BUAD 611 – Managerial Finance
Chapter Problems and Solutions - From Analysis for Financial Management
Chapter 1
1 – What happens to a company’s equity when assets rise $1 million and liabilities fall $2 million?
2 – What does it mean when cash flow from operations on a company’s cash flow statement is negative? Is this bad news? If so, it is dangerous?
3 –a – Is a company better or worse off when the market value of its assets rises $10 million? Why?
b - Is a company better or worse off when the market value of its liabilities falls $10 million? Why?
c - If you owned a company, would you prefer the market value of its assets to rise $10 million or the market value of its liabilities to fall $10 million?
4 – You manage a real estate investment company. One year ago the company purchased 10 parcels of land distributed throughout the community for $1 million each. A recent appraisal of the properties indicates that five of the parcels are now worth $600,000 each. While the other five are worth $1.5 million each.
Ignoring any income received from the properties over the year, calculate the investment company’s accounting earnings and its economic earnings in each of the following cases:
a – The company sells all of the properties at their appraisal values today.
b – The company sells none of the properties.
c – The company sells the properties that have fallen in value and keep the others.
d-The company sells the properties that have risen in value and keeps the others.
e-Upon returning from a property management seminar, an employee recommends the bank adopt an end-of-the-year policy of always selling properties that have risen in avlue since purchase and always retaining properties that have fallen in value. The employee explains that with this policy the company will never show a loss on its real estate investment activities. Do you agree with the employee? Why or why not?
5 – Selected information about Adams Wright Corporation follows.
($ in millions)1996 / 1997
Net Sales / $52 / $78
Cost of goods sold / 30 / 41
Depreciation / 10 / 12
Net income / 5 / 8
Finished goods inventory / 6 / 5
Accounts receivable / 10 / 15
Accounts payable / 6 / 9
Net fixed assets / 80 / 84
a-During 1997, how much cash did Adams Wright collect from sales?
b- During 1997, what was the cost of goods produced by the company?
c- Assuming the company sold no assets during the year, what were its capital expenditures during 1997?
6-Why do you suppose financial statements are constructed on an accrual basis rather than a cash basis when accounting is so much easier to understand?
7-Table 3-1 in Chapter 3 presents financial statements over the period 1993-1996 for R&E Suppliers, Inc.
a-Construct a sources and uses statement for the company from 1993 through 1996 (one statement for all three years).
b- What insights, if any, does the sources and uses statement give you about the financial position of R&E Supplies?
8-Use the following information to estimate ZTZ Corporation’s net cash flow from operations as it would appear on the company’s 1997 cash flow statement.
1996 / 1997Net Sales / $600 / $800
Cost of goods sold / 320 / 400
Gross income / 280 / 400
Depreciation / 60 / 80
General, selling expenses / 40 / 40
Income taz before / 180 / 280
Provision for taxes @ 40% / 72 / 112
Income tax after / 108 / 168
Cash / $200 / $100
Accounts receivable / 100 / 200
Inventory / 120 / 80
Accrued taxes / 200 / 240
Accrued wages / 120 / 60
Accounts payable / 60 / 80
9-Following are summary cash flow statements for three roughly equal-sized companies.
($ millions)A / B / C
Net cash flows from operations / $(100) / $(100) / $100
Net cash used in investing activities / (300) / (10) / (30)
Net cash from financing activities / 400 / 70 / (80)
Cash balance at the beginning of the year / 50 / 50 / 50
a-Calculate each company’s cash balance at the end of the year.
b-Explain what might cause company C’s net cash from financing activities to be negative.
c-Looking at companies A and B, which company would you prefer to own? Why?
d-Is company C’s cash flow statement cause for any concern on the part of C’s management or shareholders? Why or why not?
10- You are responsible for labor relations in your company. During heated labor negotiations, the general secretary of your largest union exclaims, “Look, this company has a $1 billion worth of assets, $500 million worth of equity, and made a profit last year of $40 million-due largely, I might add, to the effort of the union employees. So don’t tell me you can’t afford our wage demands.” How would you reply?
Chapter 2
- A company is considering the acquisitions of a very promising biotechnology company. One executive argues against the move, pointing out that because the biotech company is presently losing money, the acquiring company’s return on equity will fall.
- Is the executive correct in predicting that ROE will fall?
The return on equity (ROE) is define as the ratio between the Net Income and Shareholders’ equity. Since the company is losing money the Net Income will decrease and consequently the ROE.
b. How important should changes in ROE be in this decision?
The ROE only is not sufficient to make the decision to acquire or not a company. A time-dependent figure of merit would be necessary for a proper evaluation of the decision to acquire the company.
2. Top management measures your divisions performance by calculating the divisions return on investment, defined as division operating income per period divided by division assets. Your division has done quite well lately; its ROI is 40 percent. You believe the division should invest in a new production process, but a college disagrees, pointing out that because the new investments first-year ROI is only 35 percent, it will hurt performance. How would you respond?
First, in order to properly evaluate an investment decision several years of data is required. Secondly, investment return should be compared to the division’s historical return e year Once again is necessary to take timing into consideration
3. Answer the questions that follow based on the following information.
Company A / Company BEarning before interest and taxes / $300 / $560
Interest expense / 20 / 160
Earnings before tax / 280 / 400
Taxes at 40% / 112 / 160
Earning after tax / 168 / 240
Debt / 200 / 1,600
Equity / 800 / 400
a. Calculate each company’s ROE, ROA, and ROIC.
b. Why is company B’s ROE so much higher than A’s? Does this mean B is a better company? Why or why not?
c. Why is company A’s ROA higher than B’s? What does this tell you about the two companies?
4. Table 3-1 in Chapter 3 presents financial statements over the period 1993 through 1996 for R&E Supplies, Inc.
a. Use these statements to calculate as many of the ratios in Table 2-2 as you can.
b. What insights, if any, do these ratios for R&E Supplies provide about R&E’s financial performance? What problems, if any, does the company appear to have?
5. Selected information for DressMiss, Inc., a young woman’s clothing store, follows. (Assume all sales are credit sales, ratios are based on a 365-day year, and the payables period is based on cost of goods sold.)
Net sales / $1,200Cost of goods sold / 800
Net income after tax / 100
Accounts receivable / 200
Accounts payable / 80
Ending inventory / 400
a. Calculate the collection period.
b. Calculate the payables period.
c. Calculate the inventory period, defined as
Ending inventory/Cost of goods sold per day
d. How many days elapse, on average, between
(1) The time the company is billed for a purchase and the time it receives cash from the sale of the items purchased?
(2) The time the company is billed for a purchase and the time it pays for the purchase?
(3) The time that company pays for a purchase and the time it receives cash from the sale of the items purchase?
e. The cash cycle is defined as
Inventory period + Collection period – Payables period
What is DressMiss’s cash cycle?
f. Suppose DressMiss’s cash cycle does not change but sales double, What does this imply about the companies need for financing?
g. Suppose DressMiss’s assistant treasurer recommends reducing the companies cash cycle to zero days. Do you think this is necessarily a good idea? Why or why not?
6. Show that if a companiy’s liabilities-to-equity ratio is 300 percent, its assets-to-equity ration is 300 percent.
7. In 1996, Natural Selection, a nationwide computer dating service, had $80 million of assets and $50 million of liabilities. Earnings before interest and taxes were $10 million, interest expense was $5 million, the tax rate 40 percent, sinking fund requirements were $2 million, and annual dividends were 40 cents per share on 5 million shares outstanding.
- Calculate:
(1)Natural Selection’s liabilities-to-equity-ratio.
(2)Time interest earned.
(3)Times burden covered.
- What percentage decline is earnings before interest and taxes could Natural Selection have sustained before falling to cover
(1)Sinking fund requirements
(2)Common dividend payments?
8. Given the following facts, complete the balance sheet that follows. (Assume all sales are credit sales, ratio are based on 365-day year, and the payable period is based on goods sold.)
Collection period / 30 daysDays’ sales in cash / 6.0 days
Current ratio / 2.4 times
Inventory turnover / 4.0 times
Liabilities to assets / 50%
Payables period / 30 days
Assets
Cash / $50,000Accounts receivable
Inventory / $600,000
Total current assets
Net fixed assets
Total assets / $1,400,000
Liabilities and Owner’s Equity
Accounts payableShort-term debt
Total current liabilities
Long-term debts
Shareholders
Total liabilities & equity
Chapter 3 –
1 – Suppose you construct a pro forma balance sheet for a company and a cash budget for the same time period and the external funding required from the pro forma forecast differed from the cash surplus (deficit) estimated on the cash budget. How would you interpret this result?
2 – Suppose you constructed a pro forma balance sheet for a company and the estimate for external funding required was negative. How would you interpret this result?
3 - Table 3-4 presents a computer spreadsheet for estimated R&E Supplies’ external funding required for 1997. The text mentions that with modifications to the equations for equity and net sales, the forecast can be extended through 1998. Write the modified equations for equity and net sales.
4 – Using a computer spreadsheet, the information that follows, and the modified equations determined in question 3, extend the forecast for R&E Supplies contained in Table 3-4 through 1998. Is R&E’s external funding required in 1998 higher or lower than 1997?
R&E Supplies Assumptions for 1998
Growth rate in net sales30.0%
Cost of good sold/net sales86.0%
General, selling, &
Administrative expenses/net
sales11%
Long-term dept$560
Current portion long-term dept$100
Interest rate10.0%
Tax rate45.0%
Dividend/earning after tax50.0%
Current assets/net sales29.0%
Net fixed assets$270
Current liabilities.net sales14.4%
5. The treasurer of Michigan Milling, a wholesale distributor of knitting supplies, wants to estimate his company’s cash balance for the fist three months of 1997, Using the following information, construct a monthly cash budget for Michigan Milling for January through March 1997. Does it appear from your results that the treasurer should be concerned about investing excess cash or looking for a bank loan?
Michigan Milling Selected Information
Sales (20 percent for cash the rest on 30-day credit terms):
1996 actual
October$240,000
November$280,000
December$800,000
1997 projected
January$400,000
February$160,000
March$160,000
Purchases (all on 60-day terms):
1996 actual
October$340,000
November$360,000
December$800,000
1997 projected
January$200,000
February$80,000
March$80,000
Wages payable monthly$120,000
Principal payment due on dept in March$140,000
Interest due in March$60,000
Dividend payable in March$200,000
Taxes payable in February $120,000
Addition to accumulated in March$20,000
Cash balance on January 1, 1997$200,000
Minimum desired cash balance$100,000
6 – Continuing problem 5, Michigan Milling’s income statement and balance sheet for December 31, 1996 follow. Additional information about the company’s accounting methods and the treasurer’s expectations for the first quarter of 1997 appear in the footnotes.
Michigan Milling
Income Statement
December 31, 1996 ($000)
Net sales$4,000
Cost of goods sold (1)2,600
Gross profit1,400
Selling and administrative expenses (2)1,080
Interest expense60
Depreciation (3)60
Net profit before tax200
Tax at 33%66
Net profit after tax$134
Balance Sheet
December 31, 1996 ($000)
Assets
Cash$200
Accounts receivable640
Inventory1,200
Total current assets2,040
Gross fixed assets600
Accumulated depreciation 100
Net fixed assets 500
Total assets$2,540
Liabilities
Bank Loan $0
Accounts payable1,060
Miscellaneous accruals40
Current portion long-term dept70
Taxes payable200
Total current liabilities1,540
Long term dept660
Shareholders’ equity 340
Total liabilities and equity 2,540
(1)Cost of good sold consists entirely on purchase cost and is expected to continue to equal 65 percent of sales
(2)Selling and administrative expenses consist entirely of wages
(3)Depreciation is at the rate of $20,000 per quarter
(4)Miscellaneous accruals are not expected to change in the first quarter
(5)$140 due March 1997. No payments due 1998.
- Use this information and information in problem 5 to construct a pro forma income statement for the fist quarter of 1997 and a pro forma balance sheet for March 31, 1997. What is your estimated external financing need for March 31?
- Does the March 31, 1997, estimated financial equal your cash surplus (deficit) for this date from your cash budget in problem 5? Should it?
- Do your pro forma forecast tell you more than your cash budget does about Michigan Milling’s financial prospects?
- What do your pro forma income statement and balance sheet tell you about Michigan Milling’s need for external financing on February 28, 1997?
7 – Based on your answer to question 6, construct a first-quarter 1997 cash flow forecast for Michigan Milling.
Chapter 4-
1-Table 3-1in the last chapter presents R&E Supplies’ financial statements for the period 1993 through 1996, and Table 3-5 presents a pro forma financial forecast for 1997. Use the information in these tables to answer the following questions.
a-Calculate R&E Supplies’ sustainable growth rate in each year from 1994 through 1997.
b-Comparing the company’s sustainable growth rate to its actual growth rate in sales over these years, what growth management problems does R&E Supplies appear to face in this period.
c-How does the company appear to have coped with these problems? Do you see any difficulties with the way it has addressed its growth problems over this period? If so, what are they?
d-What advice would you offer management regarding managing future growth?
2-Following are selected financial data for Lindsay Manufacturing Company, a manufacturer of farm machinery and irrigation equipment located in Lindsay, Nebraska.
1991 / 1992 / 1993 / 1994 / 1995Profit margin(%) / 9.00 / 10.10 / 10.50 / 10.00 / 10.50
Retention ratio(%) / 1.00 / 1.00 / 1.00 / 1.00 / 1.00
Asset turnover(X) / 1.63 / 1.53 / 1.28 / 1.27 / 1.30
Financial leverage*(X) / 2.51 / 2.18 / 1.80 / 1.59 / 1.26
Growth rate in sales(%) / -3.90 / 10.40 / -6.30 / 10.40 / -1.70
*assets divided by beginning-of-period equity.
a-Calculate Lindsay’s sustainable growth rate in each year.
b-Comparing the company’s sustainable growth rate to its actual growth rate in sales, what growth problems does Lindsay appear to have faced over this period?
c-How does the company appear to have coped with these problems?
d-Lindsay’s retention ration indicates that the company did not distribute a dividend over the period. As a shareholder , would you support a n0-dividends policy for Lindsay?
e-In 1995, Lindsay repurchased some of its stock. From a growth management perspective, does this appear to have been a wise move?
3-Following are selected fianancial data for Williams-Sonoma, Inc., a chain of specialty retail stores and mail-order marketer of fine -quality cooking and servivng equipment headquartered in San Francisco.
1991 / 1992 / 1993 / 1994 / 1995Profit margin(%) / 0.50 / 0.50 / 2.70 / 3.70 / 0.40
Retention ratio(%) / 1.00 / 1.00 / 1.00 / 1.00 / 1.00
Asset turnover(X) / 2.26 / 2.35 / 2.45 / 2.43 / 2.02
Financial leverage*(x) / 1.85 / 1.85 / 2.01 / 2.29 / 2.70
Growth rate in sales(%) / 8.90 / 10.30 / 18.90 / 28.90 / 22.00
*Assets divided by beginning-of-period equity.
a-Calculate Williams-Sonoma’s sustainable growth rate in each year.
b-Comparing the company’s sustainable growth rate to its actual growth rate in sales, what growth problems does Williams-Sonoma appear to have faced over this period?
c-How does the company appear to have coped with these problems?
d-Should the company’s solution to its sustainable growth problems cause any concern for management and owners?
Chapter 4-
1-Company A has 4 million shares of common stock outstanding trading at $5 a share. Company B has 1 million shares outstanding trading at $20 a share.
a-Which company has the higher market value of equity?
b-If you owned 400 shares of company A’s stock, how many shares of company B’s stock would someone have to offer you before you would trade you’re a share for his B shares?
c-If you owned 10 percent of A’s equity, how many shares of B’s stock would someone have to offer you before you would trade you’re A shares for his B shares?
2-If the stock market in the United States is efficient , how do you explain the fact that some people make very high returns? Would it be more difficult to reconcile very high returns with efficient markets if the same people made extraordinary returns year after year?
3-The return an investor earns on a bond over a preiod of timeis known as the holding period return, defined as interest income plus or minus the change in the bond’s price, all divided by the beginning bond price. a- What is the holding period return on a bond with a par value of $1,000 and a coupon rate of 6 percent if its price at the beginning of the year was $940 and its price at the end was $1,050? Assume interest is paid annually.
b- Can you give two reasons the price of the bond might have increased over the year?
4-You bought a yen-dominated bond at the beginning of the year for Y100, 000. The bond paid 3 percent annual interest and was trading for Y110,000 at year end. The exchange rate was $1=Y94 at year-end.
a-What holding period return, measured in yen, did you earn on the bond?
b-What was your U.S. dollar holding period return on the bond?
c-What portion of the dollar return was due to the yen return as opposed to changes in currency values?
5- A company wants to raise $200 million in a new stock issue. The company’s investment banker indicates that a sale of new stock will require 5 percent underpricing and a 6 percent spread.
a-Assuming the company’s stock price does not change from its current price of $56 per share, how many shares must the company sell and at what price to the public?