagerialdishonesty.
Lostprofits(opportunitycosts)ofcomplexorganizationalstructures.
9.Creditors(theprincipal)haveafixedfinancialclaimontheresourcesofthefirmwhereas
owners(agents)havearesidualclaimonthefirm'sresources.Asaconsequence,ownersmay
attempttoincreasetheriskinessofthefirm'sinvestmentsinhopesofearninghigherreturns.
Creditorssufferfromthistypeofbehaviorbecausetheydonothaveanopportunitytosharein
thesehigherpotentialreturns,yettheysufferfromtheincreasedrisk.
10.Thecontrollerusuallyhasresponsibilityforallaccountingrelatedfunctions,suchas
financialaccounting,costaccounting,andaccountinginformationsystems.Thetreasurer
normallyhasresponsibilityfortheacquisition,custody,andexpenditureoffunds,including

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Chapter1
TheRoleandObjectiveofFinancialManagement
cashandmarketablesecuritiesmanagement,capitalbudgetinganalysis,financial,andpension
fundmanagement,andfinancialplanning.Becausenotallcompaniesdividethe
responsibilitiesinthismanner,theactualfunctionsperformedbythecontrollerandtreasurer
willvaryfromcompanytocompany.
11.a.Financialmanagementemploysthemarginalrevenuemarginalcostrelationshipsof
microeconomicsinmakinglongterminvestment(capitalbudgeting)decisionsandshortterm
investment(workingcapital)decisions.
b.Financialmanagementrequiresanunderstandingofmacroeconomicconceptsdealingwith
monetaryandfiscalpolicy.Knowledgeoftheseconceptsisnecessaryinmakingcompany
salesforecastsandinraisingfundsinthemoneyandcapitalmarkets.
12.Earningspersharefigurescanbemisleadingbecausefactorssuchas(1)reductionsinthe
numberofshares;(2)adeclineinthereturnbeingearnedonthecompany'sequity;and(3)an
increaseintheriskofthefirm,allcouldleadtoincreasedearningspershare,butnot
necessarilytoanincreaseinthevalueofthefirm'ssharesinthemarketplace.
13.ThebondholdersintheRJRNabiscotakeovercasewantedtoblockthetransactionbecause
thetakeoverwastobefinancedwithasubstantialincreaseintheamountofdebt,andtherefore
anincreaseintheriskofdefault.Thecaseofthebondholderswasrejectedinthecourts
because,itwasargued,theseknowledgeableinvestorsknewtheywereexposedtothistypeof
eventriskwhentheypurchasedthebonds,andpresumablywerecompensatedfortheexpected
riskintheformoftheriskpremiumearnedonthebonds.
14.Thethreemajorfactorsthatdeterminethemarketvalueofafirm'sstockare(1)theamount
ofthecashflowsexpectedtobegeneratedforthebenefitofstockholders;(2)thetimingof
thesecashflows;and(3)theriskofthecashflows.
15.Themarketsreactionmayhavereflected(1)anexpectationthattherewouldultimatelybe
asplittingupandspinoffofthenaturalresourcesbusinessfromthesteelbusiness,thereby
assuringthatcashflowsgeneratedbyMarathonOilwouldnotbewastedonreinvestmentinthe
lowreturnsteelbusiness;or(2)thepotentialthatthisseparationwouldmakeitmoredifficult
forthesteelsegmentofUSXtotapthecashflowsofMarathonOil.
16.Bydeclaringbankruptcy,GeneralMotors(GM)hopedtoprotectitselffromtheclaimsof
creditorswhileitsoughtawaytoeithersellorrestructureitsassets.Presumably,the
managementatGMthoughtthatthebankruptcydeclarationwouldprovideitwithan
opportunitytorestructureitself,whileitwasprotectedfromthepressuresofmaking
burdensomeinterestandotherpaymentstocreditors.
17.Firmsthatexpecttheiremployeestoactaccordingtoahighstandardofethicalbehavior
canexpecttoexperiencelowerlitigationcosts.Customers,suppliers,andinvestorscanbe
expectedtovalueafirmcommittedtomaintaininghighethicalstandardsintheconductofits

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Chapter1
TheRoleandObjectiveofFinancialManagement
business,andtherebybuildlongtermloyaltiesandbusinessrelationships.
18.Soleproprietorshipsarecharacterizedbythevirtualnonexistenceofagencyproblems
betweenownersandmanagers,becausetheownerandmanagerareusuallyoneandthesame.
Ofcourse,therestillisthepotentialagencyconflictbetweencreditorsandowners.However,
eveninthiscasetherisktocreditorsisreducedbecausetheownerhasunlimitedpersonal
liabilityforthedebtsofthefirm.Themajorshortcomingoftheproprietorshipformof
organizationisthelimitedabilityoftheownertoraisecapital,becausetheowneristhesole
sourceofequityandtheownerispersonallyliableforallofthefirm'sdebts.
Partnershipsprovideagreaterpotentialforraisingcapitalbecausethereismorethanone
ownermanager.Thecapitalraisingpotentialofpartnershipsislimitedtothenumberof
partnersofthefirm.Ownermanageragencyproblemsassumeincreasedimportanceina
partnershipbecauseeachpartneronlybearsafractionalportionofthecostofhis/heractions.
Hence,ifapartnerconsumesexcessiveperquisites,thepartnerwillonlypayafractionalshare
ofthecostofthiswastefulbehavior.Thelargerthepartnership,thegreateristhispotential
problem.
Corporationshavethegreatestpotentialforownermanageragencyproblemsbecauseofthe
separationofownershipfromcontrol.Offsettingthiscorporatedisadvantageisthenearly
unlimitedabilityofcorporationstoraisecapital,bothdebtandequity.Thecapitalraising
abilityofcorporationscanbeattributedlargelytothelimitedliabilityfeatureofcommonstock
ownership.
Thislimitedliabilityfeaturegivesrisetoincreasedagencycostproblemsbetweenownersand
creditors.

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Chapter1
TheRoleandObjectiveofFinancialManagement

CHAPTER2
THEDOMESTICANDINTERNATIONAL
FINANCIALMARKETPLACE
ANSWERSTOQUESTIONS:
1.Thesavinginvestmentcycleconsistsofnetsavers(surplusspendingunits)transferring
fundstonetinvestors(deficitspendingunits).Thetransfercanbemadethrougheither
financialmiddlemenorfinancialintermediaries.Foragiventimeperiod,actualsavingsequals
actualinvestment.
2.Financialmiddlemenandintermediariesfacilitatethetransferoffundsduringthesaving
investmentcycle.Whenfinancialmiddlemenaidinthetransferoffunds,primaryclaimsare
issuedtosurplusspendingunits.Whenfinancialintermediariesareinvolvedinthefunds
transferprocess,secondaryclaimsareissuedtosurplusspendingunits.Thesesecondary
claimsarenormallylessriskythantheprimaryclaimsreceivedbythefinancialintermediaries.
3.Moneymarketsdealinshorttermsecuritieshavingmaturitiesofapproximatelyoneyearor
less,whereascapitalmarketsdealinlongertermsecuritieshavingmaturitiesgreaterthanone
year.Primarymarketsarefinancialmarketsinwhichnewsecuritiesareboughtandsoldforthe
firsttime,whereassecondarymarketsarefinancialmarketsinwhichexistingsecuritiesare
offeredforresale.

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Chapter1
TheRoleandObjectiveofFinancialManagement
4.Financialintermediaries:
CommercialbanksSourcesoffundsaredemandandtimedeposits.Usesofthesefunds
areloanstoindividuals,businesses(shorttermcreditandtermloans),andgovernments.
ThriftinstitutionsTheseincludesavingsandloanassociations,mutualsavingsbanks,
andcreditunions.Sourcesoffundsaredemandandtimedeposits.Savingsandloan
associationsandmutualsavingsbanksinvestmostoftheirfundsinhomemortgagesand
creditunionsareengagedprimarilyinconsumerloans.
InvestmentcompaniesTheseincludemutualfundsandrealestateinvestmenttrusts
(REIT's).Mutualfundspoolthefundsofmanysaversandinvestinfinancialassets,
suchasstocks,bonds,andmoneymarketinstruments.REIT'sinvestincommercialand
residentialrealestate.
PensionfundsTheseintermediariespoolthecontributionsofemployees(and/or
employers)andinvestthesefundsinbothfinancialandrealassets.
InsurancecompaniesSourcesoffundsarepremiums(payments)fromindividualsand
organizations(policyholders).Inexchangeforthesepremiums,theinsurancecompanies
agreetomakecertainfuturecontractualpayments,suchasdeathanddisabilitybenefits
andcompensationforfinanciallossesarisingfromfire,theft,accident,orillness.The
premiumsareusedtobuildreserves,whichareinvestedinvarioustypesoffinancialand
realassets.
FinancecompaniesTheseintermediariesobtainfundsbyissuingtheirownsecuritiesand
throughloansfromcommercialbanks.Thefundsthenareloanedtoindividualsand
businesses.
5.Factorsthatshouldbeconsideredwhendeterminingtheoptimalformoforganizationfora
businessenterpriseincludethecontroldesiresofowner/managers,thefuturegrowthpotential
andtheneedforexternalcapital,thepossibilityofconflictsbetweenownersandmanagers,the
taxconsequencesoftheorganizationalstructure,andthedesireforalimitedliabilityexposure
bytheowners.
6.Inprimaryfinancialmarkets,newsecuritiesfromanissuingfirmareboughtandsoldforthe
firsttime.Hence,firmsactuallyraisethecapitaltheyneedintheprimaryfinancialmarkets.In
secondarymarkets,existingsecuritiesareofferedforresale.Theissuingfirmdoesnotreceive
anynewfundswhensecuritiestradeinasecondarymarket,suchastheNewYorkExchange.
Secondarymarketsprovideanimportantserviceofmakingsecuritiesliquid,andtherebythe
existenceofsecondarymarketslowersthecostofraisingfundsintheprimarymarkets.
7.TheNewYorkStockExchangeisaphysicallocationwherebuyersandsellersofsecurities
meettoexchangeassets.TheNewYorkStockExchangeworksthroughaspecialistsystem

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Chapter1
TheRoleandObjectiveofFinancialManagement
andcomplexcomputerlinkagesthatmatchbuyersandsellersandmaintainanorderlymarket.
Incontrast,theoverthecountermarketsarenotrepresentedbyanyphysicalplaceofdoing
business.Rather,brokeragefirmsaroundthecountryarelinkedtogetherinacomputer
networkwhichliststhesecuritiesthatareforsale(ordesiredforpurchase),bywhom,andat
whatprice.Whenaninvestorwishestobuyorsellstocksoverthecounter,thatinvestors
brokerwillcheckthecomputernetworktoseewhatotherbrokerhasthedesiredsecurityfor
sale,inwhatquantity,andatwhatprice.Whenanagreeablematchoccurs,thesecurityis
boughtfortheinvestor.
8.Inanefficientlyfunctioningcapitalmarket,securitypriceswillbebidtoalevelwherethe
security'sexpectedreturnjustequalsitsrequiredreturn.Newinformationabouttheexpected
returnandriskofasecuritywillbereflectedquickly,andinanunbiasedfashion,initsprice.
Inanefficientcapitalmarket,shareholderscanmeasuretheperformanceofafirm'smanagers
byobservingthefirm'sstockprice.Actionsthatincreaseafirm'sstockpricearecontributing
directlytothegoalofmaximizingshareholderwealth.
9.Itismucheasierandcheaperforafirmtoraisecapitalinthemarketplaceifthat
marketplaceoperatesinaninformationallyefficientmanner.Whenthecapitalmarketsare
informationallyefficient,allrelevantinformationregardingtheprospectsofafirmssecurities
isreflectedinthepriceofthosesecurities.Investorscanbuysecuritieswiththecomfortof
knowingthatthesesecuritiesarelikelytobefairlypriced,giventheirriskandreturn
characteristics.
10.a.Amultinationalcorporationisafirmthathasinvestmentsinmanufacturingand/or
distributionfacilitiesinmorethanonecountry.
b.Thespotexchangerateistherateofexchangeforcurrenciesbeingboughtandsold
forimmediatedelivery.
c.Theforwardexchangerateistherateofexchangebetweencurrenciestobe
deliveredatafuturedate,suchas30,90,or180daysfromtoday.
d.Adirectquoteisthecomecurrencypriceofoneunitofaforeigncurrency.Anindirect
quoteistheforeigncurrencypriceofoneunitofhomecurrency.
e.Anoptionisacontractorsecuritythatgivestheoptionbuyertheright,butnotthe
obligation,toeitherbuyorsellafixedamountofanothergoodorsecurity,suchasforeign
currency,atafixedpriceatatimeupto,orat,theexpirationdateoftheoption..
f.TheLondoninterbankofferrate(LIBOR)istheinterestrateatwhichbanksinthe
Eurodollarmarketlendtoeachother.
g.TheEuroisacompositecurrencywhosevalueisbasedontheweightedvalueof17
Europeancurrencies.OnJanuary1,2002,theeuroreplacedtheindividualcurrenciesofthe

17

Chapter1
TheRoleandObjectiveofFinancialManagement
original11memberEuropeancountriesandbecameacommoncurrencyofthese11
counties.Since2002,6otherEuropeancountrieshaveadoptedtheeuroastheircurrency.

18

Chapter1
TheRoleandObjectiveofFinancialManagement

SOLUTIONSTOPROBLEMS:
1. Returns over the past 12 months:
a. +6.2%
b. +7.1%
c. +3.6%
d. +8.4%
2. Percentage Holding Period (HP) Return
= [(4400 - 4000 + 4(40))/4000] x 100%
= 14%
Note: This problem ignores transaction costs. Also, since the stock
has been sold, next years expected price performance is irrelevant.
3.

Percentage HP Return = [(9500 - 10,000 + 2(600))/10,000] x100%

= 7%
Note: This solution ignores interest the investor may have
received from reinvesting the first $600 interest payment.
The information about the common stock purchases is not
relevant in computing bond returns.

4. Percentage Holding Period Return:

= [($100,000 - $99,500)/$99,500] x 100% = 0.5025%
On an annual basis, this is slightly greater than 6%.
5. Percentage Holding Period Return:
= [($1,000 - $975 + $60)/$975] x 100% = 8.72%
6.a. Expected Percentage Holding Period Return =
[(65 - 60 + 4)/60] x 100% = 15.0%
b. Realized Percentage Holding Period Return =
[(75 - 60 + 4)/60] x 100% = 31.67%
c. Realized Percentage Holding Period Return =
[(58 - 60 + 4)/60] x 100% = 3.33%
d. Realized Percentage Holding Period Return =
[(50 - 60 + 4)/60] x 100% = -10.0%
7. Percentage Holding Period (HP) Return
= [($12,800 - $14,000)/$14,000] x 100%
= -8.57%
Note: The information about Treasury bill yields is not needed to
solve this problem.
8. Percentage Holding Period (HP) Return (based on equity investment
only)

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Chapter1
TheRoleandObjectiveofFinancialManagement
= [($190,000 - $110,000)/$33,000] x 100%
= 242.42% for 6 months
Percentage Holding Period (HP) Return (based on total original cost)
= [($190,000 - $110,000)/$110,000] x 100%
= 72.73%
9. Percentage Holding Period Return
= [($45 - $35)/$35] x 100% = 28.57%
The stock appears to be a good investment because the expected
return exceeds the required rate of return.
Costs of Automobile
10. Date

Exchange Rate

March 9, 2010
Feb 25, 2013

U.S. Dollar

$0.011113/Yen

Japanese Yen

$20,000

$0.010891/Yen

1,799,694*

$19,600**

1,799,694

* $20,000 $0.011113/Yen = 1,799,694 Yen

** 1,799,694 Yen x $0.010891/Yen = $19,600

11.

Cost per watch

Exchange

No. of

U.S.

Swiss

rate

watches

Dollar

Francs

$0.9299/franc

10,000

Date
a. 03/09/10
b. 02/25/13

$1.0728/franc

117.17**

12,000

117.17

Total Cost
U. S. Dollars
a. $1,171,674*
b. $1,622,040

Swiss Francs
1,260,000
1,512,000

* 1,260,000 francs x $0.9299/franc = $1,171,674

**$1,171,674/10,000 watches = $117.17/watch
126.0 francs x $1.0728/franc = $135.17/watch

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126.0
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Chapter1
TheRoleandObjectiveofFinancialManagement
$135.17/watch x 12,000 watches = $1,622,040

12.

Exchange Rate
Country

Currency
Rupee

3/9/10

2/25/13

0.02193

0.01845

1.4995

1.5165

a.

India

b.

UK

c.

Japan

Yen

0.011113

0.010891

d.

EuroArea

Euro

1.3600

1.3062

e.

Canada

Dollar

Pound

0.9744

0.9745

a. [(0.01845 - 0.02193)(100)]/0.02193 = -15.87%

b. [(1.5165 - 1.4995)(100)]/1.4995 = +1.13%
c. [(0.010891 - 0.011113)(100)]/0.011113 = -2.00%
d. [(1.3062 1.3600)(100)]/1.3600 = -3.96%
e. [(0.9745 - 0.9744)(100)]/0.9744 = +0.01%
13.

Holding Period Return (HPR):

HPR = [$45,000 - $15,000 - 10($500) - $400] / $15,000 = 164%

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Chapter1
TheRoleandObjectiveofFinancialManagement

CHAPTER3
EVALUATIONOFFINANCIAL
PERFORMANCE
ANSWERSTOQUESTIONS:
1.

Theprimarylimitationsofratioanalysisasatechniqueoffinancialstatementanalysisare:
a. Ratiosareretrospectiveanddonotdirectlyincorporateforecastsoffutureperformance
ofafirm.
b.Ratiosonlyindicatepotentialproblemareas;theydonotidentifycausesofproblems.
c. Agoodfinancialanalystmustselectthesetofratiosthatismostappropriateforthetype
offirmbeinganalyzed.
d.Ratiosdonotprovideabsolutemeasuresforevaluation;rathertheymustbeanalyzed
againstsomestandard.Thechoiceofanappropriatestandardforcomparisoncan
sometimesbeadifficultone.

2.

Themajorlimitationofthecurrentratioasameasureofliquidityistheinclusioninthe
currentassetsfigureofsomeassetsthatmaynotbehighlyliquid,suchasinventoryand,in
somecases,accountsreceivable.Thequickratio,whichdoesnotconsiderinventories,
helpstooffsetthisproblem.
Anotherlimitationisthefactthatitisastatic(basedonthebalancesheet)measureof
liquidity,whereasliquidityisadynamic(flow)concept.Also,thecurrentratiomaybe
manipulatedeasilybythefirm.Forexample,afirmwithacurrentratiogreaterthan1xcan
increasethatratiobyusingcashtopayoffsomecurrentliabilities.Endofyearbalance
sheetmanipulationsuchasthisiscommonamongfirmshavingcurrentratioconstraints
imposedaspartoftheirfinancingagreements.

3.

Above:Thefirmishavingcollectionproblems,possiblybecauseoftooliberalacredit
grantingpolicy,inadequatecollectionefforts,orfailuretowriteoffuncollectibleaccounts.
Below:Thecompanymaybeundulyrestrictiveingrantingcreditandthereforeitmaybe

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losingsomeotherwiseprofitableaccountstocompetitors.
4.

Above:Thecompanymaybecarryingtoolittleinventoryandthusmaybesubjectto
frequentandsignificant"stockout"costs.Astrategyofcarryingasmallinventorymay
causethecompanytolosecustomers.
Below:Thecompanymayhavealotofslowmovingorobsoleteinventory.Itmayalso
notbemakinguseofefficientinventorymanagementtechniques.

5.

Thefixedassetturnoverratioissubjecttofourmajorlimitationsincomparativeanalyses.
Theratioissensitiveto:
a. Thecostoftheassetsatthedateofacquisition.
b.Thelengthoftimesinceacquisition.
c. Thedepreciationpoliciesadopted.
d.Theextenttowhichfixedassetsareleasedratherthanowned.
Eachofthesefactorswilldifferfromfirmtofirm,makingmeaningfulcomparative
analysesdifficult.

6.

Thethreemostimportantdeterminantsofafirm'sreturnonstockholders'equityarenet
profitmargin(earningsaftertax/sales),thetotalassetturnover(sales/totalassets),andthe
equitymultiplier(totalassets/stockholdersequity).

7.

Alternativeaccountingprocedurescanhaveasignificantimpactonthevalidityof
comparativefinancialanalyses.Threeofthemostsignificantareasfordisagreement
betweenfirmsareinventoryvaluation(LIFOvs.FIFO,forexample),depreciationmethods
(straightline,acceleratedorMACRSdepreciation),andthetreatmentoffinancialleases
(capitalizedornot).Anyoneoftheseitemscanlimitcomparabilitybetweenfirms.

8.

Inflationcanimpactthecomparabilityoffinancialratiosbetweenfirmsinanumberof
ways.Oneimportantexampleistheexistenceofinventoryprofitsinaperiodofrising
prices.IfafirmusesFIFO,itwillshowhigherprofits(andalargerbalancesheetinventory
figure)intimesofrisingpricesthanafirmusingLIFO.Inflationalsoaffectsthecostof
fixedassetsandthedepreciationchargedagainsttheseassets.Firmsthatownolderassets
willtendtoreporthigherprofitsthanfirmswithnewlyacquiredassets.Theuseof
replacementcostaccountingcanoffsettheseproblems.

9.

TheP/Emultipleindicateshowmuchinvestorsarewillingtopayforeachdollarofcurrent
earnings.Withagreaterlevelofrisk,investorswillofferlessforadollarofearnings
becauseofthatrisk.Also,thegreaterthegrowthprospectsofthefirm'searnings,themore
investorswillbewillingtopayforadollarofcurrentearnings.

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10. Generallyearningsqualityisenhancedthegreaterthecashportionofearningsandthemore
theearningsarecomposedofrecurring,asopposedtononrecurringitems.Balancesheet
qualityisenhancedthegreatertheinclusionoftangible,asopposedtointangibleassets.
Also,themorenearlytheassetvaluesreportedonabalancesheetarereflectiveoftheir
actualmarketvalues,thehigherthebalancesheetquality.
11. AlowerP/Eratiocanbeexpectedforatypicalnaturalgasutilitythanforacomputer
technologyfirmbecausethegrowthprospectsaremuchlowerfortheutility.Offsettingthis
tosomeextentisalowerperceivedriskoftheutility.
12. Writeoffsofnonperformingassetsshouldincreasethefutureprofitabilityratios(e.g.,
returnonassetsandcommonequity)sincethefirmstotalassetsandretainedearnings(part
ofcommonequity)willbelower.Italsoshouldincreasethefinancialleverageratios
becauseretainedearnings(partofcommonequity)willbelower.Overthelongrun,the
writeoffsofnonperformingassetsshouldincreasethemarketvalueofthefirmsequity
securities,becauseanyproceedsfromthesalesoftheseassetscanbereinvestedinmore
profitableassets(i.e.,assetswithhigherexpectedratesofreturn).
13. a. Thebankmusthavealowerequitymultiplierthanotherbanksintheindustry,on
average.Thatisthebankisemployingmoreequity(foragivenleveloftotalassets)
comparedwithotherbanks.
b.Alowequitymultiplierimpliesthatthebankisfollowingafairlyconservativefinancial
leveragepolicy,whichwouldleadtolowerrequiredratesofreturnonitsdebt(kd)and
equity(ke)securities,allotherthingsbeingequal.Hence,allotherthingsbeingequal,this
shouldleadtohigherbondandstockprices.However,thebankmaybeearningabove
averagereturnsonitsassetsbyinvestinginhigherriskassetscomparedwithotherbanks.
Thiswouldleadtohigherrequiredratesofreturnonitsdebtandequitysecuritiesandthus,
allotherthingsbeingequal,lowerbondandstockprices.Theanswercannotbedetermined
withoutmoreinformationontherelativeriskinessofthebanksassets.
14. MVA(marketvalueadded)isequaltothepresentvalueofexpectedfutureEVA(economic
valueadded).EVAistheincrementalcontributionofafirmsoperationstothecreationof
MVA.

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SOLUTIONS TO PROBLEMS:
1.

a. 50 days = Accounts Receivable/($1,600,000/365 days)

50 days = Accounts Receivable/$4,383.56
Accounts Receivable = $219,178
b. Cost of sales = (1 - 0.35)($1,600,000) = $1,040,000
Inventory Turnover = 6 = Cost of Sales/Average Inventory
6 = $1,040,000/Average Inventory
Average Inventory = $173,333

2.

a. Return on stockholders' equity = 0.03 x

($20,000,000)/$10,000,000) x ($10,000,000/$4,000,000)
= 0.15 or 15%
b. Return on stockholders' equity = 0.05 x 2.0 x 2.5 = 0.25 or 25%

3.

Credit sales = 0.8($40 million) = $32 million

Average daily credit sales = $32 million/365 days/yr.
= $87,671.23
Average accounts receivable = 45 x $87,671.23 = $3,945,205

4.

Return on stockholders' equity = 18% = (EAT/Sales) x 1.0 x 2.0

EAT/ Sales = 9.0%

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Chapter1
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5.

a.
Firm
A

Total Asset Turnover

1.33x

1.33x

1.00x

1.04x

Net Profit Margin

0.15

0.05

0.15

0.12

Equity Multiplier

1.50x

1.50x

1.07x

2.40x

Return on Equity

0.30

0.10

0.16

0.30

b.

Firm A appears to have few problems in comparison with the other

firms.
Firm B has a very weak profit margin, indicating the need for corrective
action to control costs or to change the firm's pricing strategy.
Firm C has a low asset turnover, suggesting the existence of excessive
investments in fixed assets and/or short-term assets. The low equity
multiplier suggests that the firm has not made as much use of debt as the
competing firms. This low turnover and low equity multiplier have combined
to give Firm C a lower than average return on equity.

Firm D has a lower than average asset turnover and an average profit
margin. The high return on equity has doubtlessly been earned by assuming
a very risky (debt-heavy) capital structure. This heavy use of debt exposes
the firm to substantial financial risk.

More detail about the determinants of the net profit margin and the
total asset turnover ratio would be valuable. This information could be in the
form of a Dupont chart. Also, it would be useful to know if all firms use
similar financial reporting methods.

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6.

Forecasted Balance Sheet

Cash

$104,000

Accounts receivable 1,096,000

Total current liabilities $1,200,000

Inventory

Long term debt

1,200,000

Total current assets $2,400,000

Net fixed assets
Total assets

Total debt

7,600,000

2,800,000
$4,000,000

Stockholders' equity

$10,000,000

Total liabilities and

6,000,000
$10,000,000

stockholders equity
a. Profit margin on sales = 0.05 = $1,000,000/Sales
Sales = $20,000,000
b. Total asset turnover = 2 = $20,000,000/Total assets
Total assets = $10,000,000
c. Total debt to total assets = 0.4 = Total debt/$10,000,000
Total debt = $4,000,000
d. Current liabilities to stockholders equity = 0.2 = Current
liabilities/$6,000,000
Current liabilities = $1,200,000
e. Current ratio = 2 = Current assets/$1,200,000
Current assets = $2,400,000
f.

Fixed assets = Total assets minus current assets

= $10,000,000 - $2,400,000 = $7,600,000

g. Quick ratio = 1 = ($2,400,000 - Inventories)/$1,200,000

Inventories = $1,200,000
h. Average collection period = 20 days
= Accounts receivable/($20,000,000/365)
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Accounts receivable = $1,096,000 (rounded to the nearest $1,000)
i.

Cash = Current assets minus accounts receivable minus

inventories
Cash = $2,400,000 - $1,096,000 - $1,200,000 = $104,000

7.

Reduction in accounts receivable = $5 million (20 days x $0.25

million per day)
New total assets after stock repurchase = $95 million
New common equity after stock repurchase = $35 million
Debt ratio: Old = 60%
New = 63% ($60/$95)
Return on assets: Old = 5% ($5/$100)
New = 5.26% ($5/$95)
Return on common equity: Old = 12.5% ($5/$40)
New = 14.29% ($5/$35)

8.

a. Current ratio = $3.0/$1.5 = 2x

Quick ratio = ($3.0 - $1.0)/$1.5 = 1.33x
b. Current ratio = ($3.0 - $0.25)/($1.5 - $0.25) = 2.2x
Quick ratio = ($3.0 - $1.0 - $0.25)/($1.5 - $0.25) = 1.4x
Both the current and quick ratios rise, even though real liquidity has
declined (cash balances are cut in half).

c. Current ratio = ($3.0 - $0.5)/($1.5 - $0.5) = 2.5x

Quick ratio = ($3.0 - $1.0 - $0.5)/($1.5 - $0.5) = 1.5x
Both the current and the quick ratios rise.

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d. Current ratio = ($3.0 + $1.0)/$1.5 = 2.67x

Quick ratio = ($3.0 - $1.0 + $1.0)/$1.5 = 2.0x
Both the current and the quick ratios rise.
e. These examples illustrate how easy it is for a firm to manipulate its
current and quick ratios, if necessary. Consequently, conclusions based
on an analysis of these ratios

9.

should be viewed with caution.

a. Return on equity = $600,000/$2,400,000 = 0.25 or 25%

b. Sales = $600,000/.10 = $6,000,000
Total asset turnover = $6,000,000/$4,000,000 = 1.5x
Equity multiplier = $4,000,000/$2,400,000 = 1.67x

Gulf combines a significantly higher than average profit margin (10% vs. 6%)
and a somewhat higher equity multiplier (1.67x vs. 1.4x) with a significantly
lower than average total asset turnover to achieve results that are greater
than the industry average return on equity (25% vs. 21%). However, the
higher equity multiplier of Gulf indicates a higher level of financial risk. This
offsets, at least in part, the value of the higher achieved returns.

10. a. Jackson's current ratio is 1.88x compared to the industry

average of 2.5 times. Jackson's quick ratio is 0.66x compared to an
industry average of 1.1x. Jackson has net working capital of
$750,000. Jackson's liquidity is considerably below that of the
industry average. Based on a comparison of the firm's current
ratio to that of the industry and the firm's quick ratio to that of the
industry, there is some evidence that Jackson may carry excessive or

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slow moving inventory.
b.

The company has an average collection period of 38.9 days

compared to an industry average of 35 days. The company's
inventory turnover ratio is only 1.73x compared to an industry
average of 2.4x. This provides additional evidence of Jackson's
potential inventory problems. Finally, Jackson's total asset
turnover ratio of 1.25x is below the industry average of 1.4x,
probably because of the inventory problems and the slightly
higher than average receivables balance.

c.

The company's times interest earned ratio is 2.89x compared to

the industry average of 3.5x. The company's total assets to
stockholders' equity ratio is 3.2x compared to the industry
average of 3.0x. This slightly higher amount of financial
leverage and significantly lower interest coverage ratio suggest
that Jackson either pays very high interest charges relative to
other firms, is less profitable than the average firm or a combination
of both. In any case the firm appears to have more financial risk
than the average firm.

d.

Jackson's net profit margin of 4.44% exceeds the industry

average of 4.0%. The company's return on investment of 5.56%
is only slightly below the industry average of 5.6%. Jackson's
return on stockholders' equity of 17.78% exceeds the industry
average of 16.8% because of the higher level of financial
leverage used by Jackson.

e.

Jackson seems to be carrying excessive inventory, resulting in a

lower asset turnover. The company's liquidity position is also
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weak (quick ratio). In spite of these areas for potential improvement,
the firm has outperformed the average firm in the industry and has
assumed more financial risk in doing this.
f.

ROE = Net profit margin times Total asset turnover times

Equity multiplier
ROE = ($133,320/$3,000,000) x ($3,000,000/$2,400,000) x
($2,400,000/$750,000)
ROE = 0.1778 or 17.8%
The primary area for improvement is total asset turnover (especially
inventories).
g. The biggest factor that can explain Jackson's lower P/E ratio relative to
the industry average is the higher amount of financial risk the firm
possesses.
Also, Jackson could be perceived as having a lower growth potential
than the average firm, although there is no direct evidence presented
in the data to indicate this.

11.

Profiteers, Inc.
ROI
ROE

2009

2010

2011

17.64% 14.64% 13.20%

23.64

20.50

21.25

2012

2013

10.71% 12.10%
17.67

19.72

Industry Average
ROI
ROE

15.00% 13.97% 14.30% 13.10% 13.40%

21.30

20.26

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21.02

19.78

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In the face of declining profit margins and less than average efficiency
of asset utilization, Profiteers has maintained its ROE by using more financial
leverage.

12.

a. The current ratio will increase because of the current asset

increase.
b. The return on stockholders' equity will decline because of the
increase in stockholders' equity, assuming no immediate impact on
profits from increasing inventory.
c. The quick ratio will increase because of the cash balance
increase.
d. The debt to total assets ratio will decline because of the increase in
total assets.
e. The total asset turnover ratio will decline because of the
increase in total assets.

13.

a. Return on equity = $2,000,000/$7,000,000 = 28.57%

b. Keystones net profit margin (8%) is significantly below the industry
average of 10%. Sales for Keystone are $25,000,000 ($2 million/0.08).
Keystones total asset turnover ratio is 1.5625x, compared to the
industry average of 2.0 times. Keystone has made up for these
deficiencies by assuming considerably more financial risk (equity
multiplier of 2.29x vs. an industry average of 1.5 times). Thus, overall
Keystones return on equity is below the industry average of 30% and
its level of financial risk is higher.

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c. Quick ratio = (Current assets - Inventories) / Current liabilities

= ($6 million - $3.2 million) / $3.5 million
= 0.80

14.

Cost of sales = 0.5($290,000,000) = $145,000,000

Inventory turnover (beginning of year inventory)
= $145,000,000/$25,000,000 = 5.8x
Inventory turnover (end of year inventory)
= $145,000,000/$30,000,000 = 4.83x
Monthly average inventory = $43,333,333
Inventory turnover (monthly average inventory)
= $145,000,000/$43,333,333 = 3.35x
Because of the seasonal nature of Palmer's business, the monthly
average inventory turnover is more indicative of the success of

Palmer's inventory management.

15.

The stock of both firms likely is valued on the basis of the projected
earning capacity of the firm. Obviously, the earning capacity of the
assets of Jenkins is not impressive relative to depreciated cost of
the assets the firm has in place. If Jenkins were to liquidate, it is
doubtful if the company would be able to sell its assets for their book
value because of their depressed earning capacity. In contrast,
Dataquest's earnings are not closely related to its tangible assets. For
a software firm, these assets are likely to be relatively small. The
largest asset of a software development firm is its human "capital".
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Having the copyright on a leading piece of software can generate large
projected earnings streams, and consequently a high market to book
ratio.
16.

Hoffmans present debt ratio is 44.25% ($500,000 / $1,130,000).

Hoffman could borrow an additional $130,000 and still maintain its debt
ratio at 50%:
0.5 = ($500,000 + X) / ($1,130,000 + X)
X = $130,000

If Hoffman borrows $130,000 on a short-term basis and invests this amount

in inventory and receivables, its current ratio remains above 1.5 times.
Current ratio = ($450,000 + $130,000) / ($200,000 + $130,000)
= 1.76
Therefore, Hoffman can borrow up to $130,000 without violating the terms of
its borrowing agreement.

17. a. EAT = $12 million

EBT = EAT/(1 - T)
= $12 million / (1 -0.40) = $20 million
EBIT = EBT + I
= $20 million + $5 million = $25 million
Times Interest Earned = EBIT/I
= $25 million/$5 million = 5.0 times
b. Interest = EBIT/Times Interest Earned
= $25 million/3.50 = $7.14 million
Additional interest = $7.14 million - $5 million = $2.14 million

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Additional debt = Additional interest/Interest rate
= $2.14 million/0.10 = $21.4 million
c. Additional debt = $2.14 million/0.12 = $17.83 million
As interest rates increase, the firm's debt capacity (as
measured by the times interest earned ratio) decreases.

18. a. EPS = EAT / (Average number of shares outstanding)

= $21,000,000/5,000,000 = $4.20
b. Price/earnings ratio = Market price/EPS
= $32/$4.20 = 7.6
c. Book value per share = (Common stock + Contributed capital in excess
of par value + Retained earnings)/(Average number of shares
outstanding)
= ($5,000,000 + $20,000,000 + $55,000,000)/5,000,000
= $16
d. P/BV = $32 / $16 = 2.0

e.EVEBITAmultiple=EV/EBITA
EVorEnterpriseValue=Marketvalueofequity+Marketvalueofdebt
MarketValueofEquity=Marketpriceofstockxnumberofsharesoutstanding
=$32x5million=$160million
Marketvalueofdebt=Longtermdebt+currentliabilities
=$40million+$30million=$70million
EV=$160million+$70million=$230million
EBITDA=EBIT+Depreciation=$40million+$10million=$50million
EVEBITDAmultiple=$230million/$50million=4.6times
f. Addition to retained earnings = net income - dividends
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= $21 million - $10 million = $11 million

g.

Balance Sheet

Current assets
Fixed assets, net

$ 60

Current liabilities

110

$ 20

Long-term debt

40

Common stock ($1 par)

Contributed capital in
excess of par value

49

Retained earnings

55

$170

$170

19.
Forecasted Balance Sheet
Cash

$128,500

Accounts payable

$164,250

Accounts receivable

200,000

Total current liabilities

$164,250

Inventory

164,250

Total current assets

$492,750

Fixed assets

419,750

Total assets

$912,500

Long-term debt

$200,750

Stockholders equity

$547,500

Total liabilities
and equity

$912,500

a. Total assets = $3,650,000/4 = $912,500

b. Total debt = .40($912,500) = $365,000
Stockholders equity = $912,500 $365,000 = $547,500
c. Current liabilities = .30($547,500) = $164,250
d. Accounts payable = $164,250
e. Current assets = 3($164,250) = $492,750

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f. Fixed assets = $912,500 $492,750 = $419,750
g. Accounts receivable = ($3,650,000/365)(20) = $200,000

h. ($492,750-Inventory)/$164,250 = 2
Inventory = $164,250
i.

Cash = $492,750 $200,000 $164,250 = $128,500

j.

Long-term debt = $365,000 $164,250 = $200,750

k. Total liabilities and equity = $912,500

20.

a. Current ratio = $5,750/$3,000 = 1.92 (no change)

Quick ratio = ($5,750 $2,000)/$3,000 = 1.25 (increase)
Debt-to-equity ratio = $4,750/$6,000 = 0.79 (no change)
b. Current ratio = $5,250/$3,000 = 1.75 (decrease)
Quick ratio = ($5,250 $2,500)/$3,000 = 0.92 (decrease)
Debt-to-equity ratio = $4,750/$6,000 = 0.79 (no change)
c. Current ratio = $6,250/$3,500 = 1.79 (decrease)
Quick ratio = ($6,250 $3,000)/$3,500 = 0.93 (decrease)
Debt-to-equity ratio = $5,250/$6,000= 0.88 (increase)
d. Current ratio = $5,750/$3,000 = 1.92 (no change)
Quick ratio = ($5,750 $2,500)/$3,000 = 1.08 (no change)
Debt-to-equity ratio = $6,750/$6,000 = 1.13 (increase)
e. Current ratio = $5,750/$3,000 = 1.92 (no change)
Quick ratio = ($5,750 $2,500)/$3,000 = 1.08 (no change)
Debt-to-equity ratio = $4,750/$8,000 = 0.59 (decrease)

21. a. No improvement in liquidity, because the cash that is raised is tied up in

a very non-liquid asset.

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b. No improvement in liquidity, because the firms most liquid assets (cash
and marketable securities) are consumed. Even though the current ratio
will increase, liquidity will actually decline.
c. Yes, because the debt service on long-term debt is normally less than on
short-term debt. There is no immediate refinancing risk on long-term
debt. More cashflow will be available for other uses.
d. Yes, because non-liquid assets become liquid assets.
22. No recommended solution.

CHAPTER4
FINANCIALPLANNINGAND
FORECASTING
ANSWERSTOQUESTIONS:
1.Deferredtaxesarisebecauseofthetimingdifferenceofsomeexpensesasrecordedfor
financialreportingpurposesandthesesameexpensesasrecordedforthepurposeofmakingtax
filings.Forexample,mostfirmsuseaccelerateddepreciationfortaxpurposesandstraightline
depreciationforfinancialreporting.Consequently,taxableincomeishigheronthecompanys
publicfinancialstatementsandtaxespaidalsoishigher.Actualtaxespaidaredetermined
fromacompanystaxfilings.Thedifferencebetweentaxesactuallypaid,andtaxesshownas
beingpaidonafirmspublicfinancialstatementsisrecordedasdeferredtaxesontherighthand
sideofthebalancesheet.
2.Proformafinancialstatementsarefinancialstatementsthatprojecttheresultsofsome
assumedeventsratherthanactualevents.Theassumedeventsdonotnecessarilyhavetobe
futureevents;forexample,acompanyconsideringacquiringanothercompanywillusually
prepareproformastatementsassumingthetwocompanieshadbeenmergedforthepastcouple
ofyears.
3.Thepercentageofsalesforecastingmethodisamethodofestimatingtheadditionalfinancing
thatwillbeneededtosupportagivenfuturesaleslevel.Financialanalystsshouldbeawarethat
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Chapter1
TheRoleandObjectiveofFinancialManagement
themethodassumesthatasacompany'ssalesincrease,itsassetsarealsoassumedtoincrease
proportionatelytosupportthenewsales.Inaddition,thecurrentliabilitiesthatvarydirectlywith
salesarealsoassumedtoincreaseproportionatelywiththenewsales.Theseassumptionsmay
notholdinmanyactualfinancialplanningsituations.
4.Acashbudgetisaprojectionofacompany'scashreceiptsanddisbursementsoversome
futureperiodoftime.Normallyaworksheetisprepared,showingexpectedreceiptsand
disbursementsoverthetimeperiod.Then,thereceiptsanddisbursementsfigures(normally,
monthly)arecombinedtodeterminewhenthecompanywillrequireshorttermfinancingand
whenitwillhaveexcesscash.
5.Thestatementofcashflowscanbeusedtoestimatehowmuchexternalfinancingacompany
willneedinsomefutureperiodbyestimatingtheothercashflowsofthecompanyfortheperiod.
6.Adeterministicmodelprovidesasinglenumberforecastofafinancialvariable(orvariables)
withoutspecifyingtheprobabilityofoccurrenceofthesevariables.Aprobabilisticmodel
generatesasoutputaprobabilitydistributionofpossiblevaluesofthefinancialvariable(s).

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SOLUTIONS TO PROBLEMS:
1.

ATCF = EAT + Depreciation + Deferred taxes

= $650,000 + $400,000 + $100,000
= $1,150,000

2.MidlandManufacturingCorporation
StatementofCashFlowsFortheYearEndedDecember31,2013
($millions)
CashFlowsfromOperatingActivities:
Netincome
$8.3
Adjustmentstoreconcilenetincometonetcashprovided
fromoperatingactivities
Depreciation
9.5
(Increase)decreaseincurrentassetsorliabilities
Accountsreceivable
(0.3)
Inventories
(0.7)
Accountspayable
1.5
Othercurrentliabilities
2.2
Increase(decrease)indeferredtaxes
0.2
Totaladjustments
12.4
Netcashprovidedfrom(usedby)operatingactivities
20.7
CashFlowsfromInvestingActivities
Proceedsfromsaleoffacilitiesorequipment
Capitalexpenditures($115.0$80.7+$1.0)
Netcashusedbyinvestingactivities

1.0
(35.3)
(34.3)

CashFlowsfromFinancingActivities
Proceedsfromissuanceoflongtermdebt
Repaymentsoflongtermdebt
Dividendspaid
Netcashprovidedfrom(usedby)financingactivities

15.0
(2.0)
(3.5)
9.5

NetIncrease(Decrease)inCash
CashBeginningofYear
CashEndofYear

(4.1)
4.9
$0.8

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3. a. Additional
Financing = [(A/S)(S) - (CL/S)(S)] - [EAT - D]
Needed
A = $7,500,000
S = $3,750,000

S = $15,000,000

CL = $1,500,000

D = $250,000

EAT = $18,750,000 - $18,000,000 = $750,000

Additional
Financing = [(7,500,000/15,000,000)(3,750,000) - (1,500,000/
Needed
15,000,000)(3,750,000)] - [750,000 - 250,000]
= $1,000,000
BalanceSheet
asofDecember31,2014
AssetsLiabilities
Cash

$625,000Accountspayable

$1,875,000

AccountsReceivable

2,500,000Notespayable 2,000,000

Inventories

5,000,000TotalCur.Liabilities3,875,000

TotalCur.Assets
500,000

8,125,000LongtermDebt

Fixedassets,net

1,250,000Stockholders'equity 5,000,000

Totalassets
$9,375,000Totalliabilitiesand $9,375,000
equity

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Chapter1
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IncomeStatement
fortheYearEndingDecember31,2014
Sales

$18,750,000

Expenses,includinginterestandtaxes

18,000,000

EAT

Dividends

750,000
250,000

Additiontoretainedearnings

$500,000
SelectedFinancialRatios

Currentratio

2.10times

Debtratio

46.7%

Rateofreturnonstockholdersequity

15.0%

Netprofitmarginonsales(EAT/Sales)

4.0%

Partb.c.
Add.FinancingNeeded$500,000$800,000
BalanceSheet
asofDec.31,2014
Assets
Cash

$600,000

$650,000

Accountsreceivable

2,400,000

2,600,000

Inventories

4,800,000

5,200,000

Tot.cur.assets

7,800,000

8,450,000

Fixedassets,net

1,200,000

1,300,000

Totalassets

$9,000,000

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$9,750,000

Chapter1
TheRoleandObjectiveofFinancialManagement
Liabilitiesandequityb.c.
Accountspayable

$1,800,000

$1,950,000

Notespayable

1,500,000

1,800,000

Tot.cur.liab.

3,300,000

3,750,000

Longtermdebt

500,000

Stockholders'equity
Totalliabilities
andequity

500,000

5,200,000
$9,000,000

5,500,000
$9,750,000

IncomeStatement
forYearEndingDec.31,2014
Sales$18,000,000$19,500,000
Expenses,including
interest&taxes17,050,00018,250,000
EAT950,0001,250,000
Dividends250,000250,000
Additionstoretained
earnings$700,000$1,000,000
SelectedFinancialRatios
Currentratio2.362.25
Debtratio42.2%43.6%
Returnonstockholders'
equity18.3%22.7%
Netprofitmarginonsales5.28%6.41%

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4.
AtlasProductsInc.
CashBudgetWorksheet
FirstQuarter,2014
DecemberJanuaryFebruaryMarch
EstimatedSales$825,000$730,000$840,000$920,000
EstimatedCreditSales
770,000690,000780,000855,000
EstimatedReceipts:
Cashsales
40,00060,00065,000

CollectionsofAccountsReceivable
75%oflastmonthscreditsales577,500517,500585,000
25%ofcurrentmonthcreditsales172,500195,000213,750
TotalAccountsReceivablecollections750,000712,500798,750
Estimatedpurchases$438,000504,000552,000
Estimatedpaymentsofaccountspayable438,000504,000552,000

CashBudget
FirstQuarter,2014
DecemberJanuaryFebruaryMarch
Sales
Projectedcashbalance
beginningofmonth

$825,000 $730,000 $840,000

$920,000

$100,000 $100,000

$100,000

Receipts:
Cashsales
Collectionofaccountsreceivable
Totalcashavailable

40,000
60,000
65,000
750,000712,500798,750
$890,000

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963,750

Chapter1
TheRoleandObjectiveofFinancialManagement

Disbursements:
Paymentofaccountspayable
$438,000 $504,000 $552,000
Wagesandsalaries
250,000 290,000
290,000
Rent
27,000
27,000
27,000
Otherexpenses
10,000
12,000
14,000
Taxes
105,000

Dividendsoncommonstock

40,000
Purchaseofnewequipment(capitalbudget) 75,000
Totaldisbursements

$830,000 $908,000
$60,000 ($35,500)

$923,000

Excessofavailablecashover
disbursements
Cashloansneededtomaintain
balanceof$100,000

40,000 135,500

Projectedcashbalance,endofmonth

$100,000$100,000 $100,000

*Purchasesareestimatedat60%ofnextmonthssales.
**Paymentsareestimatedtolagpurchasesbyonemonth

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Chapter1
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5.ElmwoodManufacturingCompany
CashBudgetWorksheet
FirstQuarter,2014
DecemberJanuaryFebruaryMarchApril
EstimatedSales
(alloncredit)

$4,600,000 $6,400,000

EstimatedReceipts
60%oflastmonthssales
40%ofcurrentmonthssales

TotalA/RCollections

$11,200,000

$8,400,000$7,000,000

2,760,000
2,560,000

3,840,000
4,480,000

6,720,000
3,360,000

5,320,000

8,320,000

10,080,000

EstimatedPurchases*

1,920,000

3,360,000

2,520,000

EstimatedPayments**

1,920,000

3,360,000

2,520,000

*30%ofnextmonthsestimatedsales
** Paymentslagpurchasesbyonemonth

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Chapter1
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Cash Budget
First Quarter, 2014
DecemberJanuaryFebruaryMarchApril
Sales
$4,600,000
$6,400,000

$11,200,000

$8,400,000

$7,000,000
Projectedcash
balance,beginning
ofmonth
Receipts:
CollectionofA/R
Totalcashavailable

$1,500,000

$750,000

$750,000

5,320,000
$6,820,000

8,320,000 10,080,000
$9,070,000 $10,830,000

Disbursements
PaymentsofA/P
$1,920,000
Laborexpenses
3,920,000
Factoryoverhead
650,000
Sellingandadm.Expenses
1,275,000
Taxes

Dividends

Purchaseofnewequipment
Totaldisbursements
$7,765,000

$3,360,000 $2,520,000
2,940,000
2,450,000
670,000
670,000
1,285,000
1,310,000

1,600,000

650,000
1,500,000

$9,755,000 $9,200,000

Excessofavailablecash
overdisbursements

($945,000)

($685,000) $1,630,000

Incrementalcashloansneeded
tomaintainabalanceof
$750,000
$1,695,000
$1,435,000
Loanrepayment
0

0
Projectedcashbalance,
endofmonth
$750,000
$750,000

137

$880,000
$750,000

Chapter1
TheRoleandObjectiveofFinancialManagement

6.PodraskyCorporation
ProFormaStatementofCashFlows
($millions)
CashFlowsfromOperatingActivities:
Netincome
$80
Adjustmentstoreconcilenetincometonetcashprovided
fromoperatingactivities
Depreciation
80
(Increase)decreaseincurrentassetsorliabilities
Accountsreceivable
(20)
Inventories
(20)
Totaladjustments
40
Netcashprovidedfrom(usedby)operatingactivities
120
CashFlowsfromInvestingActivities
Capitalexpenditures
Netcashusedbyinvestingactivities

(200)
(200)

CashFlowsfromFinancingActivities
Additionalfinancing
Repaymentsoflongtermdebt
Dividendspaid
Requiredincreaseincashbalance
Netcashprovidedfrom(usedby)financingactivities

X
(10)
(15)
(3)
(28)+X

Inthisproblem,theexpectedcashflowsmustequalzero.Therefore,
$120$20028+X=0
X=$108
Therefore,theadditionalfinancingrequiredis$108million.

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Chapter1
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7. a. A = $2,300,000
S = $4,000,000
S = $2,000,000
D = $50,000
EAT = $400,000
CL = $600,000
Additional
Financing = [(A/S)(S) - (CL/S)(S)] - [EAT - D]
Needed
= [(2,300,000/4,000,000)(2,000,000)
- (600,000/4,000,000)(2,000,000)]
- [400,000 - 50,000]
= $500,000
ProFormaBalanceSheetasofDec.31,2014
AssetsLiabilities
Cash$300,000AccountsPayable$900,000
AccountsReceivable600,000NotesPayable1,000,000
Inventories1,800,000LongtermDebt200,000
FixedAssets,net750,000StockholdersEquity1,350,000
TotalAssets$3,450,000TotalLiabilitiesand
Stockholders'Equity$3,450,000

b.

Projected additional sales are $2,000,000.

The required investment in accounts receivable for the projected
sales increase, assuming a 60-day average collection period is
$2,000,000 x (60/365) = $328,767
The increase in accounts receivable projected in Part a is
$200,000. Therefore, a 60-day average collection period will
increase the additional financing needed by
$328,767 - $200,000 = $128,767

c.

Pro forma current ratio = 1.6

1.6 = ($300,000 + $600,000 + $1,800,000)/CL
CL = $1,687,500

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Chapter1
TheRoleandObjectiveofFinancialManagement
The pro forma current liabilities before any additional financing is
$1,400,000 (i.e., A/P = $900,000 and N/P = $500,000). Therefore a
maximum of:
$1,687,500 - $1,400,000 = $287,500
could be in additional N/P. The remainder of the needed financing
would have to be either LTD (possibly secured by the increase in F/A)
or equity.
8.

Table 4-4 Example

Additional
Financing = [(A/S)(S) - (CL/S)S] - (EAT - D]
Needed
A = $6,500,000 (excluding fixed assets); S = $15,000,000
CL = $1,500,000

a.

S = $3,750,000

D = $250,000
EAT = $18,750,000 - $18,000,000 = $750,000

Additional
Financing = [(6,500,000/15,000,000)(3,750,000)
Needed

- (1,500,000/15,000,000)(3,750,000)]
- [750,000 - 250,000]
= $750,000

b.

S = $3,000,000

EAT = 18,000,000 - 17,050,000 = $950,000

Additional
Financing = [(6,500,000/15,000,000)(3,000,000)
Needed

- (1,500,000/15,000,000)(3,000,000)]
- [950,000 - 250,000]
= $300,000

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Chapter1
TheRoleandObjectiveofFinancialManagement

c.

S = $4,500,000

EAT = 19,500,000 - 18,250,000 = $1,250,000

Additional
Financing = [(6,500,000/15,000,000)(4,500,000)
Needed

- (1,500,000/15,000,000)(4,500,000)]
- [1,250,000 - 250,000]
= $500,000

9. Available funds before capital expansion

= EAT plus Tax Depreciation minus Dividends minus Increase in
current assets plus Increase in current liabilities minus Reduction
in long-term debt
= $40 + $18 - $12 - $5 + $2 - $8 = $35
Therefore, external financing required is $75 (capital expenditures)
minus $35 (available funds) or $40 million.

10.

Sales growth = 50 percent

Cash growth = +$2
Accounts receivable growth = +$5
Inventory growth = +$7.5
Net fixed asset growth = +$10
Accounts payable growth = +$3
EAT = $10
Dividends = $1

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Chapter1
TheRoleandObjectiveofFinancialManagement
External financing needed = +2 + 5 + 7.5 + 10 - 3 - (10 - 1)
= $12.5 million
This amount overstates total financing needs because the problem does not
include depreciation information. Financing needs would be reduced by the
amount of the expected tax depreciation a non-cash expense.

11. No recommended solution

142