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33916033 Financial Management Principles and Applications

33916033 Financial Management Principles and Applications

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CHAPTER 1

An Introduction to Financial
Management

CHAPTER ORIENTATION
This chapter lays a foundation for what will follow. First, it focuses on the goal of the firm,
followed by a review of the legal forms of business organization. Ten principles that form the
foundations of financial management then follow.
CHAPTER OUTLINE
I. Goal of the firm
A. In this book we will designate maximization of shareholder wealth, by which
we mean maximization of the total market value of the firm's common stock, to
be the goal of the firm. To understand this goal and its inclusive nature it is first
necessary to understand the difficulties involved with the frequently suggested
goal of profit maximization.
B. While the goal of profit maximization stresses the efficient use of capital
resources, it assumes away many of the complexities of the real world and for
this reason is unacceptable.
1. One of the major criticisms of profit maximization is that it assumes
away uncertainty of returns. That is, projects are compared by
examining their expected values or weighted average profit.
2. Profit maximization is also criticized because it assumes away timing
differences of returns.
1
C. Profit maximization is unacceptable and a more realistic goal is needed.
II. Maximization of shareholder wealth
A. We have chosen the goal of shareholder wealth maximization because the
effects of all financial decisions are included in this goal.
B. In order to employ this goal we need not consider every price change to be a
market interpretation of the worth of our decisions. What we do focus on is the
effect that our decision should have on the stock price if everything were held
constant.
C. The agency problem is a result of the separation between the decision makers
and the owners of the firm. As a result managers may make decisions that are
not in line with the goal of maximization of shareholder wealth.
III. Legal forms of business organization
A. The significance of different legal forms
1. The predominant form of business organization in the United States in
pure numbers is the sole proprietorship.
B. Sole proprietorship: A business owned by a single person and that has a
minimum amount of legal structure.
1. Advantages
a. Easily established with few complications
b. Minimal organizational costs
c. Does not have to share profits or control with others
2. Disadvantages
a. Unlimited liability for the owner
b. Owner must absorb all losses
c. Equity capital limited to the owner's personal investment
d. Business terminates immediately upon death of owner
C. Partnership: An association of two or more individuals coming together as co-
owners to operate a business for profit.
1. Two types of partnerships
a. General partnership: Relationship between partners is dictated
by the partnership agreement.
l. Advantages
a. Minimal organizational requirements
b. Negligible government regulations
2. Disadvantages
a. All partners have unlimited liability
b. Difficult to raise large amounts of capital
c. Partnership dissolved by the death or withdrawal of
general partner
b. Limited partnership
2
l. Advantages
a. For the limited partners, liability limited to the
amount of capital invested in the company
b. Withdrawal or death of a limited partner does not
affect continuity of the business
c. Stronger inducement in raising capital
3
2. Disadvantages
a. There must be at least one general partner who
has unlimited liability in the partnership
b. Names of limited partners may not appear in the
name of the firm
c. Limited partners may not participate in the
management of the business
d. More expensive to organize than general
partnership, as a written agreement is mandatory
2. There is also a Limited Liability Company (LLC) form of business.
This is a cross between a partnership and a corporation. It retains
limited liability for its owners, but is run and taxed like a partnership.
D. The corporation: An "impersonal" legal entity having the power to purchase,
sell, and own assets and to incur liabilities while existing separately and apart
from its owners.
1. Ownership is evidenced by shares of stock
2. Advantages
a. Limited liability of owners
b. Ease of transferability of ownership, i.e., by the sale of one's
shares of stock
c. The death of an owner does not result in the discontinuity of the
firm's life
d. Ability to raise large amounts of capital is increased
3. Disadvantages
a. Most difficult and expensive form of business to establish
b. Control of corporation not guaranteed by partial ownership of
stock
IV. The Corporation and the Financial Markets: The Interactions
A. The popularity of the corporation stems from the ease in raising capital that it
provides.
1. Initially, the corporation raises funds in the financial markets by selling
securities.
2. The corporation then invests this cash in return generating assets.
3. The cash flow from those assets is either reinvested in the corporation,
given back to the investors in the form of dividends or interest
payments, or used to repurchase stock which should cause the stock
price to rise, or given to the government in the form of taxes.
B. A primary market is a market in which new, as opposed to previously issued,
securities are traded.
4
C. An initial public offering (IPO) is the first time a company’s stock is sold to the
public.
D. A seasoned new issue refers to a stock offering by a company that already has
common stock traded.
E. The secondary market is the market in which stock previously issued by the firm
trades.
V. Ten Principles that form the foundation of financial management.
A. Principle 1: The risk-return tradeoff - we won't take additional risk unless we
expect to be compensated with additional return.
1. Almost all financial decisions involve some sort of risk-return tradeoff.
B. Principle 2: The time value of money - a dollar received today is worth more
than a dollar received in the future.
C. Principle 3: Cash -- Not Profits -- is King. In measuring value we will use cash
flows rather than accounting profits because it is only cash flows that the firm
receives and is able to reinvest.
D. Principle 4: Incremental cash flows - it's only what changes that count. In
making business decisions we will only concern ourselves with what happens
as a result of that decision.
E. Principle 5: The curse of competitive markets - why it's hard to find
exceptionally profitable projects. In competitive markets, extremely large
profits cannot exist for very long because of competition moving in to exploit
those large profits. As a result, profitable projects can only be found if the
market is made less competitive, either through product differentiation or by
achieving a cost advantage.
F. Principle 6: Efficient Capital Markets - The markets are quick and the prices are
right.
G. Principle 7: The agency problem - managers won't work for the owners unless
it's in their best interest. The agency problem is a result of the separation
between the decision makers and the owners of the firm. As a result managers
may make decisions that are not in line with the goal of maximization of
shareholder wealth.
H. Principle 8: Taxes bias business decisions.
I. Principle 9: All risk is not equal since some risk can be diversified away and
some cannot. The process of diversification can reduce risk, and as a result,
measuring a project’s or an asset's risk is very difficult.
J. Principle 10: Ethical behavior is doing the right thing, and ethical dilemmas are
everywhere in finance. Ethical behavior is important in financial management,
just as it is important in everything we do. Unfortunately, precisely how we
define what is and what is not ethical behavior is sometimes difficult.
Nevertheless, we should not give up the quest.
5
ANSWERS TO
END-OF-CHAPTER QUESTIONS
1-1. The goal of profit maximization is too simplistic in that it assumes away the problems
of uncertainty of returns and the timing of returns. Rather than use this goal, we have
chosen maximization of shareholders' wealth—that is, maximization of the market
value of the firm's common stock—because the effects of all financial decisions are
included. The shareholders react to poor investment or dividend decisions by causing
the total value of the firm's stock to fall and react to good decisions by pushing the
price of the stock upward. In this way all financial decisions are evaluated, and all
financial decisions affect shareholder wealth.
1-2. The major difference between the profit maximization goal and the goal of shareholder
wealth maximization is that the latter goal deals with all the complexities of the
operating environment, while the profit maximization goal does not. The major factors
assumed away by the profit maximization goal are uncertainty and the timing of the
returns.
1-3. The goal of shareholder wealth maximization must be looked at as a long-run goal. As
such, the public image of the firm may be of concern inasmuch as it may affect sales
and legislation. Thus, while these actions may not directly result in increased profits,
they may affect consumers' and legislators' attitudes.
1-4. Almost all financial decisions involve some sort of risk-return tradeoff. The more risk
the firm is willing to accept, the higher the expected return for the given course of
action. For example, in the area of working capital management, the less inventory
held, the higher the expected return, but also the greater the risk of running out of
inventory. While one manager might accept a given level of risk, another more risk-
averse manager may not accept that level of risk. This does not mean that one manager
is correct and one is not, only that not all managers will view the risk-return trade off in
the same manner.
1-5. (a) A sole proprietorship is a business owned by a single individual who maintains
complete title to the assets, but who is also personally liable for all indebtedness
incurred.
(b) A partnership is an association of two or more individuals coming together as
co-owners for the purpose of operating a business for profit. The partnership is
equivalent to the sole proprietorship, except that the partnership has multiple
owners.
(c). A corporation is a legal entity functioning separate and apart from its owners.
It can individually sue and be sued, purchase, sell, or own property, and be
subject to criminal punishment for crimes.
1-6. (a) The sole proprietor maintains title to the firm's assets, has unlimited liability, is
entitled to the profits from the business, but must also absorb any losses
realized. This form of business is easily initiated. Termination of the business
comes by the owner discontinuing the business or upon his death.
6
(b) In a partnership, all general partners have unlimited liability. Each partner is
liable for the actions of the other partners. The partnership agreement dictates
the basic relationships among the partners within the firm. As with the sole
proprietorship, the partnership is terminated upon the desires of any partner
within the organization, or upon a partner's death. Under certain conditions a
partner's liability may be restricted to the amount of capital invested in the
partnership. However, at least one general partner must remain in the
association for whom the privilege of limited liability does not apply.
(c) The corporation is legally separate from its owners. Ownership of the
corporation is determined by the number of shares of common stock owned by
an individual. Since the shares are transferable, the ownership in a corporation
may be easily transferred. Investors' liability is limited to the amount of their
investment. The life of the corporation is not dependent upon the status of the
investors. The death or withdrawal of an investor does not disrupt the corporate
life. However, the cost of forming a corporation is more expensive than a
proprietorship or partnership.
1-7. (a) Organizational requirements and costs favor the sole proprietorship or possibly
the general partnership depending upon the approach taken in forming the
partnership.
(b) The corporation minimizes the liability of the owners. Also, the limited
partnership permits some of the partners the privilege of limited liability.
(c) The corporation is definitely the most favorable form of business because it
provides the continuity of the business regardless of an owner's withdrawal or
death.
(d) If ease of ownership transferability is desired, the corporation is best. However,
because of certain circumstances the owners may prefer that ownership not be
easily transferred, in which case the partnership would be the most desirable.
(e) The sole proprietor is able to maintain complete and ultimate control and
minimize regulations.
(f) The corporation is the strongest form of legal entity in terms of the ease of
raising capital from external investors.
(g) In regard to income taxes, it is difficult to determine which form of business is
the most advantageous. Such a selection is dependent upon individual
circumstances.
7
SOLUTION TO INTEGRATIVE PROBLEM
1. The goal of profit maximization is too simplistic in that it assumes away the problems
of uncertainty of returns and the timing of returns. Rather than use this goal, we have
chosen maximization of shareholders' wealth—that is, maximization of the market
value of the firm's common stock—because the effects of all financial decisions are
included. The shareholders react to poor investment or dividend decisions by causing
the total value of the firm's stock to fall and react to good decisions by pushing the
price of the stock upward. In this way all financial decisions are evaluated, and all
financial decisions affect shareholder wealth.
2. Simply put, investors won't put their money in risky investments unless they are
compensated for taking on that additional risk. In effect, the return investors expect is
composed of two parts. First, they receive a return for delaying consumption which
must be greater than the anticipated rate of inflation. Second, they receive a return for
taking on added risk. Otherwise, both risky and safe investments would have the same
expected return associated with them and no one would take on the risky investments.
3. The firm receives cash flows and is able to reinvest them rather than accounting profits.
In effect, accounting profits are shown when they are earned rather than when the
money is actually in hand. Unfortunately, a firm's accounting profits and cash flows
may not be timed to occur together. For example, capital expenses, such as the
purchase of a new plant or piece of equipment, are depreciated over several years, with
the annual depreciation subtracted from profits. However, the cash flow associated
with these expenses generally occurs immediately. It is the cash inflows that can be
reinvested and cash outflows that involve paying out money. Therefore, cash flows
correctly reflect the true timing of the benefits and costs.
4. In an efficient market, information is impounded into security prices with such speed
that there are no opportunities for investors to profit from publicly available
information. Actually, what types of information are immediately reflected in security
prices and how quickly that information is reflected determine how efficient the market
actually is. The implications for us are, first, that stock prices reflect all publicly
available information regarding the value of the company. This means we can
implement our goal of maximization of shareholder wealth by focusing on the effect
each decision should have on the stock price all else held constant. It also means that
earnings manipulations through accounting changes should not result in price changes.
In effect our preoccupation with cash flows is validated.
5. The agency problem is the result of the separation of management and the ownership of
the firm. As a result managers may make decisions that are not in line with the goal of
maximization of shareholder wealth. To control this problem we monitor managers
and try to align the interests of shareholders and managers. The interests of
shareholders and managers can be aligned by setting up stock options, bonuses, and
perquisites that are directly tied to how closely management decisions coincide with
the interest of shareholders.
8
6. Ethical errors are not forgiven in the business world. Business interaction is based
upon trust and there is no way that trust can be eliminated quicker than through an
ethical violation. The fall of Arthur Andersen, Ivan Boesky and Drexel, Burnham,
Lambert and the near collapse of Salomon Brothers illustrates this fact. As a result
acting in an ethical manner is not only morally correct, but it is congruent with our goal
of maximization of shareholder wealth.
7. (1) A sole proprietorship is a business owned by a single individual who maintains
complete title to the assets, but who is also personally liable for all indebtedness
incurred.
(2) A partnership is an association of two or more individuals coming together as
co-owners for the purpose of operating a business for profit. The partnership is
equivalent to the sole proprietorship, except that the partnership has multiple
owners.
(3). A corporation is a legal entity functioning separate and apart from its owners.
It can individually sue and be sued, purchase, sell, or own property, and be
subject to criminal punishment for crimes.
SOLUTION TO CASE
LIVING AND DYING WITH ASBESTOS
With ethics cases there are no right or wrong answers—just opinions. Try to bring out as many
opinions as possible without being judgmental or allowing other students to be judgmental.
Also, it is effective to try to see if the students feel there are any possible parallels between
what has happened in this case and the tobacco industry.

9
CHAPTER 2
Understanding Financial
Statements, Taxes, and Cash Flows

CHAPTER ORIENTATION
In this chapter, we review the contents and meaning of a firm’s income statement and balance
sheet. We also look very carefully at how to compute a firm’s cash flows from a finance
perspective, which is called free cash flows.
CHAPTER OUTLINE
I. Basic Financial Statements
A. The Income Statement
1. The income statement reports the results from operating the business for
a period of time, such as a year.
2. It is helpful to think of the income statement as comprising five types of
activities:
a. Selling the product
b. The cost of producing or acquiring the goods or services sold
c. The expenses incurred in marketing and distributing the product
or service to the customer along with administrative operating
expenses
d. The financing costs of doing business: for example, interest paid
to creditors and dividend payments to the preferred stockholders
e. The taxes owed based on a firm’s taxable income
3. An example of an income statement is provided in Table 2-1 for the
Harley-Davidson Corporation.
10
B. The Balance Sheet
1. The balance sheet provides a snapshot of the firm’s financial position at
a specific point in time, presenting its asset holdings, liabilities, and
owner-supplied capital.
a. Assets represent the resources owned by the firm
(1) Current assets - consisting primarily of cash, marketable
securities, accounts receivable, inventories, and prepaid
expenses
(2) Fixed or long-term assets – comprising equipment,
buildings, and land
(3) Other assets – all assets not otherwise included in the
firm’s current assets or fixed assets, such as patents,
long-term investments in securities, and goodwill
b. The liabilities and owners’ equity indicate how the assets are
financed.
(1) The debt consists of such sources as credit extended from
suppliers or a loan from a bank.
(2) The equity includes the stockholders’ investment in the
firm and the cumulative profits retained in the business
up to the date of the balance sheet.
2. The balance sheet is not intended to represent the current market value
of the company, but rather reports the historical transactions recorded at
their costs.
3. Balance sheets for the Harley-Davidson Corporation are presented in
Table 2-2.
II Computing a Company’s Taxes
A. Types of taxpayers
1. Sole proprietors
a. Report business income on personal tax returns
b. Pay taxes at personal tax rate
2. Partnerships
a. The partnership reports income but does not pay taxes
b. Each partner reports his or her portion of income and pays the
corresponding taxes.
11
3. Corporations
a. Corporation reports income and pays taxes
b. Owners do not report these earnings except when all or part of
the profit is paid out as dividends.
c. Our focus is on corporate taxes.
B. Computing Taxable Income
1. Taxable income is based on gross income less tax-deductible expenses
a. Interest expense is tax deductible
b. Dividend payments are not tax deductible
2. Depreciation
a. Modified accelerated cost recovery system used for computing
depreciation for tax purposes
b. We use straight-line depreciation to reduce complexity.
C. Computing Taxes Owed
1. Taxes paid are based on corporate tax structure.
2. Tax rates used to calculate tax liability are marginal tax rates, or the rate
applicable to the next dollar of income.
3. Average tax rate is calculated by dividing taxes owed by the firm’s total
income
4. Marginal tax rate is used in financial decision making
III. Measuring Free Cash Flows
A. While an income statement measures a company’s profits, profits are not the
same as cash flows; profits are calculated on an accrual basis rather than a cash
basis.
B. In measuring cash flows, we could use the conventional accountant’s
presentation called a statement of cash flows. However, we are more interested
in considering cash flows from the perspective of the firm’s shareholders and
its investors, rather than from an accounting view. We will instead measure the
cash flow that is free and available to be distributed to the firm’s investors, both
debt and equity investors, or what we will call free cash flows.
C. The cash flows that are generated through a firm’s operations and investments
in assets will always equal its cash flows paid to – or received from – the
company’s investors (both creditors and stockholders).
12
D. Calculating Free Cash Flows: An Asset Perspective
1. A firm's free cash flows, from an asset perspective, is the after-tax cash
flows generated from operations less the firm's investments in assets. It
is this same amount that will be available for distributing to the firm’s
investors. That is, a firm's free cash flows for a given period is equal to:
After-tax cash flow from operations
less
the investment (increase) in net operating working capital
less
investments in fixed assets (plant and equipment) and other
assets.
2. After-tax cash flows from operations as follows:
Operating income (earnings before interest and taxes)
+ depreciation
= Earnings before interest, taxes, depreciation and
amortization (EBITDA)
- cash tax payments
= After-tax cash flows from operations
3. The increase in net operating working capital is equal to the:
1
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1

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assets current
in change
-
1
]
1

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s liabilitie current
bearing - t noninteres in change
4. Investments in fixed assets includes the change in gross fixed assets and
any other balance sheet assets not already considered.
13
E. Calculating Free Cash Flows: A Financing Perspective
1. Free cash flows from a financing perspective are equal to:
2. Free cash flow from an asset perspective must equal free cash flow from
a financing perspective.
3. Free cash flows from a financing perspective are simply the net cash
flows received by the firm’s investors, or if negative, the cash flows that
the investors are paying into the firm. In the latter situation where the
investors are putting money into the firm, it is because the firm’s free
cash flow from assets is negative, thereby requiring an infusion of
capital by the investors.
IV. Financial Statements and International Finance
A. Many countries have different guidelines for firms to use in preparing financial
statements. For example, a $1 of earnings in the United States is not the same
as 1.10 Euro (the equivalent of a U.S. dollar based on the exchange rate). The
differences are due to the two countries having different Generally Accepted
Accounting Principles which guide their firms’ financial reporting.
B. As a result of this situation, the International Accounting Standards Committee
(IASC), a private body supported by the worldwide accounting profession, is
trying to develop international financial-reporting standards that will minimize
the problem. In spite of the work to standardize accounting practices around
the world, the U.S. accounting profession has rejected efforts toward
international standards. At this time, foreign companies seeking to list their
shares in the United States must follow U.S. accounting standards.
14
Interest payments to creditors
plus dividends paid to stockholders
+ decrease in debt principal
or
- increase in debt principal
+ decrease in stock
or
- increase in stock
ANSWERS TO
END-OF-CHAPTER QUESTIONS
2-1. a. The balance sheet represents an enumeration of a firm’s resources (assets) along
with its liabilities and owners’ equity at a given date. The income statement
summarizes the net results of the operation of a firm over a specified time
interval.
The primary distinction between these two statements is that the balance sheet
shows the financial condition of a firm at a given date, whereas the income
statement deals with the revenues and expenses of the firm incurred during a
specified period of time.
b. The conventional cash flow statement as prepared by accountants provides the
information we need to know about what has happened to the firm’s cash and
why. But it does not present it in a way that makes clear the cash flows the
firm’s creditors and investors are providing to or receiving from the firm. Thus,
we choose to reformat the presentation to show the firm’s free cash flows—the
cash available to distribute to the creditors and investors. We are more
interested in considering cash flows from the perspective of the firm’s
shareholders and its investors, rather than from an accounting view. We instead
measure the cash flow that is free and available to be distributed to the firm’s
investors, both debt and equity investors, or what we will call free cash flows.
Thus, what we use is similar to a conventional cash flow statement presented as
part of a company’s financial statements, but “not exactly.” We also make the
distinction between the cash flows generated by the firm’s assets and the
financing free cash flows.
2-2. Gross profits is sales less the cost of producing or acquiring the firm’s
product or service. Operating profits is the gross profits less the
operating expenses, which consist of distributing the product or service
to the customer (namely, marketing expenses) and any general and
administrative expenses in operating the business. Net income is
operating profits less financing costs (interest expenses and preferred
stock dividends) and less income taxes.
2-3. Interest expense is the cost of borrowing money from a banker or another lender. There
typically is a fixed interest rate so that the interest expense is computed as the interest
rate times the amount borrowed. If we borrow $500,000 at an interest rate of 12 percent,
then our interest expense will be $60,000.
While interest is paid for the use of debt capital, dividends are paid to the firm’s
stockholders. Preferred stock typically has a fixed dividend rate, so that the preferred
stockholder gets a constant dividend each year. Common stockholders, on the other
hand, usually receive dividends only if management decides to pay a dividend instead of
reinvesting the firm’s profits. However, typically once a dividend has been paid to
common stockholders, management is reluctant to decrease it or cease paying a
dividend.
15
2-4 Once preferred shares are sold, dividends are paid or accrued each year based upon
preferred dividends (i.e., the percentage of the preferred stock’s par value paid as
dividends) agreed to at the selling date. However, these dividends affect the income
statement only. Common stock dividends, which may vary from year to year, also
affect the income statement; however, the investment of common shareholders varies
with the net addition to (or reduction from) retained earnings from year to year. The net
addition to retained earnings equals the difference in the period’s net income and
common dividends paid. Thus, the common equity section of the balance sheet (par
value of common stock, paid-in capital and retained earnings) varies from year to year
due to changes in the retained earnings portion of the firm’s common equity.
2.5 Net working capital is the firm’s liquid assets (current assets) less its
short-term debt. Accountants include all short-term debt when
computing net working capital; however, in computing free cash flows,
we only subtract the noninterest-bearing debt, such as accounts payables
and accruals. With this latter method, we are only considering the assets
and liabilities that are changing as a result of the normal operating cycle
of the business—beginning with the time inventory is purchased on
credit to the time the firm collects the cash from its customer.
Gross working capital is the sum of current assets, while net working capital is the
difference between current assets and current liabilities.
As already suggested, we have both interest-bearing debt and noninterest-bearing debt.
The former is debt where the lender is paid interest for providing us the money.
Noninterest-bearing debt charges no interest because the “lender” is really a supplier or
an employee to whom we owe money, but they are not requiring the firm to pay
interest.
2-6. A firm could have positive cash flows but still be in trouble because it has negative cash
flows from operations. The positive cash flows would then be the result of the firm
reducing its investments in working capital or long-term assets. Such a situation means
that the company is not earning a satisfactory rate of return on its investments. Another
company could have very attractive rates of return on its assets, but be growing so fast
that the large investments in working capital and long-term assets result in negative cash
flows. In this latter case, management is simply investing in the future. As the rate of
growth slows, positive cash flows will occur.
2-7. Examining only the income statement and the balance sheet fails to tell us how the firm
is using its cash, which is a critical issue for any company.
2-8. Free cash flows from assets equal the cash flows that are generated by the company that
are then distributed to (if positive) or received from (if negative) the firm’s creditors and
investors. It looks at cash flows from the firm’s perspective. Free cash flows from a
financing perspective looks at the cash flows from the investors’ viewpoint. It indicates
how the investor received cash in the form of interest, dividends, debt repayment or
stock repurchase and how the investor infused cash in the form of additional debt or
stock purchase. Whatever the company does is the exact opposite of what the investor
receives or pays. That is, if a company distributes $100 in cash to the investors, then the
investors must receive $100 as well. They have to be equal.
16
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
2-1A. Belmond, Inc.
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash $ 16,550
Accounts receivable 9,600
Inventory 6,500
Total current assets $ 32,650
Gross buildings & equipment $122,000
Accumulated depreciation (34,000)
Net buildings & equipment $ 88,000
Total assets $120,650
LIABILITIES AND EQUITY
Liabilities
Current Liabilities
Notes payable $ 600
Accounts payable 4,800
Total current liabilities $ 5,400
Long-term debt 55,000
Total liabilities $ 60,400
Equity
Common stock $ 45,000
Retained earnings 15,250
Total equity $ 60,250
Total liabilities and equity $120,650
Belmond, Inc.
Income Statement
For the Year Ended December 31, 2003
Sales $ 12,800
Cost of goods sold 5,750
Gross profits $ 7,050
General & admin expense $ 850
Depreciation expense 500
Total operating expense $ 1,350
Operating income (EBIT) $ 5,700
Interest expense 900
Earnings before taxes $ 4,800
17
Taxes 1,440
Net income $ 3,360
2-2A. Sharpe Mfg. Company
Balance Sheet
December 31, 2003
ASSETS
Cash $ 96,000
Accounts receivable 120,000
Inventory 110,000
Total current assets $ 326,000
Machinery and equipment $ 700,000
Accumulated depreciation (236,000)
Net fixed assets 464,000
Total assets $ 790,000
LIABILITIES & EQUITY
Liabilities
Current Liabilities
Notes payable $ 100,000
Accounts payable 90,000
Total current liabilities $ 190,000
Long-term debt 160,000
Total liabilities $ 350,000
Equity
Common stock $ 320,000
Retained earnings
Prior year 100,000
Current year 20,000
Total equity $ 440,000
Total liabilities and equity $ 790,000
Sharpe Mfg. Company
Income Statement
For the Year Ended December 31, 2003
Sales $ 800,000
Cost of goods sold 500,000
Gross profits $ 300,000
Operating expense 280,000
Net income $ 20,000
(Assume no interest accrued or taxes)
18
2-3A. Delaney, Inc. - Corporate Income Tax
Sales $4,000,000
Cost of goods sold and
cash operating expenses 2,400,000
Depreciation expense 100,000
Operating profit $1,500,000
Interest expense 150,000
Taxable Income $1,350,000
Tax Liability:
$50,000 x 0.15 = $7,500
25,000 x 0.25 = 6,250
25,000 x 0.34 = 8,500
235,000 x 0.39 = 91,650
1,015,000 x 0.34 = 345,100
$1,350,000 $459,000
2-4A. Potts, Inc. - Corporate Income Tax
Sales $ 6,000,000
Cost of goods sold and
cash operating expenses 5,600,000
Operating profit $ 400,000
Interest expense 30,000
Taxable Income $ 370,000
Tax Liability:
$50,000 x 0.15 = $7,500
25,000 x 0.25 = 6,250
25,000 x 0.34 = 8,500
235,000 x 0.39 = 91,650
35,000 x 0.34 = 11,900
$370,000 $125,800
19
2-5A. Pamplin, Inc.
Free cash flows from an asset perspective:
Operating income (EBIT) $ 360,000
Depreciation 200,000
EBITDA $ 560,000
Tax expense $ 120,000
Less change in tax payable -
Cash taxes $ 120,000
After-tax cash flows from operations $ 440,000
Change in net working capital
Change in current assets:
Change in cash $ (50,000)
Change in accounts receivable (25,000)
Change in inventory 75,000
Change in current assets $ -
Change in noninterest-bearing current debt:
Change in accounts payable $ (50,000)
Change in net operating working capital $ (50,000)
Change in long-term assets:
Purchase of fixed assets (400,000)
Free cash flows - asset perspective $ (10,000)
Free cash flows from a financing perspective:
Interest expense $ (60,000)
Less change in interest payable -
Interest paid to lenders $ (60,000)
Repayment of long-term debt -
Increase in short-term debt 150,000
Common stock dividends paid to owners (80,000)
Free cash flows - financing perspective $ 10,000
Note: The dividends were computed by comparing net income against the change in
retained earnings. Net income was $180,000, but retained earnings increased only by
$100,000; thus the balance was distributed in the form of dividends.
Pamplin, Inc. had an after-tax operating cash flow of $440,000. Additionally, Pamplin
acquired further financing though increasing short-term debt by $150,000. This cash
was mainly used to purchase fixed assets of $400,000. The remainder was used to
decrease payables to suppliers by $50,000, pay interest of $60,000, and pay dividends
back to the investors of $80,000.
20
2-6A. T.P. Jarmon
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes $ 70,000
Plus interest expense 10,000
EBIT 80,000
Depreciation 30,000
EBITDA $ 110,000
Tax expense $ 27,100
Less change in tax payable -
Cash taxes 27,100
After-tax cash flows from operations $ 82,900
Step 2: Change in net operating working capital
Change in current assets:
Change in cash $ (1,000)
Change in accounts receivable (9,000)
Change in inventory 33,000
Change in prepaid rent (100)
Change in marketable securities 200
Change in current assets $ 23,100
Change in noninterest-bearing current debt:
Change in accounts payable $ 9,000
Change in accrued expenses (1,000)
Change in noninterest-bearing current debt: $ 8,000
Change in net operating working capital $ (15,100)
Step 3: Change in long-term assets
Purchase of fixed assets $ 14,000
(Change in net fixed assets + depr. expense)
Change in other assets -
Net cash used for investments $ (14,000)
Asset free cash flows $ 53,800
Free cash flows from a financing perspective:
Interest paid to investors $(10,000)
Less change in interest payable -
Interest received by investors $ (10,000)
Decrease in long-term debt (10,000)
Decrease in notes payable (2,000)
Common stock dividends (31,800)
Financing free cash flows $ (53,800)
T.P. Jarmon had a successful year, generating an after-tax cash flow of $82,900. To
increase cash flow further, noninterest-bearing debt increased by $8,000. Part of this
cash was consumed when current assets were increased by $23,100 (of which
inventory increased by $33,000). Fixed assets of $14,000 were also purchased. The
substantial part of the cash flow, however, was distributed back to the investors. Debt
was decreased, both long-term and short-term, by $12,000. Interest of $10,000 was
also paid on this debt. Finally, investors were paid $31,800 in dividends.
21
2-7A. Abrams Manufacturing
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Operating Income $ 54,000
Depreciation 26,000
EBITDA $ 80,000
Tax expense $ 16,000
Less change in tax payable -
Cash taxes 16,000
After-tax cash flows from operations $ 64,000
Step 2: Change in net operating working capital
Change in current assets:
Change in cash $ 11,000
Change in accounts receivables 6,000
Change in inventories (12,000)
Change in prepaid expenses -
Change in current assets $ 5,000
Change in noninterest-bearing current debt:
Change in accounts payables $ 5,000
Change in accrued liabilities (5,000 )
Change in noninterest-bearing current debt: $ -
Change in net operating working capital $ (5,000)
Step 3: Change in long-term assets
Purchase of fixed assets $ 73,000
Change in other assets -
Net cash used for investments $ (73,000 )
Asset free cash flows $ (14,000 )
Free cash flows from a financing perspective:
Interest paid to investors $ (4,000)
Less change in interest payable -
Interest received by investors $ (4,000)
Decrease in long-term debt (mortgage payable) (70,000)
Increase in preferred stock 120,000
Preferred stock dividends (10,000)
Common stock dividends (22,000 )
Financing free cash flows $ 14,000
Abrams generated cash through an after-tax operating profit of $64,000 and issuing
preferred stock of $120,000. This cash was primarily used to pay down debt of
$70,000 and purchase fixed assets of $73,000. Investors also received cash back
through dividends of $32,000 and interest of $4,000. Abrams also increased current
assets in total by $5,000 by increasing cash and accounts receivable while decreasing
inventory.
22
2-8A. J.T. Williams
Williams generated $224,210 in after-tax operating cash flows(including other
income). To further increase cash flow, accounts payable and accrued expenses were
increased by $1,662 and $32,283, respectively. They also increased their short-term
debt by $30,577, increased their long-term debt by $7,018 and issued more common
stock for $61,806. They used the operating cash flow and increased financing to
purchase $58,297 in inventory and other current assets and purchased $308,336 in
fixed assets, investments, and other assets. While Williams generated a positive after-
tax cash flow from operations, investors and creditors infused $99,401 into the
operations to finance the increases in assets. Williams needs to analyze whether the
investors are receiving an acceptable return on their investments. It should be careful
not to become over-capitalized during this time of rapid growth.
2-9A. Johnson, Inc.
Johnson incurred a loss of $450,571 in after-tax operating cash flows(including other
losses). In addition, interest expense of $87,966 was paid to cover the company’s
current debt. The company increased their cash reserve, inventory and other current
assets by $587,924. Fixed assets, investments, and other assets increased in net by
$1,420,113. To finance this negative free cash flow, Johnson increased their long-term
debt by $1,118,198, increased short-term debt and other current liabilities by $227,607,
and issued more common stock in the amount of $851,016. Accounts payable to
suppliers were also increased by $349,753. While investors in Internet companies have
been satisfied with repeated annual losses, Johnson should look for ways to decrease
debt, produce positive future cash flows, and provide an acceptable rate of return to its
investors.
SOLUTION TO INTEGRATIVE PROBLEM
Davis & Howard had a successful year bringing in positive after-tax cash flows from
operations(including other income) of $174,034. This money was used in part to
increase current assets and fixed assets of $77,100 and $61,873, respectively.
Investments also increased $2,730 and other assets were sold for $9,881. The
noninterest-bearing current debt also increased by $59,062 to help finance the increase
in current assets. However, the increase in current assets was substantially due to an
increase of $57,467 in accounts receivable. Management should take measures to
reduce the average collection period or utilize other tools to maintain control of this
asset. Free cash flows of $101,274 were distributed to investors. Interest expense of
$17,024 was paid for the current debt. Davis & Howard decreased their debt
principal(including long-term debt, other liabilities, and notes payable) by a total of
$27,380. Stockholders were paid dividends of $26,912. Finally, Davis & Howard
used their free cash flows to repurchase common stock for $29,958.
23
Solutions to Problem Set B
2-1B. Warner Company
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash $ 225,000
Accounts receivable 153,000
Inventory 99,300
Prepaid expenses 14,500
Total current assets $ 491,800
Gross buildings & equipment $ 895,000
Accumulated depreciation (263,000)
Net buildings & equipment $ 632,000
Total assets $1,123,800
LIABILITIES AND EQUITY
Liabilities
Current Liabilities
Accounts payable $ 102,000
Notes payable 75,000
Taxes payable 53,000
Accrued expense 7,900
Total current liabilities $ 237,900
Long-term debt 334,000
Total liabilities $ 571,900
Equity
Common stock $ 289,000
Retained earnings 262,900
Total equity $ 551,900
Total liabilities and equity $1,123,800
Warner Company
Income Statement
For the Year Ended December 31, 2003
Sales $ 573,000
Cost of goods sold 297,000
Gross profits $ 276,000
General & admin expense $ 79,000
Depreciation expense 66,000
Total operating expense $ 145,000
Operating income (EBIT) $ 131,000
Interest expense 4,750
Earnings before taxes $ 126,250
Taxes 50,500
24
Net income $ 75,750
2-2B. Sabine Mfg. Company
Balance Sheet
December 31, 2003
ASSETS
Current assets
Cash $ 90,000
Accounts receivable 150,000
Inventory 110,000
Total current assets $ 350,000
Machinery and Equipment $ 700,000
Accumulated depreciation (236,000)
Net buildings & equipment $ 464,000
Total assets $ 814,000
LIABILITIES AND EQUITY
Liabilities
Current Liabilities
Accounts payable $ 90,000
Short-term notes payable 90,000
Total current liabilities $ 180,000
Long-term debt 160,000
Total liabilities $ 340,000
Equity
Common stock $ 320,000
Retained earnings
Prior year 84,000
Current year 70,000
Total equity $ 474,000
Total liabilities and equity $ 814,000
Sabine Mfg. Company
Income Statement
For the Year Ended December 31, 2003
Net Sales $ 900,000
Cost of goods sold 550,000
Gross profits $ 350,000
Operating expense 280,000
Net income $ 70,000
25
2-3B. Cook, Inc. - Corporate Income Tax
Sales $ 3,500,000
Cost of goods sold and
cash operating expenses 2,500,000
Depreciation expense 100,000
Operating profit $ 900,000
Interest expense 165,000
Taxable Income $ 735,000
Tax Liability:
$50,000 x 0.15 = $ 7,500
25,000 x 0.25 = 6,250
25,000 x 0.34 = 8,500
235,000 x 0.39 = 91,650
400,000 x 0.34 = 136,000
$735,000 $249,900

2-4B. Rose, Inc. - Corporate Income Tax
Sales $7,000,000
Cost of goods sold and
cash operating expenses 6,600,000
Operating profit $400,000
Interest expense 40,000
Taxable Income $ 360,000
Tax Liability:
$50,000 x 0.15 = $ 7,500
25,000 x 0.25 = 6,250
25,000 x 0.34 = 8,500
235,000 x 0.39 = 91,650
25,000 x 0.34 = 8,500
$ 360,000 $122,400
26
2-5B. J.B. Chavez
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes $ 270,000
Plus interest expense 60,000
EBIT 330,000
Depreciation 200,000
EBITDA $ 530,000
Tax expense $ 108,000
Less change in tax payable -
Cash taxes 108,000
After-tax cash flows from operations $ 422,000
Step 2: Change in net operating working capital
Change in current assets:
Change in cash $ (50,000)
Change in accounts receivable (20,000)
Change in inventory 50,000
Change in current assets $ (20,000)
Change in noninterest-bearing current debt:
Change in accounts payable $(135,000)
Change in accrued expenses -
Change in noninterest-bearing current debt: $(135,000)
Change in net operating working capital $ (115,000)
Step 3: Change in long-term assets
Purchase of fixed assets $ 300,000
Change in other assets -
Net cash used for investments $ (300,000)
Asset free cash flows $ 7,000
Free cash flows from a financing perspective:
Interest expense $ (60,000)
Less change in interest payable -
Interest paid to lenders $ (60,000)
Increase in notes payable 115,000
Common stock dividends (62,000)
Financing free cash flows $ (7,000)
After-tax cash flows from operations of $422,000 and an increase in notes payable of
$115,000 were used to pay down the accounts payable by $135,000 and increase our
inventory and fixed assets by $50,000 and $300,000, respectively. Interest of $60,000
and common stock dividends of $62,000 were paid to investors.
27
2-6B. RPI, Inc.
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes $ 110,000
Plus interest expense 10,000
EBIT 120,000
Depreciation 30,000
EBITDA $ 150,000
Tax expense $ 27,100
Less change in tax payable -
Cash taxes 27,100
After-tax cash flows from operations $ 122,900
Step 2: Change in net operating working capital
Change in current assets:
Change in cash $ 1,000
Change in marketable securities 200
Change in accounts receivable (4,000)
Change in prepaid rent (100)
Change in inventory 43,000
Change in current assets $ 40,100
Change in noninterest-bearing current debt:
Change in accounts payable $ 7,000
Change in accrued expenses (1,000)
Change in noninterest-bearing current debt: $ 6,000
Change in net operating working capital $ (34,100)
Step 3: Change in long-term assets
Purchase of fixed assets $ 34,000
(Change in net fixed assets
+ depreciation expense)
Change in other assets -
Net cash used for investments $ (34,000)
Asset free cash flows $ 54,800
Free cash flows from a financing perspective:
Interest expense $ (10,000)
Less change in interest payable -
Interest paid to lenders $ (10,000)
Decrease in notes payable (3,000)
Decrease in long-term debt (10,000)
Common stock dividends (31,800)
Financing free cash flows $ (54,800)
28
RPI had positive after-tax operating cash flows of $122,900. As a result, RPI made a
decision to evenly split the cash flow between distribution to investors and investing
back into the company. Net operating capital increased by $34,100, mostly in the area
of inventory which increased by $43,000. Fixed assets of $34,000 were also
purchased. The asset free cash flow of $54,800 was distributed back to investors
through interest of $10,000, debt repayments of $13,000, and dividends of $31,800.
2-7B. Cameron Co.
Free cash flows from an asset perspective:
Step 1: Compute after-tax cash flows from operations
Earnings before taxes $ 72,000
Plus interest expense 5,000
EBIT 77,000
Depreciation 26,000
EBITDA $ 103,000
Tax expense $ 30,000
Less change in tax payable -
Cash taxes 30,000
After-tax cash flows from operations $ 73,000
Step 2: Change in net operating working capital
Change in current assets:
Change in cash $ (19,000)
Change in accounts receivable 6,000
Change in prepaid expenses -
Change in inventory (22,000)
Change in current assets $ (35,000)
Change in noninterest-bearing current debt:
Change in accounts payable $ (5,000)
Change in accrued liabilities (5,000)
Change in noninterest-bearing current debt: $ (10,000)
Change in net operating working capital $ 25,000
Step 3: Change in long-term assets
Purchase of fixed assets $ 63,000
Change in other assets -
Net cash used for investments $ (63,000)
Asset free cash flows $ 35,000
Free cash flows from a financing perspective:
Interest expense $ (5,000)
Less change in interest payable -
Interest paid to lenders $ (5,000)
Decrease in mortgage payable (60,000)
Increase in preferred stock 70,000
Preferred stock dividends (8,000)
Common stock dividends (32,000)
Financing free cash flows $ (35,000)
29
Cameron Co. created cash flows through after-tax profits of $73,000 and issuing
$70,000 of preferred stock. Cameron also decreased current assets of $35,000 through
inventory and cash. This cash was used to decrease $10,000 in noninterest-bearing
current debt and to purchase $63,000 in fixed assets. Cameron also eliminated
$60,000 in a mortgage payable and distributed $40,000 in dividends and $5,000 in
interest to investors.
2-8B Hilary’s Ice Cream
Hilary’s had a profitable year generating after-tax operating cash flows(including other
losses) of $10,953. However, it should be noted that current assets increased by $5,038
of which accounts receivable increased by $7,495. This increase was offset by
increasing accounts payable by $5,456. Hilary’s should be concerned with the
substantial increase in payables and the even greater threat of aging receivables.
Hilary’s used some of the above operating cash flow to purchase other assets for
$3,060. The asset free cash flow of $9,688 was distributed to the investors in the form
of $1,634 in interest, $3,822 in long-term debt principal, and repurchasing $4,593 in
common stock. It is possible that Hilary’s thought it wise to lower long term debt and
repurchase stock rather than make investments in further growth.
2.9B Retail.com
In need of cash, Retail.com issued common stock for $368,463 and increased current
liabilities by $9,609. This cash was used, in part, to cover an after-tax operating
loss(including other income) of $63,689. Retail.com mainly used the cash to increase
growth by purchasing fixed assets and other investments of $31,971 and $178,108,
respectively. Retail.com also sought to increase their liquidity by increasing current
assets by $84,962, consisting mainly of a $76,680 increase in their cash reserve, which
was offset in part by increasing payables by $4,657. The remainder of the common
stock issue was paid back to investors through a dividend of $23,612. For many years,
it has been fairly easy for innovative Internet companies to raise money through the
stock market. It has been more important to grow quickly than to create profits. In
future years, Retail.com must turn these losses into profits and create true value for
their investors.

CHAPTER 3
30
Evaluating A Firm’s Financial
Performance

CHAPTER ORIENTATION
Financial analysis can be defined as the process of assessing the financial condition of a firm.
The principal analytical tool of the financial analyst is the financial ratio. In this chapter, we
provide a set of key financial ratios and a discussion of their effective use.
CHAPTER OUTLINE
I Financial ratios help us identify some of the financial strengths and weaknesses of a
company.
II. The ratios give us a way of making meaningful comparisons of a firm’s financial data
at different points in time and with other firms.
III. We could use ratios to answer the following important questions about a firm’s
operations.
A. Question 1: How liquid is the firm?
1. The liquidity of a business is defined as its ability to meet maturing debt
obligations. That is—does or will the firm have the resources to pay the
creditors when the debt comes due?
2. There are two ways to approach the liquidity question.
a. We can look at the firm’s assets that are relatively liquid in
nature and compare them to the amount of the debt coming due
in the near term.
b. We can look at how quickly the firm’s liquid assets are being
converted into cash.
B. Question 2: Is management generating adequate operating profits on the firm’s
assets?
1. We want to know if the profits are sufficient relative to the assets being
invested.
2. We have several choices as to how we measure profits: gross profits,
operating profits, or net income. Gross profits would not be acceptable
because it does not include important information such as marketing and
distribution expenses. Net income includes the unwanted effects of the
firm’s financing policies. This leaves operating profits as our best
choice in measuring the firm’s operating profitability. Thus, the
31
appropriate measure is the operating income return on investment
(OIROI):
OIROI =
assets total
income operating
C. Question 3: How is the firm financing its assets?
1. Here we are concerned with the mix of debt and equity capital the firm
is using.
2. Two primary ratios used to answer this question are the debt ratio and
times interest earned.
a. The debt ratio is the proportion of total debt to total assets.
b. Times interest earned compares operating income to interest
expense for a crude measure of the firm’s capacity to service its
debt.
D. Question 4: Are the owners (stockholders) receiving an adequate return on
their investment?
1. We want to know if the earnings available to the firm’s owners, or
common equity investors, are attractive when compared to the returns of
owners of similar companies in the same industry.
2. Return on equity (ROE) =
equity common
income net
3. We demonstrate the effect of using debt on net income through an
example showing how the use of debt affects a firm’s return on equity.
4. Return on equity is presented as a function of:
a. the operating income return on investment less the interest rate
paid, and
b. the amount of debt used in the capital structure relative to the
equity.
IV. An Integrative Approach to Ratio Analysis: The DuPont Analysis
A. The DuPont analysis is another approach used to evaluate a firm’s profitability
and return on equity.
B. Its graphic technique may be helpful in seeing how ratios relate to one another
and the account balances.
C. Return on Equity is a function of a firm’s net profit margin, total asset turnover,
and debt ratio.
V. Limitations of Ratio Analysis
A. This list warns of the many pitfalls that may be encountered in computing and
interpreting financial ratios.
B. Ratio users should be aware of these concerns prior to making decisions based
solely on ratio analysis.
32
ANSWERS TO
END-OF-CHAPTER QUESTIONS
3-1. In learning about ratios, we could simply study the different types or categories of
ratios. These categories have conventionally been classified as follows:
Liquidity ratios are used to measure the ability of a firm to pay its bills on time.
Example ratios include the current ratio and acid-test ratio.
Efficiency ratios reflect how effectively the firm has utilized its assets to generate
sales. Examples of this type of ratio include accounts receivable turnover, inventory
turnover, fixed asset turnover, and total asset turnover.
Leverage ratios are used to measure the extent to which a firm has financed its assets
with outside (non-owner) sources of funds. Example ratios include the debt ratio and
times interest earned ratio.
Profitability ratios serve as overall measures of the effectiveness of the firm’s
management relative to sales and/or to investment. Examples of profitability ratios
include the net profit margin, return on total assets, operating profit margin, operating
income return on investment, and return on common equity.
Instead, we have chosen to cluster the ratios around important questions that may be
addressed to some extent by certain ratios. These questions, along with the related
ratios may be represented as follows:
1. How liquid is the firm?
Current ratio
Quick ratio
Accounts receivable turnover (average collection period)
Inventory turnover
2. Is management generating adequate operating profits on the firm’s assets?
Operating income return on investment
Operating profit margin
Gross profit margin
Asset turnover ratios, such as for total assets, accounts receivable, inventory,
and fixed assets
33
3. How is the firm financing its assets?
Debt to total assets
Debt to equity
Times interest earned
4. Are the owners (stockholders) receiving an adequate return on their investment?
Return on common equity
In answering questions 2 through 4, we can see the linkage between operating activities
and financing activities as they influence return on common equity.
3-2. The two sources of standards or norms used in performing ratio analysis consist of
similar ratios for the firm being analyzed over a number of past operating periods, and
similar ratios for firms which are in the same general industry or have similar product
mix characteristics.
3-3. The financial analyst can obtain norms from a variety of sources. Two of the most well
known are the Dun & Bradstreet Industry Norms and Key Business Ratios and RMA’s
Annual Statement Studies. Industry norms often do not come from "representative"
samples, and it is very difficult to categorize firms into industry groups. In addition, the
industry norm is an average ratio which may not represent a desirable standard. Thus,
industry averages only provide a "rough guide" to a firm’s financial health.
3-4. Liquidity is the ability to repay short-term debt. We measure liquidity by comparing the
firm’s liquid assets—cash or assets that will be turned into cash in the operating cycle—
to the amount of short-term debt outstanding, which is the measurement provided by the
current ratio and the quick, or acid-test, ratio. We can also measure liquidity by
computing how quickly accounts receivables turn over (how long it takes to collect
them on average) and how quickly inventories turn over. The more quickly these assets
can be turned over, the more liquid the firm.
3-5. Operating income return on investment is the amount of operating income produced
relative to $1 of assets invested (total assets), while operating profit margin is the
amount of operating income per $1 of sales. The first ratio measures the profitability on
the firm’s assets, while the latter measures the profitability on the sales.
3-6. We can compute operating income return on investment (OIROI) as:
Invesment on Return
Income Operating
=
Assets Total
Income Operating
or as:
Investment on Return
Income Operating
=
Margin Profit
Operating
X
Turnover
Asset Total
Thus, we see that OIROI is a function of how well we manage the income
statement, as measured by the operating profit margin, and how
well we manage the balance sheet (the firm’s assets), as
measured by the asset turnover ratio.
34
3-7. Gross profit margin measures a firm’s pricing decisions and its ability to manage its cost
of goods sold per dollar of sales. Operating profit margin is likewise a function of
pricing and cost of goods sold, but also the amount of operating expenses (marketing
expenses and general and administrative expenses) for every dollar of sales. Net profit
margin builds on the above relationships, but then includes the firm’s financing costs,
such as interest expense. Thus, the gross profit margin measures the firm’s pricing
decisions and the ability to acquire or produce its product cheaply. The operating profit
margin then adds the cost of distributing the product to the customer. Finally, the net
profit margin adds the firm’s financing decisions to the operating performance.
3-8. Return on equity is equal to net income divided by the total equity. But knowing how to
compute return on equity is not the same as understanding what decisions drive return
on equity. It helps to know that return on equity is driven by the spread between
operating income return on investment and the interest rate paid on the firm’s debt. The
greater the OIROI compared to the interest rate, the higher the return on equity will be.
If OIROI is higher (lower) than the interest rate, as a firm increases its use of debt,
return on equity will be higher (lower).
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
3-1A. Cash 201,875 Accounts Payable 100,000
Accounts Receivable * 175,000 Long-Term Debt 320,000
Inventory 223,125 Total Liabilities 420,000
Current Assets 600,000 Common Equity 1,680,000
Net Fixed Assets 1,500,000
Total Assets 2,100,000 Total Liability & Equity 2,100,000
* Based on 360 days.
Current ratio 6
Total asset turnover 1
Gross profit margin 15%
Inventory turnover 8
Average collection period 30
Debt ratio 20%
Sales 2,100,000
Cost of goods sold 1,785,000
Total liabilities 420,000
3-2A. Mitchem's present current ratio of 2.5 to 1 in conjunction with its $2.5 million
investment in current assets indicates that its current liabilities are presently $1 million.
Letting x represent the additional borrowing against the firm's line of credit (which also
equals the addition to current assets) we can solve for that level of x which forces the
firm's current ratio down to 2 to 1; i.e.,
2 = ($2.5 million + x) / ($1.0 million + x)
35
x = $0.5 million, or $500,000
3-3A. Instructor’s Note: This is a very rudimentary "getting started" exercise. It requires no
analysis beyond looking up the appropriate formula and plugging in the corresponding
figures.
s liabilitie current
assets current
ratio Current ·
=
000 , 2 $
500 , 3 $
= 1.75X
assets total
debt total
ratio Debt ·
=
000 , 8 $
000 , 4 $
= .50 or 50%
Times interest earned =
expense interest
income operating

=
367 $
700 , 1 $
= 4.63X
Average collection period =
365 / sales credit
receivable accounts
=
365 / 000 , 8 $
000 , 2 $
= 91
days
Inventory turnover =
inventory
sold goods
of cost
=
000 , 1 $
300 , 3 $
= 3.3X
Fixed asset turnover =
assets fixed
sales net
=
500 , 4 $
000 , 8 $
= 1.78X
Total asset turnover =
assets total
sales net
=
000 , 8 $
000 , 8 $
= 1X
Gross profit margin =
sales net
profit gross
=
000 , 8 $
700 , 4 $
= .59 or 59%
Operating profit margin
sales net
income operating
·
=
000 , 8 $
700 , 1 $
= .21 or 21%
assets total
income operating
investment on
return income
Operating
·
=
000 , 8 $
700 , 1 $
= .21 or 21%
equity common
income net

equity
on Return
·
=
000 , 4 $
800 $
= .20 or 20%
or, we can calculate return on equity as:
= Return on assets ÷ (1- debt ratio)
=
assets Total
income Net
÷
,
_

¸
¸

assets Total
debt Total
1
=
( ) .50 - 1
8,000
800
÷
= .20 or 20%
36
3-4A. a. Total Assets Turnover =
assets total
sales
=
$5m
$10m
= 2x
b. 3.5 =
$5m
sales
Sales = $17.5m
Thus, the needed sales growth is $7.5 million ($17.5m - $10m), or an increase
of 75%:
$10m
$7.5m
= 75%
c. For last year,
Investment on Return
Income Operating
=
margin profit
operating
X
turnover
asset total
= 10% X 2.0
= 20%
If sales grow by 75%, then for next year-end assuming a 10% operating profit
margin:
Investment on Return
Income Operating
=
margin profit
operating
X
turnover
asset total
= 10% X 3.5
= 35%
3-5A. a.
Sales/365 Credit
Receivable Accounts

Period
Collection Average
·
Avg Collection Period =
$9m)/365 x (.75
$562,500
Avg Collection Period = 30 days
Note that the average collection period is based on credit sales, which are 75%
of total firm sales.
b.
period collection
Average
= 20 =
$9m)/365 x (.75
Receivable Accounts
Solving for accounts receivable:

receivable
Accounts
= $369,863
Thus, Brenmar would reduce its accounts receivable by
$562,500 - $369,863 = $192,637.
37
c. Inventory Turnover =
s Inventorie
Sold Goods of Cost
9 =
s Inventorie
Sales x .70
Inventories =
9
$9m x .70
= $700,000
3-6A. a. Industry
RATIO 2002 2003 Norm
Liquidity:
Current Ratio 6.0x 4.0x 5.0x
Acid-test (Quick) Ratio 3.25x 1.92x 3.0x
Average Collection Period 137 days 107 days 90 days
Inventory Turnover 1.27x 1.36x 2.2x
Operating profitability:
Operating Profit Margin 20.8% 24.8% 20.0%
Total Asset Turnover .5x .56x .75x
Average Collection Period 137 days 107 days 90 days
Inventory Turnover 1.27x 1.36x 2.2x
Fixed Asset Turnover 1.00x 1.04x 1.00x
Financing:
Debt Ratio 0.33 0.35 0.33
Times Interest Earned 5.0x 5.63x 7.0x
Return on common stockholders’ investment:
Return on Common Equity 7.5% 10.5% 9.0%
b. Regarding the firm’s liquidity in 2003, the current and acid-test (quick) ratios
are both well below the industry averages and have decreased considerably
from the prior year. Also, the average collection period and inventory turnover
do not compare favorably against the industry averages, which suggests that
accounts receivable and inventories are not of equal quality of these assets in
other firms in the industry. So, we may reasonably conclude that Pamplin is
less liquid than the average company in its industry.
38
c. In evaluating Pamplin’s operating profitability relative to the average firm in
the industry, we must first analyze the operating income return on investment
(OIROI) both for Pamplin and the industry. From the information given, this
computation may be made as follows:
investment on return
income Operating
=
margin profit
Operating
X
over turn
asset Total
Industry: 20% X 0.75 = 15%
Pamplin 2002: 20.8% X 0.50 = 10.4%
Pamplin 2003: 24.8% X 0.56 = 13.9%
Thus, given the low operating income return on investment for Pamplin relative
to the industry, we must conclude that management is not doing an adequate
job of generating operating profits on the firm’s assets. However, they did
improve between 2002 and 2003. The problem lies not with the operating
profit margin, which addresses the operating costs and expenses relative to
sales. Instead, the problem arises from Pamplin’s management not using the
firm’s assets efficiently, as indicated by the low asset turnover ratios. Here the
problem occurs in managing accounts receivable and inventories, where we see
the low turnover ratios. The firm does appear to be using the fixed assets
reasonably well—note the satisfactory fixed assets turnover.
d. Financing decisions
A balance-sheet perspective:
The debt ratio for Pamplin in 2003 is around 35%, an increase from 33% in
2002; that is, they finance slightly more than one-third of their assets with debt
and a little less than two-thirds with common equity. Also, the average firm in
the industry uses about the same amount of debt per dollar of assets as Pamplin.
An income-statement perspective:
Pamplin’s times interest earned is below the industry norm—5.0 and 5.63 in
2002 and 2003, respectively, compared to 7.0 for the industry average. In
thinking about why, we should remember that a company’s times interest
earned is affected by (1) the level of the firm’s operating profitability (EBIT),
(2) the amount of debt used, and (3) the interest rate. Items 2 and 3 determine
the amount of interest paid by the company. Here is what we know about
Pamplin:
1. The firm’s operating income return on investment is below average, but
improving. Thus, we would expect this fact to contribute to a lower, but
also improving, times interest earned. The evidence is consistent with
this thought.
2. Pamplin uses about the same amount of debt as the average firm, which
should mean that its times interest earned, all else equal, would be about
the same as for the average firm. Thus, Pamplin’s low times interest
earned is not the consequence of using more debt.
39
3. We do not have any information about Pamplin’s interest rate, so we
cannot make any observation about the effect of the interest rate. But
we know if Pamplin is paying a higher interest rate than its competitors,
such a situation would also be contributing to the problem.
e. Pamplin has improved its return on common equity from 7.5% in 2002 to
10.5% in 2003, compared to an industry norm of 9%. The sharp improvement
has come from a significant increase in the firm’s operating income return on
investment and a modest increase in the use of debt financing. It is also
possible that the higher return on equity comes from Pamplin paying a lower
interest rate on its debt, but we do not have enough information to know for
certain. Nevertheless, Pamplin has enhanced the returns to its owners, but with
a touch of additional financial risk (slightly higher debt ratio) in the process.
3-7A. a. Salco’s total asset turnover, operating profit margin, and operating income
return on investment.
Total Asset Turnover =
Assets Total
Sales
=
000 , 000 , 2 $
000 , 500 , 4 $
= 2.25 times
Operating Profit Margin =
Sales
Income Operating
=
000 , 500 , 4 $
000 , 500 $
= 11.11%
Investment on Return
Income Operating
=
Assets Total
Income Operating
=
000 , 000 , 2 $
000 , 500 $
= 25%
or =
Sales
Income Operating
x
Assets Total
Sales
= .1111 X 2.25
= 25%
40
b. The new operating income return on investment for Salco after the plant
renovation:
Investment on Return
Income Operating
=
Sales
Income Operating
x
Assets Total
Sales
=
000 , 000 , 3 $
000 , 500 , 4 $
x 13 .
= .13 x 1.5
= 19.5%
c. Return earned on the common stockholders’ investment:
Post-Renovation Analysis:
equity
common on Return
=
Equity Common
rs Stockholde Common to
Available Income Net
=
000 , 500 $ 000 , 000 , 1 $
500 , 217 $
+
= 14.5%
Net income available to common stockholders following the renovation was
calculated as follows:
Operating Income (.13 x $4.5m) $ 585,000
Less: Interest ($100,000 + $50,000) (150,000 )
Earnings Before Taxes 435,000
Less: Taxes (50%) (217,500 )
Net Income Available to Common Stockholders $ 217,500
The increase in Common equity was calculated as follows:
Total assets purchased $ 1,000,000
Less: Increase in debt ($1,500,000 - $1,000,000) (500,000 )
Increase in equity to finance purchase $ 500,000
The computation above is measuring the return on equity based on the
beginning-of-the-year common equity. The equity would increase $217,500 by
year end.
41
Pre-renovation Analysis:
The pre-renovation rate of return on common equity is calculated as follows:
Return on Common Equity =
000 , 000 , 1 $
000 , 200 $
= 20%
Comparative Analysis:
A comparison of the two rates of return would argue that the renovation not be
undertaken. However, since investments in fixed assets generally produce cash
flows over many years, it is not appropriate to base decisions about their
acquisition on a single year’s ratios. There are additional problems with this
approach to fixed asset decision making which we will discover when we
discuss capital budgeting in a later chapter.
Instructor’s Note: To help convince those students who simply cannot accept
the fact that the renovation may be worthwhile even though the return on
common equity falls in the first year, we note that the existing plant is recorded
on the firm’s books at original cost less accounting depreciation. In a period of
rising replacement costs, this means that the return on common equity of 20%
without renovation may actually overstate the true return earned on a more
realistic “replacement cost” common equity base. In addition, the issue is
probably one of when to renovate (this year or next) rather than whether or not
to renovate. That is, the existing facility may require renovation in the next two
years to continue to operate. These considerations simply cannot be
incorporated in the ratio analysis performed here. We find this a very useful
point to make at this juncture of the course since industry practice still
frequently involves use of rules of thumb and ratio guides to the analysis of
capital expenditures.
3-8A. T.P. Jarmon
Instructor’s note: This problem serves to integrate the use of the DuPont analysis with
financial ratios. The student is guided through a thorough analysis of a loan applicant
that (on the surface) appears acceptable. However, an in-depth analysis reveals that the
firm is not nearly so liquid as it first appears and has used a substantial amount of
current debt to finance its assets.
a. See the accompanying table.
b. The most important ratios to consider in evaluating the firm’s credit request
relate to its liquidity and use of financial leverage. However, the credit analyst
can also evaluate the firm’s profitability ratios as a general indication as to how
effective the firm’s management has been in managing the resources available
to it. This latter analysis would be useful in evaluating the prospects for a long
and fruitful relationship with the new client.
42
c. The DuPont Analysis for Jarmon is shown in the graph on the next page. The
earning power analysis provides an in-depth basis for analyzing Jarmon’s only
deficiency, that relating to its relatively large investment in inventories.
However, even this potential weakness is largely overcome by the firm’s
strengths. The firm’s return on assets and its return on owner capital (return on
common equity) both compare well with the respective industry norms.
Instructor’s Note
At this point, we usually note the one major deficiency of DuPont Analysis.
This relates to the lack of any liquidity ratios. Thus, the analysis of earning
power alone is not appropriate for credit analysis since no indicators of liquidity
are calculated. This deficiency can, of course, be easily corrected by appending
one or more liquidity ratios to the analysis.
43
Industry
Ratio Formula Calculation Average

Current Ratio
000 , 75 $
300 , 138 $
= 1.84 1.8
Acid-Test Ratio
s Liabilitie Current
Inventory - Assets Current
000 , 75 $
000 , 84 300 , 138 $ −
= .72 .9
Debt Ratio
300 , 408 $
000 , 225 $
= .55 .5
000 , 10 $
000 , 80 $
= 8 10
Day per Sales Credit
Receivable Accounts
365 / 000 , 600 $
000 , 33 $
=
days
20.1
days
20
Inventory Turnover
000 , 84 $
000 , 460 $
= 5.48 7
Investment on Return
Income Operating
300 , 408 $
000 , 80 $
= .196 16.8%
or 19.6%
000 , 600 $
000 , 80 $
= .133 14%
or 13.3%
4
3
Industry
Ratio Formula Calculation Average

000 , 600 $
000 , 140 $
= .233 25%
or 23.3%
300 , 408 $
000 , 600 $
= 1.47 1.2
000 , 270 $
000 , 600 $
= 2.22 1.8
Return on Assets
Assets Total
Income Net
$408,300
$42,900
= .1051 6%
or 10.51%
Return on Equity
Equity Common
rs Stockholde Common
to Available Earnings
300 , 183 $
900 , 42 $
= .234 12%
or 23.4%
4
4
Return on Equity
Return on Assets
Equity
Total Assets
divided by
Net Profit Margin
Total Asset Turnover
multipled by
divided by
Net Income
Sales
Sales
Total costs and expenses
less
Cost of goods sold
Cash operating expenses
Depreciation
Interest Expense
Taxes
divided by
Total Assets
Sales
Current Assets Other Assets Fixed Assets
Cash and
Marketable
Securites
Accounts
Receivable
Inventory
Other Current
Assets
23.4%
10.51%
0.45
7.15%
1.47
$42,900
$600,000
$408,300
$138,300 $270,000 $0
$557,100
$460,000
$20,200
$33,000
$84,000 $1,100
$30,000
$30,000
$10,000
$27,100
$600,000
$600,000
Fixed Assets
Turnover
Inventory Turnover
Collection Period
divided by
Daily Credit
Sales
Accounts
Receivables
$1,644
divided by
Inventory
Cost of
Goods Sold
$84,000
$460,000
Fixed
Assets
Sales
$600,000
$270,000
20.08 days
5.48
2.22
$33,000
÷
45
3-9A. HiTech
Industry
RATIO 2003 Norm
Liquidity:
Current Ratio 2.51 2.01
Acid-test (Quick) Ratio 2.30 1.66
Average Collection Period 45.95 72.64
Accounts Receivable Turnover 7.94 5.02
Inventory Turnover 6.13 4.42
Operating profitability:
Operating Income
Return on Investment 23.2% 9.0%
Operating Profit Margin 34.6% 13.0%
Total Asset Turnover .67 .69
Accounts Receivable Turnover 7.94 5.02
Inventory Turnover 6.13 4.42
Fixed Asset Turnover 2.51 2.27
Financing:
Debt Ratio .26 .44
Times Interest Earned 247.78 8.87
Return on common stockholders’ investment:
Return on Common Equity 22.4% 12.0%
The above analysis of HiTech reveals a strong company in many areas. First, let’s look at the
liquidity question. How liquid is HiTech’s balance sheet? The current ratio surpasses the
industry, and when we subtract inventories in the acid-test ratio, HiTech still surpasses the
industry. It is the same with the inventory turnover ratio. This suggests that HiTech has a
lower than normal inventory level. The receivable turnover and average collection period also
reveal that HiTech controls this asset better than its competitors. These ratios tell us that
HiTech’s liquidity relies on assets other than inventory and receivables. When we review the
balance sheet, this assumption is supported for we see that $11.8 million of the $17.8 million
of HiTech’s current assets is in cash and cash equivalents alone. We next turn to the
profitability question. HiTech compares impressively on the OIROI and operating profit
margin ratios. The OIROI ratio tells us that either HiTech must be doing a superior job at
sales, expenses, or generating greater sales from a lower asset level. When we look at the total
asset turnover, HiTech rates slightly lower than normal. HiTech is generating the same
proportionate level of sales from the same level of assets as its competitors. We know that
HiTech is doing a good job of turning over its current assets. The fixed asset turnover tells us
that part of the problem is in the level of fixed assets that HiTech is maintaining. As we look
at the balance sheet, we see that HiTech also maintains a high level of “other investments”.
HiTech must be doing an excellent job at controlling costs, which is supported by the excellent
operating profit margin ratio. We now look at the financing question. HiTech is maintaining a
low level of debt as compared to the industry and is more than able to service its interest
expense. This means that HiTech is financing its assets through equity. Let’s look at the
return that these owners are receiving from their investment through the final ratio. HiTech
also rates favorably on return on common equity, 22.4% as compared to the 12.0% industry
average.
46
INTEGRATIVE PROBLEM
1.
Blake International 1999 2000 2001 2002 2003
Current ratio 3.11 2.83 2.54 2.22 1.99
Acid-test ratio 1.64 1.78 1.56 1.35 1.33
Average collection period 53.16 62.00 56.29 58.63 52.48
Accounts receivable turnover 6.87 5.89 6.48 6.23 6.95
Inventory turnover 3.28 3.87 4.00 3.73 4.21
Operating income return on
investment
0.22 0.15 0.16 0.08 0.09
Gross profit margin 0.40 0.39 0.38 0.38 0.40
Operating profit margin 0.10 0.08 0.08 0.04 0.05
Total asset turnover 2.10 1.95 2.07 1.85 1.85
Fixed asset turnover 18.13 18.81 23.21 18.64 16.29
Debt ratio 0.43 0.79 0.71 0.69 0.66
Times interest earned 14.00 6.31 4.31 2.30 2.78
Return on equity 0.18 0.36 0.27 0.04 0.02
Note: Above ratio calculations may be subject to rounding errors.
Question #1
It is apparent that Blake’s liquidity is decreasing over time, as the current and acid-test
ratios indicate. However, the receivable turnover and average collection period stayed
relatively constant while the inventory turnover actually increased. When we review
the balance sheet, we note that the cash balance has actually increased while the
receivable and inventory balances decreased, creating more liquidity within the total
current assets, even though the net current asset balance decreased in total. The real
problem lies with the increase in current liabilities over time in combination with the
decrease in current assets.
Question #2
Also of great concern is the decrease in operating profitability that is shown in the
OIROI ratios over time. The problem does not seem to be in the cost of goods sold as
47
indicated by the gross profit margin ratio. The problem appears in the operating profit
margin having also decreased over time. Upon review of the income statement, we
will see that while sales have decreased, the operating expenses have stayed the same.
The total asset turnover and fixed asset turnover have also decreased, although not to
the same degree. Blake has lowered the asset balances as sales have lowered, but still
needs to work further to lower fixed assets, decrease expenses, and increase sales.
Question #3
While sales and assets have decreased over time, the level of debt to equity has
increased. As of 2003, 66% of Blake’s assets are being financed through the use of
debt. The company is quickly becoming over-leveraged and soon will lose its ability to
pay interest as the times interest earned ratio shows.
Question #4
Return on common equity has declined, especially in the last two years. This can be
the result of two factors, a lower rate of return or financing through less debt. As noted
above, Blake has increased debt greatly over the last five years. As we have also
noted, Blake’s operating profitability has also decreased over the last few years as a
result of decreasing sales and higher interest costs. We can safely assume that the
decreasing return is the result of decreasing profits.
Scott Corp. 1999 2000 2001 2002 2003
Current ratio 1.85 1.86 2.05 2.07 2.26
Acid-test ratio 1.28 1.22 1.33 1.25 1.43
Average collection period 80.75 75.92 69.69 63.96 64.71
Accounts receivable turnover 4.52 4.81 5.24 5.71 5.64
Inventory turnover 4.45 4.11 4.01 4.21 4.42
Operating income return on
investment
0.21 0.24 0.25 0.16 0.16
Gross profit margin 0.41 0.41 0.42 0.38 0.40
Operating profit margin 0.14 0.14 0.15 0.09 0.10
Total asset turnover 1.51 1.64 1.71 1.77 1.67
Fixed asset turnover 8.58 10.06 9.96 8.28 6.93
Debt ratio 0.37 0.38 0.41 0.40 0.36
Times interest earned 27.54 23.45 24.73 12.60 16.41
Return on equity 0.20 0.23 0.25 0.12 0.14
Note: Above ratio calculations may be subject to rounding errors.
Question #1
Scott’s liquidity increased over the last five years, despite its growth. While current
liabilities increased, current assets grew by over 60%. This is reflected in the positive
48
trend of the current ratio. Despite inventory growth of 90%, the acid-test ratio and
inventory turnover both increased positively over time due to strong growth in other
areas such as receivables and sales (which in turn impacted cost of goods sold on
which the inventory turnover ratio is based). The receivable turnover ratio and average
collection period also trended positively due to a slight increase in receivables as
compared to an 84% increase in sales.
Question #2
Operating profitability seems to have decreased slightly over the last five years. Upon
review of the ratios in combination with the financial statements, this seems to be the
result of two factors. One, operating expenses have grown disproportionately to sales
over the years. Depreciation has grown due to the fixed asset growth, which is the
second factor. The total asset turnover has increased as a result of the positive use of
receivables and inventories. However, fixed assets have grown considerably, affecting
both the OIROI and the fixed asset turnover.
49
Question #3
Upon initial review of the debt ratio, Scott seems to be successively financing its
growth with the same proportion of debt over the last five years. However, Scott does
need to be aware that the times interest earned is trending down due to the fact that the
operating expenses have grown disproportionately. This will impact its ability to
service debt over future years.
Question #4
Scott has decreased its return on common equity especially in the last two years. Since
Scott has not decreased its debt ratio, we must review the income statement for the
explanation. Even though Scott has almost doubled its sales, net income has remained
the same. This is the result of decreased operating profit margin and increased interest.
The increased interest is either the result of increased debt or a higher cost of debt.
2. The differences in Scott’s and Blake’s financial performance are easy to find. Scott
continues to be a thriving company while Blake seems to have many financial
problems. Scott’s sales have grown 84% while Blake’s sales have decreased by 17%.
However, they also have many similarities. Let’s look at the differences and
similarities by question.
Liquidity – Both Blake and Scott have done a good job of controlling their inventories
and receivables. Both had positive trends in these areas. The difference is that Scott
has considerable liquidity while Blake is losing this ability due to its increasing current
liabilities.
Profitability – Both Scott and Blake are having problems with operating profitability.
Their OIROI’s have trended downward over time due to increasing operating expenses
and increasing fixed assets as compared to sales.
Financing – The true differences appear in how Blake and Scott are financing their
assets. While Scott’s debt ratio has stayed the same, Blake has increased its debt ratio
to 66%. This has significantly increased the risk to the financial health of Blake.
While both Scott’s and Blake’s times interest earned have decreased due to increasing
operating expenses, Blake is dangerously close to losing its ability to service its debt.
Return on Investment – Once again, Scott and Blake are more similar than different,
except as to the severity of the amount. Scott and Blake have decreased their return on
investment. Blake has increased its debt while Scott’s stayed the same. Both have
decreased their net income as compared to sales. This is the result of increased
operating and interest costs, as gross profit margins have stayed the same.
50
Solutions for Set B
3-1B. Cash 174,363 Accounts Payable 100,000
Accounts Receivable * 80,137 Long-Term Debt 290,000
Inventory 45,500 Total Liabilities 390,000
Current Assets 300,000 Common Equity 910,000
Net Fixed Assets 1,000,000
Total Assets 1,300,000 Total Liability & Equity 1,300,000
* Based on 360 days.
Current ratio 3
Total asset turnover 0.5
Gross profit margin 30%
Inventory turnover 10
Average collection period 45
Debt ratio 30%
Sales 650,000
Cost of goods sold 455,000
Total liabilities 390,000
3-2B. Allandale’s present current ratio of 2.75 in conjunction with its $3.0 million investment
in current assets indicates that its current liabilities are presently $1.09 million. Letting
x represent the additional borrowing against the firm’s line of credit (which also equals
the addition to current assets), we can solve for that level of x which forces the firm’s
current ratio down to 2 to 1, i.e.,
2 = ($3.0 million + x) / ($1.09 million + x)
x = $.82 million
3-3B. Instructor’s Note: This is a very rudimentary "getting started" exercise. It requires no
analysis beyond looking up the appropriate formula and plugging in the corresponding
figures.
Current Ratio = =
800 , 1 $
500 , 3 $
= 1.94X
Debt Ratio = =
000 , 8 $
900 , 3 $
= .49 or 49%
Times Interest Earned = =
367 $
500 , 1 $
= 4.09X
Average Collection Period = =
365 500 , 7 $
500 , 1 $
÷
= 73
days
Inventory Turnover = =
000 , 1 $
000 , 3 $
= 3.0X
Fixed Asset Turnover = =
500 , 4 $
500 , 7 $
= 1.67X
Total Asset Turnover =
Assets Total
Sales Net
=
000 , 8 $
500 , 7 $
= .94X
51
Gross Profit Margin =
Sales Net
Profits Gross
=
500 , 7 $
500 , 4 $
= .60 or 60%
=
Sales Net
Income Operating
=
500 , 7 $
500 , 1 $
= .20 or 20%
= =
000 , 8 $
500 , 1 $
= .19 or 19%
Return on Equity = =
100 , 4 $
680 $
=.17 or 17%
or, we can calculate return on equity as:
= Return on assets ÷ (1- debt ratio)
=
assets Total
income Net
÷
,
_

¸
¸

assets Total
debt Total
1
=
( ) .49 - 1
8,000
680
÷
= .17 or 17%
3-4B. a. Total Assets Turnover =
Assets Total
Sales
=
$6m
$11m
= 1.83X
b. 2.5 =
Sales = $15m
Thus, the needed sales growth is $4 million ($15m - $11m) or an increase of
36%:
= 36%
52
c. Last year,
= X
= 6% X 1.83
= 11%
If sales grow by 36%, then for next year-end assuming a 6% operating profit
margin:
= X
= 6% X 2.5
= 15%
3-5B. a.
Period
Collection Average
=
Avg Collection Period =
5 $9.75m)/36 x (.75
$562,500
Avg Collection Period = 28.08 days
Note that the average collection period is based on credit sales, which are 75%
of total firm sales.
b. = 20 =
5 $9.75m)/36 x (.75
Receivable Accounts
Solving for accounts receivable:

Receivable
Accounts
= $400,685
Thus, Brenda Smith, Inc. would reduce its accounts receivable by
$562,500 - $400,685 = $161,815
c. Inventory Turnover =
8 =
Inventories = = $914,062.50
53
3-6B. a.
Industry
RATIO 2002 2003 Norm
Liquidity:
Current Ratio 5.00 5.35 5.00
Acid-test (Quick) Ratio 2.70 2.63 3.00
Average Collection Period 131.40 108.24 90.00
Inventory Turnover 1.22 1.40 2.20
Operating profitability:
Operating Income
Return on Investment 12.24% 13.04% 15.00%
Operating Profit Margin 24.00% 22.76% 20.00%
Total Asset Turnover .51 .57 .75
Average Collection Period 131.40 108.24 90.00
Inventory Turnover 1.22 1.40 2.20
Fixed Asset Turnover 1.04 1.12 1.00
Financing:
Debt Ratio 34.69% 32.81% 33.00%
Times Interest Earned 6.00 5.50 7.00
Rate of return on common stockholders’ investment:
Return on Common Equity 9.38% 9.53% 13.43%
b. Regarding the firm’s liquidity, the acid-test (quick) ratios are below the
industry average and have decreased from the prior year. Also, the average
collection period and inventory turnover are well below the industry averages,
which suggests that inventories and receivables are not of equal quality of these
assets in other firms in the industry. Since the current ratio is satisfactory, the
problem apparently lies in the management of inventories and receivables. So,
we may reasonably conclude that Chavez is less liquid than the average
company in its industry because it has a greater investment in inventories and
receivables than the industry average.
54
c. In evaluating Chavez’s operating profitability relative to the average firm in the
industry, we must first analyze the operating income return on investment
(OIROI) both for Chavez and the industry. From the information given, this
computation may be made as follows:
= X
Industry: 20.00% X 0.75 = 15.00%
Chavez 2002: 24.00% X 0.51 = 12.24%
Chavez 2003: 22.76% X 0.57 = 12.97%
Thus, given the low operating income return on investment for Chavez relative
to the industry, we must conclude that management is not doing an adequate
job of generating operating profits on the firm’s assets. However, they did
improve between 2002 and 2003. The problem lies not with the operating
profit margin, which addresses the operating costs and expenses relative to
sales. Instead, the problem arises from Chavez’s management not using the
firm’s assets efficiently, as indicated by the low asset turnover ratios. Here, the
problem occurs in managing accounts receivable and inventories, where we see
the low turnover ratios. The firm does appear to be using the fixed assets
reasonably well—note the satisfactory fixed assets turnover.
d. Financing decisions
A balance-sheet perspective:
The debt ratio for Chavez in 2003 is around 33%, a decrease from 34.7% in
2002; that is, they finance about one-third of their assets with debt and a little
more than two-thirds with common equity. The average firm in the industry
uses about the same amount of debt per dollar of assets as Chavez.
An income-statement perspective:
Chavez’s times interest earned is below the industry norm—6.0 and 5.5 in 2002
and 2003, respectively, compared to 7.0 for the industry average. In thinking
about why, we should remember that a company’s times interest earned is
affected by (1) the level of the firm’s operating profitability (EBIT), (2) the
amount of debt used, and (3) the interest rate. Items 2 and 3 determine the
amount of interest paid by the company. Here is what we know about Chavez:
1. The firm’s operating profitability is below average, but improving.
Thus, we would expect this fact to contribute to a lower times interest
earned. The evidence is consistent with this thought.
2. Chavez uses about the same amount of debt as the average firm, which
should mean that its times interest earned, all else equal, would be about
the same as for the average firm. Thus, Chavez’s low times interest
earned is not the consequence of using more debt.
3. We do not have any information about Chavez’s interest rate, so we
cannot make any observation about the effect of the interest rate. But
we know if Chavez is paying a higher interest rate than its competitors,
such a situation would also be contributing to the problem.
55
e. Chavez has improved its return on common equity from 9.38% in 2000 to
9.53% in 2001, compared to an industry norm of 13.43%. The improvement
has come from an increase in the firm’s operating income return on investment,
despite a slight decrease in the use of debt financing. Thus, Chavez has
enhanced the returns to its owners, and with a small decline of financial risk
(slightly lower debt ratio) in the process.
3-7B. a. Mel’s total asset turnover, operating profit margin, and operating income return
on investment.
Total Asset Turnover =
=
000 , 000 , 2 $
000 , 000 , 5 $
= 2.50 times
Operating Profit Margin =
=
000 , 000 , 5 $
000 , 500 $
= 10.00%
Investment on Return
Income Operating
=
Assets Total
Income Operating
=
$2,000,000
$500,000
= 25%
or = X
= 10% X 2.50 = 25%
b. The new operating income return on investment for Mel’s after the plant
renovation:
= x
= .13 X
000 , 000 , 3 $
000 , 000 , 5 $
= .13 X 1.67
= 21.67%
56
c. Return earned on the common stockholders’ investment:
Post-Renovation Analysis:
Return on Common Equity =
Equity Common
rs Stockholde Common to Available Income Net
=
000 , 500 $ 000 , 000 , 1 $
000 , 306 $
+
= .204 = 20.4%
Net income available to common stockholders following the renovation was
calculated as follows:
Operating Income (.13 x $5m) $ 650,000
Less: Interest ($100,000 + $40,000) (140,000 )
Earnings Before Taxes 510,000
Less: Taxes (40%) (204,000 )
Net Income Available to Common Stockholders $ 306,000
The increase in Common equity was calculated as follows:
Total assets purchased $ 1,000,000
Less: Increase in debt ($1,500,000 - $1,000,000) (500,000 )
Increase in equity to finance purchase $ 500,000
The computation above is measuring the return on equity based on the
beginning-of-the-year common equity. The equity would increase $217,500 by
year end.
Pre-renovation Analysis:
The pre-renovation rate of return on common equity is calculated as follows:
Return on Common Equity =
000 , 000 , 1 $
000 , 240 $
= 24%
57
Comparative Analysis:
A comparison of the two rates of return would argue that the renovation not be
undertaken. However, since investments in fixed assets generally produce cash
flows over many years, it is not appropriate to base decisions about their
acquisition on a single year’s ratios. There are additional problems with this
approach to fixed asset decision making which we will discover when we
discuss capital budgeting in a later chapter.
Instructor’s Note: To help convince those students who simply cannot accept
the fact that the renovation may be worthwhile even though the return on
common equity falls in the first year, we note that the existing plant is recorded
on the firm’s books at original cost less accounting depreciation. In a period of
rising replacement costs, this means that the return on common equity of 24%
without renovation may actually overstate the true return earned on a more
realistic "replacement cost" common equity base. In addition, the issue is
probably one of when to renovate (this year or next) rather than whether or not
to renovate. That is, the existing facility may require renovation in the next two
years to continue to operate. These considerations simply cannot be
incorporated in the ratio analysis performed here. We find this a very useful
point to make at this juncture of the course, since industry practice still
frequently involves use of rules of thumb and ratio guides to the analysis of
capital expenditures.
3-8B. a. See the accompanying table.
b. The most important ratios to consider in evaluating the firm’s credit request
relate to its liquidity and use of financial leverage. However, the credit analyst
can also evaluate the firm’s profitability ratios as a general indication as to how
effective the firm’s management has been in managing the resources available
to it. This latter analysis would be useful in evaluating the prospects for a long
and fruitful relationship with the new client.
58
Industry
Ratio Formula Calculation Average

Current Ratio
000 , 73 $
300 , 156 $
= 2.14 1.8
Acid-Test Ratio
abilities Current Li
Inventory Assets Current −
000 , 73 $
000 , 93 300 , 156 $ −
= .87 .9
Debt Ratio
300 , 446 $
000 , 223 $
= .50 .5
Expense Interest
Income Operating
000 , 10 $
000 , 120 $
= 12 10
365 / 000 , 700 $
000 , 38 $
=
days
19.81
days
20
Inventory Turnover
000 , 93 $
000 , 500 $
= 5.38 7
5
8
Industry
Ratio Formula Calculation Average

Investment on Return
Income Operating
300 , 446 $
000 , 120 $
= .2689 16.8%
or 26.89%
000 , 700 $
000 , 120 $
= .171 14%
or 17.1%
000 , 700 $
000 , 200 $
= .2857 25%
or 28.57%
300 , 446 $
000 , 700 $
= 1.57 1.2
000 , 290 $
000 , 700 $
= 2.41 1.8
Return on Assets
Assets Total
Income Net
$446,300
$82,900
= .1857 6.0%
or 18.57%
Return on Equity
Equity Common
rs Stockholde Common
to Available Earnings
300 , 223 $
900 , 82 $
= .3712 12%
or 37.12%
5
9
Return on Equity
Return on Assets
Equity
Total Assets
divided by
Net Profit Margin
Total Asset Turnover
multipled by
divided by
Net Income
Sales
Sales
Total costs and expenses
less
Cost of goods sold
Cash operating expenses
Depreciation
Interest Expense
Taxes
divided by
Total Assets
Sales
Current Assets Other Assets Fixed Assets
Cash and
Marketable
Securites
Accounts
Receivable
Inventory
Other Current
Assets
37.1%
18.57%
0.50
11.84%
1.57
$82,900
$700,000
$446,300
$156,300 $290,000 $0
$617,100
$500,000
$24,200
$38,000
$93,000 $1,100
$50,000
$30,000
$10,000
$27,100
$700,000
$700,000
Fixed Assets
Turnover
Inventory Turnover
Collection Period
divided by
Daily Credit
Sales
Accounts
Receivables
$1,918
divided by
Inventory
Cost of
Goods Sold
$93,000
$500,000
Fixed
Assets
Sales
$700,000
$290,000
19.81 days
5.38
2.41
$38,000
÷
61
62
3-9B. Reynolds Computer
RATIO 2003 Norm
Liquidity:
Current Ratio 1.48 1.49
Acid-test (Quick) Ratio 1.40 1.36
Average Collection Period 38.69 53.38
Accounts Receivable Turnover 9.43 6.84
Inventory Turnover 50.87 20.87
Operating profitability:
Operating Income
Return on Investment 21.4% 9.0%
Operating Profit Margin 9.7% 6.0%
Total Asset Turnover 2.20 1.58
Accounts Receivable Turnover 9.43 6.84
Inventory Turnover 50.87 20.87
Fixed Asset Turnover 33.02 13.02
Financing:
Debt Ratio .54 .47
Times Interest Earned 72.26 14.79
Rate of return on common stockholders’ investment:
Return on Common Equity 31.3% 13.0%
Liquidity – Based on the current and acid-test ratios, Reynolds Computer is performing as well as the
industry average in the area of liquidity. At a detail level, Reynolds Computer is doing much better
than average in managing both receivables and inventory. As you can observe, the acid-test ratio
changes little from the current ratio. Based upon the small effect that inventory has on the current ratio,
we might assume that Reynolds Computer is not holding a large amount of inventory. Upon review of
the balance sheet, inventory only accounts for 5% of total current assets. Cash accounts for 54% of the
total current assets making Reynolds Computer much more liquid than the current ratio indicates.
Profitability – Reynolds Computer seems to be doing an excellent job at operating profitability based
on the OIROI ratio. Let’s break down this ratio into its two components We have already ascertained
that Reynolds Computer is managing its accounts receivable and inventory effectively. From the fixed
asset ratio, Reynolds Computer is also managing a much lower amount of fixed assets as compared to
sales than the industry. Overall, Reynolds Computer is generating more sales from every $1 of assets
than its competitors. Reynolds Computer is also doing a good job at managing its income statement.
The operating profit margin shows that Reynolds Computer is controlling costs efficiently. Both the
asset turnover and profit margin contribute to Reynolds Computer’s favorable operating profitability.
Financing – Reynolds Computer finances more of its assets through debt than its competitors. This
involves more risk, but it can also provide higher returns as we will note in the next section. Reynolds
Computer must be careful not to over-leverage itself. However, Reynolds Computer’s times interest earned
ratio indicates that Reynolds Computer can service its debt more easily than the average firm.
Return on Investment- As noted above, Reynolds Computer finances more of its assets through debt
than the industry average. With more debt and less equity, this will provide a higher return to its owners as
long as the earned rate of return is higher than the cost of debt. Based on the high operating profitability and
times interest earned ratios, we can assume this is the case. As a result, the common equity owners are
receiving a higher return on their investment than the industry average.
63

CHAPTER 4
64
Financial Forecasting,
Planning, and Budgeting

CHAPTER ORIENTATION
This chapter is divided into two sections. The first section includes an overview of the role
played by forecasting in the firm's planning process. The second section focuses on the
construction of detailed financial plans, including developing a cash budget for future
periods of the firm's operations. A budget is a forecast of future events and provides the
basis for taking corrective action and can also be used for performance evaluation. The cash
budget also provides the necessary information to estimate future financing requirements of
the firm. These estimates are the key elements in our discussion of financial planning and
budgeting.
CHAPTER OUTLINE
I. Financial forecasting and planning
A. The need for forecasting in financial management arises whenever the future
financing needs of the firm are being estimated. There are three basic steps
involved in predicting financing requirements.
1. Project the firm's sales revenues and expenses over the planning
period.
2. Estimate the levels of investment in current and fixed assets, which
are necessary to support the projected sales level.
3. Determine the financing needs of the firm throughout the planning
period.
B. The key ingredient in the firm's planning process is the sales forecast. This
forecast should reflect (l) any past trend in sales that is expected to continue
and (2) the effects of any events, which are expected to have a material effect
on the firm's sales during the forecast period.
65
C. The traditional problem faced in financial forecasting begins with the
sales forecast and involves making forecasts of the impact of
predicted sales on the firm's various expenses, assets, and liabilities.
One technique that can be used to make these forecasts is the percent
of sales method.
1. The percent of sales method involves projecting the financial variable
as a percent of projected sales.
2. As sales volume changes, the level of assets required to support the
firm changes. Assets are financed by liabilities and equity, so
changes in assets lead to changes in liabilities and equity. Current
liabilities, such as accounts payable and accrued expenses, vary
spontaneously as sales change. Retained earnings are impacted by
changes in net income and dividends.
3. The difference between the projected level of assets and the projected
change in liabilities and equity is the discretionary financing needed.
4 Percent of sales forecasting can give erroneous results for assets that
have scale economies or assets that must be purchased in discrete
quantities.
II. Sustainable rate of growth
A. Sustainable rate of growth indicates how fast a firm can grow without having
to increase the firm’s debt ratio and without having to sell more stock.
B. Sustainable rate of growth, g = return on equity x (1 – dividend payout ratio)
III. Financial planning and budgeting
A. Three functions of a budget are indicating the amount and timing of future
financing needs, providing the basis for taking corrective action if actual
figures do not match budget estimates, and evaluating performance of the
firm.
B. The cash budget represents a detailed plan of future cash flows and can be
broken down into four components: cash receipts, cash disbursements, net
change in cash for the period, and new financing needed.
C. Although no strict rules exist, as a general rule, the budget period shall be
long enough to show the effect of management policies, yet short enough so
that estimates can be made with reasonable accuracy. For instance, the
capital expenditure budget may be properly developed for a 10-year period
while a cash budget may only cover 12 months.
66
D. Cash budgets can be used to develop a pro forma income statement
and a pro forma balance sheet.
1. A pro forma income statement represents a statement of planned profit or
loss for the future period and is based primarily on information generated
in the cash budget.
2. The pro forma balance sheet for a future date is developed by
adjusting present balance sheet figures for projected information
found primarily within the cash budget and pro forma income
statement.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
4-1. This rather simplistic forecast method assumes no other information is available
which would indicate a change in the observed relationship between sales and the
expense item, asset or liability being forecast. Furthermore, the percent of sales
method works best for projected sales levels that are very close to the base level sales
used to determine the "percent of sales." The greater the difference in predicted and
base level sales, in general, the less accurate will be the percent of sales forecast.
4-2. In a fixed cash budget, cash flow estimates are made for a single set of sales
estimates, whereas a variable budget involves the preparation of several cash flow
estimates, with each estimate corresponding to a different set of sales estimates.
4.3 A flexible (or variable) cash budget gives the firm's management more information
regarding the range of possible financing needs of the firm, and secondly, it provides
management with a standard against which it can measure the performance of those
subordinates who are responsible for the various cost and revenue items contained in
the budget.
4-4. The probable effect on cash flows would be as follows:
(a) increased cash inflow from sales but increased cash outflow to finance
needed increases in inventories and other assets.
(b) increased supply of available cash.
(c) decreased cash inflow.
(d) immediate decrease in cash inflows (or a cash outflow).
4-5. As a general rule, the budget period should be long enough to show the effect of
management policies yet short enough so that estimates can be made with reasonable
accuracy. Since some budgets, such as capital expenditure budgets, require long-
range planning in order to be effective while other budgets are more effective for
shorter periods, it would not be wise for a firm to establish a standard budget period
for all budgets. Instead, firms usually have a minimum of two and sometimes three
types of budgets. The short-term budget is very detailed and includes a cash budget
covering 6 months to a year. The intermediate term budget will contain pro forma
67
statements and verbal descriptions of major investment/financing plans that cover 2
to 5 years. A long-term plan would involve less detailed general statements about
the firm's strategic plans covering the next 3 to 10 years.
4-6. A cash budget can also be used to determine the amount of excess cash on hand that
will not be needed to finance future operations. This excess cash can then be
invested in securities or other profitable alternatives.
4-7. The careful budgeting of cash is of particular importance to a seasonal operation
because cash flows are not continuous. The availability of cash resources must be
carefully planned in order that the normal operation of the firm can be continued
during slow periods. In addition, it is important to plan for future cash needs so that
excess funds may be invested.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
4-1A.
2003 % of Sales 2004
Sales 12,000,000 15,000,000
Net Income 1,200,000 2,000,000
Current Assets 3,000,000 25% 3,750,000
Net fixed assets 6,000,000 50% 7,500,000
Total Assets 9,000,000 11,250,000
Liabilities and Owner's Equity
Accounts payable 3,000,000 25% 3,750,000
Long-term debt 2,000,000 NA 2,000,000
Total Liabilities 5,000,000 5,750,000
Common stock 1,000,000 NA 1,000,000
Paid-in capital 1,800,000 NA 1,800,000
Retained earnings 1,200,000 3,200,000
Common equity 4,000,000 6,000,000
Total Liabilities and Equity 9,000,000 11,750,000
DFN = (500,000)
68
4-2A.
a. % Credit Sales 0.5
Sales
February 20,000
March 30,000
April (estimated) 40,000
Accounts receivable (3/31/03) 20,000
plus credit sales for April (50% x 40,000) 20,000
less collections from Feb sales (50% x 20,000 x .5) (5,000)
less collections from March sales(50% x 30,000 x .5)(7,500 )
Accounts receivable (4/30/03) 27,500
b. Collections From:
April cash sales $ 20,000
February credit sales 5,000
March credit sales 7,500
$ 32,500
4-3A. Based upon the projections made, Sambonoza can expect to have total assets next
year equal to $1.8 million made up of the $1 million in fixed assets plus $800,000 (.2
x $4 million) in current assets. These assets will be financed by known sources of
funding comprised of $900,000 in common equity [$800,000 + (.5)(.05)($4 million)
= $900,000], plus payables and trade credit equal to 10% of projected sales
($400,000) which totals $1.3 million. This leaves $500,000 ($1.8 million - $1.3
million), which will need to be raised to meet the financing needs of the firm.
4-4A. Instructor’s Note: This is an introductory percent of sales financial forecasting
problem. Students should be able to solve it after a first reading of the chapter.
(a) Projected Financing Needs = Projected Total Assets
= Projected Current Assets + Projected Fixed Assets
={ x $20 m} +{ $5m + $.1m} = $11.77m
(b) DFN = Projected Current Assets + Projected Fixed Assets
- Present LTD - Present Owner's Equity
- [Projected Net Income - Dividends]
- Spontaneous Financing
={ x $20m} + $5.1m - $2m - $6.5m
- [.05 x $20m - $.5m] -{ x $20m}
DFN = $6.67m + $5.1m - $8.5m - $.5m - $2m = $.77m
69
(c) We first solve for the maximum level of sales for which DFN = 0:
DFN = (
15
5
- .05 -
15
5 . 1
) Sales – (5.1M-2M-6.5M +.5M)
DFN = .1833 SALES - $2.9M = 0
Thus, SALES = $15.82M
The largest increase in sales that can occur without a need to raise
"discretionary funds" is
$15.82M - $15M = $820,000.
4-5A.
Cash $ .1m Current Liabilities $.6m
Accounts Receivable .1m Long-Term Debt .4m
Inventories 1.0m Common Stock plus
Net Fixed Assets .8m Retained earnings 1.0m
$2.0m $2.0m
70
4-6A. (a) The Sharpe Corporation Cash Budget Worksheet
Nov Dec Jan Feb Mar Apr May June July
Sales $220,000 $175,000 $ 90,000 $120,000 $135,000 $240,000 $300,000 $270,000 $225,000
Collections:
Month of sale (10%) 9,000 12,000 13,500 24,000 30,000 27,000 22,500
First month (60%) 105,000 54,000 72,000 81,000 144,000 180,000 162,000
Second month (30%) 66,000 52,500 27,000 36,000 40,500 72,000 90,000
Total Collections 180,000 118,500 112,500 141,000 214,500 279,000
274,500
Purchases 72,000 81,000 144,000 180,000 162,000 135,000 90,000 75,000
Payments (one month lag) 72,000 81,000 144,000 180,000 162,000 135,000 90,000
Cash Receipts
(collections) 180,000 118,500 112,500 141,000 214,500 279,000 274,500
Cash Disbursements
Purchases 72,000 81,000 144,000 180,000 162,000 135,000 90,000
Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 22,500 22,500
Interest on Short-Term
Borrowing _______ _______ _______ _______ 605 386 _______
Total Disbursements $102,000 $111,000 $196,500 $210,000 $192,605 $187,886 $120,000
Net Monthly Change $78,000 $7,500 ($84,000) ($69,000) $21,895 $91,114 $154,500
Beginning Cash Balance 22,000 100,000 107,500 23,500 15,000 15,000 67,509
Additional Financing
Needed (Repayment) ________ _______ ________ 60,500 (21,895) (38,605) _______
6
7
Ending Cash Balance $100,000 $107,500 $ 23,500 $15,000 $ 15,000 $ 67,509
$222,009
Cumulative Borrowing 0 0 0 $ 60,500 $
38,605 0 0
(b) The firm will have sufficient funds to cover the $200,000 note payable due in July. In fact, if the firm's estimates are
realized they will have $222,009 in cash by the end of July.
72
4-7A.
Cash YES
1
Marketable Securities NO
Accounts Payable YES
Notes Payable NO
2
Plant and Equipment NO
3
Inventories YES
1
Cash receipts follow sales with a lag related to the payment habits of the
firm's customers and the firm's policy regarding payments on its accounts
payables.
2
Notes payable may well follow sales if the firm uses a line of credit to
finance its working capital needs (discussed later in Chapter 18).
3
The answer depends on whether or not the firm has excess capacity. If
there is excess capacity, plant and equipment will not vary directly with
the level of firms sales. If there is no excess capacity, plant and equipment
will vary directly.
4-8A.
(a)
Current assets
1
$16m Accounts payable
2
$ 8m
Net fixed assets 15 m Notes payable
3

3m
$31m Bonds payable 10m
Common equity 10 m
$31m
____________
1
x $80m = $16m
2
x $80m = $ 8m
3
$31m - $28m = $ 3m (Balancing figures which equal estimated discretionary
financing needs in 2004)
____________
(b) = - - bonds -
= $31m - $8m - $10m - $10m
= $3m
(c) See answer to question 4-1.
Instructor’s Note: This problem follows the text example very closely and provides an
excellent assigned exercise to accompany a first reading of the chapter.
73
4-9A.
(a) Estimating Future Financing Needs
Armadillo Dog Biscuit Co., Inc.
Projected Need for Discretionary Financing
Present % of Sales Projected Level
Level ($5m) (Based on $7m Sales)
Current Assets $2.0m = .40 or 40% .40 x $7m = $ 2.8m
Net Fixed Assets $3.0m = .60 or 60% .60 x $7m = $ 4.2m
Total $5.0m $ 7.0m
Accounts Payable $.5m = .10 or 10% .10 x 7m = .7m
Accrued Expenses $.5m = .10 or 10% .10 x 7m = .7m
Notes Payable
1
------ ----- Plug Figure = 1.11m
Current Liabilities $1.0m $ 2.51m
Long-Term Debt $2.0m No Change $2.00m
Common Stock .5m No Change .50m
Retained Earnings
2
1.5m $1.5m + .07 x $7m = $ 1.99m
Common Equity $2.0m $2.49m
Total $5.0m $ 7.00m
1
Notes payable is a balancing figure which equals discretionary financing needed, DFN, which equals: Total Assets -
Accounts Payable - Accrued Expenses - Long-Term Debt - Common Stock - Retained Earnings = $7.0m - $0.7m -
$0.7m - $2.0m - $0.5m - $1.99m = $1.11m.
2
The projected retained earnings is the sum of the beginning balance of $1.5m plus net income for the period (.07 x
$7m).
(b) Before After
Current Ratio = 2 times = 1.12 times
Debt Ratio = .60 or 60% = .644 or 64.4%

The growth in the firm's assets (due to the projected increase in sales) was financed
predominantly with notes payable (a current liability). This led to a substantial
deterioration in both the firm's liquidity (as reflected in the current ratio) and an
increase in its use of financial leverage.
74
(c) The slower rate of growth in sales would have allowed Armadillo to finance a
larger portion of the funds needed using retained earnings. For example, using
the 7 percent net profit margin Armadillo would have .07 x $6m = $420,000 it
could reinvest after one-year's operations plus .07 x $7 million = $490,000 from
the second year's sales. The total amount of retained earnings over the two
years then would be $910,000 rather than only $490,000 as before. This would
mean that notes payable would be $380,000 after one year, and only $1.11m - .
42m = $690,000 at the end of the second year. The resulting level of current
liabilities would be $2.09m. Thus, the post sales growth current ratio after two
years would be 1.34 ($2.8m/2.09m = 1.34) compared to 1.12 with a one-year
growth period. The debt ratio under the two-year growth period will be only
58% compared to approximately 64% with the single year growth period. The
slower growth pace would allow the firm to expand its assets more gradually,
thus requiring less external financing since more earnings can be retained.
4-10A.
Instructor’s Note: This problem differs from the text discussion of "discretionary
financing needed" in that it relies on the projected change in assets rather than the
projected level of total assets. Under these circumstances DFN = ∆ TA - ∆ SL - ∆ RE
where ∆ TA = the projected change in total assets, which is the amount of new
financing needed (in total); ∆ SL = the projected change in spontaneous liabilities; and
∆ RE = the projected change in retained earnings that will be available to finance a
portion of the firm's needs for new funds.
First, we estimate that the projected change in assets during the coming year will be:
∆ TA = .30 ∆ Sales
= .30 ($500,000) = $150,000
Thus, total new financing of $150,000 must be obtained during the next year to
support the growth in firm sales.
Next, we project the change in spontaneous liabilities (∆ SL)
∆ SL = .15 ∆ Sales
= .15 ($500,000) = $75,000
Finally, we project new retained earnings (∆ RE) that will be available to help finance
the firm's operations during the next year,
∆ RE = New Income - Dividends
= .05 x Projected Sales - .04 x Projected Sales
= .01 ($5,500,000)
∆ RE = $55,000
75
Discretionary Financing Needed (DFN) can now be calculated as follows:
DFN = ∆ TA - ∆ SL - ∆ RE
= $150,000 - 75,000 - 55,000
= $20,000
Note that this problem solution works with the change in financing needs rather than
totals. The same solution would result if we projected total assets, total spontaneous
financing, etc. However, in this problem we do not know the existing levels of the
assets, liabilities and owners' equity accounts. Thus, we cannot use this latter
approach to solve the problem.
76
4-11A
a. Projections based on expected sales levels:
Nov Dec Jan Feb Mar Apr May June July August
Sales 220,000 175,000 100,000 120,000 150,000 300,000 275,000 200,000 200,000 180,000
Collections:
Month of sales (20%) 20,000 24,000 30,000 60,000 55,000 40,000 40,000
First month (50%) 87,500 50,000 60,000 75,000 150,000 137,500 100,000
Second month (30%) 66,000 52,500 30,000 36,000 45,000 90,000 82,500
Total collections 173,500 126,500 120,000 171,000 250,000 267,500 222,500
Purchases 65,000 78,000 97,500 195,000 178,750 130,000 130,000 117,000 0
Payments 65,000 78,000 97,500 195,000 178,750 130,000 130,000 117,000
Cash Receipts 173,500 126,500 120,000 171,000 250,000 267,500 222,500
Cash Disbursements --
Purchases 78,000 97,500 195,000 178,750 130,000 130,000 117,000
Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 22,500 22,500
Interest on S-T 610 994 104 0
borrowing
Total Disbursements 108,000 127,500 247,500 209,360 160,994 182,604 147,000
Net Monthly Change 65,500 -1,000 -127,500 -38,360 89,006 84,896 75,500
Beginning Cash Balance 22,000 87,500 86,500 20,000 20,000 20,000 94,542
Additional Financing 61,000 38,360 (89,006) (10,354) 0
Needed (Repayment)
Ending Cash Balance 87,500 86,500 20,000 20,000 20,000 94,542 170,042
7
2
Cumulative Borrowing 61,000 99,360 10,354 0 0
78
Projections based on sale 20% higher than expected
Cash Budget
Nov Dec Jan Feb Mar Apr May June July August
Sales 220,000 175,000 120,000 144,000 180,000 360,000 330,000 240,000 240,000 216,000
Collections:
Month of sales (10%) 24,000 28,800 36,000 72,000 66,000 48,000 48,000
First month (60%) 87,500 60,000 72,000 90,000 180,000 165,000 120,000
Second month (30%) 66,000 52,500 36,000 43,200 54,000 108,000 99,000
Total collections 177,500 141,300 144,000 205,200 300,000 321,000 267,000
Purchases 78,000 93,600 117,000 234,000 214,500 156,000 156,000 140,400 0
Payments 78,000 93,600 117,000 234,000 214,500 156,000 156,000 140,400
Cash Receipts 177,500 141,300 144,000 205,200 300,000 321,000 267,000
(collections)
Cash Disbursements
Purchases 93,600 117,000 234,000 214,500 156,000 156,000 140,400
Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 22,500 22,500
Interest on S-T 923 1,325 198 0
borrowing
Total Disbursements 123,600 147,000 286,500 245,423 187,325 208,698 170,400
Net Monthly Change 53,900 -5,700 -142,500 -40,223 112,675 112,302 96,600
Beginning Cash Balance 22,000 75,900 70,200 20,000 20,000 20,000 112,454
Additional Financing 92,300 40,223 (112,675) (19,848) 0
Needed (Repayment)
Ending Cash Balance 75,900 70,200 20,000 20,000 20,000 112,454 209,054
7
3
Cumulative Borrowing 92,300 132,523 19,848 0 0
80
Projections based on sales 20% lower than expected:
Nov Dec Jan Feb Mar Apr May June July August
Sales 220,000 175,000 80,000 96,000 120,000 240,000 220,000 160,000 160,000 144,000
Collections:
Month of sales (20%) 16,000 19,200 24,000 48,000 44,000 32,000 32,000
First month (50%) 87,500 40,000 48,000 60,000 120,000 110,000 80,000
Second month (30%) 66,000 52,500 24,000 28,800 36,000 72,000 66,000
Total collections 169,500 111,700 96,000 136,800 200,000 214,000 178,000
Purchases 52,000 62,400 78,000 156,000 143,000 104,000 104,000 93,600 0
Payments 52,000 62,400 78,000 156,000 143,000 104,000 104,000 93,600
Cash Receipts 169,500 111,700 96,000 136,800 200,000 214,000 178,000
(collections)
Cash Disbursements
Purchases 62,400 78,000 156,000 143,000 104,000 104,000 93,600
Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Other expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 22,500 22,500
Interest on S-T 297 662 9 0
borrowing
Total Disbursements 92,400 108,000 208,500 173,297 134,662 156,509 123,600
Net Monthly Change 77,100 3,700 -112,500 -36,497 65,338 57,491 54,400
Beginning Cash Balance 22,000 99,100 102,800 20,000 20,000 20,000 76,632
Additional Financing 29,700 36,497 (65,338) (859) 0
Needed (Repayment)
Ending Cash Balance 99,100 102,800 20,000 20,000 20,000 76,632 131,032
7
4
Cumulative Borrowing 29,700 66,197 859 0 0
82
b. Harrison will not be able to retire the $200,000 note at the end of June.
June Ending
Sales Levels Cash Balance
Expected $94,542
+20% 112,454
-20% 76,632
4-12A.
a. Calculations of the sustainable rate of growth for ADP, Inc. for each of the years
1999 through 2003 :
2003 2002 2001 2000 1999
Net Income 150 110 90 70 60
Common Equity 812 722 656 602 560
ROE 18.47% 15.24% 13.72% 11.63% 10.71%
Dividends 60 44 36 28 24
b 40% 40% 40% 40% 40%
g* 11.1% 9.1% 8.2% 7.0% 6.4%
b. Compare actual sales growth rates to the sustainable rate if growth for each year.
2003 2002 2001 2000 1999
Sales 3,000 2,200 1,800 1,400 1,200
Sales growth rate 36.4% 22.2% 28.6% 16.7% N/A
g* 11.1% 9.1% 8.2% 7.0% 6.4%
Difference 25.3% 13.1% 20.4% 9.7% N/A
A quick review of ADP's balance sheets over the test years reveals
a growing reliance on debt financing. The firm's debt ratio
in 1999 was roughly 48% while it had grown to 70% in
2003. Thus, ADP has financed its growth with increased
debt financing.
83
4-13A.
a. Carrera Game Co.
2003 2002 2001 2000 1999
Liabilities 33,000 31,200 25,680 16,320 12,000
Assets 54,000 50,400 43,200 32,400 27,000
Debt to Assets 61.1% 61.9% 59.4% 50.4% 44.4%
Net Income 3,000 2,800 2,400 1,800 1,500
Common Equity 21,000 19,200 17,520 16,080 15,000
ROE 14.3% 14.6% 13.7% 11.2% 10.0%
Dividends 1,200 1,120 960 720 600
b 40.0% 40.0% 40.0% 40.0% 40.0%
Sales 60,000 56,000 48,000 36,000 30,000
Sales growth rate 7.1% 16.7% 33.3% 20.0% N/A
b. The sustainable rates of growth for each of the last five years are calculated as
follows:
g* 8.6% 8.8% 8.2% 6.7% 6.0%
Difference -1.5% 7.9% 25.1% 13.3% N/A
4-14A. a. Findlay's sales and inventory balances are plotted in the figure below. Note that
the relationship between the two variables is very nearly linear. However, the
intercept for the relationship is not zero, consequently the percent of sales
projections are going to provide erroneous estimates of future inventories.
b. The average of the inventories as a percent of sales ratio for the last five years was
6.39%. Thus, we project inventories for a sales level of $30 million to be
$1,917,000. That is,
Projected Inventories = x
= .0639 x $30 million = $1,917,000
Similarly, using the most recent year's percent of sales (5%) we calculate
inventories to be $1,500,000. That is,
Projected Inventories =
ofsales
percent
2003
x
= .05 x $30 million = $1,500,000
84
We can make a forecast of inventories using the relationship observed between
sales and inventories in part a by sketching a line through the observed
relationship and extrapolating the line to sales of $30,000,000.

Sales (In Thousands)
I
n
v
e
n
t
o
r
y

(

I
n

T
h
o
u
s
a
n
d
s
)

1,000
1,100
1,200
1,300
1,400
1,500
10,000 15,000 20,000 25,000 30,000 35,000
Using this graphical technique we see that the level of inventories will probably be just
over $1,300,000. The substantial difference in the percent of sales forecast and the
"true relationship" forecast is a result of the implicit assumption made when using the
percent of sales forecast. That is, the percent of sales forecast is simply a linear
extrapolation of inventories based on sales where the intercept is assumed to be zero.
As we saw in part a, above, this assumption is not valid for this problem.
85
SOLUTION TO INTEGRATIVE PROBLEM
Historical data for Phillips Petroleum: 1986-92
1986 1987 1988 1989 1990 1991 1992
Sales 10,018 10,917 11,490 12,492 13,975 13,259 12,140
Net Income 228 35 650 219 541 98 270
Earnings per share 0.89 0.06 2.72 0.90 2.18 0.38 1.04
Dividends per share 2.02 1.73 1.34 0.00 1.03 1.12 1.12
Number of Common
Shares 259,615,385
Current Assets 2,802 2,855 3,062 2,876 3,322 2,459 2,349
Total Assets 12,403 12,111 11,968 11,256 12,130 11,473 11,468
Current Liabilities 2,234 2,402 2,468 2,706 2,910 2,603 2,517
Long-term Liabilities 8,175 7,887 7,387 6,418 6,501 6,113 5,894
Total Liabilities 10,409 10,289 9,855 9,124 9,411 8,716 8,411
Preferred Stock 270 205 0 0 0 0 359
Common Equity 1,724 1,617 2,113 2,132 2,719 2,757 2,698
Total Liabilities and
Equity
12,403 12,111 11,968 11,256 12,130 11,473 11,468
1993 1994 1995 1996 1997
Projected Sales 1
3,000
1
3,500
1
4,000
1
4,500
1
5,500
7
8
1. Projected Net Income using the percent of sales method.
1986 1987 1988 1989 1990 1991 1992
Sales 10,018 10,917 11,490 12,492 13,975 13,259 12,140
Net Income 228 35 650 219 541 98 270
Net Income/Sales 2.28% 0.32% 5.66% 1.75% 3.87% 0.74% 2.22%
Average Net Income/Sales 2.406%
1993 1994 1995 1996 1997
Projected Sales 13,000 13,500 14,000 14,500 15,500
Projected Net Income 313 325 337 349 373
2. Projected total assets and current liabilities
1986 1987 1988 1989 1990 1991 1992
Sales 10,018 10,917 11,490 12,492 13,975 13,259 12,140
Total Assets 12,403 12,111 11,968 11,256 12,130 11,473 11,468
Current Liabilities 2,234 2,402 2,468 2,706 2,910 2,603 2,517
TA/Sales 123.81% 110.94% 104.16% 90.11% 86.80% 86.53% 94.46%
CL/Sales 22.30% 22.00% 21.48% 21.66% 20.82% 19.63% 20.73%
Average TA/Sales 99.54%
Average CL/Sales 21.23%
1993 1994 1995 1996 1997
Projected Sales 13,000 13,500 14,000 14,500 15,500
Projected Total Assets 12,940 13,438 13,936 14,433 15,429
Projected C. Liabilities 2,760 2,866 2,972 3,078 3,291
7
9
3. Projected discretionary financing requirements for 1993-97.
1993 1994 1995 1996 1997
Total Assets 12,940 13,438 13,936 14,433 15,429
Current Liabilities 2,760 2,866 2,972 3,078 3,291
Long-term Debt 5,894 5,894 5,894 5,894 5,894
Preferred Stock 359 359 359 359 359
Common Equity* 2,720 2,754 2,800 2,858 2,940
Discretionary Financing
Needed**
1,207 1,565 1,911 2,244 2,945
* Common dividends = $1.12 x the number of common shares outstanding in 1992 (
259,615,
385)
Thus, Common Equity (1993) = Common Equity (1992) + NI (1993) - Dividends (1993)
** Discretionary Financing Needed = Projected Total Assets - Current Liabilities - Long-term Debt - Preferred Stock - Common
Equity
8
0
Solutions to Problem Set B
4-1B.
2003 % of Sales 2004
Sales 20,000,000 25,000,000
Net Income 1,000,000 2,000,000
Current Assets 4,000,000 20% 5,000,000
Net fixed assets 8,000,000 40% 10,000,000
Total Assets 12,000,000 15,000,000
Liabilities and Owner's Equity
Accounts payable 3,000,000 15% 3,750,000
Long-term debt 2,000,000 NA 2,000,000
Total Liabilities 5,000,000 5,750,000
Common stock 1,000,000 NA 1,000,000
Paid-in capital 1,800,000 NA 1,800,000
Retained earnings 4,200,000 6,200,000
Common equity 7,000,000 9,000,000
Total Liabilities and Equity12,000,000 14,750,000
DFN = 250,000
4-2B. a. % Credit Sales 40%
Sales
February 100,000
March 80,000
April (estimated) 60,000
Accounts receivable (3/31/04) 52,000
plus credit sales (April) 24,000
less coll. from February (20,000)
less coll. from March (16,000)
Accounts receivable (4/30/04) 40,000
b. Cash Sales 36,000
Collections from February 20,000
Collections from March 16,000
Realized Cash during April 72,000
4-3B. Based upon the projections made, Simpson can expect to have total assets next year
equal to $1.75 million made up of the $1 million in fixed assets plus $.75 million in
current assets (.15 x 5m). These assets will be financed by known sources of funding
comprised of the firm's common equity, .85million ($.7 million + $.3 million. - $.15
million) plus payables and trade credit equal to 11% of projected sales ($.55 million)
which totals $1.4 million. This leaves $.35 million, which will need to be raised to
meet the financing needs of the firm.
81
4-4B. Instructor’s Note: This is an introductory percent of sales financial forecasting
problem. Students should be able to solve it after a first reading of the chapter.
(a) Projected Financing Needs = Projected Total Assets
= Projected Current Assets + Projected Fixed Assets
= (
18
7
x 25m) + 6m + .1m
= $15,822,222
(b) DFN = Projected Current Assets + Projected Fixed Assets
- Present LTD - Present Owner's Equity
- [Projected Net Income - Dividends] - Spontaneous Financing
= (
18
7
x 25m) + 6m + .1m – 2m –9.5m – (.05 x 25m - .6m) – (
18
5 . 1
x
25m)
DFN = $1,588,889
(c) We first solve for the maximum level of sales where DFN = 0:
DFN = (
18
7
-.05 -
18
5 . 1
) Sales + 6.1m –2m –9.5m +.6m
= .25556 Sales -4.8 million = 0
Thus, SALES = $18,782,282
The largest increase in sales that can occur without a need to raise "discretionary
funds" is
$18,782,282 - $18m = $782,282.
4-5B.
Cash $ .03m Current Liabilities $.39m
Accounts Receivable .14m Long-Term Debt .81m
Inventories 1.0m Common Equity .80m
Net Fixed Assets .83m
$2.0m $2.0m
4-6B. (a)
CASH BUDGET
DATA
January 100,000 May 275,000
February 110,000 June 250,000
March 130,000 July 235,000
April 250,000 August 160,000
82
83
The Carmel Corporation Cash Budget Worksheet
Nov Dec Jan Feb Mar Apr May June July Aug
$220,000 $175,000 $100,000 $110,000 $130,000 $250,000 $275,000 $250,000 $235,000 160k
Collections:
Month of sale (20%) 20,000 22,000 26,000 50,000 55,000 50,000 47,000
First month (60%) 105,000 60,000 66,000 78,000 150,000 165,000 150,000
Second month (20%) 44,000 35,000 20,000 22,000 26,000 50,000 55,000
Total Collections 169,000 117,000 112,000 150,000 231,000 265,000
252,000
Purchases 70,000 77,000 91,000 175,000 192,500 175,000 164,500 112,000 0
Payments (1 mo lag) 70,000 77,000 91,000 175,000 192,500 175,000 164,500
112,000
Cash Receipts
(collections) 169,000 117,000 112,000 150,000 231,000 265,000 252,000
Cash Disbursements
Purchases 77,000 91,000 175,000 192,500 175,000 164,500 112,000
Rent 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 23,000 23,000
Interest on Short-Term 560 1,291 1,044 579
Borrowing
Total Disbursements $107,000 $121,000 $228,000 $223,060 $206,291 $218,544 $142,579
Net Monthly Change $62,000 ($4,000) ($116,000) ($73,060) $24,709 $46,456 $109,421
Beginning Cash Balance 22,000 84,000 80,000 20,000 20,000 20,000 20,000
Additional Financing 56,000 73,060 (24,709) (46,456) (57,895)
8
3
Needed (Repayment)
Ending Cash Balance $84,000 $80,000 $20,000 $20,000 $20,000 $
20,000 $71,526
Cumulative Borrowing 0 0 56,000 $129,060 $104,351 $57,895 0
(b) The firm will not have sufficient funds to cover the $250,000 note payable due in July.
85
4-7B. Cash YES
Marketable Securities NO
Accounts Payable YES
Notes Payable NO
Plant and Equipment NO
1
Inventories YES
1
The answer depends on whether or not the firm has excess capacity. If
there is excess capacity, plant and equipment will not vary directly with
the level of firms sales. If there is no excess capacity, plant and equipment
will vary directly.
4-8B. (a) Current assets $20.00m Accounts payable $13.33m
Net fixed assets 15 .00 m Notes payable

1.67m
$35.00m Bonds payable 10.00m
Common equity 10 .00 m
$35.00m
(b) Total financing requirements = $35m--however, spontaneous financing
accounts for all but the $1.67m increase in notes payable (discretionary
financing needed).
(c) See answer to question 4-1.
4-9B. Instructor’s Note: This problem follows the text example very closely and provides an
excellent assigned exercise to accompany a first reading of the chapter.
(a) Estimating Future Financing Needs
Symbolic Logic Corporation (SLC), Inc.
Projected Need for Discretionary Financing
Present % of Sales Projected Level
Level ($5m) (Based on $8m Sales)
Current Assets $2.5m = 50% .50 x $8m = $ 4.0m
Net Fixed Assets $3.0m = 60% .60 x 8m = $ 4.80m
Total Assets $5.5m $ 8.80m
Accounts Payable $.1.0m = 20% .20 x 8m = 1.60m
Accrued Expenses $.5m = 10% .10 x 8m = .80m
Notes Payable* ------ ------- Plug Figure 1.84m
Current Liabilities $1.50m $ 4.24m
Long-Term Debt $2.00m No Change $2.00m
Common Stock .50m No Change .50m
Retained Earnings** 1.50m $1.5m + (07 x $8m) = $ 2.06m
Common Equity $2.00m $2.56m
Total Liabilities and Equity $5.50m $8.80m
*Notes payable is a balancing figure which equals discretionary financing needed,
DFN or: Total Assets - Accounts Payable - Accrued Expenses - Long-Term Debt -
Common Stock - Retained Earnings = $8.80m - 1.60m - .8m – 2m - .5m – 2.06m =
$1.84m.
86
**The projected level of retained earnings equals the beginning balance of $1.50m plus
net income for the period (.07 x $8m).
(b) Before After
Current Ratio = 1.67 times = .94 times
Debt Ratio = 64% = 71%
The growth in the firm's assets (due to the projected increase in sales) was
financed predominantly with notes payable (a current liability). This led to a
substantial deterioration in the firm's liquidity (as reflected in the current ratio)
and an increase in its use of financial leverage.
(c) The slower rate of growth in sales would have allowed SLC to finance a larger
portion of the funds needed using retained earnings.
4-10B.Instructor’s Note: This problem differs from the text discussion of "discretionary
financing needed" in that it relies on the projected change in assets rather than the
projected level of total assets. Under these circumstances DFN = ∆ TA - ∆ SL - ∆ RE
where ∆ TA = the projected change in total assets, which is the amount of new
financing needed (in total); ∆ SL = the projected change in spontaneous liabilities; and
∆ RE = the projected change in retained earnings that will be available to finance a
portion of the firm's needs for new funds.
First, we estimate that the projected change in assets during the coming year will be:
∆ TA = .40 ∆ Sales
= .40 ($500,000) = $200,000
Thus, total new financing of $200,000 must be obtained from somewhere during the
next year to support the growth in firm sales.
Next, we project the change in spontaneous liabilities (∆ SL)
∆ SL = .15 x ∆ Sales
= .15 ($500,000) = $75,000
Finally, we project new retained earnings (∆ RE) that will be available to help finance
the firm's operations during the next year,
∆ RE = New Income - Dividends
= .05 x Projected Sales - .04 x Projected Sales
= .01 ($5,500,000)
∆ RE = $55,000
Discretionary Financing Needed (DFN) can now be calculated as follows:
DFN = ∆ TA - ∆ SL - ∆ RE
= $200,000 - 75,000 - 55,000
= $70,000
Note that this problem solution works with the change in financing needs rather than
totals. The same solution would result if we projected total assets, total spontaneous
financing, etc. However, in this problem we do not know the existing levels of the
assets, liabilities and owners' equity accounts. Thus, we cannot use this latter approach
to solve this problem.
87
4-11B.
Minimum Cash Balance = 25,000
Beginning Cash Balance = 28,000
Historical Sales and Base Case Sales Predictions for Future Sales
January 120,000 May 225,000
February 160,000 June 250,000
March 140,000 July 200,000
April 190,000 August 220,000
Sales Expansion % = 0.00% Annual Interest
Purchases as a % Sales = 75% Rate = 12.00%
Collections: Current Mo. 1 Mo. Later 2 Mo. Later
30% 30% 40%
88
Cash Budget for January thru July based on expected sales
Nov Dec Jan Feb Mar Apr May June July August
Sales 230,000 225,000 120,000 160,000 140,000 190,000 225,000 250,000 210,000 220,000
Collections:
Month of sales 36,000 48,000 42,000 57,000 67,500 75,000 63,000
First month 67,500 36,000 48,000 42,000 57,000 67,500 75,000
Second month 92,000 90,000 48,000 64,000 56,000 76,000 90,000
Total Collections 195,500 174,000 138,000 163,000 180,500 218,500 228,000
Purchases 90,000 120,000 105,000 142,500 168,750 187,500 157,500 165,000
Payments 90,000 120,000 105,000 142,500 168,750 187,500 157,500 165,000
Cash Receipts 195,500 174,000 138,000 163,000 180,500 218,500 228,000
(collections)
Cash Disbursements
Payments for Purchases 120,000 105,000 142,500 168,750 187,500 157,500 165,000
Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000
Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 26,500 26,500
Interest on Short-Term 0 173 564 545
Borrowing
Total Disbursements $152,000 $137,000 $201,000 $200,750 $219,673 $216,564 $197,545
Net Monthly Change $43,500 $37,000 ($63,000) ($37,750) ($39,173) $1,936 $30,455
Analysis of Borrowing Needs
Beginning Cash Balance 28,000 71,500 108,500 45,500 25,000 25,000 25,000
Ending Cash (No Borrow) 71,500 108,500 45,500 7,750 (14,173) 26,936 55,455
Needed (Borrowing) 0 0 0 17,250 39,173 0 0
Loan Repayment 0 0 0 0 0 1,936 30,455
8
7
Ending Cash Balance $71,500 $108,500 $45,500 $25,000 $25,000 $ 25,000 $25,000
Cumulative Borrowing 0 0 0 $17,250 $56,423 $54,487 24,032
90
Cash Budget for January thru July based on a 20% increase in sales
Nov Dec Jan Feb Mar Apr May June July August
Sales 230,000 225,000 144,000 192,000 168,000 228,000 270,000 300,000 252,000 264,000
Collections:
Month of sales 43,200 57,600 50,400 68,400 81,000 90,000 75,600
First month 67,500 43,200 57,600 50,400 68,400 81,000 90,000
Second month 92,000 90,000 57,600 76,800 67,200 91,200 108,000
Total Collections 202,700 190,800 165,600 195,600 216,600 262,200 273,600
Purchases 108,000 144,000 126,000 171,000 202,500 225,000 189,000 198,000
Payments 108,000 144,000 126,000 171,000 202,500 225,000 189,000 198,000
Cash Receipts 202,700 190,800 165,600 195,600 216,600 262,200 273,600
(collections)
Cash Disbursements
Payments for Purchases 144,000 126,000 171,000 202,500 225,000 189,000 198,000
Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000
Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 26,500 26,500
Interest on Short-Term 14 403 811 672
Borrowing
Total Disbursements $176,000 $158,000 $229,500 $234,514 $257,403 $248,311 $230,672
Net Monthly Change $26,700 $32,800 -$63,900 -$38,914 -$40,803 $13,889 $42,928
Analysis of Borrowing Needs
Beginning Cash Balance 28,000 54,700 87,500 25,000 25,000 25,000 25,000
Ending Cash (No Borrow) 54,700 87,500 23,600 -13,914 -15,803 38,889 67,928
Needed (Borrowing) 0 0 1,400 38,914 40,803
8
8
Loan Repayment 0 0 0 0 0 (13,889) (42,928)
Ending Cash Balance $54,700 $87,500 $25,000 $25,000 $25,000 $ 25,000 $25,000
Cumulative Borrowing 0 0 1,400 $40,314 $81,117 $67,228 24,300
92
Cash Budget for January thru July based on a 20% decrease in sales
Nov Dec Jan Feb Mar Apr May June July August
Sales 230,000 225,000 96,000 128,000 112,000 152,000 180,000 200,000 168,000 176,000
Collections:
Month of sales 28,800 38,400 33,600 45,600 54,000 60,000 50,400
First month 67,500 28,800 38,400 33,600 45,600 54,000 60,000
Second month 92,000 90,000 38,400 51,200 44,800 60,800 72,000
Total Collections 188,300 157,200 110,400 130,400 144,400 174,800 182,400
Purchases 72,000 96,000 84,000 114,000 135,000 150,000 126,000 132,000
Payments 72,000 96,000 84,000 114,000 135,000 150,000 126,000 1320,000
Cash Receipts 188,300 157,200 110,400 130,400 144,400 174,800 182,400
(collections)
Cash Disbursements
Payments for Purchases 96,000 84,000 114,000 135,000 150,000 126,000 132,000
Rent 12,000 12,000 12,000 12,000 12,000 12,000 12,000
Other Expenditures 20,000 20,000 20,000 20,000 20,000 20,000 20,000
Tax Deposits 26,500 26,500
Interest on Short-Term 318 418
Borrowing
Total Disbursements $128,000 $116,000 $172,500 $167,000 $182,000 $184,818 $164,418
Net Monthly Change $60,300 $41,200 -$62,100 -$36,600 -$37,600 -$10,018 $17,982
Analysis of Borrowing Needs
Beginning Cash Balance 28,000 88,300 129,500 67,400 30,800 25,000 25,000
Ending Cash (No Borrow) 88,300 129,500 67,400 30,800 -6,800 14,982 42,982
Needed (Borrowing) 0 0 0 0 31,800 10,018
8
9
Loan Repayment 0 0 0 0 0 0 (17,982)
Ending Cash Balance $88,300 $129,500 $67,400 $30,800 $25,000 $ 25,000 $25,000
Cumulative Borrowing 0 0 0 0 $31,800 $41,818 23,836
94
b. Halsey will not be able to retire the $200,000 note at the end of July.
July Ending
Sales Levels Cash Balance
Expected $25,000
+20% 25,000
-20% 25,000

250
CHAPTER 5
The Time Value of Money

CHAPTER ORIENTATION
In this chapter the concept of a time value of money is introduced, that is, a dollar today is
worth more than a dollar received a year from now. Thus if we are to logically compare
projects and financial strategies, we must either move all dollar flows back to the present or
out to some common future date.
CHAPTER OUTLINE
I. Compound interest results when the interest paid on the investment during the first
period is added to the principal and during the second period the interest is earned on
the original principal plus the interest earned during the first period.
A. Mathematically, the future value of an investment if compounded annually at
a rate of i for n years will be
FV
n
= PV (l + i)
n
where n = the number of years during which the compounding
occurs
i = the annual interest (or discount) rate
PV = the present value or original amount invested at the
beginning of the first period
FV
n
= the future value of the investment at the end of n
years
1. The future value of an investment can be increased by either
increasing the number of years we let it compound or by
compounding it at a higher rate.
2. If the compounded period is less than one year, the future value of an
investment can be determined as follows:
FV
n
= PV
mn
where m= the number of times compounding occurs during the year
251
II. Determining the present value, that is, the value in today's dollars of a sum of money
to be received in the future, involves nothing other than inverse compounding. The
differences in these techniques come about merely from the investor's point of view.
A. Mathematically, the present value of a sum of money to be received in the
future can be determined with the following equation:
PV = FV
n
where: n = the number of years until payment will be received,
i = the interest rate or discount rate
PV = the present value of the future sum of money
FV
n
= the future value of the investment at the end of n
years
1. The present value of a future sum of money is inversely related to
both the number of years until the payment will be received and the
interest rate.
III. An annuity is a series of equal dollar payments for a specified number of years.
Because annuities occur frequently in finance, for example, bond interest payments,
we treat them specially.
A. A compound annuity involves depositing or investing an equal sum of money
at the end of each year for a certain number of years and allowing it to grow.
1. This can be done by using our compounding equation, and
compounding each one of the individual deposits to the future or by
using the following compound annuity equation:
FV
n
= PMT

,
_

¸
¸
+


·
1 n
0 t
t
i) (1
where: PMT = the annuity value deposited at the end of each
year
i = the annual interest (or discount) rate
n = the number of years for which the annuity will
last
FV
n
= the future value of the annuity at the end of the
nth year
B. Pension funds, insurance obligations, and interest received from bonds all
involve annuities. To compare these financial instruments we would like to
know the present value of each of these annuities.
1. This can be done by using our present value equation and discounting
each one of the individual cash flows back to the present or by using
the following present value of an annuity equation:
PV = PMT

,
_

¸
¸
+

·
n
1 t
t
i) (1
1

252
where: PMT = the annuity deposited or withdrawn at the end
of each year
i = the annual interest or discount rate
PV = the present value of the future annuity
n = the number of years for which the annuity will
last
C. This procedure of solving for PMT, the annuity value when i, n, and PV are
known, is also the procedure used to determine what payments are associated
with paying off a loan in equal installments. Loans paid off in this way, in
periodic payments, are called amortized loans. Here again we know three of
the four values in the annuity equation and are solving for a value of PMT,
the annual annuity.
IV. Annuities due are really just ordinary annuities where all the annuity payments have
been shifted forward by one year. Compounding them and determining their present
value is actually quite simple. Because an annuity, due merely shifts the payments
from the end of the year to the beginning of the year, we now compound the cash
flows for one additional year. Therefore, the compound sum of an annuity due is
FV
n
(annuity due) = PMT (FVIFA
i,n
) (1 + i)
A. Likewise, with the present value of an annuity due, we simply receive each
cash flow one year earlier – that is, we receive it at the beginning of each year
rather than at the end of each year. Thus the present value of an annuity due
is
PV(annuity due) = PMT (PVIFA
i,n
) (1 + i)
V. A perpetuity is an annuity that continues forever, that is every year from now on this
investment pays the same dollar amount.
A. An example of a perpetuity is preferred stock which yields a constant dollar
dividend infinitely.
B. The following equation can be used to determine the present value of a
perpetuity:
PV =
where: PV = the present value of the perpetuity
pp = the constant dollar amount provided by the perpetuity
i = the annual interest or discount rate
VI. To aid in the calculations of present and future values, tables are provided at the back
of Financial Management (FM).
A. To aid in determining the value of FV
n
in the compounding formula
FV
n
= PV (1 + i)
n
= PV (FVIF
i,n
)
tables have been compiled for values of FVIF
i,n
or (i + 1)
n
in Appendix B,
"Compound Sum of $1," in FM.
253
B. To aid in the computation of present values
PV = FV
n
= FV
n
(PVIF
i,n
)
tables have been compiled for values of
or PVIF
i,n
and appear in Appendix C in the back of FM.
C. Because of the time-consuming nature of compounding an annuity,
FV
n
= PMT


·
+
1 n
0 t
t
i) (1
= PMT (FVIFA
i,n
)
Tables are provided in Appendix D of FM for


·
+
1 n
0 t
t
i) (1 or

FVIFA
i,n
for various combinations of n and i.
D. To simplify the process of determining the present value of an annuity
PV = PMT

,
_

¸
¸
+

·
n
1 t
t
i) (1
1

= PMT (PVIFA
i,n
)
tables are provided in Appendix E of FM for various combinations of n and i
for the value

·
+
n
1 t
t
i) (1
1

or PVIFA
i,n
V. Spreadsheets and the Time Value of Money.
A. While there are several competing spreadsheets, the most popular one is
Microsoft Excel. Just as with the keystroke calculations on a financial
calculator, a spreadsheet can make easy work of most common financial
calculations. Listed below are some of the most common functions used with
Excel when moving money through time:
Calculation: Formula:
Present Value = PV(rate, number of periods, payment, future value, type)
Future Value = FV(rate, number of periods, payment, present value, type)
Payment = PMT(rate, number of periods, present value, future value,
type)
Number of Periods = NPER(rate, payment, present value, future value, type)
Interest Rate = RATE(number of periods, payment, present value, future
value, type, guess)
254
where: rate = i, the interest rate or discount rate
number of periods = n, the number of years or periods
payment = PMT, the annuity payment deposited or received at the
end of each period
future value = FV, the future value of the investment at the end of n
periods or years
present value = PV, the present value of the future sum of money
type = when the payment is made, (0 if omitted)
0 = at end of period
1 = at beginning of period
guess = a starting point when calculating the interest rate, if
omitted, the calculations begin with a value of 0.1 or
10%
ANSWERS TO
END-OF-CHAPTER QUESTIONS
5-1. The concept of time value of money is recognition that a dollar received today is
worth more than a dollar received a year from now or at any future date. It exists
because there are investment opportunities on money, that is, we can place our dollar
received today in a savings account and one year from now have more than a dollar.
5-2. Compounding and discounting are inverse processes of each other. In compounding,
money is moved forward in time, while in discounting money is moved back in time.
This can be shown mathematically in the
compounding equation:
FV
n
= PV (1 + i)
n
We can derive the discounting equation by multiplying each side of
this equation by and we get:
PV = FV
n
5-3. We know that
FV
n
= PV(1 + i)
n
Thus, an increase in i will increase FV
n
and a decrease in n will
decrease FV
n.
5-4. Bank C which compounds daily pays the highest interest. This occurs because,
while all banks pay the same interest, 5 percent, bank C compounds the 5 percent
daily. Daily compounding allows interest to be earned more frequently than the
other compounding periods.
255
5-5. The values in the present value of an annuity table (Table 5-8) are actually derived
from the values in the present value table (Table 5-4). This can be seen, by
examining the values represented in each table. The present value table gives values
of
for various values of i and n, while the present value of an annuity table gives values
of

·
+
n
1 t
t
i) (1
1

for various values of i and n. Thus the value in the present value of annuity table for
an n-year annuity for any discount rate i is merely the sum of the first n values in the
present value table. PVIFA
10%,10yrs
= 6.145.

·
10
1 n
PVIF10%,n = 6.144 = 0.909 +
0.826 + 0.751 + 0.683 + 0.621 + 0.564 + 0.513 + 0.467 + 0.424 + 0.386
5-6. An annuity is a series of equal dollar payments for a specified number of years.
Examples of annuities include mortgage payments, interest payments on bonds, fixed
lease payments, and any fixed contractual payment. A perpetuity is an annuity that
continues forever, that is, every year from now on this investment pays the same
dollar amount. The difference between an annuity and a perpetuity is that a
perpetuity has no termination date whereas an annuity does.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
5-1A. (a) FV
n
= PV (1 + i)
n
FV
10
= $5,000(1 + 0.10)
10
FV
10
= $5,000 (2.594)
FV
10
= $12,970
(b) FV
n
= PV (1 + i)
n
FV
7
= $8,000 (1 + 0.08)
7
FV
7
= $8,000 (1.714)
FV
7 =
$13,712
256
(c) FV
12
= PV (1 + i)
n
FV
12
= $775 (1 + 0.12)
12
FV
12
= $775 (3.896)
FV
12
= $3,019.40
(d) FV
n
= PV (1 + i)
n
FV
5
= $21,000 (1 + 0.05)
5
FV
5
= $21,000 (1.276)
FV
5
= $26,796.00
5-2A. (a) FV
n
= PV (1 + i)
n
$1,039.50 = $500 (1 + 0.05)
n
2.079 = FVIF
5%, n yr.
Thus n = 15 years (because the value of 2.079 occurs in the 15
year row of the 5 percent column of Appendix B).
(b) FV
n
= PV (1 + i)
n
$53.87 = $35 (1 + .09)
n

1.539 = FVIF
9%, n yr.
Thus, n = 5 years
(c) FV
n =
PV (1 + i)
n
$298.60 = $100 (1 + 0.2)
n

2.986 = FVIF
20%, n yr.
Thus, n = 6 years
(d) FV
n = PV (1 + i)
n
$78.76 = $53 (1 + 0.02)
n
1.486 = FVIF
2%, n yr.
Thus, n = 20 years
5-3A. (a) FV
n
= PV (1 + i)
n
$1,948 = $500 (1 + i)
12
3.896 = FVIF
i%, 12 yr.
Thus, i = 12% (because the Appendix B value of 3.896 occurs in
257
the 12 year row in the 12 percent column)
258
(b) FV
n
= PV (1 + i)
n
$422.10 = $300 (1 + i)
7
1.407 = FVIF
i%, 7 yr.
Thus, i = 5%
(c) FV
n
= PV (1 + i)
n
$280.20 = $50 (1 + i)
20
5.604 = FVIF
i%, 20 yr.
Thus, i = 9%
(d) FV
n = PV (1 + i)
n
$497.60 = $200 (1 + i)
5
= FVIF
i%, 5 yr.
Thus, i = 20%
5-4A. (a) PV = FV
n

PV = $800
PV = $800 (0.386)
PV = $308.80
(b) PV = FV
n

PV = $300
PV = $300 (0.784)
PV = $235.20
(c) PV = FV
n
PV = $1,000
PV = $1,000 (0.789)
PV = $789
259
(d) PV = FV
n
PV = $1,000
PV = $1,000 (0.233)
PV = $233
5-5A. (a) FV
n
= PMT

,
_

¸
¸
+


·
1 n
0 t
t
i) (1
FV
10
= $500

,
_

¸
¸
+


·
1 10
0 t
t
0.05) (1
FV
10
= $500 (12.578)
FV
10
= $6,289
(b) FV
n
= PMT

,
_

¸
¸
+


·
t
1 n
0 t
i) (1
FV
5
= $100

,
_

¸
¸
+


·
t
1 5
0 t
0.1) (1
FV
5
= $100 (6.105)
FV
5
= 610.50
(c) FV
n =
PMT

,
_

¸
¸
+


·
t
1 n
0 t
i) (1
FV
7
= $35

,
_

¸
¸
+


·
t
1 7
0 t
0.07) (1
FV
7
= $35 (8.654)
FV
7
= $302.89
(d) FV
n
= PMT

,
_

¸
¸
+


·
t
1 n
0 t
i) (1
FV
3
= $25

,
_

¸
¸
+


·
t
0.02) (1
1 3
0 t
FV
3
= $25 (3.060)
FV
3
= $76.50
260
5-6A. (a) PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

PV = $2,500

,
_

¸
¸
+

·
t
10
1 t
0.07) (1
1

PV = $2,500 (7.024)
PV = $17,560
(b) PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

PV = $70

,
_

¸
¸
+

·
t
3
1 t
0.03) (1
1

PV = $70 (2.829)
PV = $198.03
(c) PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

PV = $280

,
_

¸
¸
+

·
t
7
1 t
0.06) (1
1

PV = $280 (5.582)
PV = $1,562.96
(d) PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

PV = $500

,
_

¸
¸
+

·
t
10
1 t
0.1) (1
1

PV = $500 (6.145)
PV = $3,072.50
5-7A. (a) FV
n
= PV (1 + i)
n
compounded for 1 year
FV
1
= $10,000 (1 + 0.06)
1
FV
1
= $10,000 (1.06)
FV
1
= $10,600
compounded for 5 years
FV
5
= $10,000 (1 + 0.06)
5
261
FV
5
= $10,000 (1.338)
FV
5
= $13,380
compounded for 15 years
FV
15
= $10,000 (1 + 0.06)
15
FV
15
= $10,000 (2.397)
FV
15
= $23,970
(b) FV
n
= PV (1 + i)
n
compounded for 1 year at 8%
FV
1
= $10,000 (1 + 0.08)
1
FV
1
= $10,000 (1.080)
FV
1
= $10,800
compounded for 5 years at 8%
FV
5
= $10,000 (1 + 0.08)
5
FV
5
= $10,000 (1.469)
FV
5
= $14,690
compounded for 15 years at 8%
FV
15
= $10,000 (1 + 0.08)
15
FV
15
= $10,000 (3.172)
FV
15
= $31,720
compounded for 1 year at 10%
FV
1
= $10,000 (1 + 0.1)
1
FV
1
= $10,000 (1 + 1.100)
FV
1
= $11,000
compounded for 5 years at 10%
FV
5
= $10,000 (1 + 0.1)
5
FV
5
= $10,000 (1.611)
FV
5
= $16,110
compounded for 15 years at 10%
FV
15
= $10,000 (1 + 0.1)
15
FV
15
= $10,000 (4.177)
FV
15
= $41,770
(c) There is a positive relationship between both the interest rate used to
262
compound a present sum and the number of years for which the
compounding continues and the future value of that sum.
5-8A. FV
n
= PV (1 + )
mn
Account PV i m n (1 + )
mn
PV(1 + )
mn
Theodore Logan III $ 1,000 10% 1 10 2.594 $ 2,594
Vernell Coles 95,000 12% 12 1 1.127 107,065
Thomas Elliott 8,000 12% 6 2 1.268 10,144
Wayne Robinson 120,000 8% 4 2 1.172 140,640
Eugene Chung 30,000 10% 2 4 1.477 44,310
Kelly Cravens 15,000 12% 3 3 1.423 21,345
5-9A. (a) FV
n
= PV (1 + i)
n
FV
5
= $5,000 (1 + 0.06)
5
FV
5
= $5,000 (1.338)
FV
5
= $6,690
(b) FV
n
= PV (1 + )
mn
FV
5
= $5,000 (1 + )
2X5
FV
5
= $5,000 (1 + 0.03)
10
FV
5
= $5,000 (1.344)
FV
5
= $6,720
FV
n
= PV (1 + )
mn
FV
5
= 5,000 (1 + )
6X5

FV
5
= $5,000 (1 + 0.01)
30
FV
5
= $5,000 (1.348)
FV
5
= $6,740
(c) FV
n
= PV (1 + i)
n
FV
5
= $5,000 (1 + 0.12)
5
FV
5
= $5,000 (1.762)
FV
5
= $8,810
FV
5
= PV
mn
FV
5
= $5,000
2X5
263
FV
5
= $5,000 (1 + 0.06)
10
FV
5
= $5,000 (1.791)
FV
5
= $8,955
FV
5
= PV
mn
FV
5
= $5,000
6X5
FV
5
= $5,000 (1 + 0.02)
30
FV
5
= $5,000 (1.811)
FV
5
= $9,055
(d) FV
n
= PV (1 + i)
n
FV
12
= $5,000 (1 + 0.06)
12
FV
12
= 5,000 (2.012)
FV
12
= $10,060
(e) An increase in the stated interest rate will increase the future value of a given
sum. Likewise, an increase in the length of the holding period will increase
the future value of a given sum.
5-10A. Annuity A: PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

PV = $8,500

,
_

¸
¸
+

·
t
12
1 t
0.11) (1
1

PV = $8,500 (6.492)
PV = $55,182
Since the cost of this annuity is $50,000 and its present value is $55,182,
given an 11 percent opportunity cost, this annuity has value and should be
accepted.
264
Annuity B: PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

PV = $7,000

,
_

¸
¸
+

·
t
25
1 t
0.11) (1
1

PV = $7,000 (8.442)
PV = $59,094
Since the cost of this annuity is $60,000 and its present value is only $59,094,
given an 11 percent opportunity cost, this annuity should not be accepted.
Annuity C: PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

PV = $8,000

,
_

¸
¸
+

·
t
20
1 t
0.11) (1
1

PV = $8,000 (7.963)
PV = $63,704
Since the cost of this annuity is $70,000 and its present value is only $63,704,
given an 11 percent opportunity cost, this annuity should not be accepted.
5-11A. Year 1:FV
n
= PV (1 + i)
n
FV
1
= 15,000(1 + 0.2)
1
FV
1
= 15,000(1.200)
FV
1
= 18,000 books
Year 2:FV
n
= PV (1 + i)
n
FV
2
= 15,000(1 + 0.2)
2
FV
2
= 15,000(1.440)
FV
2
= 21,600 books
Year 3: FV
n
= PV (1 + i)
n
FV
3
= 15,000(1.20)
3
FV
3
= 15,000(1.728)
FV
3
= 25,920 books
265
Book sales
25,000
20,000
15,000
1 2
3
years
The sales trend graph is not linear because this is a compound growth trend.
Just as compound interest occurs when interest paid on the investment during
the first period is added to the principal of the second period, interest is
earned on the new sum. Book sales growth was compounded; thus, the first
year the growth was 20 percent of 15,000 books for a total of 18,000 books,
the second year 20 percent of 18,000 books for a total of 21,600, and the third
year 20 percent of 21,600 books for a total of 25,920.
5-12A. FV
n
= PV (1 + i)
n
FV
1
= 41(1 + 0.10)
1
FV
1
= 41(1.10)
FV
1
= 45.1 Home Runs in 1981 (in spite of the baseball strike).
FV
2
= 41(1 + 0.10)
2
FV
2
= 41(1.21)
FV
2
= 49.61 Home Runs in 1982
FV
3
= 41(1 + 0.10)
3
FV
3
= 41(1.331)
FV
3
= 54.571 Home Runs in 1983.
FV
4
= 41(1 + 0.10)
4
FV
4
= 41(1.464)
FV
4
= 60.024 Home Runs in 1984.
FV
5
= 41(1 + 0.10)
5
FV
5
= 41(1.611)
266
FV
5
= 66.051 Home Runs in 1985 (for a new major league record).
5-13A. PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

$60,000 = PMT

,
_

¸
¸
+

·
t
25
1 t
0.09) (1
1

$60,000 = PMT (9.823)
Thus, PMT = $6,108.11 per year for 25 years.
5-14A. FV
n
= PMT

,
_

¸
¸
+


·
t
1 n
0 t
i) (1
$15,000 = PMT

,
_

¸
¸
+


·
t
1 15
0 t
0.06) (1
$15,000 = PMT (23.276)
Thus, PMT = $644.44
5-15A. FV
n
= PV (1 + i)
n
$1,079.50 = $500 (FVIF
i%, 10 yr.
)
2.159 = FVIF
i%, 10 yr.
Thus, i = 8%
5-16A. The value of the home in 10 years
FV
10
= PV (1 + .05)
10
= $100,000(1.629)
= $162,900
How much must be invested annually to accumulate $162,900?
$162,900 = PMT

,
_

¸
¸
+


·
t
1 10
0 t
.10) (1
$162,900 = PMT(15.937)
PMT = $10,221.50
5-17A. FV
n
= PMT

,
_

¸
¸
+


·
t
1 n
0 t
i) (1
$10,000,000 = PMT

,
_

¸
¸
+


·
t
1 10
0 t
.09) (1
$10,000,000 = PMT(15.193)
Thus, PMT = $658,197.85
267
5-18A. One dollar at 12.0% compounded monthly for one year
FV
n
= PV
nm
FV
1
= $1(1 + .01)
1
= $1(1.127)
= $1.127
One dollar at 13.0% compounded annually for one year
FV
n
= PV (1 + i)
n
FV
1
= $1(1 + .13)
1
= $1(1.13)
= $1.13
The loan at 12% compounded monthly is more attractive.
5-19A. Investment A
PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
i

= $10,000

,
_

¸
¸
+

·
t
5
1 t
.20) (1
1

= $10,000(2.991)
= $29,910
Investment B
First, discount the annuity back to the beginning of year 5, which is the end of
year 4. Then, discount this equivalent sum to present.
PV = PMT

,
_

¸
¸
+

·
t
n
1 t
i) (1
1

= $10,000

,
_

¸
¸
+

·
t
6
1 t
.20) (1
1

= $10,000(3.326)
= $33,260--then discount the equivalent sum back to present.
PV = FV
n

= $33,260
= $33,260(.482)
= $16,031.32
Investment C
PV = FV
n

268
= $10,000 + $50,000
+ $10,000
= $10,000(.833) + $50,000(.335) + $10,000(.162)
= $8,330 + $16,750 + $1,620
= $26,700
5-20A. PV = FV
n

PV = $1,000
PV = $1,000(.513)
PV = $513
5-21A. (a) PV =
PV =
PV = $3,750
(b) PV =
PV =
PV = $8,333.33
(c) PV =
PV =
PV = $1,111.11
(d) PV =
PV =
PV = $1,900
5-22A. PV(annuity due) = PMT(PVIFA
i,n
)(l+i)
= $1,000(6.145)(1+.10)
= $6145(1.10)
= $6759.50
5-23A. FV
n = PV (1 + )
m
.
n
4 = 1(1 + )
2
.
n
4 = (1 + 0.08)
2
.
n
4 = FVIF
8%, 2n yr.
A value of 3.996 occurs in the 8 percent column and 18-year row of the table in
Appendix B. Therefore, 2n = 18 years and n = approximately 9 years.
269
5-24A. Investment A:
PV = FV
n
(PVIF
i,n
)
PV = $2,000(PVIF
10%, year 1
) + $3,000(PVIF
10%, year 2
) +
$4,000(PVIF
10%, year 3
) - $5,000(PVIF
10%, year 4
) +
$5,000(PVIF
10%, year 5
)
= $2,000(.909) + $3,000(.826) + $4,000(.751) -
$5,000(.683) + $5,000(.621)
= $1,818 + $2,478 + $3,004 - $3,415 + $3,105
= $6,990.
Investment B:
PV = FV
n
(PVIF
i,n
)
PV = $2,000(PVIF
10%, year 1
) + $2,000(PVIF
10%, year 2
) +
$2,000(PVIF
10%, year 3
) + $2,000(PVIF
10%, year 4
) +
$5,000(PVIF
10%, year 5
)
= $2,000(.909) + $2,000(.826) + $2,000(.751) + $2,000(.683)
+ $5,000(.621)
= $1,818 + $1,652 + $1,502 + $1,366 + $3,105
= $9,443.
270
Investment C:
PV = FV
n
(PVIF
i,n
)
PV = $5,000(PVIF
10%, year 1
) + $5,000(PVIF
10%, year 2
) -
$5,000(PVIF
10%, year 3
) - $5,000(PVIF
10%, year 4
) +
$15,000(PVIF
10%, year 5
)
= $5,000(.909) + $5,000(.826) - $5,000(.751) -
$5,000(.683) + $15,000(.621)
= $4,545 + $4,130 - $3,755 - $3,415 + $9,315
= $10,820.
5-25A. The Present value of the $10,000 annuity over years 11-15.
PV = PMT

,
_

¸
¸

,
_

¸
¸
+

,
_

¸
¸
+
∑ ∑
· ·
t
10
1 t
t
15
1 t
.06) (1
1

.06) (1
1

= $10,000(9.712 - 7.360)
= $10,000(2.352)
= $23,520
The present value of the $20,000 withdrawal at the end of year 15:
PV = FV
15

= $20,000(.417)
= $8,340
Thus, you would have to deposit $23,520 + $8,340 or $31,860 today.
5-26A. PV = PMT

,
_

¸
¸
+

·
t
10
1 t
.10) (1
1

$40,000 = PMT (6.145)
PMT = $6,509
5-27A. PV = PMT

,
_

¸
¸
+

·
t
5
1 t
i) (1
1

$30,000 = $10,000 (PVIFA
i%, 5 yr.
)
3.0 = PVIFA
i%, 5 yr.
i = 20%
5-28A. PV = FV
n

271
$10,000 = $27,027 (PVIF
i%, 5 yr.
)
.370 = PVIF
22%, 5 yr.
Thus, i = 22%
5-29A. PV = PMT

,
_

¸
¸
+

·
t
i) (1
1
n
1 t
$25,000 = PMT

,
_

¸
¸
+

·
t
.12) (1
1
5
1 t
$25,000 = PMT (3.605)
PMT = $6,934.81
5-30A. The present value of $10,000 in 12 years at 11 percent is:
PV = FV
n

,
_

¸
¸
+
n
i) (1
1
PV = $10,000

,
_

¸
¸
+
12
.11) (1
1
PV = $10,000 (.286)
PV = $2,860
The present value of $25,000 in 25 years at 11 percent is:
PV = $25,000

,
_

¸
¸
+
25
.11) (1
1
= $25,000 (.074)
= $1,850
Thus take the $10,000 in 12 years.
5-31A. FV
n
= PMT

,
_

¸
¸
+


·
t
1 n
0 t
i) (1
$20,000 = PMT

,
_

¸
¸
+


·
t
1 5
0 t
.12) (1
$20,000 = PMT(6.353)
PMT = $3,148.12
272
5-32A. (a) FV
n
= PMT

,
_

¸
¸
+


·
t
1 n
0 t
i) (1
$50,000 = PMT

,
_

¸
¸
+


·
t
1 15
0 t
.07) (1
$50,000 = PMT (FVIFA
7%, 15 yr.
)
$50,000 = PMT(25.129)
PMT = $1,989.73. per year
(b) PV = FV
n

PV = $50,000 (PVIF
7%, 15 yr.
)
PV = $50,000(.362)
PV = $18,100 deposited today
(c) The contribution of the $10,000 deposit toward the $50,000 goal is
FV
n
= PV(1 + i)
n
FV
n
= $10,000 (FVIF
7%, 10 yr.
)
FV
10
= $10,000(1.967)
= $19,670
Thus only $30,330 need be accumulated by annual deposit.
FV
n
= PMT

,
_

¸
¸
+


·
t
1 n
0 t
i) (1
$30,330 = PMT (FVIFA
7%, 15 yr.
)
$30,330 = PMT [25.129]
PMT = $1,206.97 per year
5-33A. (a) This problem can be subdivided into (1) the compound value of the $100,000
in the savings account (2) the compound value of the $300,000 in stocks, (3)
the additional savings due to depositing $10,000 per year in the savings
account for 10 years, and (4) the additional savings due to depositing $10,000
per year in the savings account at the end of years 6-10. (Note the $20,000
deposited in years 6-10 is covered in parts (3) and (4).)
(1) Future value of $100,000
FV
10
= $100,000 (1 + .07)
10
FV
10
= $100,000 (1.967)
FV
10
= $196,700
273
(2) Future value of $300,000
FV
10
= $300,000 (1 + .12)
10
FV
10
= $300,000 (3.106)
FV
10
= $931,800
(3) Compound annuity of $10,000, 10 years
FV
10
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
= $10,000
,
_

¸
¸
+ ∑

·
t
1 10
0 t
.07) (1
= $10,000 (13.816)
= $138,160
(4) Compound annuity of $10,000 (years 6 - 10)
FV
5
= $10,000

,
_

¸
¸
+


·
t
1 5
0 t
.07) (1
= $10,000 (5.751)
= $57,510
At the end of ten years you will have $196,700 + $931,800 + $138,160 + $57,510 =
$1,324,170.
(b) PV = PMT

,
_

¸
¸
+

·
t
20
1 t .10) (1
1

$1,324,170 = PMT (8.514)
PMT = $155,528
5-34A. PV = PMT (PVIFA
i%, n yr.
)
$100,000 = PMT (PVIFA
15%, 20 yr.
)
$100,000 = PMT(6.259)
PMT = $15,977
5-35A. PV = PMT (PVIFA
i%, n yr.
)
$150,000 = PMT (PVIFA
10%, 30 yr.
)
$150,000 = PMT(9.427)
PMT = $15,912
274
5-36A. At 10%:
PV = $50,000 + $50,000 (PVIFA
10%, 19 yr.
)
PV = $50,000 + $50,000 (8.365)
PV = $50,000 + $418,250
PV = $468,250
At 20%:
PV = $50,000 + $50,000 (PVIFA
20%, 19 yr.
)
PV = $50,000 + $50,000 (4.843)
PV = $50,000 + $242,150
PV = $292,150
5-37A. FV
n
(annuity due) = PMT(FVIFA
i,n
)(l+i)
= $1000(FVIFA
10%,10 years
)(1+.10)
= $1000(15.937)(1.1)
= $17,530.70
FV
n
(annuity due) = PMT(FVIFA
i,n
)(l+i)
= $1,000(FVIFA
15%,10 years
)(1+.15)
= $1,000(20.304)(1.15)
= $23,349.60
5-38A. PV (annuity due) = PMT(PVIFA
i,n
)(l+i)
= $1,000(PVIFA
10%,10 years
)(1+.10)
= $1,000(6.145)(1.10)
= $6,759.50
PV (annuity due) = PMT(PVIFA
i,n
)(l+i)
= $1,000(PVIFA
15%,10 years
)(l+.15)
= $1,000(5.019)(1.15)
= $5,771.85
5-39A. PV = PMT(PVIFA
i,n
)(PVIF
i,n
)
= PMT(PVIFA
10%,10 years
)(PVIF
10%,7 years
)
= $1,000(6.145)(.513)
= $3,152.39
275
5-40A. FV
n
= PV (FVIF
i%, n yr.
)
$6,500 = .12(FVIF
i%, 37 yr.
)
solving using a financial calculator:
i = 34.2575%
5-41A. (a)

$50,000 per year $250,000
$50,000
$100,000
1/04 1/09 1/14
1/19 1/24 1/29
There are a number of equivalent ways to discount these cash flows back to present,
one of which is as follows (in equation form):
PV = $50,000(PVIFA
10%, 19 yr.
- PVIFA
10%, 4 yr.
)
+ $250,000(PVIF
10%, 20 yr.
)
+ $50,000(PVIF
10%, 23 yr.
+ PVIF
10%, 24 yr.
)
+ $100,000 (PVIF
10%, 25 yr.
)
= $50,000 (8.365-3.170) + $250,000 (.149)
+ $50,000 (0.112 + .102) + $100,000 (.092)
= $259,750 + $37,250 + $10,700 + $9,200
= $316,900
(b) If you live longer than expected you could end up with no money later on in
life.
276
5-42A. rate (i) = 8%
number of periods (n) = 7
payment (PMT) = $0
present value (PV) = $900
type (0 = at end of period) = 0
Future value = $1,542.44
Excel formula: =FV(rate,number of periods,payment,present value,type)
Notice that present value ($900) took on a negative value.
5-43A In 20 years you’d like to have $250,000 to buy a home, but you only have $30,000. At
what rate must your $30,000 be compounded annually for it to grow to $250,000 in 20
years?
number of periods (n) = 20
payment (PMT) = $0
present value (PV) = $30,000
future value (FV) = $250,000
type (0 = at end of period) = 0
guess =
i = 11.18%
Excel formula: =RATE(number of periods,payment,present value,future
value,type,guess)
Notice that present value ($30,000) took on a negative value.
5-44A. To buy a new house you take out a 25 year mortgage for $300,000. What will your
monthly interest rate payments be if the interest rate on your mortgage is 8 percent?
Two things to keep in mind when you're working this problem: first, you'll have to
convert the annual rate of 8 percent into a monthly rate by dividing it by 12, and
second, you'll have to convert the number of periods into months by multiplying 25
times 12 for a total of 300 months.
Excel formula: =PMT(rate,number of periods,present value,future value,type)
rate (i) = 8%/12
number of periods (n) = 300
present value (PV) = $300,000
future value (FV) = $0
type (0 = at end of period) = 0
monthly mortgage payment = ($2,315.45)
277
Notice that monthly payments take on a negative value because you pay them.
You can also use Excel to calculate the interest and principal portion of any loan
amortization payment. You can do this using the following Excel functions:
Calculation: Formula:
Interest portion of payment =IPMT(rate,period,number of periods,present
value,future value,type)
Principal portion of payment =PPMT(rate,period,number of periods,present
value,future value,type)
Where period refers to the number of an individual periodic payment.
Thus, if you would like to determine how much of the 48th monthly payment went
toward interest and principal you would solve as follows:
Interest portion of payment 48: ($1,884.37)
The principal portion of payment 48: ($431.08)
5-45A.a. N = 378
I/Y = 6
PV = -24
PMT = 0
CPT FV = 88.27 billion dollars
b. N = 10
I/Y = 10
CPT PV = -77.108 billion dollars
PMT = 0
FV = 200. billion
c. N = 10
CPT I/Y = 14.87%
PV = -50 billion
PMT = 0
FV = 200. billion
d. N = 40
I/Y = 7
PV = -100. billion
CPT PMT = 7.5 billion dollars
278
FV = 0
279
5-46A. What will the car cost in the future?
N = 6
I/Y = 3
PV = -15,000
PMT = 0
CPT FV = 17,910.78 dollars
How much must Bart put in an account today in order to have $17,910.78 in
6 years?
N = 6
I/Y = 7.5
CPT PV = -11,605.50 dollars
PMT = 0
FV = 17,910.78
5-47A. N = 45
I/Y = 8.75
PV = 0
CPT PMT = -2,054.81 dollars
FV = 1,000,000
5-48A.First, we must calculate what Mr. Burns will need in 20 years, then we will know
what he needs in 20 years and we can then calculate how much he needs to deposit
each year in order to come up with that amount (note: once you calculate the present
value, you must multiply your answer, in this case -$4.192 billion times (1 + i)
because this is an annuity due):
N = 10
I/Y = 20
CPT PV = -4.1925 billion × 1.20 = -5.031 billion dollars
PMT = 1 billion
FV = 0
Next, we will determine how much Mr. Burns needs to deposit each year for 20
years to reach this goal of accumulating $5.031 billion at the end of the 20 years:
N = 20
I/Y = 20
PV = 0
CPT PMT= -26.9 million dollars
280
FV = 5.031 billion
5-49A. What’s the $100,000 worth in 25 years (keep in mind that Homer invested the money
5 years ago and we want to know what it will be worth in 20 years)?
N = 25
I/Y = 7.5
PV = -100,000
PMT = 0
CPT FV = 609,833.96 dollars
Now we determine what the additional $1,500 per year will grow to (note that since
Homer will be making these investments at the beginning of each year for 20 years
we have an annuity due, thus, once you calculate the present value, you must
multiply your answer, in this case $64,957.02 times (1 + i)):
N = 20
I/Y = 7.5
PV = 0
PMT = -1,500
CPT FV = 64,957.02 × 1.075 = 69,828.80 dollars
Finally, we must add the two values together:
$609,833.96 + $69,828.80 = $679,662.76
5-50A. Since this problem involves monthly payments we
must first, make P/Y = 12. Then, N becomes the number of months
or compounding periods,
N = 60
I/Y = 6.2
PV = -25,000
CPT PMT= 485.65 dollars
FV = 0
5-51A. Since this problem involves monthly payments we must first, make P/Y = 12. Then,
N becomes the number of months or compounding periods,
N = 36
CPT I/Y = 11.62%
PV = -999
PMT = 33
FV = 0
281
5-52A. First, what will be the monthly payments if Suzie goes for the 4.9 percent financing?
Since this problem involves monthly payments we must first, make P/Y = 12. Then,
N becomes the number of months or compounding periods,
N = 60
I/Y = 4.9
PV = -25,000
CPT PMT= 470.64 dollars
FV = 0
Now, calculate how much the monthly payments would be if Suzie took the $1,000
cash back and reduced the amount owed from $25,000 to $24,000. Again, since this
problem involves monthly payments we must first, make P/Y = 12.
N = 60
I/Y = 6.9
PV = -24,000
CPT PMT = 474.10 dollars
FV = 0
5-53A. Since this problem involves quarterly compounding we must first, make P/Y = 4.
Then, N becomes the number of quarters or compounding periods,
N = 16
I/Y = 6.4%
PV = 0
PMT = -1000
CPT FV = 18,071.11 dollars
5-54A. There are several ways you could solve this problem. One way would be to calculate
the future value of an amount, say $100, deposited in each of these CDs would grow
to at the end of a year. Let’s try this first. Since the first part of this problem
involves daily compounding we must first, make P/Y = 365. Then, N becomes the
number of days in a year,
N = 365
I/Y = 4.95
PV = -100
PMT = 0
CPT FV = 105.0742 or 5.0742%
282
Now, let’s look at monthly compounding we must first, and again, we’ll see what
$100 will grow to at the end of a year. First, we make P/Y = 12.
N = 12
I/Y = 5.0
PV = -100
PMT = 0
CPT FV = 105.1162 or 5.1162%
An alternative approach would be to use the ICONV button on a Texas Instruments
BA II-Plus calculator. That button calculates the APY, or annual percentage yield,
also called the effective rate.
5-55A. Since this problem involves monthly payments we must first,
make P/Y = 12. Then, N becomes the number of months or
compounding periods,
CPT N = 41.49 (rounded up to 42 months)
I/Y = 12.9
PV = -5000
PMT = 150
FV = 0
5-56A. a. Since this problem begins using annual payments, make sure your calculator
is set to P/Y=1.
N = 12
CPT I/Y = 8.37%
PV = -160,000
PMT = 0
FV = 420,000
b. Again, since this problem begins using annual payments, make sure your
calculator is set to P/Y=1
N = 10
CPT I/Y = 11.6123%
PV = -140,000
PMT = 0
FV = 420,000
283
c. Since this problem now involves monthly payments we must first, make P/Y
= 12. Then, N becomes the number of months or compounding periods,
N = 120
I/Y = 6
PV = -140,000
CPT PMT = -1,008.57 dollars
FV = 420,000
d. Since this problem now involves monthly payments we must first, make P/Y
= 12. Then, N becomes the number of months or compounding periods.
Also, since Professor ME will be depositing both the $140,000 (immediately)
and $500 (monthly), they must have the same sign,
N = 120
CPT I/Y = 8.48%
PV = -140,000
PMT = -500
FV = 420,000
SOLUTION TO INTEGRATIVE PROBLEM
1. Discounting is the inverse of compounding. We really only have one formula to
move a single cash flow through time. In some instances we are interested in
bringing that cash flow back to the present (finding its present value) when we
already know the future value. In other cases we are merely solving for the future
value when we know the present value.
2. The values in the present value of an annuity table (Table 5-8) are actually derived
from the values in the present value table (Table 5-4). This can be seen, by
examining the value, represented in each table. The present value table gives values
of
for various values of i and n, while the present value of an annuity table gives values
of
t
i) (1
1
n
1 t

+

·
for various values of i and n. Thus the value in the present value of annuity table for
an n-year annuity for any discount rate i is merely the sum of the first n values in the
present value table.
3. (a) FV
n
= PV (1 + i)
n
284
FV
10
=
$5,000(1 + 0.08)
10
FV
10
= $5,000 (2.159)
FV
10
= $10,795
(b) FV
n
= PV (1 + i)
n
$1,671 = $400 (1 + 0.10)
n
4.1775 = FVIF
10%, n yr.
Thus n= 15 years (because the value of 4.177 occurs in the 15 year row
of the 10 percent column of Appendix B).
(c) FV
n
= PV (1 + i)
n
$4,046 = $1,000 (1 + i)
10
4.046 = FVIF
i%, 10 yr.
Thus, i = 15% (because the Appendix B value of 4.046 occurs in the 10
year row in the 15 percent column)
4. FV
n
= PV
mn
= $1,000
2•5
= $1,000(1+.05)
10
= $1,629
5. An annuity due is an annuity in which the payments occur at the beginning of each
period as opposed to occurring at the end of each period, which is when the payment
occurs in an ordinary annuity.
6. PV = PMT(PVIFA
i,n
)
= $1,000(PVIFA
10%,7 years
)
= $1,000(4.868)
= $4,868
PV(annuity due) = PMT(PVIFA
i,n
)(l+i)
= $1000(4.868)(l+.10)
= $5,354.80
285
7. FV
n
= PMT(FVIFA
i,n
)
= $1,000(9.487)
= $9,487
FV
n
(annuity due) = PMT(FVIFA
i,n
)(l+i)
= $1000(9.487)(l+.10)
= $10,435.70
8. PV = PMT(PVIFA
i,n
)
$100,000 = PMT(PVIFA
10%, 25 years
)
$100,000 = PMT(9.077)
$11,016.86 = PMT
9. PV =
=
= $12,500
10. PV = PMT(PVIFA
i,n
)(PVIF
i,n
)
= $1,000(PVIFA
10%,10 years
)(PVIF
10%, 9 years
)
= $1,000(6.145)(.424)
= $2,605.48
11. PV =
= (PVIF
10%, 9 years
)
=
= $4,240.00
12. APY =
m
- 1
=
4
- 1
= [1 + .02]
4
- 1
= 1.0824 - 1
= .0824 or 8.24%
Solutions to Problem Set B
5-1B. (a) FV
n
= PV (1 + i)
n
FV
11
= $4,000(1 + 0.09)
11
286
FV
11
= $4,000 (2.580)
FV
11
= $10,320
(b) FV
n =
PV (1 + i)
n
FV
10 =
$8,000 (1 + 0.08)
10
FV
10
= $8,000 (2.159)
FV
10 =
$17,272
(c) FV
n =
PV (1 + i)
n
FV
12 =
$800 (1 + 0.12)
12
FV
12 =
$800 (3.896)
FV
12 =
$3,117
(d) FV
n =
PV (1 + i)
n
FV
6
= $21,000 (1 + 0.05)
6
FV
6
= $21,000 (1.340)
FV
6 =
$28,140
5-2B. (a) FV
n
= PV (1 + i)
n
$1,043.90 = $550 (1 + 0.06)
n
1.898 = FVIF
6%, n yr.
Thus n = 11 years (because the value of 1.898 occurs in the 11
year row of the 6 percent column of Appendix B).
(b) FV
n
= PV (1 + i)
n
$88.44 = $40 (1 + .12)
n

2.211 = FVIF
12%, n yr.
Thus, n = 7 years
(c) FV
n =
PV (1 + i)
n
$614.79 = $110 (1 + 0.24)
n

5.589 = FVIF
24%, n yr.
Thus, n = 8 years
(d) FV
n = PV (1 + i)
n
287
$78.30 = $60 (1 + 0.03)
n
1.305 = FVIF
3%, n yr.
Thus, n = 9 years
5-3B. (a) FV
n
= PV (1 + i)
n
$1,898.60 = $550 (1 + i)
13
3.452 = FVIF
i%, 13 yr.
Thus, i = 10% (because the Appendix B value of 3.452 occurs in
the 13 year row in the 10 percent column)
(b) FV
n =
PV (1 + i)
n
$406.18 = $275 (1 + i)
8
1.477 = FVIF
i%, 8 yr.
Thus, i = 5%
(c) FV
n
= PV (1 + i)
n
$279.66 = $60 ( 1 + i)
20
4.661 = FVIF
i%, 20 yr.
Thus, i = 8%
(d) FV
n = PV ( 1 + i)
n
$486.00 = $180 (1 + i)
6
2.700 = FVIF
i%, 6 yr.
Thus, i = 18%
5-4B. (a) PV = FV
n

PV = $800
PV = $800 (0.386)
PV = $308.80
(b) PV = FV
n

PV = $400
PV = $400 (0.705)
PV = $282.00
(c) PV = FV
n
288
PV = $1,000
PV = $1,000 (0.677)
PV = $677
(d) PV = FV
n
PV = $900
PV = $900 (0.194)
PV = $174.60
5-5B. (a) FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
FV
10
= $500
,
_

¸
¸
+ ∑

·
t
1 10
0 t
0.06) (1
FV
10
= $500 (13.181)
FV
10
= $6,590.50
(b) FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
FV
5
= $150
,
_

¸
¸
+ ∑

·
t
1 5
0 t
0.11) (1
FV
5
= $150 (6.228)
FV
5
= $934.20
289
(c) FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
FV
8
= $35

,
_

¸
¸
+ ∑

·
t
1 8
0 t
0.07) (1
FV
8
= $35 (10.260)
FV
8
= $359.10
(d) FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
FV
3
= $25
,
_

¸
¸
+ ∑

·
t
1 3
0 t
0.02) (1
FV
3
= $25 (3.060)
FV
3
= $76.50
5-6B. (a) PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

PV = $3,000

,
_

¸
¸
+

·
t
10
1 t 0.08) (1
1

PV = $3,000 (6.710)
PV = $20,130
(b) PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

PV = $50

,
_

¸
¸
+

·
t
3
1 t 0.03) (1
1

PV = $50 (2.829)
PV = $141.45
(c) PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

PV = $280

,
_

¸
¸
+

·
t
8
1 t 0.07) (1
1

PV = $280 (5.971)
PV = $1,671.88
290
(d) PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

PV = $600

,
_

¸
¸
+

·
t
10
1 t 0.1) (1
1

PV = $600 (6.145)
PV = $3,687.00
5-7B. (a) FV
n
= PV (1 + i)
n
compounded for 1 year
FV
1
= $20,000 (1 + 0.07)
1
FV
1
= $20,000 (1.07)
FV
1
= $21,400
compounded for 5 years
FV
5
= $20,000 (1 + 0.07)
5
FV
5
= $20,000 (1.403)
FV
5
= $28,060
compounded for 15 years
FV
15
= $20,000 (1 + 0.07)
15
FV
15
= $20,000 (2.759)
FV
15
= $55,180
(b) FV
n
= PV (1 + i)
n
compounded for 1 year at 9%
FV
1
= $20,000 (1 + 0.09)
1
FV
1
= $20,000 (1.090)
FV
1
= $21,800
compounded for 5 years at 9%
FV
5
= $20,000 (1 + 0.09)
5
FV
5
= $20,000 (1.539)
FV
5
= $30,780
compounded for 15 years at 9%
FV
5

= $20,000 (1 + 0.09)
15
FV
5
= $20,000 (3.642)
291
FV
5
= $72,840
compounded for 1 year at 11%
FV
1
= $20,000 (1 + 0.11)
1
FV
1
= $20,000 (1.11)
FV
1
= $22,200
compounded for 5 years at 11%
FV
5
= $20,000 (1 + 0.11)
5
FV
5
= $20,000 (1.685)
FV
5
= $33,700
compounded for 15 years at 11%
FV
5
= $20,000 (1 + 0.11)
15
FV
5
= $20,000 (4.785)
FV
5
= $95,700
(c) There is a positive relationship between both the interest rate used to
compound a present sum and the number of years for which the
compounding continues and the future value of that sum.
5-8B. FV
n
= PV (1 + )
mn
Account PV i m n (1 + )
mn
PV(1 + )
mn
Korey Stringer 2,000 12% 6 2 1.268 $2,536
Erica Moss 50,000 12% 12 1 1.127 56,350
Ty Howard 7,000 18% 6 2 1.426 9,982
Rob Kelly 130,000 12% 4 2 1.267 164,710
Mary Christopher 20,000 14% 2 4 1.718 34,360
Juan Diaz 15,000 15% 3 3 1.551 23,265
5-9B. (a) FV
n
= PV (1 + i)
n
FV
5
= $6,000 (1 + 0.06)
5
FV
5
= $6,000 (1.338)
FV
5
= $8,028
(b) FV
n
= PV (1 + )
mn
FV
5
= $6,000 (1 + )
2 x 5
FV
5
= $6,000 (1 + 0.03)
10
FV
5
= $6,000 (1.344)
FV
5
= $8,064
292
FV
n
= PV (1 + )
mn
FV
5
= $6,000 (1 + )
6X5

FV
5
= $6,000 (1 + 0.01)
30
FV
5
= $6,000 (1.348)
FV
5
= $8,088
(c) FV
n
= PV (1 + i)
n
FV
5
= $6,000 (1 + 0.12)
5
FV
5
= $6,000 (1.762)
FV
5
= $10,572
FV
5
= PV
mn
FV
5
= $6,000
2X5
FV
5
= $6,000 (1 + 0.06)
10
FV
5
= 6,000 (1.791)
FV
5
= $10,746
FV
5
= PV
mn
FV
5
=
$6,000
6X5
FV
5
= $6,000 (1 + 0.02)
30
FV
5
=
$6,000 (1.811)
FV
5
= $10,866
(d) FV
n
= PV (1 + i)
n
FV
12
=
$6,000 (1 + 0.06)
12
FV
12
= $6,000 (2.012)
FV
12
= $12,072
(e) An increase in the stated interest rate will increase the future value of a given
sum. Likewise, an increase in the length of the holding period will increase
the future value of a given sum.
5-10B. Annuity A: PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

293
PV = $8,500

,
_

¸
¸
+

·
t
12
1 t 0.12) (1
1

PV = $8,500 (6.194)
PV = $52,649
Since the cost of this annuity is $50,000 and its present value is $52,649, given a 12
percent opportunity cost, this annuity has value and should be accepted.
Annuity B: PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

PV = $7,000

,
_

¸
¸
+

·
t
25
1 t 0.12) (1
1

PV = $7,000 (7.843)
PV =$54,901
Since the cost of this annuity is $60,000 and its present value is only $54,901 given a
12 percent opportunity cost, this annuity should not be accepted.
Annuity C: PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

PV = $8,000

,
_

¸
¸
+

·
t
20
1 t 0.12) (1
1

PV = $8,000 (7.469)
PV = $59,752
Since the cost of this annuity is $70,000 and its present value is only $59,752,
given a 12 percent opportunity cost, this annuity should not be accepted.
5-11B. Year 1: FV
n
= PV (1 + i)
n
FV
1
= 10,000(1 + 0.15)
1
FV
1
= 10,000(1.15)
FV
1
= 11,500 books
Year 2: FV
n
= PV (1 + i)
n
FV
2
=
10,000(1 + 0.15)
2
FV
2
= 10,000(1.322)
FV
2
= 13,220 books
Year 3: FV
n
= PV (1 + i)
n
FV
3
=
10,000(1 + 0.15)
3
294
FV
3
= 10,000(1.521)
FV
3
= 15,210 books
Book sales
20,000
15,000
10,000
1 2 3
years
The sales trend graph is not linear because this is a compound growth trend.
Just as compound interest occurs when interest paid on the investment during
the first period is added to the principal of the second period, interest is
earned on the new sum. Book sales growth was compounded; thus, the first
year the growth was 15 percent of 10,000 books, the second year 15 percent
of 11,500 books, and the third year 15 percent of 13,220 books.
5-12B. FV
n
= PV (1 + i)
n
FV
1
= 41(1 + 0.12)
1
FV
1
= 41(1.12)
FV
1

= 45.92 Home Runs in 1981 (in spite of the baseball
strike).
FV
2
= 41(1 + 0.12)
2
FV
2
= 41(1.254)
FV
2
= 51.414 Home Runs in 1982
FV
3
= 41(1 + 0.12)
3
FV
3
= 41(1.405)
FV
3
= 57.605 Home Runs in 1983.
295
FV
4
= 41(1 + 0.12)
4
FV
4
= 41(1.574)
FV
4

= 64.534 Home Runs in 1984 (for a new major league
record).
FV
5
= 41(1 + 0.12)
5
FV
5
= 41(1.762)
FV
5
= 72.242 Home Runs in 1985 (again for a new major league
record).
Actually, Reggie never hit more than 41 home runs in a year. In 1982, he only hit 15,
in1983 he hit 39, in 1984 he hit 14, in 1985 25 and 26 in 1986. He retired at the end of
1987 with 563 career home runs.
5-13B. PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

$120,000 = PMT

,
_

¸
¸
+

·
t
25
1 t 0.1) (1
1

$120,000 = PMT(9.077)
Thus, PMT = $13,220.23 per year for 25 years
5-14B. FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
$25,000 = PMT
,
_

¸
¸
+ ∑

·
t
1 15
0 t
0.07) (1
$25,000 = PMT(25.129)
Thus, PMT = $994.87
5-15B. FV
n
= PV (1 + i)
n
$2,376.50 = $700 (FVIF
i%, 10 yr.
)
3.395 = FVIF
i%, 10 yr.
Thus, i = 13%
5-16B. The value of the home in 10 years
FV
10
= PV (1 + .05)
10
= $125,000(1.629)
= $203,625
How much must be invested annually to accumulate $203,625?
296
$203,625 = PMT
,
_

¸
¸
+ ∑

·
t
1 10
0 t
.10) (1
$203,625 = PMT(15.937)
PMT = $12,776.87
5-17B. FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
$15,000,000 = PMT
,
_

¸
¸
+ ∑

·
t
1 10
0 t
.10) (1
$15,000,000 = PMT(15.937)
Thus, PMT = $941,206
5-18B. One dollar at 24.0% compounded monthly for one year
FV
n
= PV (1 + )
nm
FV
1
= $1(1 + .02)
1
= $1(1.268)
= $1.268
One dollar at 26.0% compounded annually for one year
FV
n
= PV (1 + i)
n
FV
1
= $1(1 + .26)
1
= $1(1.26)
= $1.26
The loan at 26% compounded annually is more attractive.
5-19B. Investment A
PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
i

= $15,000

,
_

¸
¸
+

·
t
5
1 t .20) (1
1

= $15,000(2.991)
= $44,865
Investment B
First, discount the annuity back to the beginning of year 5, which is the end of year 4.
Then discount this equivalent sum to present.
297
PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

= $15,000

,
_

¸
¸
+

·
t
6
1 t .20) (1
1

= $15,000(3.326)
= $49,890--then discount the equivalent sum back to present.
PV = FV
n

= $49,890
= $49,890(.482)
= $24,046.98
Investment C
PV = FV
n

= $20,000 + $60,000
+ $20,000
= $20,000(.833) + $60,000(.335) + $20,000(.162)
= $16,660 + $20,100 + $3,240
= $40,000
5-20B. PV = FV
n

PV = $1,000
= $1,000(.502)
= $502
5-21B. (a) PV =
PV =
PV = $4,444
(b) PV =
PV =
PV = $11,538
(c) PV =
PV =
PV = $1,500
(d) PV =
PV =
PV = $1,667
298
5-22B. PV(annuity due) = PMT(PVIFA
i,n
)(l + i)
= $1000(3.791)(1 + .10)
= $3791(1.1)
= $4,170.10
5-23B. FV
n = PV (1 + )
m
.
n
7 = 1(1 + )
2
.
n
7 = (1 + 0.05)
2
.
n
7 = FVIF
5%, 2n yr.
A value of 7.040 occurs in the 5 percent column and 40-year row of the table in
Appendix B. Therefore, 2n = 40 years and n = approximately 20 years.
5-24A. Investment A:
PV = FV
n
(PVIF
i,n
)
PV = $5,000(PVIF
10%, year 1
) + $5,000(PVIF
10%, year 2
) +
$5,000(PVIF
10%, year 3
) - $15,000(PVIF
10%, year 4
) +
$15,000(PVIF
10%, year 5
)
= $5,000(.909) + $5,000(.826) + $5,000(.751)
- $15,000(.683) + $15,000(.621)
= $4,545 + $4,130 + $3,755 - $10,245 + $9,315
= $11,500.
299
Investment B:
PV = FV
n
(PVIF
i,n
)
PV = $1,000(PVIF
10%, year 1
) + $3,000(PVIF
10%, year 2
) +
$5,000(PVIF
10%, year 3
) + $10,000(PVIF
10%, year 4
) -
$10,000(PVIF
10%, year 5
)
= $1,000(.909) + $3,000(.826) + $5,000(.751)
+ $10,000(.683) - $10,000(.621)
= $909 + $2,478 + $3,755 + $6,830 - $6,210
= $7,762.
Investment C:
PV = FV
n
(PVIF
i,n
)
PV = $10,000(PVIF
10%, year 1
) + $10,000(PVIF
10%, year 2
) +
$10,000(PVIF
10%, year 3
) + $10,000(PVIF
10%, year 4
) -
$40,000(PVIF
10%, year 5
)
= $10,000(.909) + $10,000(.826) +
$10,000(.751) + $10,000(.683) - $40,000(.621)
= $9,090 + $8,260 + $7,510 + $6,830 - $24,840
= $6,850.
5-25B. The Present value of the $10,000 annuity over years 11-15.
PV = PMT

,
_

¸
¸

,
_

¸
¸
+

,
_

¸
¸
+
∑ ∑
· ·
t
10
1 t
t
15
1 t
.07) (1
1

.07) (1
1

= $10,000(9.108 - 7.024)
= $10,000(2.084)
= $20,840
The present value of the $15,000 withdrawal at the end of year 15:
PV = FV
15

= $15,000(.362)
= $5,430
Thus, you would have to deposit $20,840 + $5,430 or $26,270 today.
300
5-26B. PV = PMT

,
_

¸
¸
+

·
t
10
1 t .09) (1
1

$45,000 = PMT(6.418)
PMT = $7,012
5-27B. PV = PMT

,
_

¸
¸
+

·
t
5
1 t i) (1
1

$45,000 = $9,000 (PVIFA
i%, 5 yr.
)
5.0 = PVIFA
i%, 5 yr.
i = 0%
5-28B. PV = FV
n

$15,000 = $37,313 (PVIF
i%, 5 yr.
)
.402 = PVIF
20%, 5 yr.
Thus, i = 20%
5-29B. PV = PMT

,
_

¸
¸
+

·
t
n
1 t i) (1
1

$30,000 = PMT

,
_

¸
¸
+

·
t
4
1 t .13) (1
1

$30,000 = PMT(2.974)
PMT = $10,087
5-30B. The present value of $10,000 in 12 years at 11 percent is:
PV = FV
n

,
_

¸
¸
+
n
i) (1
1
PV = $10,000 ()
PV = $10,000 (.286)
PV = $2,860
The present value of $25,000 in 25 years at 11 percent is:
PV = $25,000 ()
= $25,000 (.074)
= $1,850
Thus take the $10,000 in 12 years.
5-31B. FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
301
$30,000 = PMT
,
_

¸
¸
+ ∑

·
t
1 5
0 t
.10) (1
$30,000 = PMT(6.105)
PMT =$4,914
5-32B. (a) FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
$75,000 = PMT
,
_

¸
¸
+ ∑

·
t
1 15
0 t
.08) (1
$75,000 = PMT (FVIFA
8%, 15 yr.
)
$75,000 = PMT(27.152)
PMT = $2,762.23 per year
(b) PV = FV
n

PV = $75,000 (PVIF
8%, 15 yr.
)
PV = $75,000(.315)
PV = $23,625 deposited today
(c) The contribution of the $20,000 deposit toward the $75,000 goal is
FV
n
= PV (1 + i)
n
FV
n
= $20,000 (FVIF
8%, 10 yr.
)
FV
10
= $20,000(2.159)
= $43,180
Thus only $31,820 need be accumulated by annual deposit.
FV
n
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
$31,820 = PMT (FVIFA
8%, 15 yr.
)
$31,820 = PMT [27.152]
PMT = $1,171.92 per year
302
5-33B.(a) This problem can be subdivided into (1) the compound value of the $150,000
in the savings account, (2) the compound value of the $250,000 in stocks, (3)
the additional savings due to depositing $8,000 per year in the savings
account for 10 years, and (4) the additional savings due to depositing $2,000
per year in the savings account at the end of years 6-10. (Note the $10,000
deposited in years 6-10 is covered in parts (3) and (4).)
(1) Future value of $150,000
FV
10
= $150,000 (1 + .08)
10
FV
10
= $150,000 (2.159)
FV
10
= $323,850
(2) Future value of $250,000
FV
10
= $250,000 (1 + .12)
10
FV
10
= $250,000 (3.106)
FV
10
= $776,500
(3) Compound annuity of $8,000, 10 years
FV
10
= PMT
,
_

¸
¸
+ ∑

·
t
1 n
0 t
i) (1
= $8,000
,
_

¸
¸
+ ∑

·
t
1 10
0 t
.08) (1
= $8,000 (14.487)
= $115,896
(4) Compound annuity of $2,000 (years 6-10)
FV
5
= $2,000
,
_

¸
¸
+ ∑

·
t
1 5
0 t
.08) (1
= $2,000 (5.867)
= $11,734
At the end of ten years you will have $323,850 + $776,500 +
$115,896
+ $11,734 = $1,227,980.
(b) PV = PMT

,
_

¸
¸
+

·
t
20
1 t .11) (1
1

$1,227,980 = PMT (7.963)
PMT = $154,210.72
303
5-34B. PV

= PMT (PVIFA
i%, n yr.
)
$200,000 = PMT (PVIFA
10%, 20 yr.
)
$200,000 = PMT(8.514)
PMT = $23,491
5-35B. PV = PMT (PVIFA
i%, n yr.
)
$250,000 = PMT (PVIFA
9%, 30 yr.
)
$250,000 = PMT(10.274)
PMT = $24,333
5-36B. At 10%:
PV = $40,000 + $40,000 (PVIFA
10%, 24 yr.
)
PV = $40,000 + $40,000 (8.985)
PV = $40,000 + $359,400
PV = $399,400
At 20%:
PV = $40,000 + $40,000 (PVIFA
20%, 24 yr.
)
PV = $40,000 + $40,000 (4.937)
PV = $40,000 + $197,480
PV = $237,480
5-37B FV
n
(annuity due) = PMT(FVIFA
i,n
)(l + i)
= $1000(FVIFA
5%, 5 years
)(l + .05)
= $1000(5.526)(1.05)
= $5802.30
FV
n
(annuity due) = PMT(FVIFA
i,n
)(l + i)
= $1,000(FVIFA
8%, 5 years
)(1 + .08)
= $1,000(5.867)(1.08)
= $6,336.36
5-38B. PV(annuity due) = PMT(PVIFA
i,n
)(l + i)
= $1000 (PVIFA
12%, 15 years
)(1 + .12)
= $1000(6.811)(1.12)
= $7,628.32
304
PV(annuity due) = PMT(PVIFA
i,n
)(l + i)
= $1000(PVIFA
15%, 15 years
)(l + .15)
= $1000(5.847)(1.15)
= $6,724.05
5-39B. PV = PMT(PVIFA
i,n
)(PVIF
i,n
)
= $1000(PVIFA
15%,10 years
)(PVIF
15%, 7 years
)
= $1000(5.019)(.376)
= $1,887.14
5-40B. FV
n
= PV (FVIF
i%, n yr.
)
$3,500 = .12(FVIF
i%, 38 yr.
)
solving using a financial calculator:
i = 31.0681%
5-41B. (a)

$60,000 per year $300,000
$60,000
$100,000
1/05 1/10 1/15
1/20 1/25 1/30
There are a number of equivalent ways to discount these cash flows back to
present, one of which is as follows (in equation form):
PV = $60,000 (PVIFA
10%, 19 yr.
- PVIFA
10%, 4 yr.
)
+ $300,000 (PVIF
10%, 20 yr.
)
+ $60,000 (PVIF
10%, 23 yr.
+ PVIF
10%, 24 yr.
)
+ $100,000 (PVIF
10%, 25 yr.
)
= $60,000 (8.365-3.170) + $300,000 (.149)
+ $60,000 (0.112 + .102) + $100,000 (.092)
= $311,700 + $44,700 + $12,840 + $9,200
= $378,440
(b) If you live longer than expected you could end up with no money later on in
life.
305
306
CHAPTER 7
Bonds Valuation

CHAPTER ORIENTATION
This chapter introduces the concepts that underlie asset valuation. We are specifically
concerned with bonds. We also look at the concept of the bondholder's expected rate of
return on an investment.
CHAPTER OUTLINE
I. Types of bonds
A. Debentures: unsecured long-term debt.
B. Subordinated debentures: bonds that have a lower claim on assets in the
event of liquidation than do other senior debtholders.
C. Mortgage bonds: bonds secured by a lien on specific assets of the firm, such
as real estate.
D. Eurobonds: bonds issued in a country different from the one in whose
currency the bond is denominated; for instance, a bond issued in Europe or
Asia that pays interest and principal in U.S. dollars.
E. Zero and low coupon bonds allow the issuing firm to issue bonds at a
substantial discount from their $1,000 face value with a zero or very low
coupon.
1. The disadvantages are, when the bond matures, the issuing firm will
face an extremely large nondeductible cash outflow much greater than
the cash inflow they experienced when the bonds were first issued.
2. Zero and low coupon bonds are not callable and can be retired only at
maturity.
3. On the other hand, annual cash outflows associated with interest
payments do not occur with zero coupon bonds.
F. Junk bonds: bonds rated BB or below.
307
II. Terminology and characteristics of bonds
A. A bond is a long-term promissory note that promises to pay the bondholder a
predetermined, fixed amount of interest each year until maturity. At maturity,
the principal will be paid to the bondholder.
B. In the case of a firm's insolvency, a bondholder has a priority of claim to the
firm's assets before the preferred and common stockholders. Also,
bondholders must be paid interest due them before dividends can be
distributed to the stockholders.
C. A bond's par value is the amount that will be repaid by the firm when the
bond matures, usually $1,000.
D. The contractual agreement of the bond specifies a coupon interest rate that is
expressed either as a percent of the par value or as a flat amount of interest
which the borrowing firm promises to pay the bondholder each year. For
example: A $1,000 par value bond specifying a coupon interest rate of 9
percent is equivalent to an annual interest payment of $90.
E. The bond has a maturity date, at which time the borrowing firm is committed
to repay the loan principal.
F. An indenture (or trust deed) is the legal agreement between the firm issuing
the bonds and the bond trustee who represents the bondholders. It provides
the specific terms of the bond agreement such as the rights and
responsibilities of both parties.
G. The current yield on a bond refers to the ratio of annual interest payment to
the bond’s market price.
H. Bond ratings
1. Three primary rating agencies exist—Moody’s, Standard & Poor’s,
and Fitch Investor Services.
2. Bond ratings are simply judgments about the future risk potential of
the bond in question. Bond ratings are extremely important in that a
firm’s bond rating tells much about the cost of funds and the firm’s
access to the debt market.
3. The different ratings and their implications are described.
III. Definitions of value
A. Book value is the value of an asset shown on a firm's balance sheet which is
determined by its historical cost rather than its current worth.
B. Liquidation value is the amount that could be realized if an asset is sold
individually and not as part of a going concern.
C. Market value is the observed value of an asset in the marketplace where
buyers and sellers negotiate an acceptable price for the asset.
308
D. Intrinsic value is the value based upon the expected cash flows from the
investment, the riskiness of the asset, and the investor's required rate of
return. It is the value in the eyes of the investor and is the same as the present
value of expected future cash flows to be received from the investment.
IV. Valuation: An Overview
A. The value of an asset is a function of three elements:
1. The amount and timing of the asset's expected cash flows
2. The riskiness of these cash flows
3. The investors' required rate of return for undertaking the investment
B. Expected cash flows are used in measuring the returns from an investment.
V. Valuation: The Basic Process
The value of an asset is found by computing the present value of all the future cash
flows expected to be received from the asset. Expressed as a general present value
equation, the value of an asset is found as follows:
V = ∑
·
+
N
1 t
t
t
k) (1
$C

where C
t
= the cash flow to be received at time t
V = the intrinsic value or present value of an asset
producing expected future cash flows, C
t, in
years 1 through N
k = the investor's required rate of return
N = the number of periods
VI. Bond Valuation
A. The value of a bond is simply the present value of the future interest
payments and maturity value discounted at the bondholder's required rate of
return. This may be expressed as:
V
b
=

·
+
+
+
N
1 t
N
b
t
b
t
) k (1
$M

) k (1
$I

where I
t
= the dollar interest to be received in each
payment
M = the par value of the bond at maturity
k
b
= the required rate of return for the bondholder
N = the number of periods to maturity
In other words, we are discounting the expected future cash flows to the
present at the appropriate discount rate (required rate of return).
309
B. If interest payments are received semiannually (as with most bonds), the
valuation equation becomes:
V
b
=

·

,
_

¸
¸
+
+

,
_

¸
¸
+
2N
1 t
2N
b
t
b
t
2
k
1
$M

2
k
1
2
$I

VII. Bondholder's Expected Rate of Return (Yield to Maturity)
A. We compute the bondholder's expected rate of return by finding the discount
rate that gets the present value of the future interest payments and principal
payment just equal to the bond's current market price.
B. The bondholder's expected rate of return is also the rate the investor will earn
if the bond is held to maturity, provided, of course, that the company issuing
the bond does not default on the payments.
VIII. Bond Value: Five Important Relationships
A. First relationship
A decrease in interest rates (required rates of return) will cause the value of a
bond to increase; an interest rate increase will cause a decrease in value. The
change in value caused by changing interest rates is called interest rate risk.
B. Second relationship
1. If the bondholder's required rate of return (current interest rate) equals
the coupon interest rate, the bond will sell at par, or maturity value.
2. If the bondholder's required rate of return exceeds the bond's coupon
rate, the bond will sell below par value or at a "discount."
3. If the bondholder's required rate of return is less than the bond's
coupon rate, the bond will sell above par value or at a "premium."
C. Third relationship
As the maturity date approaches, the market value of a bond approaches its
par value.
1. The premium bond sells for less as maturity approaches.
2. The discount bond sells for more as maturity approaches.
D. Fourth relationship
A bondholder owning a long-term bond is exposed to greater interest rate risk
than when owning a short-term bond.
310
E. Fifth relationship
The sensitivity of a bond's value to changing interest rates depends not only
on the length of time to maturity, but also on the pattern of cash flows
provided by the bond.
1. The duration of a bond is simply a measure of the responsiveness of
its price to a change in interest rates. The greater the relative
percentage change in a bond price in response to a given percentage
change in the interest rate, the longer the duration.
2. Calculating duration
duration =
0
t
b
t
1
P
) k (1
tC
+

·
n
t
where t = the year the cash flow is to be received
N = the number of years to maturity
C
t
= the cash flow to be received in year t
k
b
= the bondholder's required rate of return
P
0
= the bond's present value
ANSWERS TO
END-OF-CHAPTER QUESTIONS
7-1. Book value is the asset's historical value and is represented on the balance sheet as
cost minus accumulated depreciation. Liquidation value is the dollar sum that could
be realized if the assets were sold individually and not as part of a going concern.
Market value is the observed value for an asset in the marketplace where buyers and
sellers negotiate a mutually acceptable price. Intrinsic value is the present value of
the asset's expected future cash flows discounted at an appropriate discount rate.
7-2. The value of a security is equal to the present value of cash flows to be received by
the investor. Hence, the terms value and present value are synonymous.
7-3. The first two factors affecting asset value (the asset characteristics) are the asset's
expected cash flows and the riskiness of these cash flows. The third consideration is
the investor's required rate of return. The required rate of return reflects the
investor's risk-return preference.
7-4. The relationship is inverse. As the required rate of return increases, the value of the
security decreases, and a decrease in the required rate of return results in a price
increase.
311
7-5. (a) The par value is the amount stated on the face of the bond. This value does
not change and, therefore, is completely independent of the market value.
However, the market value may change with changing economic conditions
and changes within the firm.
(b) The coupon interest rate is the rate of interest that is
contractually specified in the bond indenture. As such, this rate is
constant throughout the life of the bond. The coupon interest rate
indicates to the investor the amount of interest to be received in each
payment period. On the other hand, the investor's required rate of
return is equivalent to the bond’s current yield to maturity, which
changes with the changing bond's market price. This rate may be
altered as economic conditions change and/or the investor's attitude
toward the risk-return trade-off is altered.
7-6. In the case of insolvency, claims of debt holders in general, including bonds, are
honored before those of both common stock and preferred stock. However, different
types of debt may also have a hierarchy among themselves as to the order of their
claim on assets.
Bonds also have a claim on income that comes ahead of common and preferred
stock. If interest on bonds is not paid, the bond trustees can classify the firm
insolvent and force it into bankruptcy. Thus, the bondholder's claim on income is
more likely to be honored than that of common and preferred stockholders, whose
dividends are paid at the discretion of the firm's management.
7-7. Ratings involve a judgment about the future risk potential of the bond. Although they
deal with expectations, several historical factors seem to play a significant role in
their determination. Bond ratings are favorably affected by (1) a greater reliance on
equity, and not debt, in financing the firm, (2) profitable operations, (3) a low
variability in past earnings, (4) large firm size, and (5) little use of subordinated debt.
In turn, the rating a bond receives affects the rate of return demanded on the bond by
the investors. The poorer the bond rating, the higher the rate of return demanded in
the capital markets.
For the financial manager, bond ratings are extremely important. They provide an
indicator of default risk that in turn affects the rate of return that must be paid on
borrowed funds.
7-8. The term debentures applies to any unsecured long-term debt. Because these bonds
are unsecured, the earning ability of the issuing corporation is of great concern to the
bondholder. They are also viewed as being more risky than secured bonds and as a
result must provide investors with a higher yield than secured bonds provide. Often
the issuing firm attempts to provide some protection to the holder through the
prohibition of any additional encumbrance of assets. This prohibits the future
issuance of secured long-term debt that would further tie up the firm's assets and
leave the bondholders less protected. To the issuing firm, the major advantage of
debentures is that no property has to be secured by them. This allows the firm to
issue debt and still preserve some future borrowing power.
312
A mortgage bond is a bond secured by a lien on real property. Typically, the value of
the real property is greater than that of the mortgage bonds issued. This provides the
mortgage bondholders with a margin of safety in the event the market value of the
secured property declines. In the case of foreclosure, the trustees have the power to
sell the secured property and use the proceeds to pay the bondholders. In the event
that the proceeds from this sale do not cover the bonds, the bondholders become
general creditors, similar to debenture bondholders, for the unpaid portion of the
debt.
7-9. (a) Eurobonds are not so much a different type of security as they
are securities, in this case bonds, issued in a country different from
the one in whose currency the bond is denominated. For example, a
bond that is issued in Europe or in Asia by an American company and
that pays interest and principal to the lender in U.S. dollars would be
considered a Eurobond. Thus, even if the bond is not issued in
Europe, it merely needs to be sold in a country different from the one
in whose currency it is denominated to be considered a Eurobond.
(b) Zero and very low coupon bonds allow the issuing firm to issue bonds at a
substantial discount from their $1,000 face value with a zero or very low
coupon. The investor receives a large part (or all on the zero coupon bond)
of the return from the appreciation of the bond at maturity.
(c) Junk bonds refer to any bond with a rating of BB or below. The major
participants in this market are new firms that do not have an established
record of performance. Many junk bonds have been issued to finance
corporate buyouts.
7-10. The expected rate of return is the rate of return that may be expected from
purchasing a security at the prevailing market price. Thus, the expected rate of
return is the rate that equates the present value of future cash flows with the actual
selling price of the security in the market.
7-11. When the coupon interest rate does not equal the bondholder's required rate of return,
the bond will be issued at either a premium or discount. If the investor's required
rate of return is higher than the coupon interest rate, the bond will be issued at a
discount to the investor. If the coupon rate is higher that the investor's required rate,
the bond will be issued at a premium.
7-12. A premium bond is issued when the coupon rate is higher than the bondholder's
required rate of return. The premium is the excess of the market value over the face
value of the bond. A discount bond is issued when the bondholder's required rate of
return is higher than the coupon rate. The discount is the excess of the face value of
the bond over the market value.
Over time, the premium or discount on a bond is amortized. This
amortization allows the bondholder to realize an effective yield equal to their
required rate of return.
313
7-13. A change in current interest rates (required rate of return) causes a change in
the market value of a bond. However, the impact on value is greater for long-term
bonds than it is for short-term bonds. The reason long-term bond prices fluctuate
more than short-term bond prices in response to interest rate changes is simple.
Assume an investor bought a 10-year bond yielding a 12 percent interest rate. If the
current interest rate for bonds of similar risk increased to 15 percent, the investor
would be locked into the lower rate for 10 years. If, on the other hand, a shorter-term
bond had been purchased, say one maturing in 2 years, the investor would have to
accept the lower return for only 2 years and not the full 10 years. At the end of year
2, the investor would receive the maturity value of $1,000 and could buy a bond
offering the higher 15 percent rate for the remaining 8 years. Thus, interest rate risk
is determined, at least in part, by the length of time an investor is required to commit
to an investment.
7-14. The duration of a bond is simply a measure of the responsiveness of its price to a
change in interest rates. The greater the relative percentage change in a bond price in
response to a given percentage change in the interest rate, the longer the duration.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
7-1A. Value (V
b
) =

·
+
+
+
12
1 t
12 t
.12) (1
$1,000

.12) (1
$80

12
12
80
1000
CPT
→ ANSWER -752.23
314
7-2A. If the interest is paid semiannually:
Value (V
b
) =
16
16
1 t
t
(1.04)
$1,000

(1.04)
$45
+

·
16
4
45
1000
CPT
→ ANSWER -1,058.26
If interest is paid annually:
Value (V
b
) =

·
+
8
1 t
8 t
(1.08)
$1,000

(1.08)
$90

8
8
90
1000
CPT
→ ANSWER -1,057.47
7-3A. $900 =

·
+
+
+
20
1 t
20
b
t
b /2) k (1
$1,000

/2) k (1
$40

20
900
40
1000
CPT
→ ANSWER 4.79% semiannual rate
The rate is equivalent to 9.6 percent annual rate compounded semiannually, or 9.8
percent (1.048
2
- 1) compounded annually.
315
7-4A. $945 =
20
b
20
1 t
t
b ) k (1
$1,000

) k (1
$90

+
+
+

·
20
945
90
1000
CPT
→ ANSWER 9.63%
7-5A. $1,150 =

·
+
+
+
12
1 t
12
b
t
b ) k (1
$1,000

) k (1
$70

12
1150
70
1000
CPT
→ ANSWER 5.28%
7-6A. a. $1,085 =

·
+
+
+
15
1 t
15
b
t
b ) k (1
$1,000

) k (1
$80

15
1085
80
1000
CPT
→ ANSWER 7.06%
316
b. V
b
=

·
+
15
1 t
15 t
(1.10)
$1,000

(1.10)
$80

15
10
80
1000
CPT
→ ANSWER -847.88
c. Since the expected rate of return, 7.06 percent, is less than your required rate
of return of 10 percent, the bond is not an acceptable investment. This fact is
also evident because the market price, $1,085, exceeds the value of the
security to the investor of $847.88.
7-7A. a. Value
Par Value $1,000.00
Coupon $ 100.00
Required Rate of Return 0.12
Years to Maturity 15
Market Value $ 863.78
b. Value at Alternative Rates of Return
Required Rate of Return 0.15
Market Value $ 707.63
Required Rate of Return 0.08
Market Value $1,171.19
c. As required rates of return change, the price of the bond changes, which is
the result of "interest-rate risk." Thus, the greater the investor's required rate
of return, the greater will be his/her discount on the bond. Conversely, the
less his/her required rate of return below that of the coupon rate, the greater
the premium will be.
d. Value at Alternative Maturity Dates
Years to Maturity 5
Required Rate of Return 0.15
Market Value $ 832.39
Required Rate of Return 0.08
Market Value $1,079.85
e. The longer the maturity of the bond, the greater the interest rate risk the
investor is exposed to, resulting in greater premiums and discounts.
317
7-8A. $1,250 =

·
+
+
+
15
1 t
15
b
t
b ) k (1
$1,000

) k (1
$90

15
1250
90
1000
CPT
→ ANSWER 6.36%
7-9A.(a) V
b
=

·
+
20
1 t
20 t
(1.09)
$1,000

(1.09)
$110

20
9
110
1000
CPT
→ ANSWER -1,182.57
(b) (i) V
b
=

·
+
20
1 t
20 t
(1.12)
$1,000

(1.12)
$110

20
12
110
1000
CPT
→ ANSWER -925.31
318
(b) (ii) V
b
=

·
+
20
1 t
20 t
(1.06)
$1,000

(1.06)
$110

20
6
110
1000
CPT
→ ANSWER -1,573.50
(c) We see that value is inversely related to the investor's required rate of return.
7-10A.
Value Bond P
Par Value $1,000.00
Coupon $ 100.00
Required Rate of Return 8%
Years to Maturity 5
Market Value $ 1,079.85
Value Bond Q
Par Value $1,000.00
Coupon $ 70.00
Required Rate of Return 8%
Years to Maturity 5
Market Value $ 960.07
Value Bond R
Par Value $1,000.00
Coupon $ 120.00
Required Rate of Return 8%
Years to Maturity 10
Market Value $ 1,268.40
Value Bond S
Par Value $1,000.00
Coupon $ 80.00
Required Rate of Return 8%
Years to Maturity 10
Market Value $ 1,000.00
319
Value Bond T
Par Value $1,000.00
Coupon $ 65.00
Required Rate of Return 8%
Years to Maturity 15
Market Value $ 871.61
Bond P Q R S T
$1,079.85 $960.07 $1,268.40 $1,000.00 $871.61
Years C
t
t*PV(C
t
) C
t
t*PV(C
t
) C
t
t*PV(C
t
) C
t
t*PV(C
t
) C
t
t*PV(C
t
)
1 $100 $93 $70 $65 $120 $111 $80 $74 $65 $60
2 100 171 70 120 120 206 80 137 65 111
3 100 238 70 167 120 286 80 191 65 155
4 100 294 70 206 120 353 80 235 65 191
5 1,100 3,743 1,070 3,641 120 408 80 272 65 221
6 120 454 80 302 65 246
7 120 490 80 327 65 265
8 120 519 80 346 65 281
9 120 540 80 360 65 293
10 1,120 5,188 1,080 5,002 65 301
11 65 307
12 65 310
13 65 311
14 65 310
15 1,065 5,036
) t ( * C PV t
Sumof
4,539 4,198 8,554 7,247 8,398
Duration 4.20 4.37 6.74 7.25 9.63
320
7-11A. a.$1,100 =

·
+
+
+
7
1 t
7
b
t
b ) k (1
$1,000

) k (1
$90

7
1100
90
1000
CPT
→ ANSWER 7.14%
b. V
b
=

·
+
7
1 t
7 t
(1.07)
$1,000

(1.07)
$90

7
7
90
1000
CPT
→ ANSWER -1,107.79
c. Since the expected rate of return, 7.14 percent, is more than your required
rate of return of 7 percent, the bond is an acceptable investment. This fact is
also evident because the market price, $1,100, is less than the value of the
security to the investor of $1,107.79.
7-12A. a. $915 =

·
+
+
+
12
1 t
12
b
t
b ) k (1
$1,000

) k (1
$50

12
915
50
1000
CPT
→ ANSWER 6.01%
b. Since the required rate of return(9%) is greater than the
expected rate of return(6%), you should not purchase the bond.
321
7-13A.
Value Bond I
Par Value $1,000.00
Coupon $ 130.00
Required Rate of Return 7%
Years to Maturity 7
Market Value $ 1,323.36
Value Bond II
Par Value $1,000.00
Coupon $ 90.00
Required Rate of Return 7%
Years to Maturity 6
Market Value $1,095.33
Value Bond III
Par Value $1,000.00
Coupon $ 110.00
Required Rate of Return 7%
Years to Maturity 12
Market Value $1,317.71
Value Bond IV
Par Value $1,000.00
Coupon $ 125.00
Required Rate of Return 7%
Years to Maturity 5
Market Value $1,225.51
Value Bond V
Par Value $1,000.00
Coupon $ 80.00
Required Rate of Return 7%
Years to Maturity 10
Market Value $1,070.24
322
Bond I II III IV V
Bond
Value $1,323.36 $1,095.33 $1,317.71 $1,225.51 $1,070.24
Years C
t
tPV(C
t
) C
t
tPV(C
t
) C
t
tPV(C
t
) C
t
tPV(C
t
) C
t
tPV(C
t
)
1 $130 $121 $90 $84 $110 $103 $125 $117 $80 $75
2 $130 $227 $90 $157 $110 $192 $125 $218 $80 $140
3 $130 $318 $90 $220 $110 $269 $125 $306 $80 $196
4 $130 $397 $90 $275 $110 $336 $125 $381 $80 $244
5 $130 $463 $90 $321 $110 $392 $1,125 $4,011 $80 $285
6 $130 $520 1,090 $4,358 $110 $440 $80 $320
7 1,130 $4,926 $110 $480 $80 $349
8 $110 $512 $80 $372
9 $110 $538 $80 $392
10 $110 $559 $1,080 $5,490
11
1,11
0 $5,801
12
Sum of
t*PV(Ct) $6,973 $5,415 $9,622 $5,033 $7,863
Duration 5.27 4.94 7.30 4.11 7.35
7-14A.(a) V
b
=

·
+
1 5
1 t
1 5 t
( 1 . 0 9 )
$ 1 , 0 0 0

( 1 . 0 9 )
$ 8 5

15
9
85
1000
CPT
→ ANSWER -959.70
(b) (i) V
b
=

·
+
15
1 t
15 t
(1.11)
$1,000

(1.11)
$85

15
11
85
1000
CPT
→ ANSWER -820.23
(b) (ii) V
b
=

·
+
15
1 t
15 t
(1.07)
$1,000

(1.07)
$85

15
323
7
85
1000
CPT
→ ANSWER -1,136.62
(c) As long as the required rate of return is less than the expected rate of return of
9%, you should purchase the bond Thus, if your required rate of return
decreases to 7%, you should purchase the bond.
SOLUTION TO INTEGRATIVE PROBLEM
1. Young Corp. Bond Value (V
b
) =

·
+
+
+
10
1 t
10 t
) 06 . 1 (
000 , 1 $

) 06 . 1 (
00 . 78 $

10
6
78
1000
CPT
→ ANSWER -$1,132.48
Thomas Resorts Bond Value (V
b
) =

·
+
+
+
17
1 t
17 t
) 09 . 1 (
000 , 1 $

) 09 . 1 (
00 . 75 $

17
9
75.00
1000
CPT
→ ANSWER -$871.85
324
Entertainment, Inc. Bond Value (V
b
) =
4
4
1 t
t
.08) (1
$1,000

.08) (1
$79.75

+
+
+

·
4
8
79.75
1000
CPT
→ ANSWER -$999.17
2. Young Corporation: $1,030 =

·
+
+
+
10
1
10
b
t
b ) k (1
$1,000

) k (1
$78

t
10
1,030
78
1000
CPT
→ ANSWER 7.37%
Thomas Resorts: $973 =

·
+
+
+
17
1
17
b
t
b ) k (1
$1,000

) k (1
$75

t
17
973
75.00
1000
CPT
→ ANSWER 7.79%
325
Entertainment, Inc.: $1,035 =
4
b
4
1 t
t
b ) k (1
$1,000

) k (1
$79.75

+
+
+

·

4
1,035
79.75
1000
CPT
→ ANSWER 6.94%
3. i. Young Corp. Bond Value (V
b
) =

·
+
+
+
10
1
10 t
.09) (1
$1,000

.09) (1
$78

t
10
9
78
1000
CPT
→ ANSWER - $922.99
Value Bond
Resorts Thomas
(V
b
) =

·
+
+
+
17
1 t
17 t
) 12 . 1 (
000 , 1 $

) 12 . 1 (
00 . 75 $

17
12
75.00
1000
CPT
→ ANSWER - $679.62
Entertainment, Inc. Bond Value (V
b
) =

·
+
+
+
4
1 t
4 t
) 11 . 1 (
000 , 1 $

) 11 . 1 (
75 . 79 $

4
11
79.75
1000
CPT
→ ANSWER - $906.15
3. ii Young Corp. Bond Value (V
b
) =

·
+
+
+
10
1 t
10 t
.03) (1
$1,000

.03) (1
$78

10
3
78
326
1000
CPT
→ ANSWER - $1,409.45
Value Bond
Resorts Thomas
(V
b
) =

·
+
+
+
17
1 t
17 t
.06) (1
$1,000

.06) (1
$75.00

17
6
75.00
1000
CPT
→ ANSWER - $1,157.16
Entertainment, Inc. Bond Value (V
b
) =

·
+
+
+
4
1 t
4 t
.05) (1
$1,000

.05) (1
$79.75

4
5
79.75
1000
CPT
→ ANSWER - $1,105.49
4. As the interest rates rise and fall, we see the different effects on the bond prices
depending on the length of time to maturity and whether the investor's required rate
of return is above or below the coupon interest rate. If the investor’s required rate of
return is above the coupon interest rate, the bond will sell at a discount (below par
value), but if the investor’s required rate of return is below the coupon interest rate,
the bond will sell at a price above its par value (premium).
327
5. Duration of bonds
Young Corp.
Thomas Resorts
Entertainment, Inc.
Bond Value $1,030.00 $ 973.00 $1,035.00
Required rate of return 6% 9% 8%
Year C
t
t* PV(C
t
) C
t
t* PV(C
t
) C
t
t* PV(C
t
)
1 $ 78.00 $ 73.58 $ 75.00 $ 68.81 $ 79.75 $ 73.84
2 78.00 138.84 75.00 126.25 79.75 136.75
3 78.00 196.47 75.00 173.74 79.75 189.92
4 78.00 247.13 75.00 212.53 1,079.75 3,174.59
5 78.00 291.43 75.00 243.72
6 78.00 329.92 75.00 268.32
7 78.00 363.12 75.00 287.19
8 78.00 391.51 75.00 301.12
9 78.00 415.51 75.00 310.79
10 1,078.00 6,019.50 75.00 316.81
11 75.00 319.71
12 75.00 319.98
13 75.00 318.02
14 75.00 314.21
15 75.00 308.86
16 75.00 302.24
17 1,075.00 4222.86
Sum of t*PV(C
t
) 8,467.02 8,415.17 3,575.11
Duration 8.22 8.65 3.45
The value of the Entertainment, Inc. bonds will be less sensitive to interest rate
changes than will Young Corporation and Thomas Resorts bonds.
6. Although the Young Corporation bonds and the Thomas Resorts bonds have
different terms to maturity, the duration of the two bonds is very similar. These two
bonds will likely have similar sensitivity to changes in interest rates as evidenced by
their duration values.
7. The Entertainment, Inc. and Thomas Resorts bonds have lower expected rates of
return than your required rate of return. Young Corporation’s expected rate of return
is greater than your required rate of return. So we would buy Young Corporation
and not Entertainment, Inc. or Thomas Resorts.
328
Solutions to Problem Set B
7-1B. Value (V
b
) =

·
+
+
+
10
1 t
10 t
.15) (1
$1,000

.15) (1
$90

10
15
90
1000
CPT
→ ANSWER -698.87
7-2B. If the interest is paid semiannually:
Value (V
b
) =

·
+
22
1 t
22 t
(1.045)
$1,000

(1.045)
$50

22
4.5
50
1000
CPT
→ ANSWER -1068.92
If interest is paid annually:
Value (V
b
) =

·
+
11
1 t
11 t
(1.09)
$1,000

(1.09)
$100

11
9
100
1000
CPT
→ ANSWER -1068.05
329
7-3B. $950 =

·
+
+
+
16
1 t
16
b
t
b /2) k (1
$1,000

/2) k (1
$45

16
950
45
1000
CPT
→ ANSWER 4.96%
The rate is equivalent to 9.92 percent annual rate, compounded semiannually or 10.17
percent (1.0496
2
- 1) compounded annually.
7-4B. $975 =

·
+
+
+
20
1 t
20
b
t
b ) k (1
$1,000

) k (1
$100

20
975
100
1000
CPT
→ ANSWER 10.30%
7-5B. $1,175 =

·
+
+
+
15
1 t
15
b
t
b ) k (1
$1,000

) k (1
$80

15
1175
80
1000
CPT
→ ANSWER 6.18%
330
7-6B. a. $1,100 =

·
+
+
+
14
1 t
14
b
t
b ) k (1
$1,000

) k (1
$90

14
1100
90
1000
CPT
→ ANSWER 7.80%
b. V
b
=

·
+
14
1 t
14 t
(1.10)
$1,000

(1.10)
$90

14
10
90
1000
CPT
→ ANSWER -926.33
c. Since the expected rate of return, 7.80 percent, is less than your required rate
of return of 10 percent, the bond is not an acceptable investment. This fact is
also evident because the market price, $1,100, exceeds the value of the
security to the investor of $926.33.
7-7B.
a. Value
Par Value $1,000.00
Coupon $ 80.00
Required Rate of Return 7%
Years to Maturity 20
Market Value $ 1,105.94
b. Value at Alternative Rates of Return
Required Rate of Return 10%
Market Value $ 829.73
Required Rate of Return 6%
Market Value $1,229.40
c. As required rates of return change, the price of the bond changes, which is
the result of "interest-rate risk." Thus, the greater the investor's required rate
of return, the greater will be his/her discount on the bond. Conversely, the
less his/her required rate of return is below that of the coupon rate, the
greater the premium will be.
d. Value at Alternative Maturity Dates
331
Years to Maturity 10
Required Rate of Return 10%
Market Value $ 877.11
Required Rate of Return 6%
Market Value $1,147.20
e. The longer the maturity of the bond, the greater the interest-rate risk the
investor is exposed to, resulting in greater premiums and discounts.
7-8B. $1,110 =

·
+
+
+
14
1 t
14
b
t
b ) k (1
$1,000

) k (1
$70

14
1110
70
1000
CPT
→ ANSWER 5.83%
7-9B. (a) Value (V
b
) =
17
17
1 t
.085) (1
$70

+

·
+
17
) 085 . 1 (
000 , 1 $
+
17
8.5
70
1000
CPT
→ ANSWER -867.62
332
(b) (i) Value (V
b
) =
17
17
1 t
.11) (1
$70

+

·
+
17
) 11 . 1 (
000 , 1 $
+
17
11
70
1000
CPT
→ ANSWER -698.05
(b) (ii) Value (V
b
) =
17
17
1 t
.06) (1
$70

+

·
+
17
) 06 . 1 (
000 , 1 $
+
17
6
70
1000
CPT
→ ANSWER -1,104.77
(c) We see that value is inversely related to the investor's required rate of return.
7-10B.
Value Bond A
Par Value $1,000.00
Coupon $ 90.00
Required Rate of Return 7%
Years to Maturity 5
Market Value $ 1,082.00
Value Bond B
Par Value $1,000.00
Coupon $ 60.00
Required Rate of Return 7%
Years to Maturity 5
Market Value $ 959.00
333
Value Bond C
Par Value $1,000.00
Coupon $ 120.00
Required Rate of Return 7%
Years to Maturity 10
Market Value $ 1,351.18
Value Bond D
Par Value $1,000.00
Coupon $ 90.00
Required Rate of Return 7%
Years to Maturity 15
Market Value $ 1,182.16
Value Bond E
Par Value $1,000.00
Coupon $ 75.00
Required Rate of Return 7%
Years to Maturity 15
Market Value $ 1,045.54
Bond A B C D E
value
Bond
$1,082.00 $959.00 $1,351.18 $1,182.16 $1,045.54
Years C
t
t*PV(C
t
) C
t
t*PV(C
t
) C
t
t*PV(C
t
) C
t
t*PV(C
t
) C
t
t*PV(C
t
)
1 $90 $84 $60 $56 $120 $112 $90 $84 $75 $70
2 90 157 60 105 120 210 90 157 75 131
3 90 220 60 147 120 294 90 220 75 184
4 90 275 60 183 120 366 90 275 75 229
5 1,090 3,886 1,060 3,779 120 428 90 321 75 267
6 120 480 90 360 75 300
7 120 523 90 392 75 327
8 120 559 90 419 75 349
9 120 587 90 441 75 367
10 1,120 5,694 90 458 75 381
11 90 470 75 392
12 90 480 75 400
13 90 486 75 405
14 90 489 75 407
15 1,090 5,926 1,075 5,844
) t ( * C PV t
Sumof
4,622 4,270 9,252 10,977 10,053
Duration 4.27 4.45 6.85 9.29 9.62
334
7-11B. a.$1,350 =

·
+
+
+
4
1 t
4
b
t
b ) k (1
$1,000

) k (1
$120

4
1350
120
1000
CPT
→ ANSWER 2.66%
b. V
b
=

·
+
4
1 t
4 t
(1.09)
$1,000

(1.09)
$120

4
9
120
1000
CPT
→ ANSWER -1,097.19
c. Since the expected rate of return, 2.66 percent is much less than your
required rate of return of 9 percent, the bond is not an acceptable investment.
This fact is also evident because the market price, $1,350, exceeds the value
of the security to the investor of $1,097.19.
7-12B. a. $915 =

·
+
+
+
25
1 t
25
b
t
b ) k (1
$1,000

) k (1
$80

25
915
80
1000
CPT
→ ANSWER 8.86%
b. Since the required rate of return(11%) is greater than the expected rate of
return(8.86%), you should not purchase the bond.
335
7-13B. Value Bond J
Par Value $1,000.00
Coupon $ 95.00
Required Rate of Return 10%
Years to Maturity 4
Market Value $984.15
Value Bond P
Par Value $1,000.00
Coupon $115
Required Rate of Return 10%
Years to Maturity 12
Market Value $1,102.21
Value Bond Y
Par Value $1,000.00
Coupon $ 80
Required Rate of Return 10%
Years to Maturity 16
Market Value $843.53
Value Bond Q
Par Value $1,000.00
Coupon $ 70.00
Required Rate of Return 10%
Years to Maturity 20
Market Value $744.59
Value Bond Z
Par Value $1,000.00
Coupon $ 130.00
Required Rate of Return 10%
Years to Maturity 15
Market Value $1,228.18
336
Bond J P Y Q Z
Bond
Value $984.15 $1,102.21 $843.53 $744.59 $1,228.18
Years C
t
tPV(C
t
) C
t
tPV(C
t
) C
t
tPV(C
t
) C
t
tPV(C
t
) C
t
tPV(C
t
)
1 $95 $86 $115 $105 $80 $73 $70 $64 $130 $118
2 $95 $157 $115 $190 $80 $132 $70 $116 $130 $215
3 $95 $214 $115 $259 $80 $180 $70 $158 $130 $293
4 $1,095 $2,992 $115 $314 $80 $219 $70 $191 $130 $355
5 $115 $357 $80 $248 $70 $217 $130 $404
6 $115 $389 $80 $271 $70 $237 $130 $440
7 $115 $413 $80 $287 $70 $251 $130 $467
8 $115 $429 $80 $299 $70 $261 $130 $485
9 $115 $439 $80 $305 $70 $267 $130 $496
10 $115 $443 $80 $308 $70 $270 $130 $501
11 $115 $443 $80 $308 $70 $270 $130 $501
12 1,115 $4,263 $80 $306 $70 $268 $130 $497
13 $80 $301 $70 $264 $130 $490
14 $80 $295 $70 $258 $130 $479
15 $80 $287 $70 $251 $1,130 $4,058
16 $1,080 $3,761 $70 $244
17 $70 $235
18 $70 $227
19 $70 $217
20 1,070 $3,181
Sum of
t*PV(C
t
) $3,449 $8,046 $7,581 $7,447 $9,799
Duration 3.50 7.30 8.99 10.00 7.98
7-14B.(a) V
b
=

·
+
20
1 t
20 t
(1.08)
$1,000

(1.08)
$120

20
8
120
1000
CPT
→ ANSWER -1,392.73
337
(b) (i) V
b
=

·
+
20
1 t
20 t
(1.13)
$1,000

(1.13)
$120

20
13
120
1000
CPT
→ ANSWER -929.75
(b) (ii) V
b
=

·
+
20
1 t
20 t
(1.06)
$1,000

(1.06)
$120

20
6
120
1000
CPT
→ ANSWER -1,688.20
(c) As long as the required rate of return is less than the expected rate of return of
8%, you should purchase the bond Thus, if your required rate of return
decreases to 6%, you should purchase the bond.

CHAPTER 8
338
Stock Valuation

CHAPTER ORIENTATION
This chapter continues the introduction of concepts underlying asset valuation began in
Chapter 7. We are specifically concerned with valuing preferred stock and common stock.
We also look at the concept of a stockholder’s expected rate of return on an investment.
CHAPTER OUTLINE
I. Preferred Stock
A. Features of preferred stock
1. Owners of preferred stock receive dividends instead of interest.
2. Most preferred stocks are perpetuities (non-maturing).
3. Multiple classes, each having different characteristics, can be issued.
4. Preferred stock has priority over common stock with regard to claims
on assets in the case of bankruptcy.
5. Most preferred stock carries a cumulative feature that requires all past
unpaid preferred stock dividends to be paid before any common stock
dividends are declared.
6. Preferred stock may contain other protective provisions, such as
granting voting rights in the event of non-payment of dividends.
7. Preferred stock may contain provisions to convert to a predetermined
number of shares of common stock.
8. Some preferred stock contains provisions for an adjustable rate of
return.
9. If there is a participation feature, it allows preferred stockholders to
participate in earnings beyond the payment of the stated dividend.
10. Payment-in-kind (PIK) preferred stock, grants the investor additional
preferred stock instead of dividends for a given period of time.
Eventually cash dividends are paid.
339
11. Retirement features for preferred stock are frequently included.
a. Callable preferred refers to a feature which allows preferred
stock to be called, or retired, like a bond.
b. A sinking fund provision requires the firm periodically set
aside an amount of money for the retirement of its preferred
stock.
B. Valuation of preferred stock (V
ps
):
The value of a preferred stock equals the present value of all future
dividends. If the stock is nonmaturing, where dividends are expected in
equal amount each year in perpetuity, the value may be calculated as follows:
V
ps
= =
II. Common Stock
A. Features of Common Stock
1. As owners of the corporation, common shareholders have the right to
the residual income and assets after bondholders and preferred
stockholders have been paid.
2. Common stockholders are generally the only security holders with the
right to elect the board of directors.
3. Preemptive rights (if granted) entitle the common shareholder to
maintain a proportionate share of ownership in the firm.
4. Common stockholder’s liability as an owner of the corporation is
limited to the amount invested in the stock.
5. Common stock’s value is equal to the present value of all future cash
flows expected to be received by the stockholder.
B. Valuing common stock
1. Company growth occurs by:
a. the infusion of new capital, or
b. the retention of earnings, which is called internal growth. The
internal growth rate of a firm equals:
Return on equity ×
2. Although the bondholder and preferred stockholder are promised a
specific amount each year, the dividend for common stock is based on
the profitability of the firm and management's decision either to pay
dividends or retain profits for reinvestment.
3. The common dividend typically increases with the growth in
corporate earnings.
4. The earnings growth of a firm should be reflected in a higher price for
the firm's stock.
340
5. In finding the value of a common stock (V
cs
), we should discount all
future expected dividends (D
l
, D
2
, D
3
,
..., D

) to the present at the
required rate of return for the stockholder (k
cs
). That is:
V
cs
=
1
cs
1
) k (1
D
+
+
2
cs
2
) k (1
D
+
+...+


+ ) k (1
D
cs
6. If we assume that the amount of dividend is increasing by a constant
growth rate each year,
D
t
= D
0
(l + g)
t
where g = the growth rate
D
0
= the most recent dividend payment
If the growth rate, g, is the same each year, t, and is less than the
required rate of return, k
cs
, the valuation equation for common stock
can be reduced to
V
cs
= =
III. Shareholder's Expected Rate of Return
A. The shareholder's expected rate of return is of great interest to financial
managers because it tells about the investor’s expectations.
B. Preferred stockholder's expected rate of return:
If we know the market price of a preferred stock and the amount of the
dividends to be received, the expected rate of return from the investment can
be determined as follows:
expected rate of return =
or
k ps
=
0
P
D
C. Common stockholder's expected rate of return:
1. The expected rate of return for common stock can be calculated from
the valuation equations previously discussed.
341
2. Assuming that dividends are increasing at a constant annual growth
rate, g, we can show that the expected rate of return for common
stock, k
cs
is
k
cs
= +
= + g
Since dividend ÷ price is the "dividend yield," the
Expected rate of return = +
IV. Appendix: The Relationship between Value and Earnings
A. Earnings and Value Relationship: The nongrowth firm
1. Nongrowth firms retain no profits for reinvestment purposes.
a. Investments are made to maintain status quo.
b. Earnings and dividend growth stream is constant from year to
year.
2. Value on nongrowth common stock, V
ng
:
cs
1
cs
1
ng
k
D

k
EPS
V · ·
a. Value of share changes in direct relationship with changes in
earnings per share.
b. Changes in the investor’s required rate of return will change
share value.
B. Earnings and Value Relationship: The growth firm
1. Growth firm reinvests profits back into the business.
2. Value of stock equals the present value of the dividend stream plus
the present value of the future growth resulting from reinvesting
future earnings.
NVDG
k
EPS
V
cs
1
cs
+ ·
a. NVDG is the net value of any dividend growth resulting from
reinvestment of future earnings.
b. Present value (PV
1
) from reinvesting part of the firms earnings
in year 1 equals:
) EPS (r
k
ROE EPS r
PV
1
cs
1
1
× −
× ×
·
a. Using the constant-growth model to value NVDG,
342
g k
PV
NVDG
cs
1

·
b. The value of a share of stock is therefore:
g k
PV

k
EPS
V
cs
1
cs
1
cs

+ ·
3. Value of stock is influenced by
a. Size of the firm’s EPS,
b. Percentage of profits retained,
c. Spread between return generated on new investments and the
investor’s required rate of return.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
8-1. Preferred stock is often referred to as a hybrid security. This is because preferred
stock has many characteristics of both common stock and bonds. It has
characteristics of common stock, such as no fixed maturity date, nonpayment of
dividends does not force bankruptcy, and the nondeductibility of dividends for tax
purposes. But it is like bonds because the dividends are fixed in amount like interest
payments. From the point of view of the preferred stockholder, this is not the most
advantageous combination. On one hand, the dividends are limited as with bond
interest, but the security of forced payment by the threat of bankruptcy is not there.
Thus, from the point of view of the investor, the worst features of common stock and
bonds are combined.
8-2. To a certain extent, preferred stock dividends can be thought of as a liability. The
major difference between preferred dividends in arrears and normal liabilities is that
nonpayment of them cannot force the firm into bankruptcy. However, since the goal
of the firm is common shareholder wealth maximization, which involves getting
money to the common shareholders (dividends), preferred arrearages provide a
barrier to achieving this goal.
8-3. A cumulative feature requires all past unpaid preferred stock dividends be paid
before any common stock dividends are declared. A stockholder would like
preferred stock to have a cumulative dividend feature because without it there would
be no reason why preferred stock dividends would not be omitted or passed when
common stock dividends were passed. Since preferred stock does not have the
dividend enforcement power of interest from bonds, the cumulative feature is
necessary to protect the rights of preferred stockholders.
Other frequent protective features serve to allow for voting rights in the event
of nonpayment of dividends or to restrict the payment of common stock
dividends if sinking-fund payments are not met or if the firm is in financial
343
difficulty. In effect, the protective features included with preferred stock are
similar to the restrictive provisions included with long-term debt.
8-4. Fixed rate preferred stock has dividends that do not vary from the fixed
amount or from period to period.
Adjustable rate preferred stock is preferred stock that has quarterly dividends
that fluctuate with interest rates under a formula that ties the dividend
payment at either a premium or discount to the highest of the three-month
Treasury bill rate, the 10-year Treasury bond constant maturity rate, or the
20-year Treasury bond constant maturity rate. The rates have maximum and
minimum levels called the dividend rate band.
The purpose of allowing the dividend rate to fluctuate is to minimize the
fluctuation in the value of the preferred stock. It is also very appealing in
times of high and fluctuating interest rates.
8-5. With PIK (payment-in-kind) preferred stock, investors receive no dividends
initially; they merely get more preferred stock, which in turn pays dividends
in even more preferred stock. Usually after 5 or 6 years, if all goes well for
the issuing company, cash dividends should replace the preferred stock
dividends, generally ranging from 12 percent to 18 percent, to entice
investors to purchase PIK preferred.
8-6. Convertibility allows a preferred stockholder to convert or exchange preferred stock
for shares of common stock at a predetermined exchange rate. This option gives
preferred stockholders more freedom in investment decisions by allowing them to
convert into common stock at their discretion. It gives the preferred stockholder a
higher cash return than the common stock but allows for sharing in some of the
future appreciation of the common stock if they convert the stock.
Preferred stock may be callable by the issuer so that in the event interest rates
decline and cheaper funding becomes available, the stock may be called and
new securities may be issued at a lower cost. To agree to the call feature, the
investor requires a slightly higher rate of return. Call of a convertible
preferred stock enables a company to turn the preferred stock into common
equity; i.e., calling it without having to spend the cash.
8-7. Both values are based on future cash flows to be received by stockholders. Preferred
stock typically has a predetermined constant dividend. For common stock, the
dividend is based on the profitability of the firm and on management’s decision to
pay dividends or to retain the profits for reinvestment purposes. Thus, the growth of
future dividends is a prime distinguishing feature of common stock.
8-8. The expected rate of return is the rate of return that may be expected from
purchasing a security at the prevailing market price. Thus, the expected rate of
return is the rate that equates the present value of future cash flows with the actual
selling price of the security in the market.
344
8-9. The required rate of return is the discount rate that equates the present value
of future cash flows with the intrinsic value of the security. As with the
internal rate of return for a capital budgeting problem, we have to find the
rate of return that sets the future cash flows equal to the cost of the security.
This rate may have to be developed by trial and error.
8-10. The two types of return are dividend income and capital gains. The dividend income
for common stockholders differs from preferred stockholders, in that no specified
dividend amount is to be received. However, the common stockholders are
permitted to participate in the growth of the company. As a result of this growth,
their second source of return, price appreciation, is realized.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
8-1A. Value (V
ps
) =
12 .
6 $
= $50.00
8-2A. Growth rate = return on equity x retention rate
= (16%) × (60%) = 9.6%
8-3A. Value (V
ps
) =
12 .
100 $ 14 . ×
=
12 .
14 $
= $116.67
8-4A. Expected Rate of Return
ps
=
Price
Dividend
=
16 . 42 $
95 . 1 $
= .0463, or 4.63%
8-5A. (a) Expected return =
Price
Dividend
=
40 $
40 . 3 $
= .085 = 8.5%
(b) Given your 8 percent required rate of return, the stock is worth $42.50 to you.
Value =
Return of Rate Required
Dividend
=
08 .
40 . 3 $
= $42.50
Since the expected rate of return (8.5%) is greater than your required rate of
return (8%), or since the current market price ($40) is less than the value
($42.50), the stock is undervalued and you should buy.
345
8-6A. Value (V
cs
) =
Rate) Required (1
1 Year in Dividend
+
+
Rate) Required (1
1 Year in Price
+

$50 =
) 15 . 1 (
6 $
+
+
) 15 . 1 (
P
1
+
Rearranging and solving for P
1
:
P
1
= $50 (1.15) - $6
P
1
= $51.50
The stock would have to increase $1.50 ($51.50 - $50) or 3 percent
($1.50/$50) to earn a 15% rate of return.
8-7A. (a)
) k ( return of
rate Expected
cs
=
Price Market
1 Year in Dividend
+
rate
growth
cs
=
50 . 22 $
00 . 2 $
+ .10
cs
= .1889, or 18.9%
(b) V
cs
=
10 . 17 .
00 . 2 $

= $28.57
Yes, purchase the stock. The expected return is greater than your required
rate of return. Also, the stock is selling for only $22.50, while it is worth
$28.57 to you.
8-8A. Value (V
cs
) =
Rate) Growth Rate (Required
Rate) Growth (1 Dividend Year Last

+
V
cs
=
V
cs
= $24.50
8-9A. Growth rate = return on equity x retention rate
= (18%) × (40%) = 7.2%
8-10A. Expected Rate of Return ( cs k ) =
Price
Rate) Growth (1 Dividend Year Last +
+ Growth
Rate
cs k = + 0.095
cs k = 0.193, or 19.3%
346
8-11A. Value (V
cs
) =
Rate) Required (1
1 Year in Dividend
+
+
Rate) Required (1
1 Year in Price
+

V
cs
=
) 11 . 1 (
85 . 1 $
+
) 11 . 1 (
50 . 42 $
V
cs
= $39.95
8-12A. If the expected rate of return is represented by
cs k :
Current Price =
) k (1
1 Year in Dividend
cs +
+
) k (1
1 Year in Price
cs +
cs k =
Price Current
1 Year in Price 1 Year in Dividend +
- 1
cs k =
00 . 43 $
00 . 48 $ 84 . 2 $ +
- 1
cs k = 0.1823, or 18.23%
8-13A.
(a) ps k
=
Price
Dividend
=
00 . 33 $
60 . 3 $
ps k
= 0.1091, or 10.91%
(b) Value (V
ps
) =
Return of Rate Required
Dividend
=
10 . 0
60 . 3 $
= $36
(c) The investor's required rate of return (10 percent) is less than the expected
rate of return for the investment (10.91 percent). Also, the value of the stock
to the investor ($36) exceeds the existing market price ($33), so buy the
stock.
8-14A.(a) Expected Rate of Return =
Price Market
1 Year in Dividend
+
Rate
Growth
=
50 . 23 $
) 08 . 1 ( 32 . 1 $
+ 0.08
= 0.1407, or 14.07%
(b) Investor's Value =
Rate Growth - Return of Rate Required
1 Year in Dividend
=
08 . 0 105 . 0
) 08 . 1 ( 32 . 1 $

= $57.02
(c) Yes, the expected rate of return (14.07%) is greater than your required rate of
return (10.5 percent). Also, your value of the stock ($57.02) is greater than
the current market price ($23.50).
347
8-15A (a) Dividend yield: Dividend ÷ stock price =
49 $
12 . 1 $
= 0.0229, or 2.29%
(b) Using the nominal average returns of 12.2% for large-company stocks and the
3.8% nominal average return for U.S. Treasury Bills as shown in Table 6-1,
the computation would be as follows:
return of rate
Expected
=
rate
free risk −
+ beta ×

¸
¸
return
market
-
,
_

rate
free risk
= 3.8% + 1.10 × (12.2% - 3.8%) = 13.04%
(c)
return of rate
Expected
=
Price Market
1 Year in Dividend
+
Rate
Growth
13.04% =
49 $
12 . 1 $
+ g
.1304 = .0229 + g
g = .1075, or 10.75%
8-16A
Johnson & Johnson
2003 2002 2001 2000 1999
EPS (diluted) $2.40 $2.16 $1.84 $1.61 $1.39
Dividend $0.925 $0.795 $0.70 $0.62 $0.55
Stock Price (6/24/04): $55.75
Growth rate: $2.40 = $1.39 (1 + i)
4
i = .1463, or 14.63%
k cs
=
g
P
D
0
1
+
k cs
=
.1463
$55.75
(1.1463) $0.925
+
k cs
= .0190, or 1.90%
348
8-17A.
(a) ps k
=
Price
Dividend
=
25 $
50 . 4 $
ps k
= 0.18, or 18%
(b) Value (V
ps
) =
Return of Rate Required
Dividend
=
14 . 0
50 . 4 $
= $32.14
(c) The investor's required rate of return (14 percent) is less than the expected
rate of return for the investment (18 percent). Also, the value of the stock to
the investor ($32.14) exceeds the existing market price ($25), so buy the
stock.
8-18A.
(a) Investor's Value =
Rate Growth - Return of Rate Required
1 Year in Dividend
=
05 . 0 15 . 0
) 05 . 1 ( 30 . 2 $

= $24.15
(b) Expected Rate of Return =
Price Market
1 Year in Dividend
+
Rate
Growth
=
33 $
) 05 . 1 ( 30 . 2 $
+ 0.05
= 0.1232, or 12.32%
(c) No, the expected rate of return (12.32%) is less than your required rate of
return (15 percent). Also, your value of the stock ($24.15) is less than the
current market price ($33).
8-19A. (a) Growth rate = return on equity x retention rate
= (17%) × (30%) = 5.1%
(b) (i) If retention rate is 40%:
Growth rate = return on equity x retention rate
= (17%) × (40%) = 6.8%
(ii) If retention rate is 25%:
Growth rate = return on equity x retention rate
= (17%) × (25%) = 4.25%
349
8-20A. (a)
) k ( return of
rate Expected
cs
=
Price Market
1 Year in Dividend
+
rate
growth
cs
=
50 . 29 $
) 04 . 0 1 ( 75 . 1 $ +
+ 0.04
cs
= .1017, or 10.17%
(b) V
cs
=
04 . 0 14 .
) 04 . 0 1 ( 75 . 1 $

+
= $18.20
No, do not purchase the stock. The expected return is less than your required
rate of return. Also, the stock is selling for $29.50, while it is only worth
$18.20 to you.
SOLUTION TO INTEGRATIVE PROBLEM
1. Value (V
b
) based upon your required rate of return:
Bond:
V
b
=
t
12
1 t .12) (1
$140

+

·
+
12
) 12 . 1 (
000 , 1 $
+
12
12
140
1000
CPT
→ ANSWER -1123.89
Preferred Stock:
V
ps
=
t
1 t
.14) (1
$12

+


·
However, since the dividend is a constant amount each year with no maturity
date (infinity), the equation can be reduced to
V
ps
=
Return of Rate Required
Dividend
=
14 .
12 $
= $85.71
Common Stock:
Step 1: Determine Growth Rate
350
$4.00 =

·
+
+
+
10
1 t
10
b
t
b ) k 1 (
00 . 8 $

) k 1 (
00 . 0 $

10
4
0
8
CPT
→ ANSWER 7.177%
Growth Rate (g) = 7.177%
Step 2: Solve for Value
V
cs
=
t
t
1 t
.20) (1
.07177) $3(1

+
+


·
If the growth rate (g) is assumed constant, the equation may be reduced to
V
cs
=
Rate Growth Return of Rate Required
End Year at Dividend

=
g k
D
cs
1

=
07177 . 20 .
) 07177 . 1 ( 3 $

+
= $25.08
2. Your Value Selling Price
Bond $1,123.89 $1,200.00
Preferred Stock 85.71 80.00
Common Stock 25.08 25.00
The bond should not be purchased because its market value is selling above
its value to you. You can choose between the preferred stock and the
common stock, because both have market values less than their values to
you.
351
3. Bond:
Value (V
b
) =

·
+
+
+
12
1 t
12 t
.14) (1
$1,000

.14) (1
$140

12
14
140
1000
CPT
→ ANSWER -1000.00
You would not buy the bond; it is not worth $1,200.00.
Preferred Stock:
V
ps
=
16 .
12 $
= $75.00
Do not buy. Your value is less than what you would have to pay for the
stock($80).
Common Stock:
V
cs
=
07177 . 18 .
) 07177 . 1 ( 3 $

+
= $29.71
Buy. Your value is greater than what you would have to pay for the
stock($25).
4. Assuming a growth rate of 12 percent:
00 . 42 $
12 . 20 .
) 12 . 1 ( 3
V
cs
·

+
·
Buy the stock. Because of the expected increase in future dividends, the
stock is now worth more to you ($42) than you would have to pay for it
($25) –assuming that the selling price did not increase also.
352
Solutions to Problem Set B
8-1B. Value (V
ps
) =
10 .
7 $
= $70.00
8-2B. Growth rate = return on equity x retention rate
= (24%) × (70%) = 16.8%
8-3B. Value (V
ps
) =
12 .
100 $ 16 . ×
=
12 .
16 $
= $133.33
8-4B. Expected Rate of Return
ps
=
Price
Dividend
=
16 . 55 $
35 . 2 $
= .0426, or 4.26%
8-5B. (a) Expected return =
Price
Dividend
=
50 . 38 $
25 . 3 $
= .0844 , or 8.44%
(b) Given your 8 percent required rate of return, the stock is worth $40.63 to you.
Value =
Return of Rate Required
Dividend
=
08 .
25 . 3 $
= $40.63
Since the expected rate of return (8.44%) is greater than your required rate of
return (8%), or since the current market price ($38.50) is less than the value
($40.63), the stock is undervalued and you should buy.
8-6B. Value (V
cs
) =
Rate) Required (1
1 Year in Dividend
+
+
Rate) Required (1
1 Year in Price
+
$52.75 =
) 16 . 1 (
50 . 6 $
+
+
) 16 . 1 (
P
1
+
Rearranging and solving for P
1
:
P
1
= $52.75 (1.16) - $6.50
P
1
= $54.69
The stock would have to increase $1.94 ($54.69 - $52.75), or 3.68 percent,
($1.94/$52.75) to earn a 16% rate of return.
353
8-7B. (a)
) k ( return of
rate Expected
cs
=
Price Market
1 Year in Dividend
+
Rate
Growth
cs
k =
00 . 23 $
50 . 2 $
+ .105
cs
k = 0.2137, or 21.37%
(b) V
cs
=
105 . 17 .
50 . 2 $

= $38.46
The expected rate of return exceeds your required rate of return, which means
that the value of the security to you is greater than the current market price.
Thus, you should buy the stock.
8-8B. Value (V
cs
) =
Rate) Growth Rate (Required
Rate) Growth (1 Dividend Year Last

+
V
cs
=
06 . 20 .
) 06 . 1 ( 75 . 3 $

+
V
cs
= $28.39
8-9B. Growth rate = return on equity x retention rate
= (24%) × (60%) = 14.4%
8-10B. Expected Rate of Return (
cs
k ) =
Price
Rate) Growth (1 Dividend Year Last +
+ Growth
Rate
cs
k =
84 . 33 $
) 085 . 1 ( 00 . 3 $
+ 0.085 = 0.1812, or
18.12%
8-11B. Value (V
cs
) =
Rate) Required (1
1 Year in Dividend
+
+
Rate) Required (1
1 Year in Price
+
V
cs
=
) 12 . 1 (
85 . 1 $
+
) 12 . 1 (
00 . 40 $
V
cs
= $37.37
8-12B. If the expected rate of return is represented by
cs
k :
Current Price =
) k (1
1 Year in Dividend
cs +
+
) k (1
1 Year in Price
cs +
cs
k =
Price Current
1 Year in Price 1 Year in Dividend +
- 1
cs
k =
00 . 44 $
00 . 47 $ 00 . 2 $ +
- 1
cs
k = 0.1136, or 11.36%
354
8-13B. (a) ps k
=
Price
Dividend
=
00 . 35 $
00 . 4 $
= 11.43%
(b) Value (V
ps
) =
Return of Rate Required
Dividend
=
10 . 0
00 . 4 $
= $40
(c) The investor's required rate of return (10 percent) is less than the expected
rate of return for the investment (11.43 percent). Also, the value of the stock
to the investor ($40) exceeds the existing market price ($35). The investor
should buy the stock.
8-14B. (a) Expected Rate of Return =
Pirce Market
1 Year in Dividend
+
=
00 . 25 $
) 08 . 1 ( 00 . 1 $
+ 0.08
= 0.1232, or 12.32%
(b) Investor's Value =
Rate Growth Return of Rate Required
1 Year in Dividend

=
08 . 0 11 . 0
) 08 . 1 ( 00 . 1 $

= $36.00
(c) Yes, the expected rate of return is greater than your required rate of return
(12.32 percent versus 11 percent). Also, your value of the stock ($36.00) is
higher than the current market price ($25.00).
8-15B (a) Dividend yield: Dividend ÷ stock price =
54 $
20 . 1 $
= 2.22%
(b) Using the nominal average returns of 12.2% for large-company stocks and the
3.8% nominal average return for U.S. Treasury Bills as shown in Table 6-1,
the computation would be as follows:
return of rate
Expected
=
rate
free risk −
+ beta ×

¸
¸
return
market
-
,
_

rate
free risk
= 3.8% + 0.90 × (12.2% - 3.8%) = 11.36%
(c)
return of rate
Expected
=
Price Market
1 Year in Dividend
+
Rate
Growth
11.36% =
54 $
20 . 1 $
+ g
.1136 = .0222 + g
g = .0914, or 9.14%
355
8-16B
Note to Instructor: Before the 10
th
edition of Financial Management was completed, we
had not verified the earnings per share data for First Union Corporation. After the text went
to production, we realized that First Union was merged into Wachovia Bank in 2001. We
then planned to use the Wachovia earnings per share data, only to discover the significant
volatility of the firm’s earnings over the past five years, which appears as follows:
2003 2002 2001 2000 1999
Earnings per share (diluted) $3.18 $2.60 $1.45 $0.07 $3.33
Since Wachovia’s earnings per share has actually decreased over the last five years, the
growth rate in earnings per share is =1.146 percent (using 4 years to compute the growth
rate). Clearly, the historical earnings per share do not provide a reasonable estimate of
future earnings per share, which regrettably makes the problem difficult to use without
having a meaningful growth estimate. Thus, the problem can only be used to show that
relying on historical data does not always provide reasonable results.
8-17B. (a) ps k
=
Price
Dividend
=
50 . 19 $
25 . 2 $
ps k
= 0.1154, or 11.54%
(b) Value (V
ps
) =
Return of Rate Required
Dividend
=
10 . 0
25 . 2 $
= $22.50
(c) The investor's required rate of return (10 percent) is less than the expected
rate of return for the investment (11.54 percent). Also, the value of the stock
to the investor, ($22.50) exceeds the existing market price ($19.50), so buy
the stock.
8-18B.
(a) Investor's Value =
Rate Growth - Return of Rate Required
1 Year in Dividend
=
05 . 0 12 . 0
) 05 . 1 ( 95 . 1 $

= $29.25
(b) Expected Rate of Return =
Price Market
1 Year in Dividend
+
Rate
Growth
=
26 $
) 05 . 1 ( 95 . 1 $
+ 0.05
= 0.1288, or 12.88%
(c) Yes, the expected rate of return (12.88%) is greater than your required rate of
return (12 percent). Also, your value of the stock ($29.25) is greater than the
current market price ($26).
8-19B. (a) Growth rate = return on equity x retention rate
356
= (13%) × (20%) = 2.6%
(b) (i) If retention rate is 35%:
Growth rate = return on equity x retention rate
= (13%) × (35%) = 4.55%
(ii) If retention rate is 13%:
Growth rate = return on equity x retention rate
= (13%) × (13%) = 1.69%
8-20B. (a)
) k ( return of
rate Expected
cs
=
Price Market
1 Year in Dividend
+
rate
growth
cs
=
75 . 33 $
) 07 . 0 1 ( 15 . 3 $ +
+ 0.07
cs
= .1699, or 16.99%
(b) V
cs
=
07 . 0 11 .
) 07 . 0 1 ( 15 . 3 $

+
= $84.26
Yes, purchase the stock. The expected return is significantly more than your
required rate of return. Also, the stock is selling for $33.75, while it is worth
$84.26 to you.
Solutions to Appendix 8A
8A-1. Using the NVDG model,
V
cs
=
cs
1
k
EPS
+
g k
PV
cs
1

where k
cs
= the investor's required rate of return
EPS
1
= the firm's earning per share in year 1
g = the growth rate, which is the firm's earnings retention rate times its
return on equity.
PV
1
=

,
_

¸
¸
cs
x
1
k
ROE EPS r x
- (r x EPS
1
)
r = the firm's earnings retention rate
ROE = the firm's return on equity investment
357
For our problem,
PV
1
=

,
_

¸
¸
16 . 0
) 20 . 0 ( x ) 5 ($ x ) 65 . 0 (
- (0.65 x $5)
= $4.0625 - $3.25
= $0.8125
and
V
cs
=
) 20 . 0 )( 65 . 0 ( 16 .
8125 . 0 $

16 .
5 $

+
= $31.25 + $27.08
= $58.33
Using the more traditional dividend-growth model, we get:
V
cs
=
g k
D
cs
1

Since D
1
= EPS
1
(1 - the retention rate), and
g = the retention rate x return on equity
V
cs
=
) 20 )(. 65 (. 16 .
) 65 . 1 )( 5 ($


=
03 .
75 . 1 $
= $58.33
8A-2. Given the EPS
1
is expected to be $7 and the investor's required rate of return is 18
percent, the value of the stock, assuming no growth opportunities would be:
V
cs
=
18 .
7 $

k
EPS
cs
1
· = $38.89
where k
cs
= the investor's required rate of return
EPS
1
= the firm's earning per share in year 1
To compute the present value of the growth opportunities, NVDG, for each scenario,
we use the following equation:
NVDG =
g k
PV
cs
1

where PV
1
=

,
_

¸
¸
cs
x
1
k
ROE EPS r x
- (r x EPS
1
)
g = the growth rate, which is the firm's earnings retention rate times its
return on equity.
r = the firm's earnings retention rate
ROE = the firm's return on equity investment
358
Given the different possible retention rates and ROEs, we may solve for the
respective PV
1
s. The results are as follows:
Possible Different Retention Rates
ROEs 0% 30% 60%
16% 0.00 -0.23 -0.47
18% 0.00 0.00 0.00
24% 0.00 0.70 1.40
We next calculate the NVDG for each scenario by dividing the above

PV
1
values by
k
cs
- g, which gives the following results:
Possible Different Retention Rates
ROEs 0% 30% 60%
16% 0.00 -1.77 -5.56
18% 0.00 0.00 0.00
24% 0.00 6.48 38.89
Adding the $38.89 price, assuming no growth, to the above NVDGs, we get:
Possible Different Retention Rates
ROEs 0% 30% 60%
16% 38.89 37.12 33.33
18% 38.89 38.89 38.89
24% 38.89 45.37 77.78
Thus, our results show that value is created only when management reinvests at
above the investor's required rate of return. That is, growth may actually decrease
the firm's value if the profitability of the new investments are not adequate enough to
satisfy the investor's required returns.
359

CHAPTER 9
Capital Budgeting Decision
Criteria

CHAPTER ORIENTATION
Capital budgeting involves the decision making process with respect to the investment in
fixed assets; specifically, it involves measuring the incremental cash flows associated with
investment proposals and evaluating the attractiveness of these cash flows relative to the
project's costs. This chapter focuses on the various decision criteria.
CHAPTER OUTLINE
I. Methods for evaluating projects
A. The payback period method
1. The payback period of an investment tells the number of years
required to recover the initial investment. The payback period is
calculated by adding the cash inflows up until they are equal to the
initial fixed investment.
2. Although this measure does, in fact, deal with cash flows and is easy
to calculate and understand, it ignores any cash flows that occur after
the payback period and does not consider the time value of money
within the payback period.
3. To deal with the criticism that the payback period ignores the time
value of money, some firms use the discounted payback period
method. The discounted payback period method is similar to the
traditional payback period except that it uses discounted free cash
flows rather than actual undiscounted free cash flows in calculating
the payback period.
4. The discounted payback period is defined as the number of years
needed to recover the initial cash outlay from the discounted free cash
360
flows.
361
B. Present-value methods
1. The net present value of an investment project is the present value of
its free cash flows less the investment’s initial outlay
NPV =
t
t
n
1 t
k) (1
FCF

+

·
- IO
where:
FCF
t
= the annual free cash flow in time period t (this
can take on either positive or negative values)
k = the required rate of return or appropriate
discount rate or cost of capital
IO = the initial cash outlay
n = the project's expected life
a. The acceptance criteria are
accept if NPV ≥ 0
reject if NPV < 0
b. The advantage of this approach is that it takes the time value
of money into consideration in addition to dealing with cash
flows.
2. The profitability index is the ratio of the present value of the expected future
free cash flows to the initial cash outlay, or
profitability index =
IO
k) (1
FCF

t
t
n
1 t
+

·
a. The acceptance criteria are
accept if PI ≥ 1.0
reject if PI < 1.0
b. The advantages of this method are the same as those for the
net present value.
c. Either of these present-value methods will give the same
accept-reject decisions to a project.
362
C. The internal rate of return is the discount rate that equates the present value
of the project's future net cash flows with the project's initial outlay. Thus the
internal rate of return is represented by IRR in the equation below:
IO =
t
t
n
1 t
IRR) (1
FCF

+

·
1. The acceptance-rejection criteria are:
accept if IRR ≥ required rate of return
reject if IRR < required rate of return
The required rate of return is often taken to be the firm's cost of
capital.
2. The advantages of this method are that it deals with cash flows and
recognizes the time value of money; however, the procedure is rather
complicated and time-consuming. The net present value profile
allows you to graphically understand the relationship between the
internal rate of return and NPV. A net present value profile is simply
a graph showing how a project’s net present value changes as the
discount rate changes. The IRR is the discount rate at which the NPV
equals zero.
3. The primary drawback of the internal rate of return deals with the
reinvestment rate assumption it makes. The IRR implicitly assumes
that the cash flows received over the life of the project can be
reinvested at the IRR while the NPV assumes that the cash flows over
the life of the project are reinvested at the required rate of return.
Since the NPV makes the preferred reinvestment rate assumption it is
the preferred decision technique. The modified internal rate of return
(MIRR) allows the decision maker the intuitive appeal of the IRR
coupled with the ability to directly specify the appropriate
reinvestment rate.
a. To calculate the MIRR we take all the annual free tax cash
inflows, ACIF
t
's, and find their future value at the end of the
project's life compounded at the required rate of return - this is
called the terminal value or TV. All cash outflows, ACOF
t
,
are then discounted back to present at the required rate of
return. The MIRR is the discount rate that equates the present
value of the free cash outflows with the present value of the
project's terminal value.
b. If the MIRR is greater than or equal to the required rate of
return, the project should be accepted.
363
ANSWERS TO
END-OF-CHAPTER QUESTIONS
9-1. Capital budgeting decisions involve investments requiring rather large
cash outlays at the beginning of the life of the project and commit the
firm to a particular course of action over a relatively long time
horizon. As such, they are costly and difficult to reverse, both
because of: (1) their large cost and (2) the fact that they involve fixed
assets, which cannot be liquidated easily.
9-2. The criticisms of using the payback period as a capital budgeting technique are:
(1) It ignores the timing of the free cash flows that occur during the payback
period.
(2) It ignores all free cash flows occurring after the payback period.
(3) The selection of the maximum acceptable payback period is arbitrary.
The advantages associated with the payback period are:
(1) It deals with cash flows rather than accounting profits, and therefore focuses
on the true timing of the project's benefits and costs.
(2) It is easy to calculate and understand.
(3) It can be used as a rough screening device, eliminating projects whose returns
do not materialize until later years.
These final two advantages are the major reasons why it is used frequently.
9-3. Yes. The payback period eliminates projects whose returns do not materialize until
later years and thus emphasizes the earliest returns, which in a country experiencing
frequent expropriations would certainly have the most amount of uncertainty
surrounding the later returns. In this case, the payback period could be used as a
rough screening device to filter out those riskier projects, which have long lives.
9-4. The three, discounted cash flow capital budgeting criteria are the net present value,
the profitability index, and the internal rate of return. The net present value method
gives an absolute dollar value for a project by taking the present value of the benefits
and subtracting out the present value of the costs. The profitability index compares
these benefits and costs through division and comes up with a measure of the
project's relative value—a benefit/cost ratio. On the other hand, the internal rate of
return tells us the rate of return that the project earns. In the capital budgeting area,
these methods generally give us the same accept-reject decision on projects but many
times rank them differently. As such, they have the same general advantages and
disadvantages, although the calculations associated with the internal rate of return
method can become quite tedious and it assumes cash flows over the life of the life
of the project are reinvested at the IRR. The advantages associated with these
discounted cash flow methods are:
(1) They deal with cash flows rather than accounting profits.
(2) They recognize the time value of money.
(3) They are consistent with the firm's goal of shareholder wealth maximization.
364
9-5 The advantage of using the MIRR, as opposed to the IRR technique is that the MIRR
technique allows the decision maker to directly input the reinvestment rate
assumption. With the IRR method it is implicitly assumed that the cash flows over
the life of the project are reinvested at the IRR.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
9-1A. (a) IO = FCF
t
[PVIF
IRR%,t yrs
]
$10,000 = $17,182 [PVIF
IRR%,8 yrs
]
0.582 = PVIF
IRR%,8 yrs
Thus, IRR = 7%
(b) $10,000 = $48,077 [PVIF
IRR%,10 yrs
]
0.208 = PVIF
IRR%,10 yrs
Thus, IRR = 17%
(c) $10,000 = $114,943 [PVIF
IRR%,20 yrs
]
0.087 = PVIF
IRR%,20 yrs
Thus, IRR = 13%
(d) $10,000 = $13,680 [PVIF
IRR%,3 yrs
]
.731 = PVIF
IRR%,3 yrs
Thus, IRR = 11%
9-2A. (a) I0 = FCF
t
[PVIFA
IRR%,t yrs
]
$10,000 = $1,993 [PVIFA
IRR%,10 yrs
]
5.018 = PVIFA
IRR%,10 yrs
Thus, IRR = 15%
(b) $10,000 = $2,054 [PVIFA
IRR%,20 yrs
]
4.869 = PVIFA
IRR%,20 yrs
Thus, IRR = 20%
365
(c) $10,000 = $1,193 [PVIFA
IRR%,12 yrs
]
8.382 = PVIFA
IRR%,12 yrs
Thus, IRR = 6%
(d) $10,000 = $2,843 [PVIFA
IRR%,5 yrs
]
3.517 = PVIFA
IRR%,5 yrs
Thus, IRR = 13%
9-3A. (a) $10,000 =
1
IRR) (1
$2,000
+
+
2
IRR) (1
$5,000
+
+
3
IRR) (1
$8,000
+
Try 18%:
$10,000 = $2,000(0.847) + $5,000 (0.718) + $8,000 (0.609)
= $1,694 + $3,590 + $4,872
= $10,156
Try 19%
$10,000 = $2,000 (0.840) + $5,000 (0.706) + $8,000 (0.593)
= $1,680 + $3,530 + $4,744
= $9,954
Thus, IRR = approximately 19%
(b) $10,000 =
1
IRR) (1
$8,000
+
+
2
IRR) (1
$5,000
+
+
3
IRR) (1
$2,000
+
Try 30%
$10,000 = $8,000 (0.769) + $5,000 (0.592) + $2,000 (0.455)
= $6,152 + $2,960 + $910
= $10,022
Try 31%:
$10,000 = $8,000 (0.763) + $5,000 (0.583) + $2,000 (0.445)
= $6,104 + $2,915 + $890
= $9,909
Thus, IRR = approximately 30%
366
(c) $10,000 =
t
5
1 t IRR) (1
$2,000

+

·
+
6
) IRR 1 (
000 , 5 $
+
Try 11%
$10,000 = $2,000 (3.696) + $5,000 (0.535)
= $7,392 + $2,675
= $10,067
Try 12%
$10,000 = $2,000 (3.605) + $5,000 (0.507)
= $7,210 + $2,535
= $9,745
Thus, IRR = approximately 11%
9-4A. (a) NPV =
t
6
1 t .09) (1
$450,000

+

·
- $1,950,000
= $450,000 (4.486) - $1,950,000
= $2,018,700 - $1,950,000 = $68,700
(b) PI =
000 , 950 , 1 $
700 , 018 , 2 $
= 1.0352
(c) $1,950,000 = $450,000 [PVIFA
IRR%,6 yrs
]
4.333 = PVIFA
IRR%,6 yrs
IRR = about 10% (10.1725%)
(d) Yes, the project should be accepted.
367
9-5A. (a) Payback Period = $80,000/$20,000 = 4 years
Discounted Payback Period Calculations:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF
10%,n
Cash Flows Cash Flows
0 -$80,000 1.000 -$80,000 -$80,000
1 20,000 .909 18,180 -61,820
2 20,000 .826 16,520 -45,300
3 20,000 .751 15,020 -30,280
4 20,000 .683 13,660 -16,620
5 20,000 .621 12,420 -4,200
6 20,000 .564 11,280 7,080
Discounted Payback Period = 5.0 + 4,200/11,280 = 5.37 years.
(b) NPV =
t
6
1 t .10) (1
$20,000

+

·
- $80,000
= $20,000 (4.355) - $80,000
= $87,100 - $80,000 = $7,100
(c) PI =
000 , 80 $
100 , 87 $
= 1.0888
(d) $80,000 = $20,000 [PVIFA
IRR%,6 yrs
]
4.000 = PVIFA
IRR%,6 yrs
IRR = about 13% (12.978%)
9-6A. (a) NPV
A
=
t
6
1 t .12) (1
$12,000

+

·
- $50,000
= $12,000 (4.111) - $50,000
= $49,332 - $50,000 = -$668
NPV
B
=
t
6
1 t .12) (1
$13,000

+

·
- $70,000
= $13,000 (4.111) - $70,000
= $53,443 - $70,000 = -$16,557
368
(b) PI
A
=
000 , 50 $
332 , 49 $
= 0.9866
PI
B
=
000 , 70 $
443 , 53 $
= 0.7635
(c) $50,000 = $12,000 [PVIFA
IRR%,6 yrs
]
4.1667 = PVIFA
IRR%,6 yrs
IRR
A
= 11.53%
$70,000 = $13,000 [PVIFA
IRR%,6 yrs
]
5.3846 = PVIFA
IRR%,6 yrs
IRR
B
= 3.18%
Neither project should be accepted.
9-7A. (a) Project A:
Payback Period = 2 years + $100/$200 = 2.5 years
Project A:
Discounted Payback Period Calculations:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF
10%,n
Cash Flows Cash Flows
0 -$1,000 1.000 -$1,000 -$1,000
1 600 .909 545 -455
2 300 .826 248 -207
3 200 .751 150 -57
4 100 .683 68 11
5 500 .621 311 322
369
Discounted Payback Period = 3.0 + 57/68 = 3.84 years.
Project B:
Payback Period = 2 years + $2,000/$3,000 = 2.67 years
Project B:
Discounted Payback Period Calculations:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF
10%,n
Cash Flows Cash Flows
0 -$10,000 1.000 -$10,000 -$10,000
1 5,000 .909 4,545 -5,455
2 3,000 .826 2,478 -2,977
3 3,000 .751 2,253 -724
4 3,000 .683 2,049 1,325
5 3,000 .621 1,863 3,188
Discounted Payback Period = 3.0 + 724/2,049 = 3.35 years.
Project C:
Payback Period = 3 years + $1,000/$2,000 = 3.5 years
Project C:
Discounted Payback Period Calculations:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF
10%,n
Cash Flows Cash Flows
0 -$5,000 1.000 -$5,000 -$5,000
1 1,000 .909 909 -4,091
2 1,000 .826 826 -3,265
3 2,000 .751 1,502 -1,763
4 2,000 .683 1,366 -397
5 2,000 .621 1,242 845
370
Discounted Payback Period = 4.0 + 397/1,242 = 4.32 years.
Project Traditional Payback Discounted Payback
A Accept Reject
B Accept Reject
C Reject Reject
9-8A. NPV
9%
=
t
8
1 t .09) (1
$1,000,000

+

·
- $5,000,000
= $1,000,000 (5.535) - $5,000,000
= $5,535,000 - $5,000,000 = $535,000
NPV
11%
=
t
8
1 t .11) (1
$1,000,000

+

·
- $5,000,000
= $1,000,000 (5.146) - $5,000,000
= $5,146,000 - $5,000,000 = $146,000
NPV
13%
= ∑
+
·
8
1 t
.13)t (1
$1,000,000
- $5,000,000
= $1,000,000 (4.799) - $5,000,000
= $4,799,000 - $5,000,000 = -$201,000
NPV
15%
=
t
8
1 t .15) (1
$1,000,000

+

·
- $5,000,000
= $1,000,000 (4.487) - $5,000,000
= $4,487,000 - $5,000,000 = -$513,000
9-9A. Project A:
$50,000 =
1
A
) IRR (1
$10,000
+
+
2
A
) IRR (1
$15,000
+
+
3
A
) IRR (1
$20,000
+
+
4
A
) IRR (1
$25,000
+
+
5
A
) IRR (1
$30,000
+
371
Try 23%
$50,000 = $10,000(.813) + $15,000(.661) + $20,000(.537)
+ $25,000(.437) + $30,000(.355)
= $8,130 + $9,915 + $10,740 + $10,925 + $10,650
= $50,360
Try 24%
$50,000 = $10,000(.806) + $15,000(.650) +$20,000(.524)
+ $25,000(.423) + $30,000(.341)
= $8,060 + $9,750 + $10,480 + $10,575 + $10,230
= $49,095
Thus, IRR = just over 23%
Project B:
$100,000 = $25,000 [PVIFA
IRR%,5 yrs
]
4.00 = PVIFA
IRR%,5 yrs
Thus, IRR = 8%
Project C:
$450,000 = $200,000 [PVIFA
IRR%,3 yrs
]
2.25 = PVIFA
IRR%,3 yrs
Thus, IRR = 16%
9-10A. (a) NPV =
t
10
1 t .10) (1
$18,000

+

·
- $100,000
= $18,000(6.145) - $100,000
= $110,610 - $100,000
= $10,610
(b) NPV =
t
10
1 t .15) (1
$18,000

+

·
- $100,000
= $18,000(5.019) - $100,000
= $90,342 - $100,000
= -$9,658
(c) If the required rate of return is 10% the project is acceptable as in part (a).
372
(d) $100,000 = $18,000 [PVIFA
IRR%,10 yrs
]
5.5556 = PVIFA
IRR%,10 yrs
IRR = Between 12% and 13% (12.41%)
9-11A. (a)
t
t
n
0 t k) (1
ACOF

+

·
=
n
t n

t
n
0 t
MIRR) (1
k) (1 ACIF
+
+ ∑

·
$10,000,000 =
10
10%10years
MIRR) (1
) (FVIFA $3,000,000
+
$10,000,000 =
10
) MIRR 1 (
) 937 . 15 ( 000 , 000 , 3 $
+
$10,000,000 =
10
) MIRR 1 (
000 , 811 , 47 $
+
MIRR = 16.9375%
(b) $10,000,000 =
10
12%10years
MIRR) (1
) (FVIFA $3,000,000
+
$10,000,000 =
10
) MIRR 1 (
) 549 . 17 ( 000 , 000 , 3 $
+
$10,000,000 =
10
) MIRR 1 (
000 , 647 , 52 $
+
MIRR = 18.0694%
(c) $10,000,000 =
10
years 10 % 14
) MIRR 1 (
) FVIFA ( 000 , 000 , 3 $
+
$10,000,000 =
10
) MIRR 1 (
) 337 . 19 ( 000 , 000 , 3 $
+
$10,000,000 =
10
) MIRR 1 (
000 , 011 , 58 $
+
MIRR = 19.2207%
373
SOLUTION TO INTEGRATIVE PROBLEM
1. Capital budgeting decisions involve investments requiring rather large cash outlays
at the beginning of the life of the project and commit the firm to a particular course
of action over a relatively long time horizon. As such, they are both costly and
difficult to reverse, both because of: (1) their large cost; (2) the fact that they involve
fixed assets which cannot be liquidated easily.
2. Axiom 5: The Curse of Competitive Markets—Why It's Hard to Find Exceptionally
Profitable Projects deals with the problems associated with finding profitable
projects. When we introduced that axiom we stated that exceptionally successful
investments involve the reduction of competition by creating barriers to entry either
through product differentiation or cost advantages. In effect, without barriers to
entry, whenever extremely profitable projects are found competition rushes in,
driving prices and profits down unless there is some barrier to entry.
3. Payback period
A
= 3 years +
000 , 50
000 , 20
years = 3.4 years
Payback Period
B
=
000 , 40
000 , 110
years = 2.75 years
Project B should be accepted while project A should be rejected.
4. The disadvantages of the payback period are: 1) ignores the time value of money,
2)ignores cash flows occurring after the payback period, 3)selection of the maximum
acceptable payback period is arbitrary.
5. Discounted Payback Period Calculations, Project A:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF
12%,n
Cash Flows Cash Flows
0 -$110,000 1.000 -$110,000 -$110,000
1 20,000 .893 17,860 -92,140
2 30,000 .797 23,910 -68,230
3 40,000 .712 28,480 -39,750
4 50,000 .636 31,800 -7,950
5 70,000 .567 39,690 31,740
Discounted Payback Period = 4.0 + 7,950/39,690 = 4.20 years.
374
Discounted Payback Period Calculations, Project B:
Cumulative
Undiscounted Discounted Discounted
Year Cash Flows PVIF
12%,n
Cash Flows Cash Flows
0 -$110,000 1.000 -$110,000 -$110,000
1 40,000 .893 35,720 -74,280
2 40,000 .797 31,880 -42,400
3 40,000 .712 28,480 -13,920
4 40,000 .636 25,440 11,520
5 40,000 .567 22,680 34,200
Discounted Payback Period = 3.0 + 13,920/25,440 = 3.55 years.
Using the discounted payback period method and a 3-year maximum acceptable
project hurtle, neither project should be accepted.
6. The major problem with the discounted payback period comes in
setting the firm's maximum desired discounted payback period. This
is an arbitrary decision that affects which projects are accepted and
which ones are rejected. Thus, while the discounted payback period
is superior to the traditional payback period, in that it accounts for the
time value of money in its calculations, its use should be limited due
to the problem encountered in setting the maximum desired payback
period. In effect, neither method should be used.
7. NPV
A
=
t
t
n
1 t
k) (1
FCF

+

·
- IO
= $20,000(PVIF
12%, 1 year
) + $30,000 (PVIF
12%, 2 years
)
+ $40,000(PVIF
12%, 3 years
) + $50,000 (PVIF
12%, 4 years
)
+ $70,000(PVIF
12%, 5 years
) - $110,000
= $20,000(.893) + $30,000 (.797) + $40,000 (.712) + $50,000
(.636) + $70,000 (.567) - $110,000
= $17,860 + $23,910 + $28,480 + $31,800 + $39,690 - $110,000
= $141,740-$110,000
= $31,740
NPV
B
= $40,000(PVIFA
12%, 5 years
) - $110,000
= $40,000(3.605) - $110,000
= $144,200-$110,000
= $34,200
375
Both projects should be accepted
8. The net present value technique discounts all the benefits and costs in
terms of cash flows back to the present and determines the difference.
If the present value of the benefits outweighs the present value of the
costs, the project is accepted, if not, it is rejected.
9. PI
A
=
IO
k) (1
FCF
t
t
n
1 t

,
_

¸
¸
+

·
=
000 , 110 $
740 , 141 $
= 1.2885
PI
B
=
000 , 110 $
200 , 144 $
= 1.3109
Both projects should be accepted
10. The net present value and the profitability index always give the same
accept reject decision. When the present value of the benefits
outweighs the present value of the costs the profitability index is
greater than one, and the net present value is positive. In that case,
the project should be accepted. If the present value of the benefits is
less than the present value of the costs, then the profitability index
will be less than one, and the net present value will be negative, and
the project will be rejected.
11. For both projects A and B all of the costs are already in present
dollars and, as such, will not be affected by any change in the required
rate of return or discount rate. All the benefits for these projects are
in the future and thus when there is a change in the required rate of
return or discount rate their present value will change. If the required
rate of return increased, the present value of the benefits would
decline which would in turn result in a decrease in both the net
present value and the profitability index for each project.
12. IRR
A
= 20.9698%
IRR
B
= 23.9193%
13. The required rate of return does not change the internal rate of return
for a project, but it does affect whether a project is accepted or
rejected. The required rate of return is the hurdle rate that the
project's IRR must exceed in order to accept the project.
14. The net present value assumes that all cash flows over the life of the project are
376
reinvested at the required rate of return, while the internal rate of return implicitly
assumes that all cash flows over the life of the project are reinvested over the
remainder of the project's life at the IRR. The net present value method makes the
most acceptable, and conservative assumption and thus is preferred.
15. Project A:
t
t
n
0 t k) (1
ACOF

+

·
=
n
n
0 t
t n
t
MIRR) (1
k) (1 ACIF
+
+

·

$110,000 =
5
A
12% 12%
12% 12%
) MIRR (1
$70,000
year) 1 , IF $50,000(FV years) 2 , IF $40,000(FV
years) 3 , IF $30,000(FV years) 4 , IF $20,000(FV
+
+
+ +
+
$110,000 =
5
A
) MIRR (1
000 , 70 $ ) 120 . 1 ( 000 , 50 $ ) 254 . 1 ( 000 , 40 $
) 405 . 1 ( 000 , 30 $ ) 574 . 1 ( 000 , 20 $
+
+ + +
+
$110,000 =
5
A
) MIRR (1
000 , 70 $ 000 , 56 $ 160 , 50 $ 150 , 42 $ 480 , 31 $
+
+ + + +
$110,000 =
5
A
) MIRR 1 (
790 , 249 $
+
MIRR
A
= 17.8247%
Project B:
$110,000 =
5
B
,5years
12%
) MIRR (1
) IFA $40,000(FV
+
$110,000 =
5
B
) MIRR (1
353) $40,000(6.
+
$110,000 =
5
B
) MIRR (1
$254,120
+
MIRR
B
= 18.2304%
Both projects should be accepted because their MIRR exceeds the required rate of return.
The modified internal rate of return is superior to the internal rate of return method because
377
MIRR assumes the reinvestment rate of cash flows is the required rate of return.
378
Solutions to Problem Set B
9-1B. (a) IO = FCF
t
[PVIF
IRR%,t yrs
]
$10,000 = $19,926

[PVIF
IRR%,8 yrs
]
0.502 = PVIF
IRR%,8 yrs
Thus, IRR = 9%
(b) $10,000 = $20,122

[PVIF
IRR%,12 yrs
]
0.497 = PVIF
IRR%,12 yrs
Thus, IRR = 6%
(c) $10,000 = $121,000

[PVIF
IRR%,22 yrs
]
0.083 = PVIF
IRR%,22 yrs
Thus, IRR = 12%
(d) $10,000 = $19,254 [PVIF
IRR%,5 yrs
]
0.519 = PVIF
IRR%,5 yrs
Thus, IRR = 14%
9-2B. (a) IO = FCF
t
[PVIFA
IRR%,t yrs
]
$10,000 = $2,146 [PVIFA
IRR%,10 yrs
]
4.66 = PVIFA
IRR%,10 yrs
Thus, IRR = 17%
(b) $10,000 = $1,960 [PVIFA
IRR%,20 yrs
]
5.102 = PVIFA
IRR%,20 yrs
Thus, IRR = 19%
(c) $10,000 = $1,396 [PVIFA
IRR%,12 yrs
]
7.163 = PVIFA
IRR%,12 yrs
]
Thus, IRR = 9%
(d) $10,000 = $3,197 [PVIFA
IRR%,5 yrs
]
3.128 = PVIFA
IRR%,5 yrs
Thus, IRR = 18%
379
9-3B. (a) $10,000 =
1
IRR) (1
$3,000
+
+
2
IRR) (1
$5,000
+
+
3
IRR) (1
$7,500
+
Try 21%:
$10,000 = $3,000(0.826) + $5,000 (0.683) + $7,500 (0.564)
= $2,478+ $3,415 + $4,230
= $10,123
Try 22%
$10,000 = $3,000 (0.820) + $5,000 (0.672) + $7,500 (0.551)
= $2,460 + $3,360 + $4,132.50
= $9,952.50
Thus, IRR = approximately 22%
(b) $12,000 =
1
IRR) (1
$9,000
+
+
2
IRR) (1
$6,000
+
+
3
IRR) (1
$2,000
+
Try 25%
$12,000 = $9,000 (0.800) + $6,000 (0.640) + $2,000 (0.512)
= $7,200 + $3,840 + $1,024
= $12,064
Try 26%:
$12,000 = $9,000 (0.794) + $6,000 (0.630) + $2,000 (0.500)
= $7,146 + $3,780 + $1,000
= $11,926
Thus, IRR = nearest percent is 25%
(c) $8,000 =
t
5
1 t
IRR) (1
$2,000

+

·
+
6
IRR) (1
$5,000
+
Try 18%
$8,000 = $2,000 (3.127) + $5,000 (0.370)
= $6,254 + $1,850
= $8,104
Try 19%
$8,000 = $2,000 (3.058) + $5,000 (0.352)
= $6,116 + $1,760
= $7,876
Thus, IRR = nearest percent is 18%
380
9-4B. (a) NPV =
t
6
1 t .11) (1
$750,000

+

·
- $2,500,000
= $750,000 (4.231) - $2,500,000
= $3,173,250 - $2,500,000
= $673,250
(b) PI =
000 , 500 , 2 $
250 , 173 , 3 $
= 1.2693
(c) $2,500,000 = $750,000 [PVIFA
IRR%,6 yrs
]
3.333 = PVIFA
IRR%,6 yrs
IRR = about 20% (19.90%)
(d) Yes, the project should be accepted.
9-5B. (a) Payback Period = $160,000/$40,000 = 4 years
(b) NPV =
t
6
1 t .10) (1
$40,000

+

·
- $160,000
= $40,000 (4.355) - $160,000
= $174,200 - $160,000 = $14,200
(c) PI =
000 , 160 $
200 , 174 $
= 1.0888
(d) $160,000 = $40,000 [PVIFA
IRR%,6 yrs
]
4.000 = PVIFA
IRR%,6 yrs
IRR = about 13% (12.978%)
9-6B. (a) NPV
A
=
t
6
1 t .12) (1
$12,000

+

·
- $45,000
= $12,000 (4.111) - $45,000
= $49,332 - $45,000 = $4,332
NPV
B
=
t
6
1 t .12) (1
$14,000

+

·
- $70,000
= $14,000 (4.111) - $70,000
= $57,554 - $70,000 = -$12,446
(b) PI
A
=
000 , 45 $
332 , 49 $
381
= 1.0963
PI
B
=
000 , 70 $
554 , 57 $
= 0.822
(c) $45,000 = $12,000 [PVIFA
IRR%,6 yrs
]
3.75 = PVIFA
IRR%,6 yrs
IRR
A
= 15.34%
$70,000 = $14,000 [PVIFA
IRR%,6 yrs
]
5.0000 = PVIFA
IRR%,6 yrs
IRR
B
= 5.47%
Project A should be accepted.
9-7B. (a) Project A:
Payback Period = 2 years
Project B:
Payback Period = 2 years + $1,000/$3,000 = 2.33 years
Project C:
Payback Period = 3 years + $1,000/$2,000 = 3.5 years
Project Payback Period Method
A Accept
B Accept
C Reject
9-8B. NPV
9%
=
t
8
1 t .09) (1
$2,500,000

+

·
- $10,000,000
= $2,500,000 (5.535) - $10,000,000
= $13,837,500 - $10,000,000 = $3,837,500
NPV
11%
=
t
8
1 t .11) (1
$2,500,000

+

·
- $10,000,000
= $2,500,000 (5.146) - $10,000,000
= $12,865,000 - $10,000,000 = $2,865,000
NPV
13%
=
t
8
1 t .13) (1
$2,500,000

+

·
- $10,000,000
382
= $2,500,000 (4.799) - $10,000,000
= $11,997,500 - $10,000,000 = $1,997,500
NPV
15%
=
t
8
1 t .15) (1
$2,500,000

+

·
- $10,000,000
= $2,500,000 (4.487) - $10,000,000
= $11,217,500 - $10,000,000 = $1,217,500
9-9B. Project A:
$75,000 =
1
A
) IRR (1
$10,000
+
+
2
A
) IRR (1
$10,000
+
+
3
A
) IRR (1
$30,000
+
+
4
A
) IRR (1
$25,000
+
+
5
A
) IRR (1
$30,000
+
Try 10%
$75,000 = $10,000(.909) + $10,000(.826) + $30,000(.751)
+ $25,000(.683) + $30,000(.621)
= $9,090 + $8,260 + $22,530 + $17,075 + $18,630
= $75,585
Try 11%
$75,000 = $10,000(.901) + $10,000(.812) +$30,000(.731)
+ $25,000(.659) + $30,000(.593)
= $9,010 + $8,120 + $21,930+ $16,475 + $17,790
= $73,325
Thus, IRR = just over 10%
Project B:
$95,000 = $25,000 [PVIFA
IRR%,5 yrs
]
3.80 = PVIFA
IRR%,5 yrs
Thus, IRR = just below 10%
Project C:
$395,000 = $150,000 [PVIFA
IRR%,3 yrs
]
2.633 = PVIFA
IRR%,3 yrs
Thus, IRR = just below 7%
9-10B. (a) NPV =
t
10
1 t
.09) (1
$25,000

+

·
- $150,000
383
= $25,000(6.418) - $150,000
= $160,450 - $150,000
= $10,450
(b) NPV =
t
10
1 t .15) (1
$25,000

+

·
- $150,000
= $25,000(5.019) - $150,000
= $125,475 - $150,000
= -$24,525
(c) If the required rate of return is 9% the project is acceptable in
part (a). It should be rejected in part (b) with a negative NPV.
(d) $150,000 = $25,000 [PVIFA
IRR%,10 yrs
]
6.000 = PVIFA
IRR%,10 yrs
IRR = Between 10% and 11% (10.558%)
9-11B. (a)
t
t
n
0 k) (1
ACOF

+

· t
=
n
t - n
t
n
0 t
MIRR) (1
k) (1 ACIF
+
+ ∑
·
$8,000,000 =
8
,8years
10%
MIRR) (1
) (FVIFA $2,000,000
+
$8,000,000 =
8
MIRR) (1
(11.436) $2,000,000
+
$8,000,000 =
8
MIRR) (1
$22,872000
+
MIRR = 14.0320%
b) $8,000,000 =
8
,8years
12%
MIRR) (1
) (FVIFA $2,000,000
+
$8,000,000 =
8
MIRR) (1
(12.300) $2,000,000
+
$8,000,000 =
8
MIRR) (1
0 $24,600,00
+
MIRR = 15.0749%
c) $8,000,000 =
8
,8years
14%
MIRR) (1
) (FVIFA $2,000,000
+
384
$8,000,000 =
8
MIRR) (1
(13.233) $2,000,000
+
$8,000,000 =
8
MIRR) (1
0 $26,466,00
+
MIRR = 16.1312%
FORD'S PINTO
(Ethics in Capital Budgeting)
OBJECTIVE: To force the students to recognize the role ethical behavior plays in all
areas of Finance.
DEGREE OF DIFFICULTY: Easy
Case Solution:
With ethics cases there are no right or wrong answers - just opinions. Try to bring
out as many opinions as possible without being judgmental.

CHAPTER 10
Cash Flows and Other Topics
in Capital Budgeting

CHAPTER ORIENTATION
385
Capital budgeting involves the decision-making process with respect to the investment in
fixed assets; specifically, it involves measuring the free cash flows or incremental cash
flows associated with investment proposals and evaluating the attractiveness of these cash
flows relative to the project's costs. This chapter focuses on the estimation of those cash
flows based on various decision criteria, and how to deal with capital rationing and mutually
exclusive projects.
CHAPTER OUTLINE
I. What criteria should we use in the evaluation of alternative investment proposals?
A. Use free cash flows rather than accounting profits because free cash flows
allow us to correctly analyze the time element of the flows.
B. Examine free cash flows on an after-tax basis because they are the flows
available to shareholders.
C. Include only the incremental cash flows resulting from the investment
decision. Ignore all other flows.
D. In deciding which free cash flows are relevant we want to:
1. Use free cash flows rather than accounting profits as our measurement
tool.
2. Think incrementally, looking at the company with and without the
new project. Only incremental after tax cash flows, or free cash
flows, are relevant.
3. Beware of cash flows diverted from existing products, again, looking
at the firm as a whole with the new product versus without the new
product.
386
4. Bring in working capital needs. Take account of the fact that a new
project may involve the additional investment in working capital.
5. Consider incremental expenses.
6. Do not include stock costs as incremental cash flows.
7. Account for opportunity costs.
8. Decide if overhead costs are truly incremental cash flows.
9. Ignore interest payments and financing flows.
II. Measuring free cash flows. We are interested in measuring the incremental after-tax
cash flows, or free cash flows, resulting from the investment proposal. In general,
there will be three major sources of cash flows: initial outlays, differential cash flows
over the project's life, and terminal cash flows.
A. Initial outlays include whatever cash flows are necessary to get the project in
running order, for example:
1. The installed cost of the asset
2. In the case of a replacement proposal, the selling price of the old
machine minus (or plus) any tax gain (or tax loss) offsetting the initial
outlay
3. Any expense items (for example, training) necessary for the operation
of the proposal
4. Any other non-expense cash outlays required, such as increased
working-capital needs
B. Differential cash flows over the project's life include the incremental after-tax
flows over the life of the project, for example:
1. Added revenue (less added selling expenses) for the proposal
2. Any labor and/or material savings incurred
3. Increases in overhead incurred
4. Changes in taxes.
5. Change in net working capital.
6. Change in capital spending.
7. Make sure calculations reflect the fact that while depreciation is an
expense, it does not involve any cash flows.
8. A word of warning not to include financing charges (such as interest
or preferred stock dividends), for they are implicitly taken care of in
the discounting process.
387
C. Terminal cash flows include any incremental cash flows that result at the
termination of the project, for example:
1. The project's salvage value plus (or minus) any taxable gains or losses
associated with the project
2. Any terminal cash flow needed, perhaps disposal of obsolete
equipment
3. Recovery of any non-expense cash outlays associated with the project,
such as recovery of increased working-capital needs associated with the
proposal.
III. Measuring the cash flows using the pro forma method
A. A project’s free cash flows =
project’s change in operating cash flows
- change in net working capital
- change in capital spending
B If we rewrite this, inserting the calculations for the project’s change in
operating cash flows (OCF), we get:
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
C. In addition to using the pro forma method for calculating operating cash
flows, there are three other approaches that are also commonly used. A
summary of all the different approaches follows,
D. OCF Calculation: The Pro Forma Approach:
Operating Cash Flows = Change in Earnings Before Interest and Taxes -
Change in Taxes + Change in Depreciation
E. Alternative OCF Calculation 1: Add Back Approach
Operating Cash Flows = Net income + Depreciation
E. Alternative OCF Calculation 2: Definitional Approach
Operating Cash Flows = Change in revenues - Change in cash expenses -
Change in Taxes
388
F. Alternative OCF Calculation 3: Depreciation Tax Shield Approach
Operating Cash Flows = (Revenues – cash expenses) X (1 – tax rate) +
(change in depreciation X tax rate)
You’ll notice that interest payments are no where to be found, that’s because
we ignore them when we’re calculating operating cash flows. You’ll also
notice that we end up with the same answer regardless of how we work the
problem.
IV. Mutually exclusive projects: Although the IRR and the present-value methods will,
in general, give consistent accept-reject decisions, they may not rank projects
identically. This becomes important in the case of mutually exclusive projects.
A. A project is mutually exclusive if acceptance of it precludes the acceptance of
one or more projects. Then, in this case, the project's relative ranking
becomes important.
B. Ranking conflicts come as a result of the different assumptions on the
reinvestment rate on funds released from the proposals.
C. Thus, when conflicting ranking of mutually exclusive projects results from
the different reinvestment assumptions, the decision boils down to which
assumption is best.
D. In general, the net present value method is considered to be theoretically
superior.
V. Capital rationing is the situation in which a budget ceiling or constraint is placed
upon the amount of funds that can be invested during a time period.
– Theoretically, a firm should never reject a project that yields more than the
required rate of return. Although there are circumstances that may create
complicated situations in general, an investment policy limited by capital
rationing is less than optimal.
VI. Options in Capital Budgeting. Options in capital budgeting deal with the opportunity
to modify the project. Three of the most common types of options that can add value
to a capital budgeting project are: (1) the option to delay a project until the future
cash flows are more favorable – this option is common when the firm has exclusive
rights, perhaps a patent, to a product or technology, (2) the option to expand a
project, perhaps in size or even to new products that would not have otherwise been
feasible, and (3) the option to abandon a project if the future cash flows fall short of
expectations.
389
ANSWERS TO
END-OF-CHAPTER QUESTIONS
10-1. We focus on cash flows rather than accounting profits because these are the flows
that the firm receives and can reinvest. Only by examining cash flows are we able to
correctly analyze the timing of the benefit or cost. Also, we are only interested in
these cash flows on an after tax basis as only those flows are available to the
shareholder. In addition, it is only the incremental cash flows that interest us,
because, looking at the project from the point of the company as a whole, the
incremental cash flows are the marginal benefits from the project and, as such, are
the increased value to the firm from accepting the project.
10-2. Although depreciation is not a cash flow item, it does affect the level of the
differential cash flows over the project's life because of its effect on taxes.
Depreciation is an expense item and, the more depreciation incurred, the larger are
expenses. Thus, accounting profits become lower and, in turn, so do taxes, which are
a cash flow item.
10-3. If a project requires an increased investment in working capital, the amount of this
investment should be considered as part of the initial outlay associated with the
project's acceptance. Since this investment in working capital is never "consumed,"
an offsetting inflow of the same size as the working capital's initial outlay will occur
at the termination of the project corresponding to the recapture of this working
capital. In effect, only the time value of money associated with the working capital
investment is lost.
10-4. When evaluating a capital budgeting proposal, sunk costs are ignored. We are
interested in only the incremental after-tax cash flows to the company as a whole.
Regardless of the decision made on the investment at hand, the sunk costs will have
already occurred, which means these are not incremental cash flows. Hence, they
are irrelevant.
10-5. Mutually exclusive projects involve two or more projects where the acceptance of
one project will necessarily mean the rejection of the other project. This usually
occurs when the set of projects perform essentially the same task. Relating this to
our discounted cash flow criteria, it means that not all projects with positive NPV's,
profitability indexes greater than 1.0 and IRRs greater than the required rate of return
will be accepted. Moreover, since our discounted cash flow criteria do not always
yield the same ranking of projects, one criterion may indicate that the mutually
exclusive project A should be accepted, while another criterion may indicate that the
mutually exclusive project B should be accepted.
10-6. There are three principal reasons for imposing a capital rationing constraint. First,
the management may feel that market conditions are temporarily adverse. In the
early- and mid-seventies, this reason was fairly common, because interest rates were
at an all-time high and stock prices were at a depressed level. The second reason is a
manpower shortage, that is, a shortage of qualified managers to direct new projects.
The final reason involves intangible considerations. For example, the management
may simply fear debt, and so avoid interest payments at any cost. Or the common
390
stock issuance may be limited in order to allow the current owners to maintain strict
voting control over the company or to maintain a stable dividend policy.
Whether or not this is a rational move depends upon the extent of the rationing. If it
is minor and noncontinuing, then the firm's share price will probably not suffer to
any great extent. However, it should be emphasized that capital rationing and
rejection of projects with positive net present values is contrary to the firm's goal of
maximization of shareholders’ wealth.
10-7. When two mutually exclusive projects of unequal size are compared, the firm should
select the project with the largest net present value, when there is no capital
rationing. If there is capital rationing, then the firm should select the set of projects
with the highest net present value. The firm needs to consider alternative uses of
funds if the project with the lowest net present value is chosen.
10-8. The time disparity problem and the conflicting rankings that accompany it result
from the differing reinvestment assumptions made by the net present value and
internal rate of return decision criteria. The net present value criterion assumes that
cash flows over the life of the project can be reinvested at the required rate of return;
the internal rate of return implicitly assumes that the cash flows over the life of the
project can be reinvested at the internal rate of return.
10.9. The problem of incomparability of projects with different lives is not directly a result
of the projects having different lives but of the fact that future profitable investment
proposals are being affected by the decision currently being made. Again the key is:
"Does the investment decision being made today affect future profitable investment
proposals?" If so, the projects are not comparable. While the most theoretically
proper approach is to make assumptions as to investment opportunities in the future,
this method is probably too difficult to be of any value in most cases. Thus, the most
common method used to deal with this problem is the creation of a replacement
chain to equalize life spans. In effect, the reinvestment opportunities in the future
are assumed to be similar to the current ones. Another approach is to calculate the
equivalent annual annuity of each project.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
10-1A.
(a) Tax payments associated with the sale for $35,000
Recapture of depreciation
= ($35,000-$15,000) (0.34) = $6,800
(b) Tax payments associated with sale for $25,000
Recapture of depreciation
391
= ($25,000-$15,000) (0.34) = $3,400
(c) No taxes, because the machine would have been sold for its book value.
(d) Tax savings from sale below book value:
Tax savings = ($15,000-$12,000) (0.34) = $1,020
10-2A.
New Sales $25,000,000
Less: Sales taken from
existing product lines - 5,000,000
$20,000,000
10-3A. Change in net working capital equals the increase in accounts receivable and
inventory less the increase in accounts payable = $18,000 + $15,000 - $24,000 =
$9,000.
The change in taxes will be EBIT X marginal tax rate = $475,000 X .34 = $161,500.
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $475,000
- $161,500
+ $100,000
- $9,000
$0
= $404,500
10-4A. Change in net working capital equals the increase in accounts receivable and
inventory less the increase in accounts payable = $8,000 + $15,000 - $16,000 =
$7,000.
The change in taxes will be EBIT X marginal tax rate = $900,000 X .34 = $306,000.
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $900,000
- $306,000
+ $300,000
- $7,000
- $0
392
= $887,000
393
10-5A. Given this, the firm’s net profit after tax can be calculated as:
Revenue $2,000,000
- Cash expenses 800,000
- Depreciation 200,000
= EBIT $1,000,000
- Taxes (34%) 340,000
= Net income $ 660,000
OCF Calculation: Pro Forma Approach
Operating Cash Flows =
Change in Earnings Before Interest and Taxes
- Change in Taxes
+ Change in Depreciation
= $1,000,000 - $340,000 + $200,000 = $860,000
Alternative OCF Calculation 1: Add Back Approach
Operating Cash Flows = Net income + Depreciation
= $660,000 + $200,000 = $860,000
Alternative OCF Calculation 2: Definitional Approach
Operating Cash Flows = Change in revenues - Change in cash expenses –
Change in Taxes
= $2,000,000 - $800,000 -$340,000 = $860,000
Alternative OCF Calculation 3: Depreciation Tax Shield Approach
Operating Cash Flows = (Revenues – cash expenses) X (1 – tax rate) +
(change in depreciation X tax rate)
= ($2,000,000 - $800,000) X (1-.34) + ($200,000 X.34)
= $860,000
You’ll notice that interest payments are nowhere to be found, that’s because we
ignore them when we’re calculating operating cash flows. You’ll also notice that we
end up with the same answer regardless of how we work the problem.
10-6A. Given this, the firm’s net profit after tax can be calculated as:
Revenue $3,000,000
- Cash expenses 900,000
- Depreciation 400,000
= EBIT $1,700,000
- Taxes (34%) 578,000
= Net income $1,122,000
394
As you can see, regardless of which method you use to calculate operating cash
flows, you get the same answer:
OCF Calculation: Pro Forma Approach
Operating Cash Flows = Change in Earnings Before Interest and Taxes - Change in
Taxes + Change in Depreciation
= $1,700,000 - $578,000 + $400,000 = $1,522,000
Alternative OCF Calculation 1: Add Back Approach
Operating Cash Flows = Net income + Depreciation
= $1,122,000 + $400,000 = $1,522,000
Alternative OCF Calculation 2: Definitional Approach
Operating Cash Flows = Change in revenues - Change in cash expenses –
Change in Taxes
= $3,000,000 - $900,000 -$578,000 = $1,522,000
Alternative OCF Calculation 3: Depreciation Tax Shield Approach
Operating Cash Flows = (Revenues – cash expenses) X (1 – tax rate) +
(change in depreciation X tax rate)
= ($3,000,000 - $900,000)X(1-.34) + ($400,000 X.34)
= $1,522,000
You’ll notice that interest payments are no where to be found, that’s because we
ignore them when we’re calculating operating cash flows. You’ll also notice that we
end up with the same answer regardless of how we work the problem.
10-7A. (a) Initial Outlay
Outflows:
Purchase price $1,000,000
Increased Inventory 50,000
Net Initial Outlay $1,050,000
(b) Differential annual cash flows (years 1-9)
First, given this, the firm’s net profit after tax can be calculated as:
Revenue $1,000,000
- Cash expenses 560,000
- Depreciation* 100,000
= EBIT $340,000
- Taxes (34%) 115,600
= Net income $224,400
395
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes + change in depreciation
- change in net working capital
- change in capital spending
= $340,000
- $115,600
+ $100,000*
- $0
- $0
= $324,400
*Annual Depreciation on the new machine is calculated by taking the purchase price
($1,000,000) and adding in costs necessary to get the new machine in operating order
(in this case $0) and dividing by the expected life.
(c) Terminal Cash flow (year 10)
Inflows:
Free Cash flow in year 10 $324,400
Recapture of working capital (inventory) 50,000
Total terminal cash flow $374,400
(d) NPV = $324,400 (PVIFA
10%,9 yr.
) + $374,400 (PVIF
10%, 10 yr.
) - $1,050,000
= $324,400 (5.759) + $374,400 (.386) - $1,050,000
= $1,868,220 + $144,518 - $1,050,000
= $962,738
10-8A.
(a) Initial Outlay
Outflows:
Purchase price $5,000,000
Increased Inventory 1,000,000
Net Initial Outlay $6,000,000
(b) Differential annual cash flows (years 1-4)
First, given this, the firm’s net profit after tax can be calculated as:
Revenue $5,000,000
- Cash expenses 3,500,000
- Depreciation* 1,000,000
= EBIT $ 500,000
- Taxes (34%) 170,000
396
= Net income $ 330,000
397
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $500,000
- $170,000
+ $1,000,000*
- $0
- $0
= $1,330,000
*Annual Depreciation on the new machine is calculated by taking the purchase price
($5,000,000) and adding in costs necessary to get the new machine in operating order
($0) and dividing by the expected life.
(c) Terminal Cash flow (year 5)
Inflows:
Free Cash flow in year 5 $1,330,000
Recapture of working capital (inventory) 1,000,000
Total terminal cash flow $2,330,000
(d) NPV = $1,330,000 (PVIFA
10%,4 yr.
) + $2,330,000 (PVIF
10%, 5 yr.
) - $6,000,000
= $1,330,000 (3.170) + $2,330,000 (.621) - $6,000,000
= $4,216,100 + $1,446,930 - $6,000,000
= -$336,970
Since the NPV is negative, this project should be rejected.
10-9A.
(a) Initial Outlay
Outflows:
Purchase price $100,000
Installation Fee 5,000
Increased Working Capital Inventory 5,000
Net Initial Outlay $110,000
398
(b) Differential annual free cash flows (years 1-9)
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $35,000
- $11,900
+ $10,500*
- $0
- $0
= $33,600
* Annual Depreciation on the new machine is calculated by taking the purchase price
($100,000) and adding in costs necessary to get the new machine in operating order
(the installation fee of $5,000) and dividing by the expected life.
(c) Terminal Free Cash flow (year 10)
Inflows:
Free Cash flow in year 10 $33,600
Recapture of working capital (inventory) 5,000
Total terminal cash flow $ 38,600
(d) NPV = $33,600 (PVIFA
15%,9 yr.
) + $38,600 (PVIF
15%, 10 yr.
) - $110,000
= $33,600 (4.772) + $38,600 (.247) - $110,000
= $160,339.20 + $9,534.20 - $110,000
= $59,873.40
Yes, the NPV > 0.
10-10A.(a) Initial Outlay
Outflows:
Purchase price $ 500,000
Installation Fee 5,000
Training Session Fee 25,000
Increased Inventory 30,000
Net Initial Outlay $560,000
399
(b) Differential annual free cash flows (years 1-9)
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $150,000
- $51,000
+ $50,500*
- $0
- $0
= $149,500
*Annual Depreciation on the new machine is calculated by taking the purchase price
($500,000) and adding in costs necessary to get the new machine in operating order
(the installation fee of $5,000) and dividing by the expected life.
(c) Terminal Free Cash flow (year 10)
Inflows:
Free Cash flow in year 10 $149,500
Recapture of working capital (inventory) 30,000
Total terminal cash flow $ 179,500
(d) NPV = $149,500 (PVIFA
15%,9 yr.
) + $179,500 (PVIF
15%, 10 yr.
) - $560,000
= $149,500 (4.772) + $179,500 (.247) - $560,000
= $713,414 + $44,336.50 - $560,000
= $197,750.50
Yes, the NPV > 0.
10-11A.(a) Initial Outlay
Outflows:
Purchase price $ 200,000
Installation Fee 5,000
Training Session Fee 5,000
Increased Inventory 20,000
Net Initial Outlay $230,000
400
(b) Differential annual cash flows (years 1-9)
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $50,000
- $17,000
+ $20,500*
- $0
- $0
= $53,500
*Annual Depreciation on the new machine is calculated by taking the purchase price
($200,000) and adding in costs necessary to get the new machine in operating order
(the installation fee of $5,000) and dividing by the expected life.
(c) Terminal Cash flow (year 10)
Inflows:
Free Cash flow in year 10 $53,500
Recapture of working capital (inventory) 20,000
Total terminal cash flow $ 73,500
(d) NPV = $53,500 (PVIFA
10%,9 yr.
) + $73,500 (PVIF
10%, 10 yr.
) - $230,000
= $53,500 (5.759) + $73,500 (.386) - $230,000
= $308,106.50 + $28,371 - $230,000
= $106,477.50
Yes, the NPV > 0.
401
10-12A
Section I. Calculate the change in EBIT, Taxes, and Depreciation (this becomes an input in the calculation of Operating Cash Flow in Section II).
Year 0 1 2 3 4 5
Units Sold 70,000 120,000 120,000 80,000 70,000
Sale Price $300 $300 $300 $300 $250
Sales Revenue $21,000,000 $36,000,000 $36,000,000 $24,000,000 $17,500,000
Less: Variable Costs 9,800,000 16,800,000 16,800,000 11,200,000 9,800,000
Less: Fixed Costs $700,000 $700,000 $700,000 $700,000 $700,000
Equals: EBDIT $10,500,000 $18,500,000 $18,500,000 $12,100,000 $7,000,000
Less: Depreciation $3,000,000 $3,000,000 $3,000,000 $3,000,000 $3,000,000
Equals: EBIT $7,500,000 $15,500,000 $15,500,000 $9,100,000 $4,000,000
Taxes (@34%) $2,550,000 $5,270,000 $5,270,000 $3,094,000 $1,360,000
Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV).
Operating Cash Flow:
EBIT $7,500,000 $15,500,000 $15,500,000 $9,100,000 $4,000,000
Minus: Taxes $2,550,000 $5,270,000 $5,270,000 $3,094,000 $1,360,000
Plus: Depreciation $3,000,000 $3,000,000 $3,000,000 $3,000,000 $3,000,000
Equals: Operating Cash Flow $7,950,000 $13,230,000 $13,230,000 $9,006,000 $5,640,000
Section III. Calculate the Net Working Capital (this becomes an input in the calculation of Free Cash Flows in Section IV)
Change in Net Working Capital:
Revenue: $21,000,000 $36,000,000 $36,000,000 $24,000,000 $17,500,000
Initial Working Capital Requirement $200,000
Net Working Capital Needs: $2,100,000 $3,600,000 $3,600,000 $2,400,000 $1,750,000
Liquidation of Working Capital $1,750,000
Change in Working Capital: $200,000 $1,900,000 $1,500,000 $0 ($1,200,000) ($2,400,000)
Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending).
Free Cash Flow:
Operating Cash Flow $7,950,000 $13,230,000 $13,230,000 $9,006,000 $5,640,000
Minus: Change in Net Working Capital $200,000 $1,900,000 $1,500,000 $0 ($1,200,000) ($2,400,000)
Minus: Change in Capital Spending $15,000,000 $0 $0 $0 $0 $0
Free Cash Flow: ($15,200,000 ) $6,050,000 $11,730,000 $13,230,000 $10,206,000 $8,040,000
NPV $17,461,989
PI 2.15
2
6
4
IRR 45%
Should accept project
403
10-13A
Section I. Calculate the change in EBIT, Taxes, and Depreciation (this becomes an input in the calculation of Operating Cash Flow in Section II).
Year 0 1 2 3 4 5
Units Sold 80,000 100,000 120,000 70,000 70,000
Sale Price $250 $250 $250 $250 $250
Sales Revenue $20,000,000 $25,000,000 $30,000,000 $17,500,000 $14,000,000
Less: Variable Costs 10,400,000 13,000,000 15,600,000 9,100,000 9,100,000
Less: Fixed Costs $300,000 $300,000 $300,000 $300,000 $300,000
Equals: EBDIT $9,300,000 $11,700,000 $14,100,000 $8,100,000 $4,600,000
Less: Depreciation $1,400,000 $1,400,000 $1,400,000 $1,400,000 $1,400,000
Equals: EBIT $7,900,000 $10,300,000 $12,700,000 $6,700,000 $3,200,000
Taxes (@34%) $2,686,000 $3,502,000 $4,318,000 $2,278,000 $1,088,000
Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV).
Operating Cash Flow:
EBIT $7,900,000 $10,300,000 $12,700,000 $6,700,000 $3,200,000
Minus: Taxes $2,686,000 $3,502,000 $4,318,000 $2,278,000 $1,088,000
Plus: Depreciation $1,400,000 $1,400,000 $1,400,000 $1,400,000 $1,400,000
Equals: Operating Cash Flow $6,614,000 $8,198,000 $9,782,000 $5,822,000 $3,512,000
Section III. Calculate the Net Working Capital (this becomes an input in the calculation of Free Cash Flows in Section IV)
Change in Net Working Capital:
Revenue: $20,000,000 $25,000,000 $30,000,000 $17,500,000 $14,000,000
Initial Working Capital Requirement $100,000
Net Working Capital Needs: $2,000,000 $2,500,000 $3,000,000 $1,750,000 $1,400,000
Liquidation of Working Capital $1,400,000
Change in Working Capital: $100,000 $1,900,000 $500,000 $500,000 ($1,250,000) ($1,750,000)
Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending).
Free Cash Flow:
Operating Cash Flow $6,614,000 $8,198,000 $9,782,000 $5,822,000 $3,512,000
Minus: Change in Net Working
Capital
$100,000 $1,900,000 $500,000 $500,000 ($1,250,000) ($1,750,000)
Minus: Change in Capital Spending $7,000,000 $0 $0 $0 $0 $0
Free Cash Flow: ($7,100,000 ) $4,714,000 $7,698,000 $9,282,000 $7,072,000 $5,262,000
NPV $15,582,572.99
2
6
5
PI
3.19
IRR
85%
Should accept project.
405
10-14A.(a) NPV
A
=
( )
1
10 . 0 1
700 $
+
- $500
= $636.30 - $500
= $136.30
NPV
B
=
( )
1
10 . 0 1
000 , 6 $
+
- $5,000
= $5,454 - $5,000
= $454
(b) PI
A
=
00 . 500 $
30 . 636 $
= 1.2726
PI
B
=
000 , 5 $
454 , 5 $
= 1.0908
(c) $500 = $700 [PVIF
IRR%,1 yr
]
0.714 = PVIF
IRR%,1 yr
Thus, IRR
A
= 40%
$5,000 = $6,000 [PVIF
IRR%,1 yr
]
0.833 = [PVIF
IRR%,1 yr
]
Thus, IRR
B
= 20%
(d) If there is no capital rationing, project B should be accepted because it has a
larger net present value. If there is a capital constraint, the problem then
focuses on what can be done with the additional $4,500 freed up if project A is
chosen. If Dorner Farms can earn more on project A, plus the project financed
with the additional $4,500, than it can on project B, then project A and the
marginal project should be accepted.
10-15A.(a) Payback A = 3.2 years
Payback B = 4.5 years
B assumes even cash flow throughout year 5.
(b) NPV
A
=
t
5
1 t 0.10) (1
$15,625

+

·
- $50,000
= $15,625 (3.791) - $50,000
= $59,234 - $50,000
= $9,234
406
NPV
B
=
5
) 10 . 0 1 (
000 , 000 , 1 $
+
- $50,000
= $100,000 (0.621) - $50,000
= $62,100 - $50,000
= $12,100
(c) $50,000 = $15,625 [PVIFA
IRR
A
%,5 yrs
]
3.2 = PVIFA
IRR%,5 yrs
Thus, IRR
A
= 17%
$50,000 = $100,000 [PVIF
IRR
B
%,5 yrs
]
.50 = PVIF
IRR
B
%,5 yrs
Thus, IRR
B
= 15%
(d) The conflicting rankings are caused by the differing reinvestment assumptions
made by the NPV and IRR decision criteria. The NPV criterion assumes that
cash flows over the life of the project can be reinvested at the required rate of
return or cost of capital, while the IRR criterion implicitly assumes that the cash
flows over the life of the project can be reinvested at the internal rate of return.
(e) Project B should be taken because it has the largest NPV. The NPV criterion is
preferred because it makes the most acceptable assumption for the wealth
maximizing firm.
10-16A.
(a) Payback A = 1.589 years
Payback B = 3.019 years
(b) NPV
A
=
t
3
1 t 0.15) (1
$12,590

+

·
- $20,000
= $12,590 (2.283) - $20,000
= $28,743 - $20,000
= $8,743
NPV
B
=
t
9
1 t
0.15) (1
$6,625

+

·
- $20,000
= $6,625 (4.772) - $20,000
= $31,615 - $20,000
= $11,615
407
(c) $20,000 = $12,590 [PVIFA
IRR
A
%,3 yrs
]
Thus, IRR
A
= 40%
$20,000 = $6,625 [PVIFA
IRR
B
%,9 yrs
]
Thus, IRR
B
= 30%
(d) These projects are not comparable because future profitable investment
proposals are affected by the decision currently being made. If project A is
taken, at its termination the firm could replace the machine and receive
additional benefits while acceptance of project B would exclude this possibility.
(e) Using 3 replacement chains, project A's cash flows would become:
Year Cash flow
0 -$20,000
1 12,590
2 12,590
3 - 7,410
4 12,590
5 12,590
6 - 7,410
7 12,590
8 12,590
9 12,590
NPV
A
=
t
9
1 t 0.15) (1
$12,590

+

·
- $20,000 -
6 3
) 15 . 0 1 (
000 , 20 $

) 15 . 0 1 (
000 , 20 $
+

+
= $12,590(4.772) - $20,000 - $20,000 (0.658) - $20,000 (0.432)
= $60,079 - $20,000 - $13,160 - $8,640
= $18,279
The replacement chain analysis indicated that project A should be selected as the
replacement chain associated with it has a larger NPV than project B.
Project A's EAA:
Step 1: Calculate the project's NPV (from part b):
NPV
A
= $8,743
Step 2: Calculate the EAA:
EAA
A
= NPV / PVIFA
15%, 3 yr.
= $8,743 / 2.283
= $3,830
Project B's EAA:
408
Step 1: Calculate the project's NPV (from part b):
NPV
B
= $11,615
Step 2: Calculate the EAA:
EAA
B
= NPV / PVIFA
15%, 9 yr.
= $11,615 / 4.772
= $2,434
Project A should be selected because it has a higher EAA.
10-17A.(a) Project A's EAA:
Step1: Calculate the project's NPV:
NPV
A
= $20,000 (PVIFA
10%, 7 yr.
) - $50,000
= $20,000 (4.868) - $50,000
= $97,360 - $50,000
= $47,360
Step 2: Calculate the EAA:
EAA
A
= NPV / PVIFA
10%, 7 yr.
= $47,360 / 4.868
= $9,729
Project B's EAA:
Step 1: Calculate the project's NPV:
NPV
B
= $36,000 (PVIFA
10%, 3 yr.
) - $50,000
= $36,000 (2.487) - $50,000
= $89,532 - $50,000
= $39,532
Step 2: Calculate the EAA:
EAA
B
= NPV / PVIFA
10%, 3 yr.
= $39,532 / 2.487
= $15,895
Project B should be selected because it has a higher EAA.
(b) NPV

,A
= $9,729 / .10
= $97,290
NPV

,B
= $15,895 / .10
409
= $158,950
410
10-18A.(a)
Present Value
Profitability of Future
Project Cost Index Cash Flows NPV
A $4,000,000 1.18 $4,720,000 $ 720,000
B 3,000,000 1.08 3,240,000 240,000
C 5,000,000 1.33 6,650,000 1,650,000
D 6,000,000 1.31 7,860,000 1,860,000
E 4,000,000 1.19 4,760,000 760,000
F 6,000,000 1.20 7,200,000 1,200,000
G 4,000,000 1.18 4,720,000 720,000
COMBINATIONS WITH TOTAL COSTS BELOW $12,000,000
Projects Costs NPV
A&B $ 7,000,000 $ 960,000
A&C 9,000,000 2,370,000
A&D 10,000,000 2,580,000
A&E 8,000,000 1,480,000
A&F 10,000,000 1,920,000
A&G 8,000,000 1,440,000
B&C 8,000,000 1,890,000
B&D 9,000,000 2,100,000
B&E 7,000,000 1,000,000
B&F 9,000,000 1,440,000
B&G 7,000,000 960,000
C&D 11,000,000 3,510,000
C&E 9,000,000 2,410,000
C&F 11,000,000 2,850,000
C&G 9,000,000 2,370,000
D&E 10,000,000 2,620,000
D&F 12,000,000 3,060,000
D&G 10,000,000 2,580,000
E&F 10,000,000 1,960,000
E&G 8,000,000 1,480,000
F&G 10,000,000 1,920,000
A&B&C 12,000,000 2,610,000
A&B&G 11,000,000 1,680,000
A&B&E 11,000,000 1,720,000
A&E&G 12,000,000 2,200,000
B&C&E 12,000,000 2,650,000
B&C&G 12,000,000 2,610,000
Thus projects C&D should be selected under strict capital rationing as they provide the
combination of projects with the highest net present value.
(b) Because capital rationing forces the rejection of profitable projects it is not an
optimal strategy.
411
SOLUTION TO INTEGRATIVE PROBLEMS
1. We focus on free cash flows rather than accounting profits because these are the flows
that the firm receives and can reinvest. Only by examining cash flows are we able to
correctly analyze the timing of the benefit or cost. Also, we are only interested in these
cash flows on an after tax basis as only those flows are available to the shareholder. In
addition, it is only the incremental cash flows that interest us, because, looking at the
project from the point of the company as a whole, the incremental cash flows are the
marginal benefits from the project and, as such, are the increased value to the firm from
accepting the project.
2. Although depreciation is not a cash flow item, it does affect the level of the differential
cash flows over the project's life because of its effect on taxes. Depreciation is an
expense item and, the more depreciation incurred, the larger are expenses. Thus,
accounting profits become lower and in turn, so do taxes which are a cash flow item.
3. When evaluating a capital budgeting proposal, sunk costs are ignored. We are
interested in only the incremental after-tax cash flows, or free cash flows, to the
company as a whole. Regardless of the decision made on the investment at hand, the
sunk costs will have already occurred, which means these are not incremental cash
flows. Hence, they are irrelevant.
412
Solution to Integrative Problem, parts 4, 5, & 6.
Section I. Calculate the change in EBIT, Taxes, and Depreciation (this become an input in the calculation of Operating Cash Flow in Section II).
Year 0 1 2 3 4 5
Units Sold 70,000 120,000 140,000 80,000 60,000
Sale Price $300 $300 $300 $300 $260
Sales Revenue $21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000
Less: Variable Costs 12,600,000 21,600,000 25,200,000 14,400,000 10,800,000
Less: Fixed Costs $200,000 $200,000 $200,000 $200,000 $200,000
Equals: EBDIT $8,200,000 $14,200,000 $16,600,000 $9,400,000 $4,600,000
Less: Depreciation $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000
Equals: EBIT $6,600,000 $12,600,000 $15,000,000 $7,800,000 $3,000,000
Taxes (@34%) $2,244,000 $4,284,000 $5,100,000 $2,652,000 $1,020,000
Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV).
Operating Cash Flow:
EBIT $6,600,000 $12,600,000 $15,000,000 $7,800,000 $3,000,000
Minus: Taxes $2,244,000 $4,284,000 $5,100,000 $2,652,000 $1,020,000
Plus: Depreciation $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000
Equals: Operating Cash Flow $5,956,000 $9,916,000 $11,500,000 $6,748,000 $3,580,000
Section III. Calculate the Net Working Capital (This becomes an input in the calculation of Free Cash Flows in Section IV).
Change In Net Working Capital:
Revenue: $21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000
Initial Working Capital Requirement $100,000
Net Working Capital Needs: $2,100,000 $3,600,000 $4,200,000 $2,400,000 $1,560,000
Liquidation of Working Capital $1,560,000
Change in Working Capital: $100,000 $2,000,000 $1,500,000 $600,000 ($1,800,000) ($2,400,000)
Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending).
Free Cash Flow:
Operating Cash Flow $5,956,000 $9,916,000 $11,500,000 $6748,000 $3,580,000
Minus: Change in Net Working Capital $100,000 $2,000,000 $1,500,000 $600,000 ($1,800,000) ($2,400,000)
Minus: Change in Capital Spending $8,000,000 0 $0 0 0 0
Free Cash Flow: ($8,100,000 ) $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000
NPV = $16,731,095.66
2
7
2
IRR = 77%
414
7. Cash flow diagram
$3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,000
($8,100,000)
8. NPV = $16,731,095.66
9. IRR = 77%
10. Yes. This project should be accepted because the NPV ≥ 0. and the IRR ≥ required rate of
return.
11. a. NPV
A
=
1
) 10 . 0 1 (
000 , 240 $
+
- $195,000
= $218,182 - $195,000
= $23,182
NPV
B
=
1
) 10 . 0 1 (
000 , 650 , 1 $
+
- $1,200,000
= $1,500,000 - $1,200,000
= $300,000
b. PI
A
=
000 , 195 $
182 , 218 $
= 1.1189
PI
B
=
000 , 200 , 1 $
000 , 500 , 1 $
= 1.25
c. $195,000 = $240,000 [PVIF
IRR
A
%,1 yr
]
0.8125 = PVIF
IRR
A
%,1 yr
Thus, IRR
A
= 23%
415
$1,200,000 = $1,650,000 [PVIF
IRR
B
%,1 yr
]
0.7273 = [PVIF
IRR
B
%,1 yr
]
Thus, IRR
B
= 37.5%
d. If there is no capital rationing, project B should be accepted because it has a
larger net present value. If there is a capital constraint, the problem then
focuses on what can be done with the additional $1,005,000 freed up if project
A is chosen. If Caledonia can earn more on project A, plus the project financed
with the additional $1,005,000, than it can on project B, then project A and the
marginal project should be accepted.
12. a. Payback A = 3.125 years
Payback B = 4.5 years
B assumes even cash flow throughout year 5.
b. NPV
A
=
t
5
1 t 0.11) (1
$32,000

+

·
- $100,000
= $32,000 (3.696) - $100,000
= $118,272 - $100,000
= $18,272
NPV
B
=
5
) 11 . 0 1 (
000 , 200 $
+
- $100,000
= $200,000 (0.593) - $100,000
= $118,600 - $100,000
= $18,600
c. $100,000 = $32,000 [PVIFA
IRR
A
%,5 yrs
]
3.125 = PVIFA
IRR
A
%,5 yrs
Thus, IRR
A
= 18.03%
$100,000 = $200,000 [PVIF
IRR
B
%,5 yrs
]
.50 = PVIF
IRR
B
%,5 yrs
Thus IRR
B
is just under 15% (14.87%).
416
d. The conflicting rankings are caused by the differing reinvestment assumptions
made by the NPV and IRR decision criteria. The NPV criterion assume that
cash flows over the life of the project can be reinvested at the required rate of
return or cost of capital, while the IRR criterion implicitly assumes that the cash
flows over the life of the project can be reinvested at the internal rate of return.
e. Project B should be taken because it has the largest NPV. The NPV criterion is
preferred because it makes the most acceptable assumption for the wealth
maximizing firm.
13. a. Payback A = 1.5385 years
Payback B = 3.0769 years
b. NPV
A
=
t
3
1 t 0.14) (1
$65,000

+

·
- $100,000
= $65,000 (2.322) - $100,000
= $150,930 - $100,000
= $50,930
NPV
B
=
t
9
1 t 0.14) (1
$32,500

+

·
- $100,000
= $32,500 (4.946) - $100,000
= $160,745 - $100,000
= $60,745
c. $100,000 = $65,000 [PVIFA
IRR
A
%,3 yrs
]
Thus, IRR
A
= over 40% (42.57%)
$100,000 = $32,500 [PVIFA
IRR
B
%,9 yrs
]
Thus, IRR
B
= 29%
d. These projects are not comparable because future profitable investment
proposals are affected by the decision currently being made. If project A is
taken, at its termination the firm could replace the machine and receive
additional benefits while acceptance of project B would exclude this possibility.
417
e. Using 3 replacement chains, project A's cash flows would become:
Year Cash flow
0 -$100,000
1 65,000
2 65,000
3 -35,000
4 65,000
5 65,000
6 - 35,000
7 65,000
8 65,000
9 65,000
NPV
A
=
t
9
1 t 0.14) (1
$65,000

+

·
- $100,000 -
6 3
) 14 . 0 1 (
000 , 100 $

) 14 . 0 1 (
000 , 100 $
+

+
= $65,000(4.946) - $100,000 - $100,000 (0.675)
- $100,000 (0.456)
= $321,490 - $100,000 - $67,500 - $45,600
= $108,390
The replacement chain analysis indicated that project A should be selected as the
replacement chain associated with it has a larger NPV than project B.
Project A's EAA:
Step 1: Calculate the project's NPV (from part b):
NPV
A
= $50,930
Step 2: Calculate the EAA:
EAA
A
= NPV / PVIFA
14%, 3 yr.
= $50,930/ 2.322
= $21,934
Project B's EAA:
Step 1: Calculate the project's NPV (from part b):
NPV
B
= $60,745
Step 2: Calculate the EAA:
EAA
B
= NPV / PVIFA
14%, 9 yr.
= $60,745 / 4.946
418
= $12,282
Project A should be selected because it has a higher EAA.
Solutions to Problem Set B
10-1B.
(a) Tax payments associated with the sale for $45,000:
Recapture of depreciation
= ($45,000-$20,000) (0.34) = $8,500
(b) Tax payments associated with sale for $40,000:
Recapture of depreciation
= ($40,000-$20,000) (0.34) = $6,800
(c) No taxes, because the machine would have been sold for its book value.
(d) Tax savings from sale below book value:
Tax savings
= ($20,000-$17,000) (0.34) = $1,020
10-2B.
New Sales $100,000,000
Less: Sales taken from
existing product lines - 40,000,000
$60,000,000
10-3B.
Change in net working capital equals the increase in accounts receivable and inventory
less the increase in accounts payable = $34,000 + $80,000 - $50,000 = $64,000.
The change in taxes will be EBIT X marginal tax rate = $775,000 X .34 = $263,500.
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $775,000
- $263,500
+ $200,000
- $64,000
- $0
= $647,500
419
10-4B.
Change in net working capital equals the decrease in accounts receivable, the increase
in inventory less the increase in accounts payable = -$10,000 + $15,000 - $36,000 = -
$31,000.
The change in taxes will be EBIT X marginal tax rate = $300,000 X .34 = $102,000.
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $300,000
- $102,000
+ $50,000
- ($31,000)
- $0
= $279,000
10-5B.
(a) Initial Outlay
Outflows:
Purchase price $ 250,000
Installation Fee 10,000
Increased Working Capital Inventory 15,000
Net Initial Outlay $275,000
(b) Differential annual free cash flows (years 1-9)
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $70,000
- $23,800
+ $26,000*
- $0
- $0
= $72,200
*Annual Depreciation on the new machine is calculated by taking the purchase price
($250,000) and adding in costs necessary to get the new machine in operating order
420
(the installation fee of $10,000) and dividing by the expected life.
(c) Terminal Free Cash flow (year 10)
Inflows:
Differential free cash flow in year 10 $72,200
Recapture of working capital (inventory) 15,000
Total terminal cash flow $87,200
(d) NPV = $72,200 (PVIFA
15%,9 yr.
) + $87,200 (PVIF
15%, 10 yr.
)
- $275,000
= $72,200 (4.772) + $87,200 (.247) - $275,000
= $344,538.40 + $21,538.40 - $275,000
= $91,076.80
Yes, the NPV > 0.
10-6B.
(a) Initial Outlay
Outflows:
Purchase price $ 1,000,000
Installation Fee 50,000
Training Session Fee 100,000
Increased Inventory 150,000
Net Initial Outlay $ 1,300,000
(b) Differential annual free cash flows (years 1-9)
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $400,000
- $136,000
+ $105,000*
- $0
- $0
= $369,000
*Annual Depreciation on the new machine is calculated by taking the purchase price
($1,000,000) and adding in costs necessary to get the new machine in operating order
(the installation fee of $50,000) and dividing by the expected life.
421
(c) Terminal Free Cash flow (year 10)
Inflows:
Differential flow in year 10 $369,000
Recapture of working capital (inventory) 150,000
Total terminal cash flow $519,000
(d) NPV = $369,000 (PVIFA
12%,9 yr.
) + $519,000 (PVIF
12%, 10 yr.
)
- $1,300,000
= $369,000 (5.328) + $519,000 (.322) - $1,300,000
= $1,966,032 + $167,118 - $1,300,000
= $833,150
Yes, the NPV > 0.
10-7B. (a) Initial Outlay
Outflows:
Purchase price $ 100,000
Installation Fee 5,000
Training Session Fee 5,000
Increased Inventory 25,000
Net Initial Outlay $ 135,000
(b) Differential annual free cash flows (years 1-9)
A project’s free cash flows =
Change in earnings before interest and taxes
- change in taxes
+ change in depreciation
- change in net working capital
- change in capital spending
= $25,000
- $8,500
+ $10,500*
- $0
- $0
= $27,000
*Annual Depreciation on the new machine is calculated by taking the purchase price
($100,000) and adding in costs necessary to get the new machine in operating order
(the installation fee of $5,000) and dividing by the expected life.
422
(c) Terminal Free Cash flow (year 10)
Inflows:
Differential flow in year 10 $27,000
Recapture of working capital (inventory) 25,000
Total terminal cash flow $52,000
(d) NPV = $27,000 (PVIFA
12%,9 yr.
) + $52,000 (PVIF
12%, 10 yr.
)
- $135,000
= $27,000 (5.328) + $52,000 (.322) - $135,000
= $143,856 + $16,744 - $135,000
= $25,600
Yes, the NPV > 0.
423
10-8B
Section I. Calculate the change in EBIT, Taxes, and Depreciation (this becomes an input in the calculation of Operating Cash Flow in Section II).
Year 0 1 2 3 4 5
Units Sold 1,000,000 1,800,000 1,800,000 1,200,000 700,000
Sale Price $800 $800 $800 $800 $600
Sales Revenue $800,000,000 $1,440,000,000 $1,440,000,000 $960,000,000 $420,000,000
Less: Variable Costs 400,000,000 720,000,000 720,000,000 480,000,000 280,000,000
Less: Fixed Costs $10,000,000 $10,000,000 $10,000,000 $10,000,000 $10,000,000
Equals: EBDIT $390,000,000 $710,000,000 $710,000,000 $470,000,000 $130,000,000
Less: Depreciation $40,000,000 $40,000,000 $40,000,000 $40,000,000 $40,000,000
Equals: EBIT $350,000,000 $670,000,000 $670,000,000 $430,000,000 $90,000,000
Taxes (@34%) $119,000,000 $227,800,000 $227,800,000 $146,200,000 $30,600,000
Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV).
Operating Cash Flow:
EBIT $350,000,000 $670,000,000 $670,000,000 $430,000,000 $90,000,000
Minus: Taxes $119,000,000 $227,800,000 $227,800,000 $146,200,000 $30,600,000
Plus: Depreciation $40,000,000 $40,000,000 $40,000,000 $40,000,000 $40,000,000
Equals: Operating Cash Flow $271,000,000 $482,200,000 $482,200,000 $323,800,000 $99,400,000
Section III. Calculate the Net Working Capital (this becomes an input in the calculation of Free Cash Flows in Section IV)
Change in Net Working Capital:
Revenue: $800,000,000 $1,440,000,000 $1,440,000,000 $960,000,000 $420,000,000
Initial Working Capital Requirement $2,000,000
Net Working Capital Needs: $80,000,000 $144,000,000 $144,000,000 $96,000,000 $42,000,000
Liquidation of Working Capital $42,000,000
Change in Working Capital: $2,000,000 $78,000,000 $64,000,000 $0 ($48,000,000) ($96,000,000)
Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending).
Free Cash Flow:
Operating Cash Flow $271,000,000 $482,200,000 $482,200,000 $323,800,000 $99,400,000
Minus: Change in Net Working Capital $2,000,000 $78,000,000 $64,000,000 $0 ($48,000,000) ($96,000,000)
Minus: Change in Capital Spending $200,000,000 $0 $0 $0 $0 $0
Free Cash Flow: ($202,000,000 ) $193,000,000 $418,200,000 $482,200,000 $371,800,000 $195,400,000
NPV $908,825,886.69
PI 5.5
2
8
2
IRR 140%
Accept project
425
10-9B
Section I. Calculate the change in EBIT, Taxes, and Depreciation (this becomes an input in the calculation of Operating Cash Flow in Section II).
Year 0 1 2 3 4 5
Units Sold 70,000 100,000 140,000 70,000 60,000
Sale Price $280 $280 $280 $280 $180
Sales Revenue $19,600,000 $28,000,000 $39,200,000 $19,600,000 $10,800,000
Less: Variable Costs 9,800,000 14,000,000 19,600,000 9,800,000 8,400,000
Less: Fixed Costs $300,000 $300,000 $300,000 $300,000 $300,000
Equals: EBDIT $9,500,000 $13,700,000 $19,300,000 $9,500,000 $2,100,000
Less: Depreciation $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000
Equals: EBIT $7,500,000 $111,700,000 $17,300,000 $7,500,000 $100,000
Taxes (@34%) $2,550,000 $3,978,600 $5,882,000 $2,550,000 $34,000
Section II. Calculate Operating Cash Flow (this becomes an input in the calculation of Free Cash Flow in Section IV).
Operating Cash Flow:
EBIT $7,500,000 $11,700,000 $17,300,000 $7,500,000 $100,000
Minus: Taxes $2,550,600 $3,978,600 $5,882,000 $3,107,600 $34,000
Plus: Depreciation $2,000,000 $2,000,000 $2,000,000 $2,000,000 $2,000,000
Equals: Operating Cash Flow $6,950,400 $9,722,400 $13,418,000 $6,950,000 $2,066,000
Section III. Calculate the Net Working Capital (this becomes an input in the calculation of Free Cash Flows in Section IV)
Change in Net Working Capital:
Revenue: $19,600,000 $28,000,000 $39,200,000 $19,600,000 $10,800,000
Initial Working Capital Requirement $100,000
Net Working Capital Needs: $1,960,000 $2,800,000 $3,920,000 $1,960,000 $1,080,000
Liquidation of Working Capital $1,080,000
Change in Working Capital: $100,000 $1,860,000 $840,800 $1,120,000 ($1,960,000) ($1,960,000)
Section IV. Calculate Free Cash Flow (using information calculated in Sections II and III, in addition to the Change in Capital Spending).
Free Cash Flow:
Operating Cash Flow $6,950,000 $9,722,400 $13,418,000 $6,950,400 $2,066,000
Minus: Change in Net Working Capital $100,000 $1,860,000 $840,000 $1,120,000 ($1,960,000) ($1,960,000)
Minus: Change in Capital Spending $10,000,000 $0 $0 $0 $0 $0
Free Cash Flow: ($10,100,000 ) $5,090,400 $8,882,400 $12,298,400 $8,910,400 $4,026,000
NPV $16,232,618
PI 2.6
2
8
3
IRR 68.6%
Accept project
427
10-10B.
(a) NPV
A
=
1
) 10 . 0 1 (
800 $
+
- $650
= $727.20 - $650
= $77.20
NPV
B
=
1
) 10 . 0 1 (
500 , 5 $
+
- $4,000
= $5,000 - $4,000
= $1,000
(b) PI
A
=
00 . 650 $
20 . 727 $
= 1.1188
PI
B
=
000 , 4 $
000 , 5 $
= 1.25
(c) $650 = $800 [PVIF
IRR
A
%,1 yr
]
0.8125 = PVIF
IRR
A
%,1 yr
Thus, IRR
A
= 23%
$4,000 = $5,500 [PVIF
IRR
B
%,1 yr
]
0.7273 = [PVIF
IRR
B
%,1 yr
]
Thus, IRR
B
= 37.5%
(d) If there is no capital rationing, project B should be accepted because it has a
larger net present value. If there is a capital constraint, the problem then
focuses on what can be done with the additional $3,350 freed up if project A
is chosen. If Unk's Farms can earn more on project A, plus the project
financed with the additional $3,350, than it can on project B, then project A
and the marginal project should be accepted.
34
10-11B.
(a) Payback A = 3.125 years
Payback B = 4.5 years
B assumes even cash flow throughout year 5.
(b) NPV
A
=
t
5
1 t 0.11) (1
$16,000

+

·
- $50,000
= $16,000 (3.696) - $50,000
= $59,136 - $50,000
= $9,136
NPV
B
=
5
) 11 . 0 1 (
000 , 100 $
+
- $50,000
= $100,000 (0.593) - $50,000
= $59,300 - $50,000
= $9,300
(c) $50,000 = $16,000 [PVIFA
IRR
A
%,5 yrs
]
3.125 = PVIFA
IRR
A
%,5 yrs
Thus, IRR
A
= 18%
$50,000 = $100,000 [PVIF
IRR
B
%,5 yrs
]
.50 = PVIF
IRR
B
%,5 yrs
Thus IRR
B
is just under 15%.
(d) The conflicting rankings are caused by the differing reinvestment
assumptions made by the NPV and IRR decision criteria. The NPV criterion
assume that cash flows over the life of the project can be reinvested at the
required rate of return or cost of capital, while the IRR criterion implicitly
assumes that the cash flows over the life of the project can be reinvested at
the internal rate of return.
(e) Project B should be taken because it has the largest NPV. The NPV criterion
is preferred because it makes the most acceptable assumption for the wealth
maximizing firm.
35
10-12B.
(a) Payback A = 1.5385 years
Payback B = 3.0769 years
(b) NPV
A
=
t
3
1 t 0.14) (1
$13,000

+

·
- $20,000
= $13,000 (2.322) - $20,000
= $30,186 - $20,000
= $10,186
NPV
B
=
t
9
1 t 0.14) (1
$6,500

+

·
- $20,000
= $6,500 (4.946) - $20,000
= $32,149 - $20,000
= $12,149
(c) $20,000 = $13,000 [PVIFA
IRR
A
%,3 yrs
]
Thus, IRR
A
= over 40% (42.57%)
$20,000 = $6,500 [PVIFA
IRR
B
%,9 yrs
]
Thus, IRR
B
= 29.3%
(d) These projects are not comparable because future profitable investment
proposals are affected by the decision currently being made. If project A is
taken, at its termination the firm could replace the machine and receive
additional benefits while acceptance of project B would exclude this
possibility.
(e) Using 3 replacement chains, project A's cash flows would become:
Year Cash flow
0 -$20,000
1 13,000
2 13,000
3 - 7,000
4 13,000
5 13,000
6 - 7,000
7 13,000
8 13,000
9 13,000
36
NPV
A
=
t
9
1 t 0.14) (1
$13,000

+

·
- $20,000 -
6 3
) 14 . 0 1 (
000 , 20 $

) 14 . 0 1 (
000 , 20 $
+

+
= $13,000(4.946) - $20,000 - $20,000 (0.675)
- $20,000 (0.456)
= $64,298 - $20,000 - $13,500 - $9,120
= $21,678
The replacement chain analysis indicated that project A should be selected as the
replacement chain associated with it has a larger NPV than project B.
Project A's EAA:
Step 1: Calculate the project's NPV (from part b):
NPV
A
= $10,186
Step 2: Calculate the EAA:
EAA
A
= NPV / PVIFA
14%, 3 yr.
= $10,186 / 2.322
= $4,387
Project B's EAA:
Step 1: Calculate the project's NPV (from part b):
NPV
B
= $12,149
Step 2: Calculate the EAA:
EAA
B
= NPV / PVIFA
14%, 9 yr.
= $12,149 / 4.946
= $2,456
Project A should be selected because it has a higher EAA.
37
10-13B.
(a) Project A's EAA:
Step 1: Calculate the project's NPV:
NPV
A
= $20,000 (PVIFA
10%, 7 yr.
) - $40,000
= $20,000 (4.868) - $40,000
= $97,360 - $40,000
= $57,360
Step 2: Calculate the EAA:
EAA
A
= NPV / PVIFA
10%, 7 yr.
= $57,360 / 4.868
= $11,783
Project B's EAA:
Step 1: Calculate the project's NPV:
NPV
B
= $25,000 (PVIFA
10%, 5 yr.
) - $40,000
= $25,000 (3.791) - $40,000
= $94,775 - $40,000
= $54,775
Step 2: Calculate the EAA:
EAA
B
= NPV / PVIFA
10%, 5 yr.
= $54,775 / 3.791
= $14,449
Project B should be selected because it has a higher EAA.
(b) NPV

,A
= $11,783 / .10
= $117,830
NPV

,B
= $14,449 / .10
= $144,490
38
10-14B.
(a)
Present Value
Profitability of Future
Project Cost Index Cash Flows NPV
A $4,000,000 1.18 $4,720,000 $ 720,000
B 3,000,000 1.08 3,240,000 240,000
C 5,000,000 1.33 6,650,000 1,650,000
D 6,000,000 1.31 7,860,000 1,860,000
E 4,000,000 1.19 4,760,000 760,000
F 6,000,000 1.20 7,200,000 1,200,000
G 4,000,000 1.18 4,720,000 720,000
COMBINATIONS WITH TOTAL COSTS BELOW $12,000,000
Projects Costs NPV
A&B $ 7,000,000 $ 960,000
A&C 9,000,000 2,370,000
A&D 10,000,000 2,580,000
A&E 8,000,000 1,480,000
A&F 10,000,000 1,920,000
A&G 8,000,000 1,440,000
B&C 8,000,000 1,890,000
B&D 9,000,000 2,100,000
B&E 7,000,000 1,000,000
B&F 9,000,000 1,440,000
B&G 7,000,000 960,000
C&D 11,000,000 3,510,000
C&E 9,000,000 2,410,000
C&F 11,000,000 2,850,000
C&G 9,000,000 2,370,000
D&E 10,000,000 2,620,000
D&F 12,000,000 3,060,000
D&G 10,000,000 2,580,000
E&F 10,000,000 1,960,000
E&G 8,000,000 1,480,000
F&G 10,000,000 1,920,000
A&B&C 12,000,000 2,610,000
A&B&E 11,000,000 1,720,000
A&B&G 11,000,000 1,680,000
A&E&G 12,000,000 2,200,000
B&C&E 12,000,000 2,650,000
B&C&G 12,000,000 2,610,000
Thus projects C&D should be selected under strict capital rationing as they provide
the combination of projects with the highest net present value.
(b) Because capital rationing forces the rejection of profitable projects it is not an
optimal strategy.
39

40
CHAPTER 11
Capital Budgeting
and Risk Analysis

CHAPTER ORIENTATION
The focus of this chapter will be on how to adjust for the riskiness of a given project or
combination of projects.
CHAPTER OUTLINE
I. Risk and the investment decision
A. Up to this point we have treated the expected cash flows resulting from an
investment proposal as being known with perfect certainty. We will now
introduce risk.
B. The riskiness of an investment project is defined as the variability of its cash
flows from the expected cash flow.
II. What measure of risk is relevant in capital budgeting?
A. In capital budgeting, a project can be looked at on three levels.
1. First, there is the project standing alone risk, which is a project’s risk
ignoring the fact that much of this risk will be diversified away as the
project is combined with the firm’s other projects and assets.
2. Second, we have the project’s contribution-to-firm risk, which is the
amount of risk that the project contributes to the firm as a whole; this
measure considers the fact that some of the project’s risk will be
diversified away as the project is combined with the firm’s other
projects and assets, but ignores the effects of diversification of the
firm’s shareholders.
3. Finally, there is systematic risk, which is the risk of the project from
the viewpoint of a well-diversified shareholder; this measure
considers the fact that some of a project’s risk will be diversified
away as the project is combined with the firm’s other projects, and, in
addition, some of the remaining risk will be diversified away by
shareholders as they combine this stock with other stocks in their
portfolio.
41
B. Because of bankruptcy costs and the practical difficulties involved in
measuring a project’s level of systematic risk, we will give consideration to
the project’s contribution-to-firm risk and the project’s systematic risk.
III. Methods for incorporating risk into capital budgeting
A. The certainty equivalent approach involves a direct attempt to allow the
decision maker to incorporate his or her utility function into the analysis.
1. In effect, a riskless set of cash flows is substituted for the original set
of risky cash flows, between which the financial manager is
indifferent.
2. To simplify calculations, certainty equivalent coefficients (
t
's) are
defined as the ratio of the certain outcome to the risky outcome
between which the financial manager is indifferent.
3. Mathematically, certainty equivalent coefficients can be defined as
follows:
α
t
=
t
t
flow cash risky
flow cash certain
4. The appropriate certainty equivalent coefficient is multiplied by the
original cash flow (which is the risky cash flow) with this product
being equal to the equivalent certain cash flow.
5. Once risk is taken out of the cash flows, those cash flows are
discounted back to present at the risk-free rate of interest and the
project's net present value or profitability index is determined.
6. If the internal rate of return is calculated, it is then compared with the
risk-free rate of interest rather than the firm's required rate of return.
7. Mathematically, the certainty equivalent approach can be summarized
as follows:
NPV =

·
+
n
1 t
t
rf
t
) k (1
FCF

t
α
- IO
where α
t
= the certainty equivalent coefficient for time
period t
FCF
t
= the annual expected free cash flow in time period
t
IO = the initial cash outlay
n = the project's expected life
k
rf
= the risk-free interest rate
42
B. The use of the risk-adjusted discount rate is based on the concept that
investors demand higher returns for more risky projects.
1. If the risk associated with the investment is greater than the risk
involved in a typical endeavor, then the discount rate is adjusted
upward to compensate for this risk.
2. The expected cash flows are then discounted back to present at the
risk-adjusted discount rate. Then the normal capital budgeting criteria
are applied, except in the case of the internal rate of return, in which
case the hurdle rate to which the project's internal rate of return is
compared now becomes the risk-adjusted discount rate.
3. Expressed mathematically, the net present value using the risk-
adjusted discount rate becomes
NPV = ∑
·
+
n
1 t
t
t
k*) (1
FCF

- IO
where FCF
t
= the annual expected free cash flow in time period
t
IO = the initial outlay
k* = the risk-adjusted discount rate
n = the project's expected life
IV. Methods for measuring a project's systematic risk
A. Theoretically, we know that systematic risk is the "priced" risk, and thus, the
risk that affects the stock's market price and thus the appropriate risk with
which to be concerned. However, if there are bankruptcy costs (which are
assumed away by the CAPM), if there are undiversified shareholders who are
concerned with more than just systematic risk, if there are factors that affect a
security's price beyond what the CAPM suggests, or if we are unable to
confidently measure the project's systematic risk, then the project's individual
risk carries relevance. Moreover, in general, a project's individual risk is
highly correlated with the project's systematic risk, making it a reasonable
proxy to use.
B. In spite of problems in confidently measuring an individual firm's level of
systematic risk, if the project appears to be a typical one for the firm, then
using the CAPM to determine the appropriate risk return tradeoffs and then
judging the project against them may be a warranted approach.
C. If the project is not a typical project, we are without historical data and must
either estimate the beta using accounting data or use the pure-play method for
estimating beta.
1. Using historical accounting data to substitute for historical price data
in estimating systematic risk: To estimate a project's beta using
accounting data we need only run a time series regression of the
43
division's return on assets on the market index. The regression
coefficient from this equation would be the project's accounting beta
and serves as an approximation for the project's true beta.
2. The pure play method for estimating a project's beta: The pure play
method attempts to find a publicly traded firm in the same industry as
the capital-budgeting project. Once the proxy or pure-play firm is
identified, its systematic risk is determined and then used as a proxy
for the project's systematic risk.
V. Additional approaches for dealing with risk in capital budgeting
A. A simulation imitates the performance of the project being evaluated by
randomly selecting observations from each of the distributions that affect the
outcome of the project, combining those observations to determine the final
output of the project, and continuing with this process until a representative
record of the project's probable outcome is assembled.
1. The firm's management then examines the resultant probability
distribution, and if management considers enough of the distribution
lies above the normal cutoff criterion, it will accept the project.
2. The use of a simulation approach to analyze investment proposals
offers two major advantages:
a. The financial managers are able to examine and base their
decisions on the whole range of possible outcomes rather than
just point estimates.
b. They can undertake subsequent sensitivity analysis of the
project.
B. A probability tree is a graphical exposition of the sequence of possible
outcomes; it presents the decision maker with a schematic representation of
the problem in which all possible outcomes are graphically displayed.
VI. Other sources and measures of risk
A. Many times, especially with the introduction of a new product, the cash flows
experienced in early years affect the size of the cash flows experienced in
later years. This is called time dependence of cash flows, and it has the effect
of increasing the riskiness of the project over time.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
11-1. The payback period method is frequently used as a rough risk screening device to
eliminate projects whose returns do not materialize until later years. In this way, the
earliest returns are emphasized, which in all likelihood have less uncertainty
surrounding them.
44
11-2. The use of the risk-adjusted discount rate assumes that risk increases over time.
When using the risk-adjusted discount rate method, we are adjusting downward the
value of future cash flows that occur later in the future more severely than earlier
ones. This assumption can be justified because flows that are expected further out in
the future are more difficult to forecast and less certain than are flows that are
expected in the near future.
11-3. The primary difference between the certainty equivalent approach and the risk-
adjusted discount rate approach is where the adjustment for risk is incorporated into
the calculations. The certainty equivalent approach penalizes or adjusts downwards
the value of the expected annual free cash flows, while the risk-adjusted discount
rate leaves the cash flows at their expected value and adjusts the required rate of
return, k, upwards to compensate for added risk. In either case the net present value
of the project is being adjusted downwards to compensate for additional risk. An
additional difference between these methods is that the risk-adjusted discount rate
assumes that risk increases over time and that cash flows occurring later in the future
should be more severely penalized. The certainty equivalent method, on the other
hand, allows each cash flow to be treated individually.
11-4. A probability tree is a graphical exposition of the sequence of possible outcomes,
presenting the decision maker with a schematic representation of the problem in
which all possible outcomes are graphically displayed. Moreover, the computations
and results of the computations are shown directly on the tree, so that the information
can be easily understood. Thus the probability tree allows the manager to quickly
visualize the possible future events, their probabilities, and outcomes. In addition,
the calculation of the expected internal rate of return and enumeration of the
distribution should aid the financial manager in his decision-making process.
11-5. The idea behind simulation is to imitate the performance of the project being
evaluated. This is done by randomly selecting observations from each of the
distributions that affect the outcome of the project, combining each of those
observations and determining the final outcome of the project, and continuing with
this process until a representative record of the project's probable outcome is
assembled. In effect, the output from a simulation is a probability distribution of net
present values or internal rates of return for the project. The decision maker then
bases his decision on the full range of possible outcomes.
11-6. The time dependence of cash flows refers to the fact that, many times, cash flows in
later periods are dependent upon the cash flows experienced in earlier periods. For
example, if a new product is introduced and the initial public reaction is poor,
resulting in low initial cash flows, then cash flows in future periods are likely to be
low also. Examples include the introduction of any new products, for example, the
Edsel on the negative side, and hopefully this book on the positive side.
45
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
11-1A. (a) =

·
n
1 i
X
i
P(X
i
)
A
= $4,000 (0.15) + $5,000 (0.70) + $6,000 (0.15)
= $600 + $3,500 + $900
= $5,000
B
= $2,000 (0.15) + $6,000 (0.70) + $10,000 (0.15)
= $300 + $4,200 + $1,500
= $6,000
(b) NPV =
t
t
n
1 t
k*) (1
FCF

+

·
- I0
NPV
A
= $5,000 (3.605) - $10,000
= $18,025 - $10,000
= $8,025
NPV
B
= $6,000 (3.352) - $10,000
= $20,112 - $10,000
= $10,112
(c) One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.
46
11-2A. (a) =

·
n
1 i
X
i
P(X
i
)
A
= $35,000 (0.10) + $40,000 (0.40) + $45,000 (0.40)
+ $50,000 (0.10)
= $3,500 + $16,000 + $18,000 + $5,000
= $42,500
B
= $10,000 (0.10) + $30,000 (0.20) + $45,000 (0.40)
+ $60,000 (0.20) + $80,000 (0.10)
= $1,000 + $6,000 + $18,000 + $12,000 + $8,000
= $45,000
(b) NPV =
t
t
n
1 t
k*) (1
FCF

+

·
- IO
NPV
A
= $42,500 (3.605) - $100,000
= $153,212.50 - $100,000
= $53,212.50
NPV
B
= $45,000 (3.517) - $100,000
= $158,265 - $100,000
= $58,265
(c) One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.
11-3A.
Project A:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) ×


t
) 5% Value
0 -$1,000,000 1.00 -$1,000,000 1.000 -$1,000,000
1 500,000 .95 475,000 .952 452,200
2 700,000 .90 630,000 .907 571,410
3 600,000 .80 480,000 .864 414,720
4 500,000 .70 350,000 .823 288,050
NPV
A
= $ 726,380
47
Project B:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) × ( α
t
) 5% Value
0 -$1,000,000 1.00 -$1,000,000 1.000 -$1,000,000
1 500,000 .90 450,000 .952 428,400
2 600,000 .70 420,000 .907 380,940
3 700,000 .60 420,000 .864 362,880
4 800,000 .50 400,000 .823 329,200
NPV
B
= $ 501,420
Thus, project A should be selected, as it has a higher NPV.
11-4A.
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) × ( α
t
) 7% Value
0 -$90,000 1.00 -$90,000 1.000 -$90,000
1 25,000 0.95 23,750 .935 22,206
2 30,000 0.90 27,000 .873 23,571
3 30,000 0.83 24,900 .816 20,318
4 25,000 0.75 18,750 .763 14,306
5 20,000 0.65 13,000 .713 9,269
NPV = $ -330
Thus, this project should not be accepted because it has a negative NPV.
11-5A.
NPV
A
=
t
t
n
1 t
k*) (1
FCF

+

·
- I0
= $30,000 (.893) + $40,000(.797) + $50,000(.712)
+ $90,000(.636) + $130,000(.567) - $250,000
= $26,790 + $31,880 + $35,600 + $57,240 + $73,710 - $250,000
= - $24,780
NPV
B
=
t
n
1 t
k*) (1
FCF

+

·
- I0
= $135,000(3.127) - $400,000
= $422,145 - $400,000
48
= $22,145
49
11-6A.
Project A:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) × ( α
t
) 6% Value
0 -$ 50,000 1.00 -$ 50,000 1.000 -$ 50,000.00
1 15,000 .95 14,250 .943 13,437.75
2 15,000 .85 12,750 .890 11,347.50
3 15,000 .80 12,000 .840 10,080.00
4 45,000 .70 31,500 .792 24,948.00
NPV
A
= $ 9,813.25
Project B:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) × ( α
t
) 6% Value
0 -$ 50,000 1.00 -$ 50,000 1.000 -$ 50,000.00
1 20,000 .90 18,000 .943 16,974.00
2 25,000 .85 21,250 .890 18,912.50
3 25,000 .80 20,000 .840 16,800.00
4 30,000 .75 22,500 .792 17,820.00
NPV
B
= $ 20,506.50
Thus project B should be selected, as it has a higher NPV
50
Internal Rate
of Return for Joint
0 Year 1 Year 2 Years each Branch Probability (A)(B)
$300,000 -12.95% 0.18 -2.33%
$700,000 10.92% 0.36 3.93%
$1,100,000 29.25% 0.06 1.76%
$400,000 3.15% 0.06 0.19%
$700,000 19.60% 0.15 2.94%
$1,000,000 33.33% 0.06 2.00%
$1,300,000 45.36% 0.03 1.36%
$600,000 23.74% 0.01 0.24%
$900,000 37.77% 0.05 1.89%
$1,100,000 46.08% 0 .04 1 .84%
1.00
Expected internal rate of return = 13 .82%
d. The range of possible IRR’s from –12.95% to 46.08%
1
1
-
7
A
.


(
a


c
)
- $1,200,000
p = 0.6
$850,000
p = 0.3
p = 0.6
p = 0.3
p = 0.2
P = 0.1
p = 0.5
p = 0.2
p = 0.1
p = 0.5
$1,000,000
p = 0.1
p = 0.4
p = 0.1
$700,000
2
9
9
Internal Rate
of Return for Joint
0 Year 1 Year 2 Years 3 Years each Branch Probability (A)(B)
$230,000 130.25% 0.09 11.72%
$180,000 124.68% 0.09 11.22%
$205,000 121.09% 0.15 18.16%
$155,000 114.96% 0.15 17.24%
$180,000 111.30% 0.06 6.68%
$130,000 104.46% 0.06 6.27%]
$10,000 -42.44% 0.24 -10.19%
$0 -90.00% 0 .16 -14 .40%
1.00
Expected internal rate of return = 46 .70%
d. The range of possible IRR’s from –90.00% to 130.25%.
1
1
-
8
A
.


(
a


c
)
$-100,000
p = 0.6 $100,000
$175,000
$150,000
p = 0.5
p = 0.5
p = 0.3
$200,000
p = 0.5
p = 0.5
p = 0.5
p = 0.5
p = 0.5
p = 1.0
p = 0.6
$10,000
p = 1.0
p = 0.4
$0
$10,000
p = 0.4
3
0
0
p = 0.2
SOLUTIONS TO INTEGRATIVE PROBLEM
1. First there is the project standing alone risk, which is a project's risk ignoring the
fact that much of this risk will be diversified away as the project is combined with
the firm's other projects and assets. Second, we have the project's contribution-to-
firm risk, which is the amount of risk that the project contributes to the firm as a
whole; this measure considers the fact that some of the project's risk will be
diversified away as the project is combined with the firm's other projects and assets,
but ignores the effects of diversification of the firm's shareholders. Finally, there is
systematic risk, which is the risk of the project from the viewpoint of a well
diversified shareholder; this measure considers the fact that some of a project's risk
will be diversified away as the project is combined with the firm's other projects,
and, in addition, some of the remaining risk will be diversified away by the
shareholders as they combine this stock with other stocks in their portfolio.
2. According to the CAPM, systematic risk is the only relevant risk for capital
budgeting purposes; however, reality complicates this somewhat. In many instances
a firm will have undiversified shareholders; for them the relevant measure of risk is
the project's contribution to firm risk. The possibility of bankruptcy also affects our
view of what measure of risk is relevant. Because the project's contribution to firm
risk can affect the possibility of bankruptcy, this may be an appropriate measure of
risk since there are costs associated with bankruptcy.
3. The primary difference between the certainty equivalent approach and the risk-
adjusted discount rate approach is where the adjustment for risk is incorporated into
the calculations. The certainty equivalent approach penalizes or adjusts downwards
the value of the expected annual free cash flows, while the risk-adjusted discount
rate leaves the cash flows at their expected value and adjusts the required rate of
return, k, upwards to compensate for added risk. In either case the net present value
of the project is being adjusted downwards to compensate for additional risk. An
additional difference between these methods is that the risk-adjusted discount rate
assumes that risk increases over time and that cash flows occurring later in the future
should be more severely penalized. The certainty equivalent method, on the other
hand, allows each cash flow to be treated individually.
4. A probability tree is a graphical exposition of the sequence of possible outcomes,
presenting the decision maker with a schematic representation of the problem in
which all possible outcomes are graphically displayed. Moreover, the computations
and results of the computations are shown directly on the tree, so that the information
can be easily understood. Thus the probability tree allows the manager to quickly
visualize the possible future events, their probabilities, and outcomes. In addition,
the calculation of the expected internal rate of return and enumeration of the
distribution should aid the financial manager in his decision-making process.
5. The idea behind simulation is to imitate the performance of the project being
evaluated. This is done by randomly selecting observations from each of the
distributions that affect the outcome of the project, combining each of those
40
observations and determining the final outcome of the project, and continuing with
this process until a representative record of the project's probable outcome is
assembled. In effect, the output from a simulation is a probability distribution of net
present values or internal rates of return for the project. The decision maker then
bases his decision on the full range of possible outcomes.
6. Sensitivity analysis involves determining how the distribution of possible net present
values or internal rates of return for a particular project is affected by a change in one
particular input variable. This is done by changing the value of one input variable
while holding all other input variables constant.
7. The time dependence of cash flows refers to the fact that, many times,
cash flows in later periods are dependent upon the cash flows
experienced in earlier periods. For example, if a new product is
introduced and the initial public reaction is poor, resulting in low
initial cash flows, then cash flows in future periods are likely to be
low also. Examples include the introduction of any new products, for
example, the Edsel on the negative side, and hopefully this book on
the positive side.
8. Project A:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) ×


t
) 7% Value

0 -$150,000 1.00 -$150,000 1.000 -$150,000
1 40,000 .90 36,000 .935 33,660
2 40,000 .85 34,000 .873 29,682
3 40,000 .80 32,000 .816 26,112
4 100,000 .70 70,000 .763 53,410
NPV
A
= - $ 7,136
Project B:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
YearCash Flow α
t
Cash Flow ) × (α
t
) 7% Value
0 -$200,000 1.00 -$200,000 1.000 -$200,000
1 50,000 .95 47,500 .935 44,413
2 60,000 .85 51,000 .873 44,523
3 60,000 .80 48,000 .816 39,168
4 50,000 .75 37,500 .763 28,613
NPV
B
= - $ 43,283
41
Thus, neither project should be selected, as they both have negative NPVs.
42
Internal Rate
of Return for Joint
0 Year 1 Year 2 Years each Branch Probability (A)(B)
$200,000 -12.08% 0.12 -1.45%
$300,000 0.00% 0.28 0.00%
$250,000 0.00% 0.08 0.00%
$450,000 20.55% 0.20 4.11%
$650,000 37.26% 0.12 4.47%
$300,000 17.54% 0.04 0.70%
$500,000 36.19% 0.10 3.62%
$700,000 51.84% 0.04 2.07%
$1,000,000 71.94% 0 .02 1 .44%
1.00
Expected internal rate of return = 14 .96%
The range of possible IRR’s from -12.08% to 71.94%.
P
a
r
t

9
-$600,000
$350,000
p = 0.3
p = 0.7
p = 0.4
$300,000
p = 0.2
p = 0.5
p = 0.4
p = 0.3
p = 0.2
p = 0.1
p =0.5
p = 0.2
$450,000
p = 0.2
2
9
8
Solutions to Problem Set B
11-1B. (a) X =

·
n
1 i
X
i
P(X
i
)
XA = $5,000 (0.20) + $6,000 (0.60) + $7,000 (0.20)
= $1,000 + $3,600 + $1,400
= $6,000
X
B
= $3,000 (0.20) + $7,000 (0.60) + $11,000 (0.20)
= $600 + $4,200 + $2,200
= $7,000
(b) NPV =
t
t
n
1 t
k*) (1
FCF

+

·
- I0
NPV
A
= $6,000 (3.517) - $10,000
= $21,102 - $10,000
= $11,102
NPV
B
= $7,000 (3.127) - $10,000
= $21,889 - $10,000
= $11,889
(c) One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.
44
11-2B. (a) X =

·
n
1 i
X
i
P(X
i
)
X
A
= $40,000 (0.10) + $45,000 (0.40)
+ $50,000 (0.40) + $55,000 (0.10)
= $4,000 + $18,000 + $20,000 + $5,500
= $47,500
X
B
= $20,000 (0.10) + $40,000 (0.20)
+ $55,000 (0.40) + $70,000 (0.20) + $90,000 (0.10)
= $2,000 + $8,000 + $22,000 + $14,000 + $9,000
= $55,000
(b) NPV =
t
t
n
1 t
k*) (1
FCF

+

·
- I0
NPV
A
= $47,500 (3.696) - $125,000
= $175,560 - $125,000
= $50,560
NPV
B
= $55,000 (3.517) - $125,000
= $193,435 - $125,000
= $68,435
(c) One might also consider the potential diversification effect associated with
these projects. If the project's cash flow patterns are cyclically divergent
from those of the company, the overall risk of the company may be
significantly reduced.
45
11-3B.
Project A:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) × (α
t
) 5% Value
0 -$100,000 1.00 -$100,000 1.000 -$100,000
1 600,000 .90 540,000 .952 514,080
2 750,000 .90 675,000 .907 612,225
3 600,000 .75 450,000 .864 388,800
4 550,000 .65 357,500 .823 294,222 .50
NPV
A
= $ 1,709,327 .50
Project B:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) × (α
t
) 5% Value
0 -$100,000 1.00 -$100,000 1.000 -$100,000
1 600,000 .95 570,000 .952 542,640
2 650,000 .75 487,500 .907 442,162.50
3 700,000 .60 420,000 .864 362,880
4 750,000 .60 450,000 .823 370,350
NPV
B
= $1,618,032 .50
Thus, project A should be selected, as it has a higher NPV.
11-4B.
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) ×
.
( α
t
) 8% Value
0 -$100,000 1.00 -$100,000 1.000 -$100,000
1 30,000 0.95 28,500 .926 26,391
2 25,000 0.90 22,500 .857 19,283
3 30,000 0.83 24,900 .794 19,771
4 20,000 0.75 15,000 .735 11,025
5 25,000 0.65 16,250 .681 11,066
NPV = -$ 12,464
46
Thus, this project should not be accepted because it has a negative NPV.
47
11-5B.
NPV
A
=
t
t
n
1 t
k*) (1
FCF

+

·
- IO
= $30,000 (.885) + $40,000(.783) + $50,000(.693)
+ $80,000(.613) + $120,000(.543) - $300,000
= $26,550 + $31,320 + $34,650 + $49,040
+ $65,160 - $300,000
= - $93,280
NPV
B
=
t
n
1 t
k*) (1
FCF

+

·
- IO
= $130,000(3.127) - $450,000
= $406,510 - $450,000
= -$43,490
11-6B.
Project A:
(A) (B)(A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) x ( α
t
) 7% Value
0 -$ 75,000 1.00 -$ 75,000 1.000 -$ 75,000.00
1 20,000 .95 19,000 .935 17,765.00
2 20,000 .85 17,000 .873 14,841.00
3 15,000 .80 12,000 .816 9,792.00
4 50,000 .70 35,000 .763 26,705 .00
NPV
A
= ($ 5,897 .00)
Project B:
(A) (B) (A x B)
Present Value
Expected (Expected Factor at Present
Year Cash Flow α
t
Cash Flow ) x ( α
t
) 7% Value

0 -$ 75,000 1.00 -$ 75,000 1.000 -$ 75,000.00
1 25,000 .95 23,750 .935 22,206.25
2 30,000 .85 25,500 .873 22,261.50
3 30,000 .80 24,000 .816 19,584.00
4 25,000 .75 18,750 .763 14,306 .25
48
NPV
B
= $ 3,358 .00
Thus project B should be selected, as it has a higher NPV.
49
Internal Rate
of Return for Joint
0 Year 1 Year 2 Years each Branch Probability (A)(B)
$300,000 -15.12% 0.06 -0.9072%
$700,000 7.69% 0.30 2.3070%
$1,100,000 25.25% 0.24 6.0600%
$400,000 0.00% 0.06 0.0000%
$700,000 15.75% 0.15 2.3625%
$900,000 24.73% 0.06 1.4838%]
$1,300,000 40.44% 0.03 1.2132%
$600,000 46.82% 0.03 1.4046%
$900,000 58.94% 0.06 3.5364%
$1,100,000 66.27% 0 .01 0 .6627%
1.00
Expected internal rate of return = 18 .1230%
(d) The range of possible IRR’s from -15.12% to 66.27
1
1
-
7
B
.


(
a


c
)

-$1,300,000
p = 0.2
p = 0.1
p = 0.5
p = 0.3
$750,000
p = 0.6
p = 0.2
p = 0.4
p = 0.1
p = 0.5
p = 0.6
$1,500,000 p = 0.1
p = 0.3
p = 0.1
3
0
3
$900,000
Internal Rate
of Return for Joint
0 Year 1 Year 2 Years 3 Years each Branch Probability (A)(B)
$255,000 115.83% .105 12.16227%
$205,000 110.76% .105 11.6298%
$210,000 101.15% .175 17.7013%
$160,000 95.18% .175 16.6565%
$170,000 86.57% .070 6.0599%
$120,000 79.42% .070 5.5594%
$10,000 -46.70% .180 -8.4060%
$0 -91.67% .120 -11 .0004%
1.00
Expected internal rate of return = 50 .3627%
(d) The range of possible IRR’s from –91.67% to 115.83%
1
1
-
8
B
.


(
a


c
)
-$120,000
p = 0.7
$100,000
$180,000
p = 0.2
$140,000
p = 0.5
p = 0.5
p = 0.3
$225,000
p = 0.5
p = 0.5
p = 0.5
p = 0.5
p = 0.5
p = 1.0
p = 0.6
$10,000
p = 1.0
p = 0.4
$0
$10,000
p = 0.3
3
0
4
MADE IN THE U. S. A., DUMPED IN BRAZIL, AFRICA, . . .
(Ethics in Capital Budgeting)
OBJECTIVE: To force the student to recognize the role ethical behavior plays in all
areas of Finance.
DEGREE OF DIFFICULTY: Easy
Case Solution:
With ethics cases there are no right or wrong answers - just opinions. Try to bring
out as many opinions as possible without being judgmental. In this case the question
centers around what to do when a product is no longer salable.

136
CHAPTER 12
Cost of Capital

CHAPTER ORIENTATION
In Chapters 7 and 8 we considered the valuation of debt and equity instruments. The
concepts advanced there serve as a foundation for determining the required rate of return for
the firm and for specific investment projects. The objective in this chapter is to determine
the required rate of return to be used in evaluating investment projects.
CHAPTER OUTLINE
I. The concept of the cost of capital
A. Defining the cost of capital:
1. The rate that must be earned in order to satisfy the required rate of
return
2. The rate of return on investments at which the price of a firm's
common stock will remain unchanged.
B. Investor’s required rate of return is not the same as the firm’s cost of capital
due to
1. Taxes: Interest payments on debt are tax deductible to the firm.
2. Flotation costs: Firms incur expenses when issuing securities that
reduce the proceeds to the firm.
C. Financial Policy
1. Each type of capital used by the firm (debt, preferred stock, and
common stock) should be incorporated into the cost of capital, with
the relative importance of a particular source being based on the
percentage of the financing provided by each source of capital.
2. Using the cost of a single source of capital as the hurdle rate is
tempting to management, particularly when an investment is financed
entirely by debt. However, doing so is a mistake in logic and can
cause problems.
II. Computing the weighted cost of capital. A firm's weighted cost of capital is a
function of (l) the individual costs of capital, (2) the capital structure mix, and (3) the
level of financing necessary to make the investment.
A. Determining individual costs of capital.
137
1. The before-tax cost of debt is found by trial-and-error by solving for
k
d
in
NP
d
=
t
d
t
n
1 t ) k (1
$I

+

·
+
n
d
) k (1
$M
+
where NP
d
= the market price of the debt, less flotation
costs,
$I
t
= the dollar interest paid to the investor each
period,
$M = the maturity value of the debt
k
d
= before-tax cost of the debt (before-tax
required rate of return on debt)
n = the number of periods to maturity.
The after-tax cost of debt equals: k
d
(1 - T)
where T = corporate tax rate
2. Cost of preferred stock (required rate of return on preferred stock),
k
ps
, equals the dividend yield based upon the net price (market price
less flotation costs), or
k
ps =
price net
dividend

=
ps
NP
D
3. Cost of Common Stock. There are two measurement techniques to
obtain the required rate of return on common stock.
a. dividend-growth model
b. capital asset pricing model
4. Dividend growth model
a. Cost of internally generated common equity, k
cs
k
cs
=
price market
year1 in dividend
+

,
_

¸
¸
dividends in
growth annual
k
cs
=
cs
1
P
D
+ g
138
b. Cost of new common stock, k
ncs
k
ncs
=
cs
1
NP
D
+ g
where NP
cs
= the market price of the common stock less
flotation costs incurred in issuing new shares.
5. Capital asset pricing model
k
c
= k
rf
+ β (k
m
- k
rf
)
where k
c
= the cost of common stock
k
rf
= the risk-free rate
β = beta, measure of the stock's systematic risk
k
m
= the expected rate of return on the market
6. It is important to notice that the major difference between the
equations presented here and the equations from Chapters 7 and 8 is
that the firm must recognize the flotation costs incurred in issuing the
security.
B. Selection of weights. The individual costs of capital will be different for each
source of capital in the firm's capital structure. To use the cost of capital in
investment analyses, we must compute a weighted, or overall, cost of capital.
1. It will be assumed that the company's current financial mix resulting
from the financing of previous investments is relatively stable and
that these weights will closely approximate future financing patterns.
2. In computing weights, we could use either the current market
values of the firm's securities or the book values as shown in the
balance sheet. Since we will be issuing new securities at their current
market value, and not at book (historical) values, we should use the
market value of the securities in calculating our weights.
III. PepsiCo approach to weighted average cost of capital
A. PepsiCo calculates the divisional cost of capital for its snack, beverage and
restaurant organizations by first finding peer-group firms for each division
and using their average betas, after adjusting for differences in financial
leverage, to compute the division's cost of equity. They also use accounting
betas in estimating the cost of equity. They then compute the cost of debt for
each division. Finally, they calculate a weighted cost of capital for each
division.
139
B. PepsiCo's WACC basic computation
k
wacc
= k
cs

,
_

¸
¸
+E D
E
+ k
d
[1-T]

,
_

¸
¸
+E D
D
where:
k
wacc
= the weighted average cost of capital
k
cs
= the cost of equity capital
k
d
= the before-tax cost of debt capital
T = the marginal tax rate
E/(D+E)= percentage of financing from equity
D/(D+E)= percentage of financing from debt
C. Calculating the Cost of Equity
Based on capital asset pricing model:
k
cs
= k
rf
+ β (k
m
- k
rf
)
where:
k
cs
= the cost of common stock
k
rf
= the risk-free rate
β = beta, measure of the stock's systematic risk
k
m
= the expected rate of return on the market
Betas for each division are estimated by calculating an average unlevered
beta from a group of divisional peers.
The average beta for each division's peer group is unlevered and then re-
levered using that division's target debt-to-equity ratio.
D. Calculating the Cost of Debt
The after-tax cost of debt is equal to:
k
d
(1 - T)
where:
k
d
= before-tax cost of debt
T = marginal tax rate
140
IV. Required rate of return for individual projects
A. Using the weighted cost of capital. Investments with an internal rate
of return exceeding the weighted cost of capital should be accepted.
Doing so, we must assume that the project has similar business risk as
existing assets. Otherwise, the weighted cost of capital does not
apply.
B. The weighted cost of capital, k
wacc
does not allow for varying levels of project
risk. We need to specify the appropriate required rates of return for
investments having different amounts of risk.
C. Risk also results from the decisions made within the company. This risk is
generally divided into two classes:
1. Business risk is the variability in returns on assets and is affected by
the company’s investment decisions.
2. Financial risk is the increased variability in returns to the common
stockholder as a result of using debt and preferred stock.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
12-1. The cost of capital is the rate that must be earned on investments in order to satisfy
the required rate of return of the firm's investors. This rate is a function of the
investors' required rate of return, the corporation's tax rate, and the flotation costs
incurred in issuing new securities. Therefore, the cost of capital determines the rate
of return that must be achieved on the company's investments, so as to earn the target
return of the firm's investors. Stated differently, the cost of capital is the rate of
return that will leave the price of the common stock unchanged.
12-2. Two objectives may be given for determining a company's weighted average cost of
capital:
(1) The weighted average cost of capital is used as the minimum acceptable rate
of return for capital investments. The value of the firm should be maximized
by accepting all projects where the net present value is positive when
discounted at the firm's weighted average cost of capital.
(2) The weighted average cost of capital is also used in evaluating a firm’s
historical performance. That is, to create shareholder value a firm must not
only earn a profit in the traditional accounting sense, but it must earn a return
on its invested capital that is acceptable to the investors who provide the
firm’s financing. This “acceptable return” is the firm’s weighted average
cost of capital.
12-3. All types of capital, including debt, preferred stock, and common stock, should be
incorporated into the cost of capital computation, with the relative importance of a
particular source being based upon the percentage of financing to be provided.
141
12-4. The effect of taxes on the firm's cost of capital is observed in computing the cost of
debt. Since interest is a tax deductible expense, the use of debt indirectly decreases
the firm's taxes. Therefore, since we have computed the internal rate of return on an
after-tax basis, we also compute the cost of debt on an after-tax basis. In completing
a security offering, investment bankers and other involved individuals receive a
commission for their services. As a result, the amount of capital net of these
flotation costs is less than the funds invested by the individual purchasing the
security. Consequently, the firm must earn more than the investors' required rate of
return to compensate for this leakage of capital.
12-5. a. Equity capital can be raised by either retaining profits within the firm or by
issuing new common stock. Either route represents funds invested by the
common stockholder. The first avenue simply indicates that the common
stockholder permits management to retain capital that could be remitted to
these investors.
b. Even though a new stock issue does not result from retaining internal
common equity, these funds should not be reinvested unless management can
reasonably expect to satisfy the investors' required rate of return. In essence,
even though no explicit out-of-pocket cost results from retaining the capital,
the cost in measuring a firm's cost of capital is actually the opportunity cost
associated with these funds for the investor.
c. The two popular methods for computing the cost of equity capital include (1)
the dividend-growth model, and (2) the capital asset pricing model. The first
approach finds the rate of return that equates the present value of future
dividends, assuming a constant growth rate, with the current market price of
the security. The CAPM finds the appropriate required rate of return, given
the firm's systematic risk.
12-6 In general, the relative costs of various sources of capital reflect the riskness
of the source to the investor. For example, for a given firm, we would expect debt
securities to be less risky than preferred stock which is less risky than common stock.
Consequently, debt would demand a lower required return than the firm’s preferred
stock, which is lower than the required rate of return for common stock.
142
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
The following notations are used in this group of problems:
k
ps
= the cost of preferred stock.
k
cs
= the cost of internally generated common funds
k
ncs
= the cost of new common stock.
g = the growth rate.
k
d
= the before-tax cost of debt.
T = the marginal tax rate.
D
t
= dollar dividend per share, where D
o
is the most recently paid dividend
and D
1
is the forthcoming dividend.
P = the value (present value) of a security.
NP = the value of a security less any flotation costs incurred in issuing the
security
12-1A.
a. Net price after flotation costs = $1,125 (1 - .05)
= $1068.75
$1068.75 =
t
d
10
1 t
) k (1
$110

+

·
+
10
d
) k (1
$1,000
+
k
d
= 9.89%
= k
d
(1-T)
= 6.53%
b. k
ncs
=
cs
1
NP
D
+ g
=
) 05 . 1 ( 50 . 27 $
) 07 . 1 ( 80 . 1 $

+
+ .07
= .1437 = 14.37%
c. k
cs
=
cs
1
P
D
+ g
143
=
43 $
50 . 3 $
+ .07
= .1514 = 15.14%
d. k
ps
=
ps
NP
D
=
) 12 . 1 ( 175 $
150 $ 09 .

x
=
154 $
50 . 13 $
= .0877 = 8.77%
e.
debt of cost
After tax
= k
d
(1 - T)
= 12% (1 - .34)
= 7.92%
12-2A.
a.
debt of cost
After tax
= k
d
(1 - T)
= 8%(1 - 0.34)
= 5.28%
b. k
ncs
=
cs
1
NP
D
+ g
k
ncs
=
) 09 . 0 1 ( 25 $
) 05 . 0 1 ( 05 . 1 $

+
+ 0.05= 9.85%
c. $1,150(.90) = $1,035 = net price after flotation costs
$1,035 =
t
d
20
1 t
) k (1
$120

+

·
+
20
d
) k (1
$1,000
+
Rate Value Value
144
For: 11% $1,079.56 $1,079.56
k
d
% 1,035.00
12% 1,000 .00
$ 44 .56 $ 79 .56
k
d
= 0.11 +
,
_

¸
¸
56 . 79 $
56 . 44 $
× 0.01 = .1156 = 11.56%
debt of cost
After tax
= k
d
(1 - T)
debt of cost
After tax
= 11.56% (1 - 0.34) = 7.63%
d. k
ps
=
ps
NP
D
k
ps
=
85 $
7 $
= 8.24%
e. k
cs
=
cs
1
P
D
+ g
k
cs
=
38 $
3 $
+ 0.04 = 11.90%
12-3A. k
ncs
=
cs
1
NP
D
+ g
k
ncs
=
) 06 . 0 1 ( 27 $
) 06 . 0 1 ( 45 . 1 $

+
+ 0.06 = .1206 = 12.06%
145
12-4A. $958 (1 - 0.11) = $852.62 = the net price (value less flotation
costs).
$852.62 =
t
d
15
1 t ) k (1
$70

+

·
+
15
d
) k (1
$1,000
+
Rate Value Value
For: 8% $914.20 $914.13
k
d
% 852.62
9% ______ 839 .27
$61 .58 $74 .86
k
d
= 0.08 +
,
_

¸
¸
86 . 74 $
58 . 61 $
× 0.01= .0882 = 8.82%
= 8.82% (1 - 0.18) = 7.23%
12-5A. k
ps
=
ps
NP
D
=
50 . 32 $
50 . 2 $
= 7.69%
12-6A. NP
d
=
t
d
t
n
1 t ) k (1
$I

+

·
+
n
d
) k (1
$M
+
$945 =
t
d
15
1 t ) k (1
$120

+

·
+
15
d
) k (1
$1,000
+
Since the net price on the bonds, $945, is less than the $1,000 par value, the before-
tax cost of the debt must be greater than the 12 percent coupon interest rate ($120 ÷
$1,000).
Rate Value Value
12% $1,000.00 $1,000.00
k
d
% 945.00
13% _______ 935.44
$ 55.00 $ 64.56
k
d
= .12 +
,
_

¸
¸
56 . 64 $
00 . 55 $
× .01 = .1285 = 12.85%
debt of cost
After tax
= k
d
(1 - T) = 12.85%(1 - .34) = 8.48%
146
12-7A. Cost of preferred stock (k
ps
)
k
ps
=
Price Net
Dividend
=
ps
NP
D
=
$98
$100 x 14%
=
98 $
14 $
= 14.29%
12-8A. k
cs
=
cs
1
P
D
+ g
=
50 . 21 $
) 15 . 0 1 ( 70 . 0 $ +
+ 0.15
= .1874 = 18.74%
12-9A.If the firm pays out 50 percent of its earnings in dividends, its recent earnings must
have been $8 ($4 dividend divided by .5).
Thus, earnings increased from $5 to $8 in five years. Using Appendix C and looking
for a table value of .625 ($5/$8), the annual growth rate is approximately ten percent.
a. Cost of internal common stock (k
cs
):
k
cs
=

,
_

¸
¸
cs
1
P
D
+ g
=
58 $
) 10 . 1 ( 4 $ +
+ .10 =
58 $
40 . 4 $
+ .10
= .1759 = 17.59%
b. Cost of external common (new common) stock, k
ncs
k
ncs
=

,
_

¸
¸
cs
1
NP
D
+ g
=
) 08 . 0 1 ( 58 $
40 . 4 $

+ .10
=
36 . 53 $
40 . 4 $
+ .10
= .1825 = 18.25%
12-10A.
147
a. Price (P
d
) =
t
10
1 t 0.09) (1
$140

+

·
+
10
) 09 . 0 1 (
000 , 1 $
+
= $140(6.418) + $1000(.422)
= $1,320.52
b. NP
d
= $1,320.52(1 - 0.105)
= $1,181.87
c. Number of Bonds =
87 . 181 , 1 $
000 , 500 $
= 423.06 ≈ 424 Bonds
d. Cost of debt:
$1,181.87 =
t
d
10
1 t ) k (1
$140

+

·
+
10
d
) k (1
$1,000
+
Rate Value Value
For 10% $1,246.30 $1,246.30
k
d
% 1,181.87
11% ________ 1,176 .46
$ 64 .43 $ 69 .84
k
d
= 0.10 + ) 01 . 0 (
84 . 69 $
43 . 64 $
×
,
_

¸
¸
= .1092 = 10.92%
debt of cost
After tax
= 10.92%(1 - 0.34) = 7.21%
12-11A.
a. 1. Price (P
d
) =
t
10
1 t 0.09) (1
$100

+

·
+
10
) 09 . 0 1 (
000 , 1 $
+
= $100 (6.418) + $1,000 (.422)
= $1,063.80
148
2. NP
d
= $1,063.80 (1 - 0.105)
= $952.10
3. Number of Bonds =
10 . 952 $
000 , 500 $
= 525.15 ≈ 526 Bonds
4. Cost of debt:
$952.10 =
t
d
10
1 t ) k (1
$100

+

·
+
10
d
) k (1
$1,000
+
Rate Value Value
For: 10% $1,000.00 $1,000.00
kd% 952.10
11% ________ 940 .90
$ 47 .90 $ 59 .10
k
d
= 0.10 + ) 01 . 0 (
10 . 59 $
90 . 47 $
×
,
_

¸
¸
= .1081 = 10.81%
debt of cost
After tax
= 10.81%(1 - 0.34) = 7.13%
b. There is a very slight decrease in the cost of debt because the flotation costs
associated with the higher coupon bond are higher ($138.65 in flotation costs
for the 14 percent coupon bond versus $111.70 for the 10 percent coupon
bond).
12-12A.
Source Capital Structure After-tax cost of capital Weighted cost
Common Stock 40% 18% 7.2%
Preferred Stock 10% 10% 1.0%
Debt 50% 8% x (1-.35) 2.6%
k
wacc
= 10.8%
149
12-13A.
Net price after flotation costs = $975 - $15
= $960.00
Cost of debt:
$960.00 =
t
d
15
1 t
) k (1
$60

+

·
+
15
d
) k (1
$1,000
+
Rate Value Value
For: 6% $1,000.00 $1,000.00
k
d
% 960.00
7% ________ 908 .48
$ 40 .00 $ 91 .52
k
d
= 0.06 + ) 01 . 0 (
52 . 91 $
00 . 40 $
×
,
_

¸
¸
= .064 = 6.4%
debt of cost
After tax
= 6.4%(1 - 0.30) = 4.48%
Cost of common stock, k
ncs
k
ncs
=

,
_

¸
¸
cs
1
NP
D
+ g
=
) 05 . 0 1 ( 30 $
25 . 2 $

+ .05
= .129 = 12.9%
Source Capital Structure After-tax cost of capital Weighted cost
Debt 60% 4.48% 2.69%
Common Stock 40% 12.9% 5.16%
k
wacc
= 7.85%
150
12-14A.
Net price after flotation costs = $1,050 (1-.04)
= $1,008.00
Cost of debt:
$1,008.00 =
t
d
10
1 t
) k (1
$70

+

·
+
10
d
) k (1
$1,000
+
Rate Value Value
For: 6% $1,096.84 $1,096.84
k
d
% 1,008.00
7% ________ 1,000 .00
$ 88 .84 $ 96 .84
k
d
= 0.06 + ) 01 . 0 (
84 . 96 $
84 . 88 $
×
,
_

¸
¸
= .069 = 6.9%
debt of cost
After tax
= 6.9 %(1 - 0.30) = 4.8%
Cost of preferred stock (k
ps
)
k
ps
=
Price Net
Dividend
=
ps
NP
D
=
3 $ 25 $
00 . 2 $

=
22 $
2 $
= .091 = 9.1%
Cost of common stock, k
ncs
k
ncs
=

,
_

¸
¸
cs
1
NP
D
+ g
=
5 $ 55 $
) 10 . 1 ( 3 $

+
+ .10
= .166 = 16.6%
Source Market Value Weight After-tax cost of capital Weighted Cost
Bonds $4,000,000 .33 4.8% 1.6%
Preferred Stock 2,000,000 .17 9.1% 1.5%
Common Stock 6,000,000 .50 16.6% 8.3%
12,000,000 1.00 k
wacc
= 11.4%
151
SOLUTION TO INTEGRATIVE PROBLEM
Nealon, Inc. - Weighted Cost of Capital
Cost of Debt:
$1,035 (1 - .15) = $879.75 = NP
d
$879.75 =
t
d
16
1 t ) k (1
$80

+

·
+
16
d
) k (1
$1,000
+
Rate Value Value
For: 9% $917.04 $917.04
k
d
% 879.75
10% 843 .92
$ 37 .29 $ 73 .12
k
d
= 0.09 + ) 01 . 0 ( x
12 . 73 $
29 . 37 $

,
_

¸
¸
= .0951 = 9.51%
debt of cost
After tax
= 9.51%(1 - .34) = 6.28%
Cost of Preferred Stock:
k
ps
=
ps
NP
D
=
) 01 . 2 $ 19 ($
50 . 1 $

= 8.83%
Cost of Internal Common Equity:
k
cs
=
cs
1
P
D
+ g
=
35 $
) 06 . 0 1 ( 50 . 2 $ +
+ 0.06
= .1357 = 13.57%
Weighted Cost of Capital (k
wacc
) is calculated as follows:
Weights Costs Weighted Costs
Bonds .38 6.28% 2.39%
Preferred Stock .15 8.83% 1.32%
Common Stock .47 13.57% 6 .38%
1.00 k
wacc
= 10.09%
152
Solutions for Problem Set B
The following notations are used in this group of problems:
k
ps
= the cost of preferred stock.
k
cs
= the cost of internally generated common funds
k
ncs
= the cost of new common stock.
g = the growth rate.
k
d
= the before-tax cost of debt.
T = the marginal tax rate.
D
t
= dollar dividend per share, where D
o
is the most recently paid dividend
and D
1
is the forthcoming dividend.
P = the value (present value) of a security.
NP = the value of a security less any flotation costs incurred in issuing the
security
12-1B.
a. Net price after flotation costs = $1,125 (1 - .06)
= $1,057.50
$1,057.50 =
t
d
10
1 t ) k (1
$120

+

·
+
10
d
) k (1
$1,000
+
Rate Value Value
For: 11% $1,058.68 $1,058.68
k
d
% 1,057.50
12% 1,000 .00
$ 1 .18 $ 58 .68
k
d
= .11 +

,
_

¸
¸
68 . 58 $
18 . 1 $
× .01 = .1102 = 11.02%
debt of cost
After tax
= k
d
(1 - T)
debt of cost
After tax
= 11.02%(1 - .34) = 7.27%
153
b. k
ncs
=
cs
1
NP
D
+ g
=
) 05 . 1 ( 00 . 28 $
) 08 . 1 ( 75 . 1 $

+
+ .08
= .1511 = 15.11%
c. k
cs
=
cs
1
P
D
+ g
=
50 . 43 $
25 . 3 $
+ .07
= .1447 = 14.47%
d. k
ps
=
ps
NP
D
=
) 12 . 1 ( 150 $
) 125 $ ( 10 .

=
132 $
5 . 12 $
= .0947 = 9.47%
e.
debt of cost
After tax
= k
d
(1 - T)
= 13% (1 - .34)
= 8.58%
12-2B.
a.
debt of cost
After tax
= k
d
(1 - T)
debt of cost
After tax
= 9%(1 - 0.34)
debt of cost
After tax
= 5.94%
154
b. k
ncs
=
cs
1
NP
D
+ g
k
ncs
=
) 09 . 0 1 ( 30 $
) 06 . 0 1 ( 25 . 1 $

+
+ 0.06 = 10.85%
c. $1,125(.90) = $1,012.50 = net price after flotation costs
$1,012.50 =
t
d
20
1 t
) k (1
$130

+

·
+
20
d
) k (1
$1,000
+
Rate Value Value
For: 12% $1,074.97 $1,074.97
k
d
% 1,012.50
13% 1,000 .00
$ 62 .47 $ 74 .97
k
d
= 0.12 +
,
_

¸
¸
97 . 74 $
47 . 62 $
0.01 = .1283 = 12.83%
debt of cost
After tax
= k
d
(1 - T)
debt of cost
After tax
= 12.83% (1 - 0.34) = 8.47%
d. k
ps
=
ps
NP
D
k
ps
=
90 $
75 . 8 $
= 9.72%
e. k
cs
=
cs
1
P
D
+ g
k
cs
= + 0.05 = 15.52%
155
12-3B. k
ncs
=
cs
1
NP
D
+ g
k
ncs
=
) 06 . 0 1 ( 28 $
) 07 . 0 1 ( 30 . 1 $

+
+ 0.07 = .1229 = 12.29%
12-4B. $950 (1 - 0.11) = $845.50 = the net price (value less flotation
costs).
$845.50 =
t
d
15
1 t ) k (1
$80

+

·
+
15
d
) k (1
$1,000
+
Rate Value Value
For: 10% $847.48 $847.48
k
d
% 845.50
11% 784 .28
$1 .98 $63 .20
k
d
= 0.10 +

,
_

¸
¸
20 . 63 $
98 . 1 $
× 0.01 = .1004 = 10.04%
debt of cost
After tax
= 10.04% (1 - 0.19) = 8.13%
12-5B. k
ps
=
ps
NP
D
=
50 . 32 $
75 . 2 $
= 8.46%
12-6B. NP
d
=
t
d
t
n
1 t ) k (1
$I

+

·
+
n
d
) k (1
$M
+
$950 =
t
d
15
1 t ) k (1
$130

+

·
+
15
d
) k (1
$1,000
+
Since the net price on the bonds, $950, is less than the $1,000 par value, the before-
tax cost of the debt must be greater than the 13 percent coupon interest rate ($130 ÷
$1,000).
Rate Value Value
13% $1,000.00 $1,000.00
k
d
% 950.00
14% 938 .46
$ 50 .00 $ 61 .54
k
d
= .13 +
,
_

¸
¸
54 . 61 $
00 . 50 $
× .01 = .1381 = 13.81%
debt of cost
After tax
= k
d
(1 - T) = 13.81%(1 - .34) = 9.11%
156
12-7B. Cost of preferred stock (k
ps
)
=
Price Net
Dividend
=
ps
NP
D
=
97 $
100 $ % 13 x
=
97 $
13 $
= 13.40%
12-8B. k
cs
=
cs
1
P
D
+ g
=
50 . 22 $
) 16 . 0 1 ( 80 . 0 $ +
+ 0.16
= .2012 = 20.12%
12-9B. If the firm pays out 50 percent of its earnings in dividends, its recent earnings must
have been $9 ($4.50 dividend divided by .5).
Thus, earnings increased from $5 to $9 in five years. Using Appendix C and looking
for a table value of .556 ($5/$9), the annual growth rate is approximately twelve
percent.
a. Cost of internal common stock (k
cs
):
k
cs
=

,
_

¸
¸
cs
1
P
D
+ g
=
60 $
) 12 . 1 ( 50 . 4 $ +
+ .12
=
60 $
04 . 5 $
+ .12
= .204 = 20.4%
b. Cost of external common (new common) stock, k
ncs
k
ncs
=

,
_

¸
¸
cs
1
NP
D
+ g
=
) 09 . 0 1 ( 60 $
04 . 5 $

+ .12
=
60 . 54 $
04 . 5 $
+ .12
= .2123 = 21.23%
12-10B.
157
a. Price (P
d
) =
t
10
1 t 0.10) (1
$150

+

·
+
10
) 10 . 0 1 (
000 , 1 $
+
= $150(6.145) + $1000(.386)
= $1,307.75
b. NP
d
= $1,307.75(1 - 0.115)
= $1,157.36
c. Number of Bonds =
36 . 157 , 1 $
000 , 600 $
= 518.4 ≈ 519 bonds
d. Cost of debt:
$1,157.36 =
t
)
d
k (1
$150
10
1 t

+

·
+
10
d
) k (1
$1,000
+
Rate Value Value
For 12% $1,169.50 $1,169.50
k
d
% 1,157.36
13% 1,108 .90
$ 12 .14 $ 60 .60
k
d
= 0.12 + ) 01 . 0 (
60 . 60 $
14 . 12 $
×
,
_

¸
¸
= 12.20%
debt of cost
After tax
= 12.20%(1 - 0.34) = 8.05%
12-11B.
a. 1. Price (P
d
) =

·
+
1 0
t
t
1
) 1 0 . 0 1 (
1 0 0 $
+
10
) 10 . 0 1 (
000 , 1 $
+
= $100 (6.145) + $1,000 (.386)
= $1,000.00
2. NP
d
= $1,000.00 (1 - 0.115)
= $885.00
158
3. Number of Bonds =
00 . 885 $
000 , 600 $
= 678 Bonds
4. Cost of debt:
$885.00 =
t
d
10
1 t ) k (1
$100

+

·
+
10
d
) k (1
$1,000
+
Value Value
For: 12% $887.00 $887.00
k
d
% 885.00
13% 837.60
$2.00 $49.40
k
d
= 0.12 + ) 01 . 0 (
40 . 49 $
00 . 2 $
×
,
_

¸
¸
= .1204 = 12.04%
debt of cost
After tax
= 12.04%(1 - 0.34) = 7.95%
b, There is a very slight decrease in the cost of debt because the flotation costs
associated with the higher coupon bond are higher (flotation costs are
$150.39 for the 15 percent coupon bond versus $115 for the 10 percent
coupon bond)
12-12B. Bias Corporation - Weighted Cost of Capital
Capital Individual Weighted
Structure Weights Costs Costs
Bonds $1,100 0.2178 6.0% 1.31%
Preferred Stock 250 0.0495 13.5% 0.67%
Common Stock 3,700 0 .7327 19.0% 13 .92%
$5,050 1.0000 15.90%
12-13B.
Source Capital Structure After-tax cost of capital Weighted cost
Common Stock 50% 20% 10.0%
Preferred Stock 15% 12% 1.8%
Debt 35% 10% (1-.34) 2.3%
100% k
wacc
= 14.1%
159
12-14B.
Net price after flotation costs = $1,100- $20
= $1,080.00
Cost of debt:
$1,080.00 =
t
d
40
1 t
) k (1
$40

+

·
+
40
d
) k (1
$1,000
+
Semi-annual Rate Value Value
For: 3% $1,231.60 $1,231.60
k
d
% 1,080.00
4% ________ 1,000 .00
$ 151 .60 $ 231 .60
semi-annual k
d
= 0.03 + ) 01 . 0 (
60 . 231 $
6 . 151 $
×
,
_

¸
¸
= .0365 = 3.65%
annual k
d
= 3.65% x 2 = 7.3%
debt of cost
After tax
= 7.3%(1 - 0.34) = 4.8%
Cost of common stock, k
ncs
k
ncs
=

,
_

¸
¸
cs
1
NP
D
+ g
=
) 10 . 0 1 ( 80 $
00 . 2 $

+ .08
= .108 = 10.8%
Source Capital
St
r
u
ct
u
re
After-tax cost of capital Weighted cost
Common Stock 60% 10.8% 6.48%
Debt 40% 4.8% 1.92%
k
wacc
= 8.4%
160
12-15B.
Net price after flotation costs = $950 (1-.06)
= $893.00
Cost of debt:
$893.00 =
t
d
20
1 t
) k (1
$80

+

·
+
20
d
) k (1
$1,000
+
Rate Value Value
For: 9% $908.32 $908.32
k
d
% 893.00
10% ________ 830 .12
$ 15 .32 $ 78 .20
k
d
= 0.09 + ) 01 . 0 (
20 . 78 $
32 . 15 $
×
,
_

¸
¸
= .092 = 9.2%
debt of cost
After tax
=10.4 % x (1 - 0.34) = 6.07%
Cost of preferred stock (k
ps
)
k
ps
=
Price Net
Dividend
=
ps
NP
D
=
5 $ 35 $
50 . 2 $

=
30 $
50 . 2 $
= .083 = 8.3%
Cost of common stock, k
ncs
k
ncs
=

,
_

¸
¸
cs
1
NP
D
+ g
=
) 10 . 1 ( 50 $
) 08 . 1 ( 2 $

+
+ .08
= .128 = 12.8%
Source Market Value Weight After-tax cost of capital Weighted Cost
Bonds $500,000 .50 6.07% 3.04%
Preferred Stock 100,000 .10 8.3% .83%
Common Stock 400,000 .40 12.8% 5.12%
$1,000,000 1.00 k
wacc
= 8.99%

161

CHAPTER 13
Managing for Shareholder Value


CHAPTER ORIENTATION
This chapter identifies methods to measure firm value and techniques that can be employed
to assure management and the firm’s board of directors make decisions that increase the
value of the firm. Increases in firm value lead to increases in stock value, which aligns with
the firm’s goal of maximizing shareholder wealth. Measures such as free-cash flow
valuation, market value added, and economic value added can be used to evaluate the firm’s
performance. Management of the firm can be provided compensation incentives that guide
their decisions toward increasing the value of the firm.
CHAPTER OUTLINE
I. Top Creators of Shareholder Wealth
A. Market Value Added (MVA) measures wealth created by the firm
1. MVA = Firm value – invested capital
2. Firm value = market value of firm’s outstanding debt and equity
securities
3. Invested capital = total funds invested in the firm
B. Value creation results from two activities:
1. Identifying performance measures linked to value creation that are
under management’s control
2. Designing incentives to encourage employees to base decisions on
these performance metrics.
II. Business Valuation
A. Accounting model
1. Focuses on firm’s earnings
2. Assumes increases (decreases) in earnings will lead directly to increases
(decreases) in stock price based on the price-earnings relationship
3. Decreases in current earnings may result in increases in future cash
flows, which may increase firm value and stock price.
162
B. Free cash flow model
1. Focuses on firm’s projected cash flows for all future years
a. Future years cash flows consist of the cash flows during a
planning period of a finite number of years and a terminal
value of all years beyond the planning period
b. Firm value is calculated as
4
)
wacc
k (1
4
Value Terminal

4
)
wacc
k (1
4
Flow Cash Free

3
)
wacc
k (1
3
Flow Cash Free

2
)
wacc
k (1
2
Flow Cash Free

1
)
wacc
k (1
1
Flow Cash Free

Value
Firm
+
+
+
+
+
+
+
+
+
·
Terminal value is calculated as
wacc
5
4
k
Flow Cash Free
Value Terminal ·
2. Components of free cash flow values
a. Estimated revenues
b. Estimated net operating profits
c. Investment in net working capital
d. Capital expenditures
3. Firm value equals market value of its debt and equity
III. Value Drivers
A. Managers can increase firm value by managing value drivers.
B. Using value drivers to increase firm value may increase equity value.
IV. Economic Value Added (EVA®)
A. EVA is the change in firm value during a specific time interval, usually 1 year
B. EVA is calculated as
[ ]

,
_

¸
¸
× −
1
1
]
1

¸

·
1
]
1

¸

1 - t
Capital
Invested

)
wacc
(k Capital
of Cost
Average Weighted

(NOPAT) Tax
After Profit
Operating Net
EVA
t
t
C. EVA can also be calculated as
1 t
wacc
t
t
(IC) Capital
Invested

) (k Capital of Cost
Average Weighted

(ROIC) Capital
Invested on Return
EVA

×

,
_

¸
¸
− ·
163
V. Paying for Performance
A. Agency problems arise when firm ownership and management are separate.
B. Linking EVA measures to employee compensation encourages employees to
act on behalf of owners
C. Compensation Policy
1. Three components of compensation are base pay, bonus, and long-
term compensation
2. The mix of base pay and performance-based pay is important in
attracting quality employees and achieving target performance
measures.
3. Percentage of total compensation that is ‘at-risk’ typically increases
with employee rank.
4. Incentive pay should be linked to achieving target performance
measures.
a. Incentive pay can be calculated as

,
_

¸
¸

,
_

¸
¸

,
_

¸
¸
·
e Performanc Target
e Performanc Actual

Risk at
Pay of
Fraction

Pay
Base

Pay
Incentive
b. Bounded incentive pay rewards employees only when a
minimum threshold of performance is achieved and caps the
bonus payout at a maximum level of performance.
c. Unbounded incentive pay has no upper or lower bonus limits.
5. Incentive pay can be paid in cash, stock, or a combination of cash and
stock.
a. Stock rewards employees for current and future performance.
b. Stock compensation may be the majority of CEO and Board of
Directors’ pay.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
13-1. The accounting model of equity evaluation focuses on reported earnings in
conjunction with the market’s valuation of those earnings as reflected in the price-
earnings ratio. For example, if the price-earnings ratio is 20 then a dollar increase in
earnings per share should create $20 in additional equity value per share. Similarly,
a one-dollar loss in earnings per share may lead to a drop of $20 in share value.
164
The accounting model has its limitations, however. For example, this method relies
on historical earnings and ignores other factors that may influence the share value in
the market.
13-2. The free cash flow valuation model provides a method for analyzing firm value as
the present value of the firm's projected free cash flows.
13-3. A. Sales growth—annual growth of revenues. Steps a firm’s management can
take to manage its sales growth:
• Implement a new promotional campaign to promote existing or new
products.
• Form a distributional alliance to enter a new market.
• Invest in R&D to create new products.
• Acquire a competitor’s firm.
B. Operating profit margin—net operating income as a percent of a firm’s
revenue. Steps that can be taken to manage the operating profit margin:
• Initiate cost control programs to reduce operating and administrative
expenses.
• Invest in a promotional campaign aimed at improving the brand
image of the firm’s products or services in an effort to support
premium-pricing policies.
C. Net working capital to sales ratio—the percent of new investments in current
assets (excluding the part financed by non-interest bearing liabilities) relative
to firm sales. Steps to manage the net working capital to sales ratio:
• Initiate inventory control policies designed to reduce the time that
inventory is held before sale.
• Implement a program of credit analysis and control designed to either
decrease the time customers take to pay for their purchases or to
incorporate penalties for late payment.
• Negotiate more lenient credit terms from the firm’s suppliers.
D. Property, plant, and equipment to sales ratio—the percent of firm sales that is
invested in property, plant, and equipment. Steps to manage the property,
plant, and equipment to sales ratio:
• Consider outsourcing of production to strategic partners who might be
more efficient in their operations so as to reduce the firm’s need for
plant and equipment.
• Implement stringent controls over the acquisition of new plant and
equipment to assure that all purchases are economically viable.
165
• Improve maintenance of existing plant and equipment to improve
operating time, which reduces the need for additional plant and
equipment.
166
13-4. Economic Value Added (EVA) measures the change in firm value over a specific
period of time. Managers of a firm use EVA to evaluate the performance of the firm
over specific intervals of time, usually one year. EVA for a particular year (e.g., year
t) is defined as follows:

,
_

¸
¸
1
]
1

¸


×
1
1
]
1

¸


1
1
]
1

¸

·
1 t
Capital
Invested

)
wacc
(k Capit al
of Cost
Average Weighted

(NOPAT) Tax
After Profit
Operati ng Net
EVA
t
t
An alternative definition of EVA is:
1
]
1

¸

×

,
_

¸
¸
− ·
−1 t
wacc
t
t
(IC) Capital
Invested

) (k Capital of Cost
Average Weighted
(ROIC) Capital
Invested Return
EVA
EVA is related to MVA in the following way: MVA is the present value of all future
EVAs over the life of the firm. Thus, managing the firm in ways that increase EVA
will generally lead to a higher MVA.
13-5. Fundamental components of a firm’s compensation program:
A. Base pay is the fixed salary component of compensation.
B. Bonus payment. This is generally a quarterly, semi-annual, or annual cash
payment that is dependent upon firm performance compared to targets set at
the beginning of the period. EVA provides one such performance measure
that can be used in this regard.
C. Long-term compensation. This consists of stock options and grants that are
also made periodically to employees. This type of compensation is the most
direct method available to the firm to align the interests of the firm’s
employees with those of its shareholders.
Note that both bonus and long-term compensation are at-risk in that they are both
dependent upon performance of the individual and the firm. We often use the term
incentive or performance-based compensation to describe this at-risk component of
managerial compensation.
13-6. The four basic issues that every firm’s compensation program must address are:
A. How much to pay for a particular job
B. The portion of the total compensation package should be in base salary and
the portion should be incentive based
C. How to link incentive pay to performance
D. The portion of the incentive pay to be paid as a cash bonus and the portion to
be paid in long-term (equity) compensation
Issue #1: How much to pay?
How much to pay for a particular job is dictated by market forces. This means that a firm
must be constantly comparing its pay scales with the labor market because the firm will
167
only be able to hire good employees where it offers a competitive level of total
compensation. The size of the total compensation package may determine where
employees go to work, but the mix of base pay and performance based pay will
determine how hard they will work.
Issue #2: Base pay versus at-risk or incentive compensation
Usually a firm's highest-ranking employees generally have a larger fraction of their
total compensation “at-risk” and the fraction declines with the employee's rank in the
firm. Most firms base the at-risk fraction of an employee’s compensation on either
salary level or responsibilities. This often mirrors the responsibilities of the firm’s
top managers and their ability to control firm performance.
Issue #3: Linking incentive compensation to performance
The third issue in designing a compensation program relates to choosing a functional
relationship between performance and pay for the incentive portion of the
compensation package. The basic formula for specifying this relationship is:

,
_

¸
¸

,
_

¸
¸

,
_

¸
¸
·
e Performanc Target
e Performanc Actual

Risk - at
Pay of
Fraction

Pay
Base

Pay
Incentive
There are two types of incentive compensation plans based on the above formula.
The first type is called unbounded incentive compensation plan. This means in the
above equation there are no limits specified as to the maximum or minimum levels
of incentive pay that can be earned.
The other type is called bounded incentive compensation plan. This system provides
for a minimum or threshold level of performance (in relation to the target level)
before the incentive plan kicks in, and a maximum level of performance (again in
relation to the target) above which no incentive pay is rewarded. Consequently,
incentive compensation is only paid for performance levels that fall within the
minimum and maximum levels.
Issue #4: Paying with a cash bonus versus equity
A firm can pay its compensation plan in cash, stock or some mixture of the two. If
the firm chooses stock then the employees are rewarded for current performance and
are also provided with a long-term incentive to improve performance. Equity-based
compensation is an important and valuable tool in a firm’s compensation package.
Solutions to Problem Set A
13-1A.
Given:
Earnings for 2001 per share $ 1.90
Closing stock price for 2001 $25.50
Estimated earnings per share for 2002 $ 1.06
168
Price-earnings ratio: Closing stock price/earnings per share 13.42
Estimated stock price for 2002:
Price-earnings ratio × estimated earnings
per share for 2002
$14.23
13-2A.
Given:
Sales growth for years 1-3 10.0%
Operating profit margin 16.0%
Net working capital to sales ratio 13.0%
Property, plant, and equipment to sales ratio 18.0%
Beginning sales $ 27,272.73
Cash tax rate 30.0%
Total liabilities $ 4,000.00
Cost of capital 12.0%
Number of shares 2,000.00
FREE CASH FLOWS:
Years
1 2 3 4
Sales $30,000.00 $33,000.00 $36,300.00 $36,300.00
Operating income (Earnings Before Interest and Taxes) 4,800.00 5,280.00 5,808.00 5,808.00
Less cash tax payments (1,440.00) (1,584.00) (1,742.40) (1,742.40)
Net operating profits after taxes (NOPAT) $ 3,360.00 $ 3,696.00 $ 4,065.60 $ 4,065.60
Less investments:
Investment in Net Working Capital (354.55) (390.00) (429.00) -
Capital expenditures (CAPEX) (490.91) (540.00) (594.00) -
Total investments $ (845.46) $ (930.00) $ (1,023.00) $ -
Free cash flow $ 2,514.54 $ 2,766.00 $ 3,042.60 $ 4,065.60
PV of FCF 2,245.13 2,205.04 2,165.66 $24,115.11
Present value of free cash flows:
Planning horizon cash flows $ 6,615.83
Terminal value in year 4: 33,880.00
PV of terminal value $ 24,115.11
a) Firm value $ 30,730.94
Invested capital (year 0) $ 9,818.18
b) Market Value Added $ 20,912.76
Debt $ 4,000.00
Shareholder value ($30,730.94 – 4,000) $ 26,730.94
No. of shares 2,000.00
c) Value per share $ 13.37
169
13-3A.
Sales growth for years 1-3 10.0%
Operating profit margin 16.0%
Net working capital to sales ratio 13.0%
Current assets to sales ratio 18.0%
Property, plant, and equipment to sales ratio 18.0%
Beginning sales $27,272.73
Cash tax rate 30.0%
Total liabilities $ 4,000.00
Cost of capital 12.0%
Number of shares 2,000.00
Years
0 1 2 3 4
Change in current assets $ 354.55 $ 390.00 $ 429.00 $ -
Current assets $ 4,909.09 $ 5,263.64 $ 5,653.64 $ 6,082.64 $ 6,082.64
Capital expenditures $ 490.91 $ 540.00 $ 594.00 $ -
Property, plant and equipment 4,909.09 $ 5,400.00 $ 5,940.00 $ 6,534.00 $ 6,534.00
Total Capital = Total Assets - Non-interest
liabilities
$ 9,818.18 $10,663.64 $11,593.64 $12,616.64 $12,616.64
a) Calculation of EVA:
Years
0 1 2 3 4 and beyond
Sales $30,000.00 $33,000.00 $36,300.00 $ 36,300.00
Operating income 4,800.00 5,280.00 5,808.00 $ 5,808.00
Less cash tax payments (1,440.00) (1,584.00) (1,742.40) (1,742.40)
Net operating profits after taxes (NOPAT) $3,360.00 $ 3,696.00 $ 4,065.60 $ 4,065.60
Less capital charge (Invested Capital x
Kwacc)
$(1,178.18) $(1,279.64) $ (1,391.24) $ (1,514.00)
Economic Value Added $2,181.82 $2,416.36 $ 2,674.36 $ 2,551.60
Invested Capital $ 9,818.18 $ 10,663.64 $11,593.64 $12,616.64 $12,616.64
b) Return on Invested Capital
(NOPATt ÷ ICt-1) 34.22% 34.66% 35.07% 32.22%
c) Market Value Added = PV(EVAs) $20,640.89
Plus Invested Capital (year 0) 9,818.18
Firm Value $31,459.07
a. The EVAs are positive each year, indicating Bergman is creating value for its
shareholders.
b. The ROIC is greater than the cost of capital, so the firm is creating value for its
shareholders. When the ROIC is greater than the cost of capital, we should see
positive EVAs.
c. The present value of the EVAs exceeds the market value added in Problem 13-2A.
170
13-4A.
Given:
Base pay $ 100,000.00
Incentive % 20.00%
Target EVA Performance $ 20,000,000.00
a. Unbounded incentive plan
Scenario A Scenario B Scenario C
Actual EVA Performance $ 15,000,000 $ 20,000,000 $ 30,000,000
Plant Manager Compensation
Base pay $ 100,000.00 $ 100,000.00 $ 100,000.00
Incentive pay 15,000.00 20,000.00 30,000.00
Total compensation $ 115,000.00 $ 120,000.00 $ 130,000.00
b. Bounded incentive plan (80/120)
Scenario A Scenario B Scenario C
Actual EVA Performance $15,000,000 $20,000,000 $30,000,000
Plant Manager Compensation
Base pay $ 100,000.00 $ 100,000.00 $ 100,000.00
Incentive pay - 20,000.00 24,000.00
Total compensation $ 100,000.00 $ 120,000.00 $ 124,000.00
This plan encourages employees to meet targets only within range of performance
where payout varies with performance (between floor and cap). Employees have no
incentive to improve performance if below floor or above cap.
SOLUTION TO
INTEGRATIVE PROBLEM
A. From the financial statements of RealNetworks over the 1996-98 period we can tell
that it did not earn profit. Indeed, it suffered increasing losses in every year, and in
1998, the firm lost over $20 million.
B. The invested capital for RealNetworks at the end of 1998 should be the sum of the
current figure of total assets less noninterest-bearing liabilities in its balance sheet
and part of the marketing and R&D expenditure it paid but will generate value in
future years.
Charging the full marketing and R&D expenditures against revenues in the year in
which the expenditures are made will distort total assets as an indication of the firm’s
invested capital. The investment in marketing and R&D does not create value only
for the year it is made. Actually, it will bring benefits for the company in several
future years. Therefore, putting the whole amount in the income statement for one
year cannot properly reveal the company’s performance for that year because the
revenue the company created only related to a part of the total investment in
marketing and R&D.
171
C. The EVA for year t is defined as following:
1
]
1

¸

×
1
1
]
1

¸


1
1
]
1

¸

·
−1 t
wacc t
t
Capital
Invested

) (k Capital
of Cost
Average Weighted

(NOPAT) Tax
After Profit
Operating Net
EVA
Using the GAAP financial reports of 1998, assuming that the invested capital equals
total assets – accounts payable – accrued expenses – other current liabilities –
deferred revenue, and weighted average cost of capital is 20%, we get the following
result:
EVA1998 = (-20840) – (20% x 78,865) = -36,613
However, as we discussed in part B, NOPAT is understated since we put the entire
marketing and R&D expenditure for 1998 in the GAAP accounting earnings sheet
for that year. Invested capital is also understated for the same reason. If we amortize
the marketing and R&D expenditures over several years, during which it will
generate value, our EVA result will be positive.
Solutions to Problem Set B
13-1B.
Given:
Earnings for 2001 per share $ 0.87
Closing stock price for 2001 $ 16.06
Estimated earnings per share for 2002 $ 1.09
Price-earnings ratio: Closing stock price/ earnings per share 18.46
Estimated stock price for 2002:
Price-earnings ratio × estimated
earnings per share for 2000
$ 20.12
172
13-2B.
Given:
Sales growth for years 1-3 10.0%
Operating profit margin 17.0%
Net working capital to sales ratio 13.0%
Property, plant and equipment to sales ratio 18.0%
Beginning sales $ 31,363.64
Cash tax rate 28%
Total liabilities $ 6,000.00
Cost of capital 15.0%
No. of shares 4,000.00
FREE CASH FLOWS: Years
1 2 3 4
Sales $ 34,500.00 $ 37,950.00 $ 41,745.00 $ 41,745.00
Operating income (Earnings Before Int. & Taxes) 5,865.00 6,451.50 7,096.65 7,096.65
Less cash tax payments (1,642.20) (1,806.42) (1,987.06) (1,987.06)
Net operating profits after taxes (NOPAT) $ 4,222.80 $ 4,645.08 $ 5,109.59 $ 5,109.59
Less investments:
Investment in Net Working Capital (407.73) (448.50) (493.35) -
Capital expenditures (CAPEX) (564.55) (621.00) (683.10) -
Total investments $ (972.28) $ (1,069.50) $ (1,176.45) $ -
Free cash flow $ 3,250.52 $ 3,575.58 $ 3,933.14 $ 5,109.59
PV of FCF 2,826.54 2,703.65 2,586.10 $ 22,397.59
Present value of free cash flows:
Planning horizon $ 8,116.29
Terminal value
In year 10: 34,063.93
PV of terminal value $ 22,397.59
a) Firm value $ 30,513.88
Invested capital in year (0) 11,290.91
b) Market Value Added $ 19,222.97
c) Calculation of equity value
Firm Value $ 30,513.88
Less: Debt $ 6,000.00
Equals: Shareholder value $ 24,513.88
Number of shares 4,000.00
Value per share $ 6.13
173
13-3B.
Given:
Sales growth for years 1-3 10.0%
Operating profit margin 17.0%
Net working capital to sales ratio 13.0%
Current assets to sales ratio 18.0%
Property, plant and equipment to sales ratio 18.00%
Beginning sales $ 31,363.64
Cash tax rate 28.00%
Total liabilities $ 6,000.00
Cost of capital 15.00%
Number of shares 4,000.00
Years
0 1 2 3 4
Change in current assets $ 407.73 $ 448.50 $ 493.35 $ -
Current assets $ 5,645.45 $ 6,053.18 $ 6,501.68 $ 6,995.03 $ 6,995.03
Capital expenditures $ 564.55 $ 621.00 $ 683.10 $ -
Property, plant and equipment 5,645.45 $ 6,210.00 $ 6,831.00 $ 7,514.10 $ 7,514.10
Total Capital = Total Assets - Non-interest $ 11,290.90 $12,263.18 $13,332.68 $14,509.13 $14,509.13
liabilities (Invested Capital)
a) Calculation of EVA:
Years
0 1 2 3 4 & beyond
Sales $34,500.00 $37,950.00 $41,745.00 $ 41,745.00
Operating income 5,865.00 6,451.50 7,096.65 7,096.65
Less cash tax payments (1,642.20) (1,806.42) (1,987.06) (1,987.06)
Net operating profits after taxes (NOPAT) $ 4,222.80 $ 4,645.08 $ 5,109.59 $ 5,109.59
Less capital charge (Invested Capital x Kwacc) $(1,693.64) $(1,839.48) $ (1,999.90) $(2,176.37)
Economic Value Added $ 2,529.16 $ 2,805.60 $ 3,109.69 $ 2,933.22
b) Return on Invested Capital
(NOPATt ÷ ICt-1) 37.40% 37.88% 38.32% 35.22%
c) MVA and the present value of future
EVAs
Market Value Added = PV(EVAs) $ 19,996.52
Plus Invested Capital (year 0) 11,290.90
Firm Value $31,287.42
a. The EVAs are positive each year, indicating the Bergman is creating value for its
shareholders.
b. The ROIC is greater than the cost of capital, so the firm is creating value for its
shareholders. When the ROIC is greater than the cost of capital, the EVAs are positive.
c. The present value of the EVAs exceeds the market value added in Problem 13-2B.
174
13-4B.
Given:
Base pay $ 150,000
Incentive % 30.00%
Target EVA Performance $30,000,000
a. Unbounded incentive plan
Scenario A Scenario B Scenario C
Actual EVA Performance $20,000,000 $30,000,000 $40,000,000
Division Manager Compensation
Base pay $ 150,000.00 $ 150,000.00 $ 150,000.00
Incentive pay 30,000.00 45,000.00 60,000.00
Total compensation $ 180,000.00 $ 195,000.00 $ 210,00.00
b. Bounded incentive plan (80/120)
Scenario A Scenario B Scenario C
Actual EVA Performance $20,000,000 $30,000,000 $40,000,000
Division Manager Compensation
Base pay $ 150,000.00 $ 150,000.00 $ 150,000.00
Incentive pay - 30,000.00 54,000.00
Total compensation $ 150,000.00 $ 180,000.00 $ 204,000.00
This plan encourages employees to meet targets within range of performance where
payout varies with performance (between floor and cap). Employees have no incentive to
improve performance if below floor or above cap.

175
CHAPTER 14
Raising Capital
in the Financial Markets

CHAPTER ORIENTATION
This chapter considers the market environment in which long-term capital is raised. The
underlying rationale for the existence of security markets is presented, investment banking
services and procedures are detailed, private placements are discussed, and security market
regulation is reviewed.
CHAPTER OUTLINE
I. The mix of corporate securities sold in the capital market.
A. When corporations raise cash in the capital market, what type of financing
vehicle is most favored? The answer to this question is corporate bonds. The
corporate debt markets clearly dominate the corporate equity markets when
new (external) funds are being raised.
B. From our discussion on the cost of capital, we understand that the U.S. tax
system inherently favors debt as a means of raising capital. During the 1999-
2001 period, bonds and notes accounted for about 76.9 percent of new
corporate securities sold for cash.
II. Why financial markets exist
A. Financial markets consist of institutions and procedures that facilitate
transactions in all types of financial claims.
B. Some economic units spend more than they earn during a given period of
time. Some economic units spend less than they earn. Accordingly, a
mechanism is needed to facilitate the transfer of savings from those economic
units that have a savings surplus to those that have a savings deficit. Financial
markets provide such a mechanism.
C. The function of financial markets then is to allocate savings in an economy to
the ultimate demander (user) of the savings.
D. If there were no financial markets, the wealth of an economy would be
lessened. Savings could not be transferred to economic units, such as
business firms, which are most in need of those funds.
176
III. Financing business: The movement of funds through the economy.
A. In a normal year the household sector is the largest net supplier of funds to
the financial markets. We call the household sector then a savings-surplus
sector.
1. The household sector can also be a savings-deficit sector.
2. From 1995 – 1999, the household sector was a net user of financial
capital as a result of taking advantage of low interest rate mortgages.
B. In contrast, the nonfinancial business sector is typically a savings-deficit
sector.
1. The nonfinancial business sector can also be a savings-surplus sector.
2. Economic conditions and corporate profitability influence the ability
of this sector to provide funds to the financial market.
C. In recent years, the foreign sector has become a major savings-surplus sector.
D. Within the domestic economy, the nonfinancial business sector is dependent
on the household sector to finance its investment needs.
E. The movement of savings through the economy occurs in three distinct ways:
1. The direct transfer of funds
2. Indirect transfer using the investment banker
3. Indirect transfer using the financial intermediary
IV. Components of the U.S. financial market system
A. Public offerings can be distinguished from private placements.
1. The public (financial) market is an impersonal market in which both
individual and institutional investors have the opportunity to acquire
securities.
a. A public offering takes place in the public market.
b. The security-issuing firm does not meet (face-to-face) the
actual investors in the securities.
2. In a private placement of securities, only a limited number of
investors have the opportunity to purchase a portion of the issue.
a. The market for private placements is more personal than its
public counterpart.
b. The specific details of the issue may actually be developed on
a face-to-face basis among the potential investors and the
issuer.
177
c. Venture capital
(1) Start-up firms often turn to venture capitalists to raise
funds.
(a) Broader public markets find these firms too
risky.
(b) Venture capitalists are willing to accept the
risks because of an expectation of higher
returns.
(1) Venture capital firms that acquire equity in a start-up
firm manage risk by sitting on the firm’s board of
directors or actively monitoring management’s
activities.
(2) Venture capital is often provided by established non-
venture-capitalist firms that take a minority investment
position in an emerging firm or create a separate
venture capital subsidiary.
(a) The investment approach allows the established
firm to gain access to new technology and to
create strategic alliances.
(b) The subsidiary approach allows the established
firm to retain human and intellectual capital.
B. Primary markets can be distinguished from secondary markets.
1. Securities are first offered for sale in a primary market. For example,
the sale of a new bond issue, preferred stock issue, or common stock
issue takes place in the primary market. These transactions increase
the total stock of financial assets in existence in the economy.
2. Trading in currently existing securities takes place in the secondary
market. The total stock of financial assets is unaffected by such
transactions.
C. The money market can be distinguished from the capital market.
1. The money market consists of the institutions and procedures that
provide for transactions in short-term debt instruments which are
generally issued by borrowers who have very high credit ratings.
a. "Short-term" means that the securities traded in the money
market have maturity periods of not more than 1 year.
b. Equity instruments are not traded in the money market.
c. Typical examples of money market instruments are (l) U.S.
Treasury bills, (2) federal agency securities, (3) bankers'
acceptances, (4) negotiable certificates of deposit, and (5)
commercial paper.
178
2. The capital market consists of the institutions and procedures that
provide for transactions in long-term financial instruments. This
market encompasses those securities that have maturity periods
extending beyond 1 year.
D. Organized security exchanges can be distinguished from over-the-counter
markets.
1. Organized security exchanges are tangible entities whose activities
are governed by a set of bylaws. Security exchanges physically
occupy space and financial instruments are traded on such premises.
a. Major stock exchanges must comply with a strict set of
reporting requirements established by the Securities and
Exchange Commission (SEC). These exchanges are said to be
registered.
b. Organized security exchanges provide several benefits to both
corporations and investors. They (l) provide a continuous
market, (2) establish and publicize fair security prices, and (3)
help businesses raise new financial capital.
c. A corporation must take steps to have its securities listed on an
exchange in order to directly receive the benefits noted above.
Listing criteria differ from exchange to exchange.
2. Over-the-counter markets include all security markets except the
organized exchanges. The money market is a prominent example.
Most corporate bonds are traded over-the-counter.
a. NASDAQ, a telecommunication system providing an
information link among brokers and dealers in the OTC
markets, accounted for 43% of the national exchange equity
market trading in the U.S., measured in dollar volume for the
year 1998.
Nasdaq Stock Market, Inc. trades securities of over 3,600
public companies as of 2002.
V. The Investment Banker
A. The investment banker is a financial specialist who acts as an intermediary in
the selling of securities. The investment banker works for an investment
banking house (firm).
B. Three basic functions are provided by the investment banker:
1. The investment banker assumes the risk of selling a new security
issue at a satisfactory (profitable) price. This is called underwriting.
Typically, the investment banking house, along with the underwriting
syndicate, actually buys the new issue from the corporation that is
raising funds. The syndicate (group of investment banking firms) then
sells the issue to the investing public at a higher (hopefully) price than
it paid for it.
179
2. The investment banker provides for the distribution of the securities
to the investing public.
3. The investment banker advises firms on the details of selling
securities.
C. Several distribution methods are available for placing new securities into the
hands of final investors. The investment banker's role is different in each
case.
1. In a negotiated purchase, the firm in need of funds contacts an
investment banker and begins the sequence of steps leading to the
final distribution of the securities that will be offered. The price that
the investment banker pays for the securities is "negotiated" with the
issuing firm.
2. In a competitive-bid purchase, the investment banker and
underwriting syndicate are selected by an auction process. The
syndicate willing to pay the greatest dollar amount per new security to
the issuing firm wins the competitive bid. This means that it will
underwrite and distribute the issue. In this situation, the price paid to
the issuer is not negotiated; instead, it is determined by a sealed-bid
process much on the order of construction bids.
3. In a commission (or best-efforts), offering the investment banker does
not act as an underwriter but rather attempts to sell the issue in return
for a fixed commission on each security that is actually sold. Unsold
securities are simply returned to the firm hoping to raise funds.
4. In a privileged subscription, the new issue is not offered to the
investing public. It is sold to a definite and limited group of investors.
Current stockholders are often the privileged group.
5. In a direct sale, the issuing firm sells the securities to the investing
public without involving an investment banker in the process. This is
not a typical procedure.
VI. More on Private placements: The Debt Side
A. Each year billions of dollars of new securities are privately (directly) placed
with final investors. In a private placement, a small number of investors
purchase the entire security offering. Most private placements involve debt
instruments.
B. Large financial institutions are the major investors in private placements.
These include (l) life insurance firms, (2) state and local retirement funds,
and (3) private pension funds.
C. The advantages and disadvantages of private placements as opposed to public
offerings must be carefully evaluated by management.
1. The advantages include (a) greater speed than a public offering in
actually obtaining the needed funds, (b) lower flotation costs than are
180
associated with a public issue, and (c) increased flexibility in the
financing contract.
2. The disadvantages include (a) higher interest costs than are ordinarily
associated with a comparable public issue, (b) the imposition of
restrictive covenants in the financing contract, and (c) the possibility
that the security may have to be registered some time in the future at
the lender's option.
VII. Flotation costs
A. The firm raising long-term capital typically incurs two types of flotation
costs: (l) the underwriter's spread and (2) issuing costs. The former is
typically the larger.
1. The underwriter's spread is the difference between the gross and net
proceeds from a specific security issue. This absolute dollar
difference is usually expressed as a percent of the gross proceeds.
2. Many components comprise issue costs. The two most significant are
(l) printing and engraving and (2) legal fees. For comparison
purposes, these are usually expressed as a percent of the issue's gross
proceeds.
B. SEC data reveal two relationships about flotation costs.
1. Issue costs (as a percent of gross proceeds) for common stock exceed
those of preferred stock, which exceed those of bonds.
2. Total flotation costs per dollar raised decrease as the dollar size of the
security issue increases.
VIII. Regulation
A. The primary market is governed by the Securities Act of 1933.
1. The intent of this federal regulation is to provide potential investors
with accurate and truthful disclosure about the firm and the new
securities being sold.
2. Unless exempted, the corporation selling securities to the public must
register the securities with the SEC.
3. Exemptions allow follow for a variety of conditions. For example, if
the size of the offering is small enough (less than $1.5 million), the
offering does not have to be registered. If the issue is already
regulated or controlled by some other federal agency, registration
with the SEC is not required. Railroad issues and public utility issues
are examples.
4. If not exempted, a registration statement is filed with the SEC
containing particulars about the security-issuing firm and the new
security.
5. A copy of the prospectus, a summary registration statement, is also
filed. It will not yet have the selling price of the security printed on it;
181
it is referred to as a red herring and called that until approved by the
SEC.
6. If the information in the registration statement and prospectus is
satisfactory to the SEC, the firm can proceed to sell the new issue. If
the information is not satisfactory, a stop order is issued which
prevents the immediate sale of the issue. Deficiencies have to be
corrected to the satisfaction of the SEC before the firm can sell the
securities.
7. The SEC does not evaluate the investment quality of any issue. It is
concerned instead with the presentation of complete and accurate
information upon which the potential investor can act.
B. The secondary market is regulated by the Securities Exchange Act of 1934.
This federal act created the SEC. It has many aspects.
1. Major security exchanges must register with the SEC.
2. Insider trading must be reported to the SEC.
3. Manipulative trading that affects security prices is prohibited.
4. Proxy procedures are controlled by the SEC.
5. The Federal Reserve Board has the responsibility of setting margin
requirements. This affects the proportion of a security purchase that
can be made via credit.
C. The Securities Acts Amendments of 1975 touched on three important issues.
1. Congress mandated the creation of a national market system (NMS).
Implementation details of the NMS were left to the SEC. Agreement
on the final form of the NMS is yet to come.
2. Fixed commissions (also called fixed brokerage rates) on public
transactions in securities were eliminated.
3. Financial institutions, like commercial banks and insurance firms,
were prohibited from acquiring membership on stock exchanges
where their purpose in so doing might be to reduce or save
commissions on their own trades.
D. In March 1982, the SEC adopted "Rule 415." This process is now known as a
shelf registration or a shelf offering.
1. This allows the firm to avoid the lengthy, full registration process
each time a public offering of securities is desired.
2. In effect, a master registration statement that covers the financing
plans of the firm over the coming two years is filed with the SEC.
After approval, the securities are sold to the investing public in a
piecemeal fashion or "off the shelf."
3. Prior to each specific offering, a short statement about the issue is
filed with the SEC.
182
E. Congress passed in July 2002 the Public Company Accounting Reform and
Investor Protection Act. The short name for the act became the Sarbanes-
Oxley Act of 2002.
1. The Sarbanes-Oxley Act was passed as the result of a large series of
corporate indiscretions.
2. The act contains 11 “titles” which tightened significantly the latitudes
given to corporate advisors (like accountants, lawyers, company
officers, and boards of directors) who have access to or influence
company decisions.
3. The initial title of the act created the Public Company Accounting
Oversight Board. This board’s purpose is to regulate the accounting
industry relative to public companies that they audit. Members are
appointed by the SEC.
4. As recently June of 2003, the oversight board itself published a set of
ethics rules to police its own set of activities.
IX. The Multinational Firm: Efficient Financial Markets and Intercountry Risk
A. The United States’ highly developed, complex and competitive financial
markets facilitate the transfer of savings from the saving-surplus sector to the
saving-deficit sector.
B. Multinational firms are reluctant to invest in countries with ineffective
financial systems.
1. Financial and political systems lacking integrity will often be rejected
for direct investment by multinational firms.
2. Countries that experience significant devaluation of its currency may
also be considered too risky for investment.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
14-1. Financial markets are institutions and procedures that facilitate transactions in all
types of financial claims. Financial markets perform the function of allocating
savings in the economy to the ultimate demander(s) of the savings. Without these
financial markets, the total wealth of the economy would be lessened. Financial
markets aid the rate of capital formation in the economy.
14-2. A financial intermediary issues its own type of security which is called an indirect
security. It does this to attract funds. Once the funds are attracted, the intermediary
purchases the financial claims of other economic units in order to generate a return
on the invested funds. A life insurance company, for example, issues life insurance
policies (its indirect security) and buys corporate bonds in large quantities.
183
14-3. The money market consists of all institutions and procedures that accomplish
transactions in short-term debt instruments issued by borrowers with (typically) high
credit ratings. Examples of securities traded in the money market include U.S.
Treasury Bills, bankers’ acceptances, and commercial paper. Notice that all of these
are debt instruments. Equity securities are not traded in the money market. It is
entirely an over-the-counter market. On the other hand, the capital market provides
for transactions in long-term financial claims (those claims with maturity periods
extending beyond one year). Trades in the capital market can take place on
organized security exchanges or over-the-counter markets.
14-4. Organized stock exchanges provide for:
(1) A continuous market. This means a series of continuous security prices is
generated. Price changes between trades are dampened, reducing price
volatility, and enhancing the liquidity of securities.
(2) Establishing and publicizing fair security prices. Prices on an organized
exchange are determined in the manner of an auction. Moreover, the prices
are published in widely available media like newspapers.
(3) An aftermarket to aid businesses in the flotation of new security issues. The
continuous pricing mechanism provided by the exchanges facilitates the
determination of offering prices in new flotations. The initial buyer of the
new issue has a ready market in which he can sell the security should he need
liquidity rather than a financial asset.
14-5. The criteria for listing can be labeled as follows: (1) profitability; (2) size; (3) market
value; (4) public ownership.
14-6. Most bonds are traded among very large financial institutions. Life insurance
companies and pension funds are typical examples. These institutions deal in large
quantities (blocks) of securities. An over-the-counter bond dealer can easily bring
together a few buyers and sellers of these large quantities of bonds. By comparison,
common stocks are owned by millions of investors. The organized exchanges are
necessary to accomplish the "fragmented" trading in equities.
14-7. The investment banker is a middleman involved in the channeling of savings into
long-term investment. He performs the functions of: (1) underwriting; (2)
distributing; (3) advising. By assuming underwriting risk, the investment banker and
his syndicate purchase the securities from the issuer and hope to sell them at a higher
price. Distributing the securities means getting those financial claims into the hands
of the ultimate investor. This is accomplished through the syndicate's selling group.
Finally, the investment banker can provide the corporate client with sound advice on
which type of security to issue, when to issue it, and how to price it.
14-8. In a negotiated purchase, the corporate security issuer and the managing investment
banker negotiate the price that the investment banker will pay the issuer for the new
offering of securities. In a competitive-bid situation, the price paid to the corporate
security issuer is determined by competitive (sealed) bids, which are submitted by
several investment banking syndicates hoping to win the right to underwrite the
offering.
184
14-9. Investment banking syndicates are established for three key reasons: (1) the
investment banker who originates the business probably cannot afford to purchase
the entire new issue himself; (2) to spread the risk of loss among several
underwriters; (3) to widen the distribution network.
14-10. Several positive benefits are associated with private placements. The first is speed.
Funds can be obtained quickly, primarily due to the absence of a required
registration with the SEC. Second, flotation costs are lower as compared to public
offerings of the same dollar size. Third, greater financing flexibility is associated
with the private placement. All of the funds, for example, need not be borrowed at
once. They can be taken over a period of time. Elements of the debt contract can
also be renegotiated during the life of the loan.
14-11. As a percent of gross proceeds, flotation costs are inversely related to the dollar size
of the new issue. Additionally, common stock is more expensive to issue than
preferred stock, which is more expensive to issue than debt.
14-12. The answer on this is clear. The corporate debt markets dominate the corporate
equity markets when new funds are raised. The tax system of the U.S. economy
favors debt financing by making interest expense deductible from income when
computing the firm's federal tax liability. Consider all corporate securities offered
for cash over the period 1999-2001. The percentage of the total represented by
bonds and notes was 76.9 percent compared to 23.1 percent equity.
14-13. The household sector is the largest net supplier of savings to the financial markets.
Foreign financial investors have recently been net suppliers of savings to the
financial markets. On the other hand, the nonfinancial corporate business sector is
most often a savings-deficit sector. The U.S. Government sector too is a deficit
sector in most years.
14-14. First, there may be a direct transfer of savings from the investor to the borrower.
Second, there may be an indirect transfer that used the services provided by an
investment banker. Third, there may be an indirect transfer that uses the services of
a financial intermediary. Private pension funds and life insurance companies are
prominent examples of the latter case.

185
CHAPTER 15
Analysis and Impact
of Leverage

CHAPTER ORIENTATION
This chapter focuses on useful aids for the financial manager in determining the firm's
proper financial structure. It includes the definitions of the different kinds of risk, a review
of breakeven analysis, the concepts of operating leverage, financial leverage, the
combination of both leverages, and their effect on EPS (earnings per share).
CHAPTER OUTLINE
I. Business risk and financial risk
A. Risk is defined as the likely variability associated with expected revenue
streams.
1. The variations in the income stream can be attributed to
a. The firm's exposure to business risk
b. The firm's decision to incur financial risk
B. Business risk is defined as the variability of the firm's expected earnings
before interest and taxes.
1. Business risk is measured by the firm's corresponding expected
coefficient of variation.
2. Dispersion in operating income does not cause business risk. It is the
result of several influences, such as the company’s cost structure,
product demand characteristics, and intra-industry competition.
C. Financial risk is a direct result of the firm's financing decision. It refers to the
additional variability in earnings available to the firm’s common stockholders
and the additional chance of insolvency borne by the common shareholder
when financial leverage is used.
1. Financial leverage is the financing of a portion of the firm's assets
with securities bearing a fixed rate of return in hopes of increasing the
return to the common shareholders.
186
2. Financial risk is passed on to the common shareholders who must
bear most of the inconsistencies of returns to the firm after the
deduction of fixed payments.
II. Break-even Analysis
A. The objective of break-even analysis is to determine the break-even quantity
of output by studying the relationships among the firm’s cost structure,
volume of output, and operating profit.
1. The break-even quantity of output results in an EBIT level equal to
zero.
B. Use of the model enables the financial officer to
1. Determine the quantity of output that must be sold to cover all
operating costs.
2. Calculate the EBIT achieved at various output levels.
C. Some potential applications include
1. Capital expenditure analysis as a complementary technique to
discounted cash flow evaluation models
2. Pricing policy
3. Labor contract negotiations
4. Evaluation of cost structure
5. Financial decision making
D. Essential elements of the break-even model
1. Production costs must be separated into fixed costs and variable costs.
Fixed costs do not vary as the sales volume or the quantity of output
changes. Examples include
a. Administrative salaries
b. Depreciation
c. Insurance premiums
d Property taxes
e. Rent
2. Variable costs vary in total as output changes. Variable costs are fixed
per unit of output. Examples include
a. Direct materials
b. Direct labor
c. Energy cost associated with production
d. Packaging
e. Freight-out
187
f. Sales commissions
3. In order to implement the break-even model, it is necessary for the
financial manager to
a. Identify the most relevant output range for planning purposes.
b. Approximate all costs in the semifixed and semivariable range
and allocate them to the fixed and variable cost categories.
4. Total revenue and volume of output
a. Total revenue (sales dollars) is equal to the selling price per
unit multiplied by the quantity sold.
b. Volume of output refers to the firm’s level of operations and is
expressed as a unit quantity or sales dollars.
E. Finding the break-even point
1. The break-even model is just an adaptation of the firm's income
statement expressed as
sales - (total variable costs + total fixed costs) = profit
2. Three ways to find the break-even point are explained.
a. Trial and error
(1) Select an arbitrary output level.
(2) Calculate the corresponding EBIT amount.
(3) When EBIT equals zero, the break-even point has been
found.
b. Contribution margin analysis
(1) Unit selling price - unit variable cost = contribution
margin
(2) Fixed cost divided by the contribution margin per unit
equals the break-even quantity in units.
c. Algebraic analysis
(l) Q
B
= the break-even level of units sold,
P = the unit sales price,
F = the total fixed cost for the period,
V = unit variable cost.
(2) Then,
Q
B

=
V P
F

188
F. The break-even point in sales dollars
1. It is convenient to calculate the break-even point in terms of sales
dollars if the firm deals with more than one product. It can be
computed by using data from the firm's annual report.
2. Since variable cost and selling price per unit are assumed constant,
the ratio of total variable costs to total sales is a constant for any level
of sales.
G. Limitations of break-even analysis
1. Assumes linear cost-volume-profit relationship.
2. The total revenue curve is presumed to increase linearly with the
volume of output.
3. Assumes constant production and sales mix.
4. This is a static form of analysis.
III. Operating Leverage
A. Operating leverage is the responsiveness of a firm's EBIT to fluctuations in
sales. Operating leverage results when fixed operating costs are present in
the firm's cost structure.
B. This responsiveness can be measured as follows:
level sales base
the from leverage
operating of degree
= DOL
s
=
sales in change %
EBIT in change %
C. If unit costs are available, the DOL can be measured by
DOL
s
=
F V) Q(P
V) Q(P
− −

D. If an analytical income statement is the only information available, the
following formula is used:
DOL
s
=
EBIT
costs fixed before revenue
=
F VC S
VC S
− −

Note: All three formulas provide the same results.
E. Implications of operating leverage
1. At each point above the break-even level, the degree of operating
leverage decreases.
2. At the break-even level of sales, the degree of operating leverage is
undefined.
3. Operating leverage is present when the percentage change in EBIT
divided by the percentage change in sales is greater than one.
4. The degree of operating leverage is attributed to the business risk that
a firm faces.
189
IV. Financial Leverage
A. To see if financial leverage has been used to benefit the common shareholder,
the focus will be on the responsiveness of the company's earnings per share
(EPS) to changes in its EBIT.
B. The firm is using financial leverage and is exposing its owners to financial
risk when
EBIT in change %
EPS in change %
is greater than 1.00
C. A measure of the firm's use of financial leverage is as follows:
level EBIT base
the from leverage
financial of degree
= DFL
EBIT
=
EBIT in change %
EPS in change %
1. The degree of financial leverage concept can be either in the positive
or negative direction.
2. The greater the degree of financial leverage, the greater the
fluctuations in EPS.
D. An easier way to measure financial leverage is
DFL
EBIT
=
I EBIT
EBIT

where I is the sum of all fixed financing costs
V. Combining operating and financial leverage
A. Changes in sales revenues cause greater changes in EBIT. If the firm
chooses to use financial leverage, changes in EBIT turn into larger variations
in both EPS and EAC. Combining operating and financial leverage causes
rather large variations in EPS.
B. One way to measure the combined leverage can be expressed as
level sales base
the from leverage
combined of degree
= DCL
s
=
sales in change %
EPS in change %
If the DCL is equal to 5.0 times, then a 1% change in sales will result in a 5%
change in EPS.
C. The degree of combined leverage is the product of the two independent
leverage measures. Thus:
DCL
S

= (DOL
S

) x (DFL
EBIT
)
190
D. Another way to compute DCL
s
is with the following equation:
DCL
s
=
I F V) Q(P
V) Q(P
− − −

E. Implications of combining operating and financial leverage
1. Total risk can be managed by combining operating and financial
leverage in different degrees.
2. Knowledge of the various leverage measures helps to determine the
proper level of overall risk that should be accepted.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
15-1. Business risk is the uncertainty that envelops the firm's stream of earnings before
interest and taxes (EBIT). One possible measure of business risk is the coefficient of
variation in the firm's expected level of EBIT. Business risk is the residual effect of
the: (1) company's cost structure, (2) product demand characteristics, (3) intra-
industry competitive position. The firm's asset structure is the primary determinant
of its business risk. Financial risk can be identified by its two key attributes: (1) the
added risk of insolvency assumed by the common stockholder when the firm chooses
to use financial leverage; (2) the increased variability in the stream of earnings
available to the firm's common stockholders.
15-2. Financial leverage is financing a portion of the firm's assets with securities bearing a
fixed (limited) rate of return. Anytime the firm uses preferred stock to finance
assets, financial leverage is employed.
15-3. Operating leverage is the use of fixed operating costs in the firm's cost structure.
When operating leverage is present, any percentage fluctuation in sales will result in
a greater percentage fluctuation in EBIT.
15-4. Break-even analysis, as it is typically presented, categorizes all operating costs as
being either fixed or variable. Based upon this division of costs, the break-even
point is computed. The computation procedure for the cash break-even point omits
any noncash expenses that the firm might incur. Typical examples of noncash
expenses include depreciation and prepaid expenses. The ordinary break-even point
will always exceed the cash break-even point, provided some noncash charges are
present.
15-5. The most important shortcomings of break-even analysis are:
(1) The cost-volume-profit relationship is assumed to be linear over the entire
range of output.
(2) All of the firm's production is assumed to be salable at the fixed selling price.
(3) The sales mix and production mix is assumed constant.
191
(4) The level of total fixed costs and the variable cost to sales ratio is held
constant over all output and sales ranges.
15-6. Total risk exposure is the result of the firm's use of both operating leverage and
financial leverage. Business risk and financial risk produce this total risk. A
company that is normally exposed to a high degree of business risk may manage its
financial structure in such a way as to minimize financial risk. A firm that enjoys a
stable pattern in its earnings before interest and taxes might reasonably elect to use a
high degree of financial leverage. This would increase both its earnings per share
and its rate of return on the common equity investment.
15-7. By taking the degree of combined leverage times the sales change of a negative 15
percent, the earnings available to the firm's common shareholders will decline by 45
percent.
15-8. As the sales of a firm increase, two things occur that bias the cost and revenue
functions toward a curvilinear shape. First, sales will increase at a decreasing rate.
As the market approaches saturation, the firm must cut its price to generate sales
revenue. Second, as production approaches capacity, inefficiencies occur that result
in higher labor and material costs. Furthermore, the firm's operating system may
have to bear higher administrative and fixed costs. The result is higher per unit costs
as production output increases.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions To Problem Set A
15-1A.
Product Line Sales V.C. C.M. C.M. Ratio
Piano 61,250 41,650 19,600 32%
Violin 37,500 22,500 15,000 40%
Cello 98,750 61,225 37,525 38%
Flute 52,500 25,725 26,775 51%
Total 250,000 151,100 98,900 40%
Break-even Point
S* = F/(1-VC/S) = 50,000/(1-VC/S) = 50,000/.4 = 125,000
S* =

,
_

¸
¸

S
VC
1
F
=

,
_

¸
¸

$250,000
$151,100
1
50,000
=
.4
50,000
= 125,000
192
15-2A. Break-even Quantity = Q
B
Q
B
=
V) (P
F

Q
B
=
(.70)($30) - $30
$360,000
Q
B
= 40,000 bottles
15-3A. Degree of Operating Leverage = DOL
S
DOL
S
=
F] V) [Q(P
V) Q(P
− −

V = 70% x $30 =$21
DOL
S
=
] 000 , 360 $ ) 21 $ 30 ($ 000 , 50 [
) 21 $ 30 ($ 000 , 50
− −

DOL
S
= 5 times
15-4A.
(a)
Jake's Sarasota Jefferson
Lawn Chairs Sky Lights Wholesale
Sales $600,640.00 $2,450,000 $1,075,470
Variable Costs $326,222 .60 $1,120,000 $957,000
Revenue before
fixed costs $274,417.40 $1,330,000 $118,470
Fixed costs $120,350 .00 $850,000 $89,500
EBIT $ 154,067 .40 $ 480,000 $ 28,970
(b)
Jake's Lawn Chairs: Q
B

=
V P
F

=
38 . 17 $ 32 $
350 , 120 $

=
62 . 14 $
350 , 120 $
= 8,232
Sarasota Skylights: Q
B

=
400 $ 875 $
000 , 850 $

=
475 $
000 , 850 $
= 1,789
Jefferson Wholesale: Q
B

=
87 $ 77 . 97 $
500 , 89 $

=
77 . 10 $
500 , 89 $
= 8,310
(c)
Jake's Sarasota Jefferson
Lawn Chairs Skylights Wholesale
EBIT
Costs Fixed
Before Revenue
=
40 . 067 , 154 $
40 . 417 , 274 $
$480,000
$1,330,000
970 , 28 $
470 , 118 $
= 1.78 times 2.77 times 4.09 times
193
(d) Jefferson Wholesale, since its degree of operating leverage exceeds that of
the other two companies.
15-5A.
(a)
EBIT
Costs Fixed Before Revenue
=
000 , 750 , 13 $
000 , 950 , 22 $
= 1.67 times
(b)
I EBIT
EBIT

=
000 , 350 , 1 $ 000 , 750 , 13 $
000 , 750 , 13 $

=
000 , 400 , 12 $
000 , 750 , 13 $
= 1.11 times
(c) DCL
45,750,000
= (1.67) (1.11) = 1.85 times
(d) S* =
S
VC
1
F

=
000 , 750 , 45 $
000 , 800 , 22 $
1
000 , 200 , 9 $

=
498 . 1
000 , 200 , 9 $

=
502 .
000 , 200 , 9 $
= $18,326,693.23
(e) (25%) × (1.85) = 46.25%
15-6A.
(a) Q
B
=
V P
F

=
58 $ 85 $
000 , 170 $

=
27 $
000 , 170 $
= 6,296 pairs of shoes
(b) S* =
S
VC
1
F

=
85 $
58 $
1
000 , 170 $

=
682 . 1
000 , 170 $

=
318 .
000 , 170 $
= $534,591.20
(c)
7,000 9,000 15,000
Pairs of Shoes Pairs of Shoes Pairs of Shoes
Sales $595,000 $765,000 $1,275,000
Variable Costs 406,000 522,000 870,000
Revenue before
fixed costs $189,000 $243,000 $405,000
Fixed costs 170,000 170,000 170,000
EBIT $ 19,000 $ 73,000 $ 235,000
194
(d)
7,000 9,000 15,000
Pairs of Shoes Pairs of Shoes Pairs of Shoes
000 , 19 $
000 , 189 $

000 , 73 $
000 , 243 $

000 , 235 $
000 , 405 $
= 9.95 times 3.33 times 1.72 times
Notice that the degree of operating leverage decreases as the firm's sales level
rises above the break-even point.
15-7A.
(a) Q
B
=
V P
F

=
110 $ 180 $
000 , 630 $

=
70 $
000 , 630 $
= 9000 Units
(b) S* = 9000 units × $180 = $1,620,000
Alternatively,
S* =
S
VC
1
F

=
180 $
110 $
1
000 , 630 $

=
6111 . 0 1
000 , 630 $

=
3889 .
000 , 630 $
= $1,619,954
Note: $1,619,954 differs from $1,620,000 due to rounding.
(c) 12,000 15,000 20,000
units units units
Sales $2,160,000 $2,700,000 $3,600,000
Variable Costs 1,320,000 1,650,000 2,200,000
Revenue before
fixed costs 840,000 1,050,000 1,400,000
Fixed costs 630,000 630,000 630,000
EBIT $ 210,000 $ 420,000 $ 770,000
(d) 12,000 units 15,000 units 20,000 units
000 , 210 $
000 , 840 $
000 , 420 $
000 , 050 , 1 $
000 , 770 $
000 , 400 , 1 $
= 4 times = 2.5 times = 1.82 times
Notice that the degree of operating leverage decreases as the firm's
sales level rises above the break-even point.
15-8A. (a)
Blacksburg Lexington Williamsburg
195
Furniture Cabinets Colonials
Sales $1,125,000 $1,600,000 $520,000
Variable costs 926,250 880,000 188,500
Revenue before
fixed costs $198,750 $720,000 $331,500
Fixed costs 35,000 100,000 70,000
EBIT $163,750 $620,000 $261,500
(b)
: Furniture
Blacksburg
Q
B
=
V P
F

=
35 . 12 $ 00 . 15 $
000 , 35 $

=
65 . 2 $
000 , 35 $
= 13,208
units
: Cabinets
Lexington
Q
B
=
220 $ 400 $
000 , 100 $

=
180 $
000 , 100 $
= 556 units
: Colonials
rg Williamsbu
Q
B
=
50 . 14 $ 00 . 40 $
000 , 70 $

=
50 . 25 $
000 , 70 $
= 2745 units
(c)
Blacksburg Lexington Williamsburg
Furniture Cabinets Colonials
EBIT
Costs Fixed
Before Revenue
750 , 163 $
750 , 198 $
000 , 620 $
000 , 720 $
500 , 261 $
500 , 331 $
= 1.21 times 1.16 times 1.27 times
(d) Williamsburg Colonials, since its degree of operating leverage
exceeds that of the other two companies.
15-9A.
(a) {S- (VC + F)} (1-T) = $50,000
( ) T 1 F
S
VC
S S −
¹
)
¹
¹
'
¹
1
]
1

¸

+
,
_

¸
¸

= $50,000
[S – VC - } (1 – T) = $50,000
{$375,000 - $206,250 – F} (0.6) = $50,000
($168,750 - F) (0.6) = $50,000
F = $85,416.67
(b) Q
B

=
V P
F

=
85 . 14 $ 00 . 27 $
67 . 416 , 85 $

=
15 . 12 $
67 . 416 , 85 $
= 7,030 units
S* =
S
VC
1
F

=
55 . 1
67 . 416 , 85 $

= $189,815
196
15-10A.(a) Find the EBIT level at the forecast sales volume:
S
EBIT
= .26
Therefore, EBIT = (0.26) ($3,250,000) = $845,000
Next, find total variable costs:
S
VC
= 0.5,
so, VC = (0.5) $3,250,000 = $1,625,000
Now, solve for total fixed costs:
S - (VC + F) = $845,000
$3,250,000 - ($1,625,000 + F) = $845,000
F = $780,000
(b) S* =
5 . 0 1
000 , 780 $

= $1,560,000
15-11A.
(a)
EBIT
costs Fixed before Revenue
=
000 , 500 , 8 $
000 , 500 , 16 $
= 1.94 times
(b)
I EBIT
EBIT

=
000 , 500 , 7 $
000 , 500 , 8 $
= 1.13 times
(c) DCL
$30,000,000
= (1.94) × (1.13) = 2.19 times
(d) S* =
S
VC
1
F

=
m
m
0 . 30 $
5 . 13 $
1
000 , 000 , 8 $

=
45 . 0 1
000 , 000 , 8 $

=
55 . 0
000 , 000 , 8 $
=
$14,545,455
(e) (25%) × (2.19) = 54.75%
15-12A.Given the data for this problem, several approaches are possible for finding the
break-even point in units. The approach below seems to work well with students.
Step (1) Compute the operating profit margin:
Operating Profit Margin x Operating Asset Turnover = Return
on operating assets
(M) x (5) = 0.25
M = .05
197
Step (2) Compute the sales level associated with the given output level:
0 $20,000,00
Sales
= 5
Sales = $100,000,000
Step (3) Compute EBIT:
(.05) ($100,000,000) = $5,000,000
Step (4) Compute revenue before fixed costs. Since the degree of
operating leverage is 4 times, revenue before fixed costs
(RBF) is 4 times EBIT as follows:
RBF = (4) × ($5,000,000) = $20,000,000
Step (5) Compute total variable costs:
(Sales) - (Total variable costs) = $20,000,000
$100,000,000 - (Total variable costs) = $20,000,000
Total variable costs = $80,000,000
Step (6) Compute total fixed costs:
RBF - Fixed costs = $5,000,000
$20,000,000 - fixed costs = $5,000,000
Fixed costs = $15,000,000
Step (7) Find the selling price per unit, and the variable cost per unit:
P =
000 , 000 , 10
000 , 000 , 100 $
= $10.00
V =
000 , 000 , 10
000 , 000 , 80 $
= $8.00
Step (8) Compute the break-even point:
Q
B

=
V P
F

=
) 8 ($ ) 10 ($
000 , 000 , 15 $

=
2 $
000 , 000 , 15 $
=
7,500,000 units
198
15-13A.
(a) Q
B

=
V P
F

=
126 $ 180 $
000 , 540 $

=
54 $
000 , 540 $
= 10,000 units
(b) S* =
S
VC
1
F

=
180 $
126 $
1
000 , 540 $

=
7 . 0 1
000 , 540 $

=
3 .
000 , 540 $
= $1,800,000

(c) 12,000 15,000 20,000
Units Units Units
Sales $2,160,000 $2,700,000 $3,600,000
Variable costs 1,512,000 1,890,000 2,520,000
Revenue before fixed costs $ 648,000 $ 810,000 $1,080,000
Fixed costs 540,000 540,000 540,000
EBIT $ 108,000 $ 270,000 $ 540,000
(d) 12,000 units 15,000 units 20,000 units
000 , 108 $
000 , 648 $
= 6 times
000 , 270 $
000 , 810 $
= 3 times
000 , 540 $
000 , 080 , 1 $
= 2 times
Notice that the degree of operating leverage decreases as the firm's sales level
rises above the break-even point.
15-14A.
(a) Oviedo Gainesville Athens
Seeds Sod Peaches
Sales $1,400,000 $2,000,000 $1,200,000
Variable costs 1,120,000 1,300,000 840,000
Revenue before fixed costs $280,000 $ 700,000 $ 360,000
Fixed costs 25,000 100,000 35,000
EBIT $ 255,000 $ 600,000 $ 325,000
(b) Oviedo Seeds: Q
B

=
V P
F

=
20 . 11 $ 00 . 14 $
000 , 25 $

=
80 . 2 $
000 , 25 $
= 8,929 units
Gainesville Sod: Q
B
=
130 $ 200 $
000 , 100 $

=
70 $
000 , 100 $
= 1,429 units
Athens Peaches: Q
B
=
50 . 17 $ 00 . 25 $
000 , 35 $

=
50 . 7 $
000 , 35 $
= 4,667 units
199
(c)
Oviedo Gainesville
Seeds Sod
000 , 255 $
000 , 280 $
= 1.098 times
000 , 600 $
000 , 700 $
= 1.167 times
Athens
Peaches
000 , 325 $
000 , 360 $
= 1.108 times
(d) Gainesville Sod, since its degree of operating leverage exceeds that of the
other two companies.
15-15A.
(a) {S - [VC + F]} (1 - T) = $40,000
( ) T 1 F
S
VC
S S −
¹
)
¹
¹
'
¹
1
]
1

¸

+
,
_

¸
¸

= $40,000
{($400,000) - ($160,000) - F} (0.6) = $40,000
($240,000 - F) (0.6) = $40,000
F = $173,333.33
(b) Q
B
=
V P
F

=
12 $
33 . 333 , 173 $
= 14,444 units
S* =
S
VC
1
F

=
40 . 0 1
33 . 333 , 173 $

= $288,888.88
15-16A.
(a) {S - [VC + F] } (1-T) = $80,000
( ) T 1 F
S
VC
S S −
¹
)
¹
¹
'
¹
1
]
1

¸

+
,
_

¸
¸

= $80,000
{($2,000,000) - (1,400,000) - F} (.6) = $80,000
($600,000 - F) (.6) = $80,000
$360,000 - .6F = $80,000
F = $466,666.67
(b) Q
B
=
V P
F

=
24 $
67 . 666 , 466 $
= 19,444 units
200
S* =
S
VC
1
F

=
7 . 1
67 . 666 , 466 $

=
3 .
67 . 666 , 466 $
= $1,555,555.57
15-17A.
(a) S (1 - 0.75) - $300,000 = $240,000
0.25S = $540,000
S = $2,160,000 = (P × Q)
Now, solve the above relationship for P:
200,000 (P) = $2,160,000
P = $10.80
(b) Sales $2,160,000
Less: Total variable costs 1,620,000
Revenue before fixed costs $540,000
Less: Total fixed costs 300,000
EBIT $ 240,000
15-18A.
(a) S (1 - .6) - $300,000 = $250,000
.4S = $550,000
S = $1,375,000 = (P × Q)

Solve the above relationship for P.
200,000 (P) = $1,375,000
P = $6.875
(b) Sales $1,375,000
Less: Total variable costs 825,000
Revenue before fixed costs $550,000
Less: Total fixed costs 300,000
EBIT $ 250,000
201
15-19A.
(a) First, find the EBIT level at the forecast sales volume:
= 0.28
So: EBIT = (0.28) $3,750,000 = $1,050,000
Next, find total variable costs:
= 0.5
So: VC = (0.50) $3,750,000 = $1,875,000
Then, solve for total fixed costs:
S - (VC + F) = $1,050,000
$3,750,000 - ($1,875,000 + F) = $1,050,000
F = $825,000
(b) S*

=
5 . 0 1
000 , 825 $

= $1,650,000
15-20A.
(a) Q
B
=
V P
F

=
150 $
000 , 180 $
= 1,200 units
(b) S* =
S
VC
1
F

=
70 . 0 1
000 , 180 $

= $600,000
(c) DOL
$2,500,000
=
000 , 180 $ ) 350 $ 500 ($ 000 , 5
) 350 $ 500 ($ 000 , 5
− −

000 , 570 $
000 , 750 $
= 1.316 times
(d) (20%) x (1.316) = 26.32% Increase
202
15-21A.
(a) Q
B

=
V P
F

=
15 $ 25 $
000 , 50 $

=
10 $
000 , 50 $
= 5,000 units
(b) S* =
S
VC
1
F

=
25 $
15 $
1
000 , 50 $

=
6 . 0 1
000 , 50 $

=
4 .
000 , 50 $
= $125,000
(c) 4000 units 6000 units 8000 units
Sales $100,000 $150,000 $200,000
Variable costs 60,000 90,000 120,000
Revenue before fixed costs $ 40,000 $ 60,000 $ 80,000
Fixed costs 50,000 50,000 50,000
EBIT $-10,000 $ 10,000 $ 30,000
(d) 4000 units 6000 units 8000 units
000 , 10 $
000 , 40 $

= -4X
000 , 10 $
000 , 60 $
= 6X
000 , 30 $
000 , 80 $
= 2.67X
(e) The degree of operating leverage decreases as the firm's sales level rises
above the break-even point.
15-22A. Compute the present level of break-even output:
Q
B
=
V P
F

=
7 $ 12 $
000 , 120 $

= 24,000 units
Compute the new level of fixed costs at the break-even output:
S – V – F = 0
($12) (24,000) - ($5) (24,000) - F = 0
$288,000 - $120,000 - F = 0
$168,000 = F
Compute the addition to fixed costs:
$168,000 - $120,000 = $48,000 addition
203
15-23A. DOL
$360,000
=
000 , 120 $ ) 7 $ 12 ($ 000 , 30
) 7 $ 12 ($ 000 , 30
− −

=
000 , 30 $
000 , 150 $
= 5 times
Any percentage change in sales will magnify EBIT by a factor of 5.
15-24A.
(a) DOL
$480,000
=
000 , 120 ) 7 $ 12 ($ 000 , 40
) 7 $ 12 ($ 000 , 40
− −

=
000 , 80 $
000 , 200 $
= 2.5 times
(b) DFL
$80,000
=
000 , 30 $ 000 , 80 $
000 , 80 $

= 1.6 times
(c) DCL
$480,000
=
000 , 30 $ 000 , 120 $ ) 7 $ 12 ($ 000 , 40
) 7 $ 12 ($ 000 , 40
− − −

=
000 , 50 $
000 , 200 $
= 4 times
Alternatively:
(DOL
S
) x (DFL
EBIT
) = DCL
S

(2.5) x (1.6) = 4 times
15-25A. The task is to find the break-even point in units for the firm. Several
approaches are possible, but the one presented below makes intuitive sense to
students.
Step (1) Compute the operating profit margin:
(Operating Profit Margin) x (Operating Asset Turnover) =
Return on Operating Assets
(M) x (5) = 0.15
M = 0.03
Step (2) Compute the sales level associated with the given output level:
$3,000,000
Sales
= 5
Sales = $15,000,000
Step (3) Compute EBIT:
(0.03) ($15,000,000) = EBIT = $450,000
204
Step (4) Compute revenue before fixed costs. Since the degree of
operating leverage is 8 times, revenue before fixed costs
(RBF) is 8 times EBIT as follows:
RBF = (8) × ($450,000) = $3,600,000
Step (5) Compute total variable costs:
Sales - Total variable costs = $3,600,000
$15,000,000 - Total variable costs = $3,600,000
Total variable costs = $11,400,000
Step (6) Compute total fixed costs:
RBF - Fixed costs = $450,000
$3,600,000 - Fixed costs = $450,000
Fixed costs = $3,150,000
Step (7) Find the selling price per unit, and the variable cost per unit:
P =
000 , 600 , 1
000 , 000 , 15 $
= $9.375
V =
000 , 600 , 1
000 , 400 , 11 $
= $7.125
Step (8) Compute the break-even point:
Q
B
=
V P
F

=
) 125 . 7 ($ ) 375 . 9 ($
000 , 150 , 3 $

=
25 . 2 $
000 , 150 , 3 $
= 1,400,000 units
15-26A. Compute the present level of break-even output:
Q
B

=
V P
F

=
14 $ 20 $
000 , 300 $

= 50,000 units
Compute the new level of fixed costs at the break-even output.
S – V – F = 0
($20) (50,000) - ($12) (50,000) – F = 0
$400,000 = F
Compute the addition to fixed costs:
$400,000 - $300,000 = $100,000 addition
15-27A.
(a)
EBIT
costs fixed before Revenue
=
000 , 000 , 1 $
000 , 000 , 3 $
= 3 times
205
(b)
I EBIT
EBIT

=
000 , 800 $
000 , 000 , 1 $
= 1.25 times
(c) DCL
$12,000,000
= (3) × (1.25) = 3.75 times
(d) S* =
S
VC
1
F

=
$12m
$9m
1
$2,000,000

=

75 . 0 1
000 , 000 , 2 $

=
25 . 0
000 , 000 , 2 $
= $8,000,000
15-28A.
(a)
EBIT
costs fixed before Revenue
=
000 , 000 , 4 $
000 , 000 , 8 $
= 2 times
(b)
I EBIT
EBIT

=
000 , 500 , 2 $
000 , 000 , 4 $
= 1.6 times
(c) DCL
$16,000,000
= (2) (1.6) = 3.2 times
(d) (20%) (3.2) = 64% Increase
(e) S* =
S
VC
1
F

=
$16m
$8m
1
$4,000,000

=
5 . 0 1
000 , 000 , 4 $

= $8,000,000
206
15-29A.a. A B C D Total
Sales $40,000 $50,000 $20,000 $10,000 $120,000
Variable costs* 24,000 34,000 16,000 4,000 78,000
Contribution margin $16,000 $16,000 $ 4,000 $ 6,000 $ 42,000
Contribution margin ratio 40% 32% 20% 60% 35%
*Variable costs = (Sales) (1 - contribution margin ratio)
b. 35%
c.. Break-even point in sales dollars:
S* =
S
VC
1
F

=
65 . 0 1
400 , 29 $

=
35 . 0
400 , 29 $
= $84,000
15-30A. A B C D Total
Sales $30,000 $44,000 $40,000 $6,000 $120,000
Variable costs* 18,000 29,920 32,000 2,400 82,320
Contribution margin $12,000 $14,080 $ 8,000 $ 3,600 $ 37,680
Contribution margin ratio 40% 32% 20% 60% 31.4%
*Variable costs = (sales) (1- contribution margin ratio).
b. 31.4%
c.. Break-even point in sales dollars:
S* =
S
VC
1
F

=
314 . 0
400 , 29 $
= $93,631
Toledo's management would prefer the sales mix identified in problem 15-29A. That
sales mix provides a higher EBIT ($12,600 vs. $8,280) and a lower break-even point
($84,000 vs. $93,631).
SOLUTION TO INTEGRATIVE PROBLEM:
In solving for the break-even point in units, the following step-by-step approach seems to be
the most logical to students and the easiest for them to understand.
COMPUTE BREAK-EVEN POINT:
STEP 1: Compute the operating profit margin:
Operating Profit Margin [M] x Operating Asset Turnover = Return on
operating assets
M x 7 = 35%
M = 5%
207
STEP 2: Compute the sales level associated with the given output level:
Operating Assets x Operating Asset Turnover = Sales
$2,000,000 x 7 = Sales
Sales = $14,000,000
STEP 3: Compute EBIT:
Sales [STEP 2] x Operating Profit Margin [STEP 1] = EBIT
$14,000,000 x 5% = EBIT
EBIT = $700,000
STEP 4: Compute revenue before fixed costs:
EBIT [STEP 3] x Degree of Operating Leverage = Revenue before Fixed
Costs
$700,000 x 5 = Revenue before Fixed Costs
Revenue before Fixed Costs = $3,500,000
STEP 5: Compute total variable costs:
Sales [STEP 2] - Revenue before Fixed Costs [STEP 4] = Total Variable
Costs
$14,000,000 - $3,500,000 = Total Variable Costs
Total Variable Costs = $10,500,000
STEP 6: Compute total fixed costs:
Revenue before Fixed Costs [STEP 4] - EBIT [STEP 3] = Fixed Costs
$3,500,000 - $700,000 = Fixed Costs
Fixed Costs = $2,800,000
STEP 7: Find selling price per unit (P) and variable cost per unit (V):
P = Sales [STEP 2] / Output in Units
P = $14,000,000 / 50,000 units
P = $280.00
V = Total Variable Costs [STEP 5] / Output in Units
V = $10,500,000 / 50,000 units
V = $210.00
208
STEP 8: Compute break-even point (in units):
Q
B
= F [STEP 6] / (P - V) [STEP 7]
Q
B
= $2,800,000 / ($280.00 - $210.00)
Q
B
= 40,000 units
After determining the break-even point using the approach described above, the students
have the information necessary to prepare an analytical income statement as follows:
Sales [STEP 2] $14,000,000
Variable Costs [STEP 5] 10,500,000
Revenue before Fixed Costs $3,500,000
Fixed Costs [STEP 6] 2,800,000
EBIT $700,000
Interest Expense 400,000
Earnings Before Taxes $300,000
Taxes (35%) 105,000
Net Income $195,000
Thereafter, the students have the data they need to answer questions (a) - (e) as follows:
(a) Degree of financial leverage:
DFL
EBIT
= EBIT / (EBIT - Interest)
DFL
EBIT
= $700,000 / ($700,000 - $400,000)
DFL
EBIT
= 2.33
(b) Degree of Combined Leverage:
DCL
S
= DOL
S
x DFL
EBIT
DCL
S
= 5 x 2.33
DCL
S
= 11.65
(c) Break-even point in sales dollars:
S* =
S
VC
1
F

S* =
0 $14,000,00
0 $10,500,00
- 1
$2,800,000
S* = $11,200,000
(d) “If sales increase 30%, by what percent would EBT increase?”
% increase in EBT = % increase in Sales x DCL
S
209
% increase in EBT = 30% x 11.65
% increase in EBT = 350%
(e) Analytical Income Statement to verify effect of 30% increase in sales:
Sales] $18,200,000
Variable Costs 13,650,000
Revenue Before Fixed Costs $4,550,000
Fixed Costs [STEP 6] 2,800,000
EBIT $1,750,000
Interest Expense 400,000
Earnings Before Taxes $1,350,000
Taxes (35%) 472,500
Net Income $877,500
It may be useful to develop the following “proof” to assist in explaining the inter-
relationships of the various values:
% change in EBT = (EBT
after
- EBT
before
) / EBT
before
% change in EBT = ($1,350,000 - $300,000) / $300,000
% change in EBT = 350%
which agrees with the following:
% change in EBT = % change in Sales x DCL
S
% change in EBT = 30% x 11.65
% change in EBT = 350%
Solutions To Problem Set B
15-1B. Break-even Quantity = Q
B
Q
B
=
V) (P
F

P =
units 40,000,000
0 $20,000,00
= $.50 per unit
V =
units 40,000,000
0 $16,000,00
= $.40 per unit
thus,
Q
B
=
) 40 . 0 $ 50 . 0 ($
000 , 400 , 2 $

Q
B
= 24,000,000 units
210
211
15-2B. Degree of Combined Leverage = DCL
S
Degree of Operating Leverage = DOL
S
Degree of Financial Leverage = DFL
EBIT
DOL
S
=
F] V) [Q(P
V) Q(P
− −

P =
units 40,000,000
0 $20,000,00
= $.50 per unit
V =
units 40,000,000
0 $16,000,00
= $.40 per unit
thus,
DOL
S
=
[ ] 000 , 400 , 2 $ ) 40 . 0 $ 50 . 0 ($ 000 , 000 , 40
) 40 . 0 $ 50 . 0 ($ 000 , 000 , 40
− −

DOL
S
= 2.50 times
DFL
EBIT
=
1) (EBIT
EBIT

DFL
EBIT
=
) 000 , 800 $ 000 , 600 , 1 ($
000 , 600 , 1 $

DFL
EBIT
= 2.00 times
and
DCL
S
=
I] F V) [Q(P
V) Q(P
− − −

DCL
S
=
[ ] 000 , 800 $ 000 , 400 , 2 $ ) 40 . 0 $ 50 . 0 ($ 000 , 000 , 40
) 40 . 0 $ 50 . 0 ($ 000 , 000 , 40
− − −

DCL
S
=
000 , 800 $
000 , 000 , 4 $
DCL
s
= 5.00 times
15-3B.
(a) Q
B
=
V P
F

=
115 $ 175 $
000 , 650 $

=
60 $
000 , 650 $
= 10,833 Units
212
(b) S* = (10,833 units) × ($175) = $1,895,775
Alternatively,
S* =
S
VC
1
F

=
175 $
115 $
1
000 , 650 $

=
6571 . 0 1
000 , 650 $

=
3429 .
000 , 650 $
= $1,895,596
Note: $1,895,596 differs from $1,895,775 due to rounding.
(c) 10,000 16,000 20,000
units units units
Sales $1,750,000 $2,800,000 $3,500,000
Variable costs 1,150,000 1,840,000 2,300,000
Revenue before fixed costs 600,000 960,000 1,200,000
Fixed costs 650,000 650,000 650,000
EBIT -$50,000 $ 310,000 $ 550,000
(d) 10,000 units 16,000 units 20,000 units
000 , 50 $
000 , 600 $

= -12 times
$310,000
$960,000
= 3.1 times
000 , 550 $
000 , 200 , 1 $
= 2.2
times
Notice that the degree of operating leverage decreases as the firm's sales level
rises above the break-even point.
15-4B.
(a) Durham Raleigh Charlotte
Furniture Cabinets Colonials
Sales $1,600,000 $1,957,500 $525,000
Variable costs 1,100,000 1,080,000 236,250
Revenue before
fixed costs $500,000 $877,500 $288,750
Fixed costs 40,000 150,000 60,000
EBIT $460,000 $727,500 $228,750
(b) Q
B
=
V P
F

=
75 . 13 $ 00 . 20 $
000 , 40 $

=
25 . 6 $
000 , 40 $
=
6,400 units
Q
B
=
240 $ 435 $
000 , 150 $

=
195 $
000 , 150 $
= 769 units
Q
B
=
75 . 15 $ 00 . 35 $
000 , 60 $

=
25 . 19 $
000 , 60 $
= 3,117 units
213
(c)
Durham Raleigh Charlotte
Furniture Furniture Colonials
=
000 , 460 $
000 , 500 $
=
500 , 727 $
500 , 877 $
=
750 , 228 $
750 , 288 $
= 1.09 times 1.21 times 1.26 times
(d) Charlotte Colonials, since its degree of operating leverage exceeds that of the
other two companies.
15-5B.
(a) {S - [VC + F]} (1 - T) = $55,000
( ) T 1 F
S
VC
S S −
¹
)
¹
¹
'
¹
1
]
1

¸

+
,
_

¸
¸

= $55,000
{$400,008 - [257,148 + F ]} (0.55) = $55,000
($142,860 - F) (0.55) = $55,000
F = $42,860
(b) Q
B

=
V P
F

=
00 . 18 $ 00 . 28 $
860 , 42 $

=
00 . 10 $
860 , 42 $
= 4,286 units
S* =
S
VC
1
F

=
643 . 0 1
860 , 42 $

= $120,056
15-6B. (a) Find the EBIT level at the forecast sales volume:
S
EBIT
= .28
Therefore, EBIT = (0.28) ($3,750,000) = $1,050,000
Next, find total variable costs:
S
VC
= 0.55,
so: VC = (0.55) $3,750,000 = $2,062,500
Now, solve for total fixed costs:
S - (VC + F) = $1,050,000
$3,750,000 - ($1,687,500 + F) = $1,050,000
F = $637,500
214
(b) S* =
55 . 0 1
500 , 637 $

= $1,416,667
15-7B.
(a) =
000 , 000 , 14 $
000 , 000 , 24 $
= 1.71 times
(b)
I EBIT
EBIT

=
000 , 850 , 12 $
000 , 000 , 14 $
= 1.09 times
(c) DCL
$40,000,000
= (1.71) × (1.09) = 1.86 times
(d) S* =
S
VC
1
F

=
$40m
$16m
1
0 $10,000,00

=
4 . 0 1
000 , 000 , 10 $

=
6 . 0
000 , 000 , 10 $
= $16,666,667
(e) (20%) × (1.86) = 37.2%
15-8B. Given the data for this problem, several approaches are possible for finding the
break-even point in units. The approach below seems to work well with students.
Step (1) Compute the operating profit margin:
(Operating Profit Margin) x (Operating Asset Turnover) = Return on
Operating Assets
(M) x (5) = 0.25
M = .05
Step (2) Compute the sales level relative to the given output level:
0 $18,000,00
Sales
= 5
Sales = $90,000,000
Step (3) Compute EBIT:
(.05) ($90,000,000) = $4,500,000
Step (4) Compute revenue before fixed costs. Since the degree of operating
leverage is 6 times, revenue before fixed costs (RBF) is 6 times EBIT
as follows:
RBF = (6) × ($4,500,000) = $27,000,000
215
Step (5) Compute total variable costs:
(Sales) - (Total variable costs) = $27,000,000
$90,000,000 - (Total variable costs) = $27,000,000
Total variable costs = $63,000,000
Step (6) Compute total fixed costs:
RBF - Fixed costs = $4,500,000
$27,000,000 - fixed costs = $4,500,000
Fixed costs = $22,500,000
Step (7) Find the selling price per unit, and the variable cost per unit:
P =
000 , 000 , 7
000 , 000 , 90 $
= $12.86
V =
000 , 000 , 7
000 , 000 , 63 $
= $9.00
Step (8) Compute the break-even point:
Q
B

=
V P
F

=
) 9 ($ ) 86 . 12 ($
000 , 500 , 22 $

=
86 . 3 $
000 , 500 , 22 $
= 5,829,016 units
15-9B.
(a) Q
B

=
V P
F

=
140 $ 175 $
000 , 550 $

=
35 $
000 , 550 $
= 15,714
units
(b) S* =
S
VC
1
F

=
175 $
140 $
1
000 , 550 $

=
8 . 0 1
000 , 550 $

=
2 .
000 , 550 $
= $2,750,000

(c) 12,000 15,000 20,000
Units Units Units
Sales $2,100,000 $2,625,000 $3,500,000
Variable costs 1,680,000 2,100,000 2,800,000
Revenue before fixed costs $ 420,000 $ 525,000 $700,000
Fixed costs 550,000 550,000 550,000
EBIT -$130,000 -$25,000 $ 150,000
216
(d) 12,000 units 15,000 units 20,000 units
000 , 130 $
000 , 420 $

= -3.2 times
000 , 25 $
000 , 525 $

= -21 times
000 , 150 $
000 , 700 $
= 4.67
times
15-10B.
(a) Farm City Empire Golden
Seeds Sod Peaches
Sales $1,800,000 $1,710,000 $1,400,000
Variable costs 1,410,000 1,305,000 950,000
Revenue before fixed costs $390,000 $ 405,000 $ 450,000
Fixed costs 30,000 110,000 33,000
EBIT $ 360,000 $ 295,000 $ 417,000
(b) Farm City: Q
B

=
V P
F

=
75 . 11 $ 00 . 15 $
000 , 30 $

=
25 . 3 $
000 , 30 $
= 9,231
units
Empire Sod: Q
B
=
145 $ 190 $
000 , 110 $

=
45 $
000 , 110 $
= 2,444 units
Golden Peaches: Q
B
=
19 $ 00 . 28 $
000 , 33 $

=
9 $
000 , 33 $
= 3,667 units
(c) Farm City Empire Golden
Seeds Sod Peaches
000 , 360 $
000 , 390 $
= 1.083 times
000 , 295 $
000 , 405 $
= 1.373 times
000 , 417 $
000 , 450 $
= 1.079 times
(d) Empire Sod, since its degree of operating leverage exceeds that of the other
two companies.
15-11B.
(a) {S – [VC + F]} (1-T) = $38,000
( ) T 1 F
S
VC
S S −
¹
)
¹
¹
'
¹
1
]
1

¸

+
,
_

¸
¸

= $38,000
[($420,002) - ($222,354) - F] (0.65) = $38,000
($197,648 - F) (0.65) = $38,000
F = $139,186.46
217
(b) Q
B

=
V P
F

=
8 $
46 . 186 , 139 $
= 17,398 units
S* =
S
VC
1
F

=
5294 . 0 1
46 . 186 , 139 $

= $295,764
15-12B.
(a) {S – [VC + f]} (1 – T) = $70,000
( ) T 1 F
S
VC
S S −
¹
)
¹
¹
'
¹
1
]
1

¸

+
,
_

¸
¸

= $70,000
[ ($2,500,050) - (1,933,372) - F ]

(.55) = $70,000
($566,678 - F) (.55) = $70,000
($311,672.9 - .55F) = $70,000
F = $439,405.27
(b) Q
B

=
V P
F

=
17 $
27 . 405 , 439 $
= 25,847 units
S* =
S
VC
1
F

=
.7733 1
7 $439,405.2

=
.2267
7 $439,405.2
= $1,938,268 =
2267 .
27 . 405 , 439 $
15-13B.
(a) S (1 - 0.8) - $335,000 = $270,000
0.2S = $605,000
S = $3,025,000 = (P × Q)
Now, solve the above relationship for P:
175,000 (P) = $3,025,000
P = $17.29
(b) Sales $3,025,750
Less: Total variable costs 2,420,600
Revenue before fixed costs $605,150
Less: Total fixed costs 335,000
EBIT $ 270,150
218
15-14B.
(a) S (1-.75) - $300,000 = $250,000
.25S = $550,000
S = $2,200,000 = (P × Q)
Solve the above relationship for P:
190,000 (P) = $2,200,000
P = $11.58
(b) Sales $2,200,000
Less: Total variable costs 1,650,000
Revenue before fixed costs $550,000
Less: Total fixed costs 300,000
EBIT $ 250,000
15-15B.
(a) First, find the EBIT level at the forecast sales volume:
S
EBIT
= 0.25
So: EBIT = (0.25) $4,250,000 = $1,062,500
Next, find total variable costs:
= 0.4
So: VC = (0.40) $4,250,000 = $1,700,000
Then, solve for total fixed costs:
S - (VC + F) = $1,062,500
$4,250,000 - ($1,700,000 + F) = $1,062,500
F = $1,487,500
(b) S*

=
4 . 1
500 , 487 , 1 $

= $2,479,167
15-16B.
(a) Q
B

=
V P
F

=
125 $
000 , 200 $
= 1,600 units
(b) S* =
S
VC
1
F

=
0.7368 1
$200,000

= $759,878
219
(c) DOL
$2,850,000
=
000 , 200 $ ) 350 $ 475 ($ 000 , 6
) 350 $ 475 ($ 000 , 6
− −


000 , 550 $
000 , 750 $
= 1.364 times
(d) (13%) x (1.364) = 17.73% Increase
15-17B.
(a) Q
B

=
V P
F

=
17 $ 28 $
000 , 55 $

=
11 $
000 , 55 $
= 5,000 units
(b) S* =
S
VC
1
F

=
28 $
17 $
1
000 , 55 $

=
607 . 0 1
000 , 55 $

=
393 .
000 , 55 $
=
$139,949
(c) 4,000 units 6,000 units 8,000 units
Sales $112,000 $168,000 $224,000
Variable costs 68,000 102,000 136,000
Revenue before fixed costs $ 44,000 $ 66,000 $ 88,000
Fixed costs 55,000 55,000 55,000
EBIT -$11,000 $ 11,000 $ 33,000
(d) 4000 units 6000 units 8000 units
000 , 11 $
000 , 44 $

= -4X
000 , 11 $
000 , 66 $
= 6X
000 , 33 $
000 , 88 $
= 2.67X
(e) The degree of operating leverage decreases as the firm's sales level rises
above the break-even point.
15-18B. Compute the present level of break-even output:
Q
B

=
V P
F

=
6 $ 13 $
000 , 135 $

= 19,286 units
Compute the new level of fixed costs at the break-even output:
S – V – F = 0
($13) (19,286) - ($5) (19,286) - F = 0
$250,718 - $96,430 - F = 0
$154,288 = F
Compute the addition to fixed costs:
$154,288 - $135,000 = $19,288 addition
220
15-19B. DOL
$520,000
=
000 , 135 $ ) 6 $ 13 ($ 000 , 40
) 6 $ 13 ($ 000 , 40
− −

=
000 , 145
000 , 280 $
= 1.93 times
Any percentage change in sales will magnify EBIT by a factor of 1.93.
15-20B.
(a) DOL
$650,000
=
000 , 135 ) 6 $ 13 ($ 000 , 50
) 6 $ 13 ($ 000 , 50
− −

=
000 , 215 $
000 , 350 $
= 1.63 times
(b) DFL
$215,000
=
000 , 60 $ 000 , 215 $
000 , 215 $

= 1.39 times
(c) DCL
$650,000
=
000 , 60 $ 000 , 135 $ ) 6 $ 13 ($ 000 , 50
) 6 $ 13 ($ 000 , 50
− − −

=
000 , 155 $
000 , 350 $
= 2.26 times
Alternatively:
DOL
S
x DFL
EBIT
= DCL
S

1.63 x 1.39 = 2.26 times
15-21B. The task is to find the break-even point in units for the firm. Several
approaches are possible, but the one presented below makes intuitive sense to
students.
Step (1) Compute the operating profit margin:
(Operating Profit Margin) x (Operating Asset Turnover) = Return on
Operating Assets
(M) x (6) = 0.16
M = 0.0267
Step (2) Compute the sales level associated with the given output level:
$3,250,000
Sales
= 6
Sales = $19,500,000
Step (3) Compute EBIT:
(0.0267) ($19,500,000) = EBIT = $520,000
221
Step (4) Compute revenue before fixed costs. Since the degree of operating
leverage is 9 times, revenue before fixed costs (RBF) is 9 times EBIT
as follows:
RBF = (9) ($520,000) = $4,680,000
Step (5) Compute total variable costs:
Sales - Total variable costs = $4,680,000
$19,500,000 - Total variable costs = $4,680,000
Total variable costs = $14,820,000
Step (6) Compute total fixed costs:
RBF - Fixed costs = $520,000
$4,680,000 - Fixed costs = $520,000
Fixed costs = $4,160,000
Step (7) Find the selling price per unit, and the variable cost per unit:
P =
000 , 700 , 1
000 , 500 , 19 $
= $11.471
V =
000 , 700 , 1
000 , 820 , 14 $
= $8.718
Step (8) Compute the break-even point:
Q
B
=
V P
F

=
) 718 . 8 ($ ) 471 . 11 ($
000 , 160 , 4 $

=
753 . 2 $
000 , 160 , 4 $
=
1,511,079 units
15-22B. Compute the present level of break-even output:
Q
B

=
V P
F

=
13 $ 25 $
000 , 375 $

= 31,250 units
Compute the new level of fixed costs at the break-even output.
S – V – F = 0
($25) (31,250) - ($11) (31,250) - F = 0
$437,500 = F
Compute the addition to fixed costs:
$437,500 - $375,000 = $62,500 addition
15-23B.
(a)
EBIT
costs fixed before Revenue
=
000 , 250 , 1 $
000 , 250 , 4 $
= 3.4 times
(b)
I EBIT
EBIT

=
000 , 000 , 1 $
000 , 250 , 1 $
= 1.25 times
(c) DCL
$13,750,000
= (3.4) × (1.25) = 4.25 times
222
(d) S* =
S
VC
1
F

=
$13.75m
$9.5m
1
3,000,000

=
0.6909 1
$3,000,000

=
0.3091
$3,000,000
= $9,705,597
15-24B.
(a)
EBIT
costs fixed before Revenue
=
000 , 000 , 5 $
000 , 000 , 11 $
= 2.2 times
(b)
I EBIT
EBIT

=
000 , 250 , 3 $
000 , 000 , 5 $
= 1.54 times
(c) DCL
$18,000,000
= (2.2) × (1.54) = 3.39 times
(d) (15%) × (3.39) = 50.9%
(e) S* =
S
VC
1
F

=
$18m
$7m
1
$6,000,000

=
389 . 0 1
000 , 000 , 6 $

= $9,819,967
15-25B.a. A B C D Total
Sales $38,505 $61,995 $29,505 $19,995 $150,000
Variable costs* 23,103 42,157 23,604 7,998 96,862
Contribution margin $15,402 $19,838 $ 5,901 $ 11,997 $ 53,138
Contribution margin ratio 40% 32% 20% 60% 35.43%
*Variable costs = (Sales) (1 - contribution margin ratio)
b. 35.43%
c. Break-even point in sales dollars:
S* =
S
VC
1
F

=
000 , 150 $
862 , 96 $
1 −
= $98,800
223
15-26B.a. A B C D Total
Sales $49,995 $62,505 $25,005 12,495 $150,000
Variable costs* 29,997 42,503 20,004 4,998 97,502
Contribution margin $19,998 $20,002 $ 5,001 $ 7,497 $ 52,498
Contribution margin ratio 40% 32% 20% 60% 35%
*Variable costs = (sales) (1- contribution margin ratio).
b. 35%
c. Break-even point in sales dollars:
S* =
S
VC
1
F

=
35 . 0
000 , 35 $
= $100,000
Wayne's management would prefer the sales mix identified in problem 15-25B. That
first sales mix provides a higher EBIT ($18,138 vs. $17,498) and a lower break-even
point ($98,800 vs. $100,000).

224
CHAPTER 16
Planning the
Firm's Financing Mix

CHAPTER ORIENTATION
This chapter concentrates on the way the firm arranges its sources of funds. The cost of
capital – capital structure argument is highlighted. A moderate view on the effect of
financial leverage use on the composite cost of capital is adopted. Later, techniques useful to
the financial officer faced with the determination of an appropriate financing mix are
described.
CHAPTER OUTLINE
I. Introduction
A. A distinction between financial structure and capital structure
1. Financial structure is the mix of items on the right-hand side of the
firm's balance sheet.
2. Capital structure is the mix of long-term sources of funds.
3. The main focus will be capital structure management and not the
appropriate maturity composition of the sources of funds.
B. The objective of capital structure management is to mix the permanent
sources of funds in a manner that will maximize the company's common
stock price. This proper mix of fund sources is referred to as the optimal
capital structure.
II. A glance at capital structure theory
A. The cost of capital – capital structure argument may be characterized by this
question: Can the firm affect its overall cost of funds by varying the mixture
of financing sources used?
B. If the firm's cost of capital can be affected by the degree to which it uses
financial leverage, then capital structure management is important.
225
C. The analytical discussion revolves around a simplified version of the basic
dividend valuation model.
1. It assumes (a) cash dividends paid will not change over the infinite
holding period, and (b) the firm retains none of its current earnings.
2. The analytical setting for the discussion of capital structure theory
assumes (a) corporate income is not subject to any taxation, (b)
capital structures consist of only stocks and bonds, (c) the expected
values of all investors' forecasts of the future levels of net operating
income for each firm are identical, and (d) securities are traded in
perfect or efficient financial markets.
III. Extreme position 1: The Independence Hypothesis (NOI Theory)
A. When business income is not subject to taxation, the firm's composite cost of
capital and common stock price are both independent of the degree to which
the firm chooses to use financial leverage.
B. Total market value of the firm's outstanding securities is unaffected by the
arrangement of the right-hand side of the balance sheet.
C. The independence hypothesis rests upon what is called the net operating
income (NOI) approach to valuation.
D. The use of a greater degree of financial leverage may result in greater
earnings and dividends, but the firm's cost of common equity will rise at
precisely the same rate as the earnings and dividends.
IV. Extreme position 2: The Dependence Hypothesis (NI Theory)
A. The dependence hypothesis suggests that both the weighted cost of capital
and the firm's common stock price are affected by the firm's use of financial
leverage.
B. Regardless of the firm's use of debt financing, both its cost of debt and equity
capital will not be affected by capital structure adjustments.
C. The cost of debt is less than the cost of common equity, implying greater
financial leverage use will lower the weighted cost of capital indefinitely
D. The dependence hypothesis rests upon what is called the net income (NI)
approach to valuation.
V. A moderate position: Corporate Income is Taxed and Firms May Fail
A. Admits to the following facts: (1) interest expense is tax deductible, and (2)
the probability of suffering bankruptcy costs is directly related to the use of
financial leverage.
226
B. When interest expense is tax deductible, the sum of the cash flows that the
firm could pay to all contributors of corporate capital is affected by its
financing mix. This is not the case when an environment of no corporate
taxation is presumed.
1. The amount of the tax shield on interest may be calculated as
Tax shield = r (M) (t)
where r = the interest rate paid on outstanding debt
M = the principal amount of the debt
t = the firm's tax rate
2. This position presents the view that the tax shield must have value in the
marketplace.
3. Therefore, financial leverage affects firm value, and it must also
affect the cost of corporate capital.
C. There is some point at which the expected cost of default is large enough to
outweigh the tax shield advantage of debt financing. At that point, the firm
will turn to common equity financing.
D. The determination of the firm's financing mix is centrally important to both
the financial manager and the firm's owners.
VI. Firm Value, Agency Costs, the Static Trade-off Theory, and the Pecking Order
Theory
A. To ensure that agent-managers act in the stockholders' best interest requires
1. Proper incentives to do so through compensation plans and perquisites
2. Decisions that are monitored through bonding, auditing financial
statements, limiting decisions, and reviewing the perquisites
B. Agency problems stem from conflicts of interest between firm management
and owners; capital structure management encompasses a natural conflict
between stockholders and bondholders.
1. To reduce the conflict of interest, creditors and stockholders may
agree to include several protective covenants in the bond contract.
2. Monitoring costs should differ in direct proportion to low or high
levels of leverage.
C. Static trade-off theory distinguished from pecking order theory
1. Static trade-off theory provides for the identification of a precise
optimum financing mix. This financing mix should logically
determine the firm's targeted leverage ratio.
2. Static trade-off theory "prices" both expected financial distress costs
and agency costs.
227
3. Pecking order theory suggests that firm's finance projects within a
well-defined hierarchy that begins with internally generated funds and
ends with new common equity (the least desired funds source).
4. Thus, pecking order theory provides no precisely defined target
leverage ratio since typical leverage metrics just reflect the firm's
cumulative external financing needs over time.
VII. Agency costs, free cash flow, and capital structure
A. Free cash flow, as defined by Professor Michael C. Jensen, is the "cash flow
in excess of that required to fund all projects that have positive net present
values when discounted at the relevant cost of capital."
B. Like the pecking order theory, the free cash flow theory of capital structure
does not give a precise solution that determines the firm's optimal financing
mix.
C. The free cash flow theory does provide a framework and rationale for
justifying why shareholders and their boards of directors might use more debt
(financial leverage) to control management behavior and decisions.
D. The upshot of all of these theories and perspectives is that the determination
of the firm's financing mix is centrally important to the financial manager.
The firm's stockholders are indeed affected by capital structure decisions;
these decisions affect the firm's stock price.
VIII. Basic tools of capital structure management
A. The use of financial leverage has two effects on the earnings stream flowing
to common stockholders: (l) the added variability in the earnings per share
(EPS) stream that accompanies the use of fixed-charge securities and (2) the
level of EPS at a given earnings before interest and taxes level (EBIT)
associated with a specific capital structure.
B. The objective of EBIT-EPS analysis is to find the EBIT level that will equate
EPS regardless of the financing plan chosen
1. A graphic or algebraic analysis can be used.
2. By allowing for sinking fund payments, the analysis can focus upon
uncommitted earnings per share.
3. EBIT-EPS analysis considers only the level of the earnings stream
and ignores the variability in it.
C. Comparative leverage ratios involve the computation of various balance sheet
leverage ratios and coverage ratios.
D. The use of industry norms in conjunction with comparative leverage ratios
can aid in arriving at an appropriate financing mix.
228
E. Cash flow analysis (company-wide cash flows) is the study of projected
impact of capital structure decisions on corporate cash flows. According to
this tool, the appropriate level of financial leverage is reached when the
chance of running out of cash is exactly equal to that which management will
assume. An underlying assumption is that management's risk-bearing
preferences are conditioned by the investing marketplace.
IX. The Multinational Firm: Beware of Currency Risk
A. Currency risk exists for firms that have sales in non-U.S. markets.
B. Earnings must be converted from foreign currencies into dollars and reported
in the firm’s financial statements.
C. Variations in exchange rates impact firm’s overall earnings.
1. This can impact stock price, negatively if foreign currency
depreciated in value against the dollar or positively if the currency
appreciated in value.
2. Firms with high exposure to currency risk may choose to minimize
other financial risk.
X. How financial managers use this material
A. The opinions and practices of financial executives reinforce the major topics
covered in this chapter.
B. Target debt ratios are widely used by financial officers.
C. Executives operationalize debt capacity in different ways. The most popular
approach is to define the firm's debt capacity as a target percent of total
capitalization.
D. Changes in the aggregate business environment, known as business cycles,
affect capital structure decisions. Some phases of the cycle favor debt
financing over equity financing; in other phases equity financing is preferred.
E. The single most important factor that should affect the firm's financing mix is
the underlying nature of the business in which it operates. A firm's business
risk must be carefully assessed.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
16-1. (a) Financial structure: the mix of all items that appear on the right-hand side of
the company's balance sheet.
(b) Capital structure: the mix of long-term funds used by the firm.
(c) Optimal capital structure: the mix of long-term funds that will minimize the
composite cost of capital for raising a given amount of funds.
229
(d) Debt capacity: the maximum proportion of debt that the firm can include in
its capital structure and still maintain its lowest composite cost of capital.
16-2. The decision to use financial leverage by the firm affects both the level and
variability of the EPS flowing to the common stockholders. EBIT-EPS analysis
deals only with the level (amount) of EPS available under a given financing plan.
The variability in the earnings stream associated with the plan is ignored. EBIT-EPS
analysis then disregards the riskiness inherent to a particular financing alternative.
16-3. The objective of capital structure management is to mix the permanent sources of
funds used by the firm in a manner that will maximize the company's common stock
price.
16-4. Balance sheet leverage ratios compare the firm's use of funds supplied by creditors to
those supplied by owners. The inputs to these metrics come from the company's
balance sheet. Coverage ratios relate the earnings or cash flow amounts that are
available for servicing financing contracts to the associated financing costs. The
inputs to computing coverage ratios generally come from the company's income
statement. At times, footnotes to the financial statements might have to be consulted
to complete some coverage ratios. Table 16-7 in the text identifies the calculation
methods for several popular leverage ratios.
16-5. If revenues from sales are highly volatile, then other things being equal, cash flows
will be volatile. This would make it difficult to meet, on a timely basis, a large
amount of fixed financing costs. Because of this, a high degree of financial risk will
be avoided by firms that operate in industries which experience large sales
fluctuations.
16-6. If the firm's overall cost of capital is not affected by varying the mixture of financing
sources used, then capital structure management would be a meaningless activity.
Likewise, this infers that if the value of the firm is independent of the firm's
financing mix, then capital structure management is a sterile process.
16-7. Within the realm of capital structure theory, the independence hypothesis offers that
both common stock price and the composite cost of capital are not affected by the
firm's use of financial leverage. This presumes that interest expense is not tax
deductible.
16-8. Professors Modigliani and Miller are leading proponents of this theory.
16-9. This means that the shape of the firm's composite cost of capital curve is saucer-
shaped, or U-shaped, with respect to the use of financial leverage. Over moderate
degrees of leverage use, the overall cost of capital decreases. Throughout the
optimal range of leverage use, the cost of capital curve is relatively flat. At
excessive degrees of leverage use, the overall cost of capital rises. The result is a
saucer shaped cost of capital curve.
16-10. The EBIT-EPS indifference point is the level of EBIT that will equate EPS
regardless of the financing plan ultimately chosen from a set of two alternatives.
16-11. UEPS is the earnings available to the common shareholders minus sinking fund
payments that have been honored.
230
16-12. Industry norms for the various balance sheet leverage ratios and coverage ratios only
provide rough guidelines for the design of the firm's financing mix. Norms are
usually averages or some other measure of central tendency. Few firms in reality
will have the same operating characteristics as a hypothetical "normal" firm. Thus,
norms are best used on an "exception" basis. That is, if the firm's capital structure
ratios differ widely from the norms, then a defensible explanation for that condition
should be available.
16-13. Free cash flow is the cash flow in excess of that required to fund all projects that
have positive net present values when discounted at the relevant cost of capital.
16-14. The free cash flow theory of capital structure suggests that management works "best"
under the threat of financial failure. By increasing the use of leverage-inducing
instruments in the firm's capital structure, then shareholders will enjoy increased
control over management. This, in turn, reduces the agency costs of free cash flow.
16-15. During the 1980s several studies suggest that financial leverage use increased
substantially compared to the 1970s. This trend began reversing in the early 1990s
as the market for common equities improved.
16-16. It makes sense for financial managers to be familiar with the business cycle because
financial market and product market conditions can change abruptly during the
cycle. This means that company policies and decisions may differ over different
phases (say expansion or contraction) of the cycle.
16-17. Financial managers clearly favor the use of internally generated equity in the
financing of capital budgets.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
16-1A.
a. FC = Interest + Sinking Fund
FC = ($15 Million) (.18) +
years 30
million $15
FC = $2,700,000 + $500,000 = $3,200,000
b. CB
r
= Cb
0
+ NCF
r
– FC
Where: CB
0
= $2,000,000
FC = $3,200,000
and NCF
r
= $4,950,000 - $4,000,000 = $950,000
so, CB
r
= $2,000,000 + $950,000 - $3,200,000
CB
r
= -$250,000
231
c. We see that the company has a preference for a $2 million cash
balance. The combination of the recessionary period and
the proposed issue of bonds would put the firm’s
recessionary cash balance (CB
r
) at -$250,000. The
combination of the negative number and the statement
that the firm likes a cash balance of $2 million suggest
strongly that the proposed bond issue be postponed.
16-2A. The following formula can be used to solve for the amount of cash collections on
sales, C
S
, required to provide the desired end of year cash balance:
CB
r
= C
0
+ (C
S
+ OR) - (P
a
+ RM + E
n
) - FC
Solving for the required minimum cash receipts from sales:
C
S
= CB
r
- {C
0
+ OR - (P
a
+ RM + E
n
) - FC}
then, simplifying:
C
S
= CB
r
- C
0
- OR + P
a
+ RM + E
n
+ FC
where
CB
r
= desired cash balance at end of recessionary period = $200,000
C
0
= cash balance at beginning of period = $200,000
OR = other cash receipts (as percent of sales receipts) = 5%
P
a
= payroll expenditures (as percent of sales receipts) = 30%
RM = raw material payments (as percent of sales receipts) = 25%
E
n
= total nondiscretionary expenditures = $500,000
FC = fixed financial charges = $140,000
thus
C
S
= {CB
r
- C
0

+ E
n
+ FC} / {1 - (-OR% + P
a
% + RM%)}
C
S
=
} {
} { %) 25 % 30 % 5 ( 1
000 , 140 $ 000 , 500 $ 000 , 200 $ 000 , 200 $
+ + − −
+ + −
= $1,280,000
PROOF:
CB
r
= C
0
+ (C
S
+ OR) - (P
a
+ RM + E
n
) - FC
CB
r
= $200,000 + ($1,280,000 + .05 x $1,280,000) - (.30 x $1,280,000
+ .25 x $1,280,000 + $500,000) - $140,000
CB
r
= $200,000 + $1,280,000 + $64,000 - $384,000 - $320,000 - $500,000 - $140,000
CB
r
= $200,000
232
16-3A. At the EBIT indifference level:
EPS (All Debt Plan) = EPS (Debt and Equity Plan)
that is,
AllDebt
S
SF] P t) I)(1 [(EBIT − − − −
=
DebtEquity
S
SF] P t) I)(1 [(EBIT − − − −
100,000
$50,000] .35) $90,000)(1 [(EBIT − − −
=
30,000) (100,000
$20,000] .35) $32,000)(1 [(EBIT
+
− − −
10
$108,500 .65EBIT −
=
13
$40,800 .65EBIT −
EBIT = $514,103
16-4A.
(a)
s
S
P t) I)(1 (EBIT − − −
=
b
S
P t) I)(1 (EBIT − − −
1,000,000
0 0.5) $0)(1 (EBIT − − −
=
700,000
0 0.5) 1 $600,000)( (EBIT − − −
10
0.5EBIT
=
7
$300,000 0.5EBIT −
EBIT = $2,000,000
(b) Plan A Plan B
EBIT $2,000,000 $2,000,000
Interest 0 600,000
EBT $2,000,000 $1,400,000
Taxes 1,000,000 700,000
NI $1,000,000 $ 700,000
P 0 0
EAC $1,000,000 $ 700,000
EPS $ 1.00 $ 1.00
(c) See following analysis chart.
233
(d) Since $2,400,000 exceeds $2,000,000, the levered plan (Plan B) will provide
for higher EPS.

$2
1.5
1.0
0.5
0
$ 1 M i l . $ 2 M i l . $ 3 M i l . $ 4 M i l .
Plan B
Plan A
$1.0 Indif. level
$600,000
16-5A.
(a) ($30) (900,000 shares) = $27,000,000
(b) K
c
=
o
t
P
D
=
o
t
P
E
=
30 $
6 $
= 20%
In the all equity firm K
c
= K
o
, Thus, K
o
= 20%
(c) K
c
=
0 . 30 $
21 . 6 $
= 20.7%
(1) EBIT $5,400,000
- Interest 120,000
EAC $5,280,000
÷ 850,000 shares
*
= D
t
$6.21
*$1,500,000 ÷ $30 = 50,000 shares retired.
(2)
00 . 6 $
00 . 6 $ 21 . 6 $ −
= 0.035 or 3.5%
234
(3)
% 0 . 20
% 0 . 20 % 7 . 20 −
= 0.035 or 3.5%
(4)
%) 7 . 20 (
27
5 . 25
+
%) 0 . 8 (
27
5 . 1
= 20.0%
16-6A.
(a)
shares 80,000
0.4) 0)(1 (EBIT − −
=
shares 40,000
0.4) 1 $120,000)( (EBIT − −
80
0.6EBIT
=
40
$72,000 0.6EBIT −
EBIT = $240,000
(b) Plan A Plan B
EBIT $240,000 $240,000
Interest 0 120,000
EBT $240,000 $120,000
Taxes (40%) 96,000 48,000
EAC $144,000 $72,000
÷ No. of common shares 80,000 40,000
EPS $1.80 $1.80
16-7A.
(a)
shares 100,000
0.34) 0)(1 (EBIT − −
=
shares 50,000
0.34) 1 $110,000)( (EBIT − −
10
0.66EBIT
=
5
$72,600 0.66EBIT −
EBIT = $220,000
(b) Since $300,000 exceeds the indifference level of $220,000 from part (a), the
levered alternative (Plan B) will generate the higher EPS.
235
(c) Here we compute EPS for each financing plan, apply the relevant
price/earnings ratios, and, thereby, forecast a common stock price for each
plan. Thus, we have:
Plan A Plan B
EBIT $300,000 $300,000
Interest 0 110,000
EBT $300,000 $190,000
Taxes (34%) 102,000 64,600
NI $198,000 $125,400
P 0 0
EAC $198,000 $125,400
÷ No. of common shares 100,000 50,000
EPS $1.98 $2.508
x P-E ratio 19 15
= Projected Stock Price $37.62 $37.62
The added riskiness of Plan B, owing to the use of financial leverage, is
reflected in the lower P-E ratio associated with Plan B (i.e., 15x versus 19x
for Plan A). The rational investor will prefer Plan A (unlevered) as the same
projected stock price ($37.62) can be obtained with a lower level of risk
exposure.
16-8A.
(a)
shares 75,000
0.34) 0)(1 (EBIT − −
=
shares 50,000
0.34) 1 $150,000)( (EBIT − −
75
.66EBIT
=
50
$99,000 .66EBIT −
EBIT = $450,000
(b) Plan A Plan B
EBIT $450,000 $450,000
Interest 0 150,000
EBT $450,000 $300,000
Taxes (34%) 153,000 102,000
EAC $297,000 $198,000
÷ No. of common shares 75,000 50,000
EPS $3.96 $3.96
236
16-9A.
(a)
shares 100,000
0.5) $0)(1 (EBIT − −
=
shares 50,000
0.5) 1 $320,000)( (EBIT − −
10
0.5EBIT
=
5
$160,000 0.5EBIT −
EBIT = $640,000
(b) Plan A Plan B
EBIT $640,000 $640,000
Interest 0 320,000
EBT $640,000 $320,000
Taxes (50%) 320,000 160,000
NI $320,000 $160,000
P 0 0
EAC $320,000 $160,000
÷ No. of Common Shares 100,000 50,000
EPS $ 3 .20 $ 3 .20
(c) Since $800,000 exceeds the calculated indifference level of $640,000, the
levered plan (Plan B) will generate the higher EPS.
(d) To solve this part of problem 10-6A, compute EPS under each financial
alternative. Then apply the relevant price-earnings ratio for each plan. An
associated common stock price for each plan can then be forecast. This
follows.
Plan A Plan B
EBIT $800,000 $800,000
Interest 0 320,000
EBT $800,000 $480,000
Taxes (50%) 400,000 240,000
NI $400,000 $240,000
P 0 0
EAC $400,000 $240,000
÷ No. of Common Shares 100,000 50,000
EPS $ 4.00 $ 4.80
X P-E Ratio 12 10
= Projected Stock Price $48.00 $48.00
The riskiness is reflected in a lower P-E ratio for Plan B of 10 versus that of
12 for Plan A (the all common equity plan). The decision now can logically
shift to Plan A (unlevered). The investors obtain the same stock price of
$48.00 under both plans. The risk of Plan A is lower, so it would be
preferable.
237
16-10A.
(a) FC = Interest + Sinking Fund
FC = ($10 million) (.15) +
20yr.
n) ($10millio
FC = $1,500,000 + $500,000 = $2,000,000
(b) CB
r
= CB
0
+ NCF
r
- FC
where:
CB
0
= $1,000,000
FC = $2,000,000
and,
NCF
r
= $4,300,000 - $3,400,000 = $900,000
so,
CB
r
= $1,000,000 + $900,000 - $2,000,000
CB
r
= - $100,000
(c) We see that the company has a preference for a $1 million cash balance. The
combination of the recessionary period and the proposed issue of bonds
would put the firm's recessionary cash balance (CB
r
) at -$100,000. The
combination of this negative number and the statement that the firm likes a
cash balance of $1 million suggests strongly that the proposed bond issue be
postponed.
16-11A.
(a)
60,000
0.4) $0)(1 (EBIT − −
=
40,000
0.4) 1 $100,000)( (EBIT − −
6
0.6EBIT
=
4
$60,000 0.6EBIT −
EBIT = $300,000
(b) Plan A Plan B
EBIT $300,000 $300,000
Interest 0 100,000
EBT $300,000 $200,000
Taxes (40%) 120,000 80,000
NI $180,000 $120,000
P 0 0
EAC $180,000 $120,000
EPS $ 3.00 $ 3.00
238
16-12A.
(a)
s
S
P t) I)(1 (EBIT − − −
=
b
S
P t) I)(1 (EBIT − − −
1,400,000
0 0.5) $0)(1 (EBIT − − −
=
1,000,000
0 0.5) 1 $320,000)( (EBIT − − −
14
0.5EBIT
=
10
$160,000 0.5EBIT −
EBIT = $1,120,000
(b) Plan A Plan B
EBIT $1,120,000 $1,120,000
Interest 0 320,000
EBT $1,120,000 $ 800,000
Taxes 560,000 400,000
NI $ 560,000 $ 400,000
P 0 0
EAC $ 560,000 $ 400,000
EPS $ 0.40 $ 0.40
(c) Analysis chart is on the following page.
(d) Since $1,800,000 exceeds $1,120,000, the levered plan (Plan B) will provide
for higher EPS.
16-13A.
(a) At EBIT of $1,800,000 the respective EPS amounts are:
Plan A = $0.64 (rounded from $0.6429)
Plan B = $0.74
The stock prices then are:
Plan A: ($0.64) (12) = $7.68
Plan B: ($0.74) (10) = $7.40
So Plan A offers the higher stock price.
(b) ($0.74) (PE) = $7.68
PE = = 10.378 times
(c) The penalized price/earnings ratio resulting from use of financial leverage
may well favor the unlevered financing plan when the ultimate effect on the
firm's stock price is considered.
239
$0..5 Mil. $1.0 Mil. $1.5 Mil. $2.0 Mil.
0.10
0.20
0.30
0.40
0.50
$0.60
$0.40 Indif. level
Plan A
Plan B
$1,120,000
$320,000
E
P
S
EBIT
0
16-14A.
(a) FC = Interest + Sinking Fund
FC = $400,000 + $250,000 = $650,000
(b) CB
r
= CB
o
+ NCF
r
- FC
where:
CB
o
= $500,000
FC = $650,000
and,
NCF
r
= $3,200,000 - $2,900,000 = $300,000
so,
CB
r
= $ 500,000 + $300,000 - $650,000
CB
r
= $150,000
240
(c) The firm ordinarily carries a $500,000 cash balance. This analysis shows that
during a tight economic period the firm's cash balance (CB
r
) could fall to as
low as $150,000. Management might well decide not to issue the proposed
bonds.
16-15A.
(a) Firm C appears to be excessively levered. Both its debt ratio and burden
coverage ratio are unfavorable relative to the industry norm. The firm's
price/earnings ratio is significantly lower (6 versus 10) than the industry
norm.
(b) Firm B.
(c) The investing market place seems to place more weight on coverage ratios
than balance sheet leverage measures. Thus, Firm B's price/earnings ratio
exceeds that of Firm A.
16-16A.
(a) Firm Y seems to be most appropriately levered. Its price/earnings ratio
exceeds that of both Firms X and Z.
(b) The first financial leverage effect refers to the added variability in the
earnings-per-share stream caused by the firm's use of leverage-inducing
financial instruments. The second financial leverage effect concerns the level
of earnings per share at a specific EBIT associated with a specific capital
structure. Beyond some critical EBIT level, earnings per share will be higher
if more (rather than less) leverage is used. Based on the tabular data in this
problem the market seems to be weighing the second leverage effect more
heavily. Thus, Firm Z seems to be underlevered.
16-17A.
(a) ($20) (1,000,000 shares) = $20,000,000
(b) K
c
=
o
t
P
D
=
o
t
P
E
=
20 $
5 $
= 25%
In the all equity firm K
c
= K
o
, thus, K
o
= 25%
(c) K
c
=
0 . 20 $
179 . 5 $
= 25.895%
(1) EBIT $5,000,000
- Interest 80,000
EAC $4,920,000
÷ 950,000
= D
t
$5.179
(2)
000 . 5
000 . 5 $ 179 . 5 $ −
= 0.0358 or 3.58%
(3)
% 000 . 25
% 000 . 25 % 895 . 25 −
= 0.0358 or 3.58%
(4)
) 895 . 25 (
20
19
+
) 00 . 8 (
20
1
= 25.0%
241
16-18A.
(a) ($40) (600,000 shares) = $24,000,000
(b) K
c
=
o
t
P
D
=
o
t
P
E
=
40 $
7 $
= 17.5%
In the all equity firm K
c
= K
o,
thus, K
o
= 17.5%
(c) K
c
=
000 . 40 $
13 . 7 $
= 17.825%
(1) EBIT $4,200,000
- Interest 100,000
EAC $4,100,000
÷ 575,000 shares
*
= D
t
$7.13
*$1,000,000 ÷ $40 = 25,000 shares retired
(2)
00 . 7 $
00 . 7 $ 13 . 7 $ −
= 1.86%
(3)
% 500 . 17
% 500 . 17 % 825 . 17 −
= 1.86%
(4)
%) 825 . 17 (
24
23
+
%) 00 . 10 (
24
1
= 17.5%
16-19A.
(a) Plan B will always dominate Plan C, the preferred stock alternative, by 0.5
($1,800)/8,000 shares or $0.1125 a share. Thus, only alternative A versus B
and A versus C need be evaluated. Those calculations appear below.
Plan A versus Plan B
10,000
0 0.5) $0)(1 (EBIT − − −
=
8,000
0.5) $1,800)(1 (EBIT − −
EBIT = $9,000
Plan A versus Plan C
10,000
0 0.5) $0)(1 (EBIT − − −
=
8,000
$1,800 0.5) 0)(1 (EBIT − − −
EBIT = $18,000
(b) Since long-term EBIT is forecast to be $22,000, the data favor use of
financing alternative B, the bond plan. This is well above the A versus B
indifference level of $9,000.
242
SOLUTION TO INTEGRATIVE PROBLEM
PART I EBIT-EPS ANALYSIS
1. At the EBIT indifference level:
EPS (LLP) = EPS (HLP)
LLP
S
P] t) I)(1 [(EBIT − − −
=
HLP
S
P] t) I)(1 [(EBIT − − −
400,000
0] .35) 1 $220,000)( [(EBIT − − −
=
200,000
0] .35) 1 $840,000)( [(EBIT − − −
40
$143,000 .65EBIT −
=
20
$546,000 .65EBIT −
EBIT = $1,460,000
See graph on following page.
2. The analytical income statement demonstrating that EPS (LLP) = EPS (HLP)
is as follows:
LLP HLP
EBIT $1,460,000 $1,460,000
Interest 220,000 840,000
EBT $1,240,000 $620,000
Taxes (35%) 434,000 217,000
NI $806,000 $403,000
P 0 0
EAC $806,000 $403,000
÷ # of common shares 400,000 200,000
EPS $2 .015 $2 .015
3. The expected long-term EBIT of $1,300,000 does not exceed the EBIT indifference
level. Consequently, the low leveraged plan, LLP, will produce the higher EPS.
4. To determine the financing plan that should be recommended, it is necessary to
compute the expected stock price under each plan. To do so, EPS is computed first,
then the projected stock price is computed, as follows:
243
$4.000
$3.500
$3.000
$2.500
$2.000
$1.500
$1.000
$0.500
$0.000
$0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000 $1,800,000 $2,000,000
4
1
1
EBIT-EPS INDIFFERENCE CHART
E
P
S

i
n

D
O
L
L
A
R
S
$2.015
EBIT Indifference Level
$1,460,000
HLP
LLP
EBIT in Dollars
245
LLP HLP
EBIT $1,300,000 $1,300,000
Interest 220,000 840,000
EBT $1,080,000 $460,000
Taxes (35%) 378,000 161,000
NI $702,000 $299,000
P 0 0
EAC $702,000 $299,000
÷ Number of common shares 400,000 200,000
EPS $1.755 $1.495
x P/E ratio 18 14
= Projected stock price $31.590 $20.930
The preferred plan is the one with the higher projected stock price, namely LLP. It
also can be noted that the greater riskiness of HLP results in the market applying a
lower price/earnings multiple to the expected EPS.
5. To find the P/E ratio that equates the stock prices for both plans at the given EBIT
level, it is only necessary to solve the formula, EARNINGS x P/E RATIO =
PRICE, as follows:
Price [under LLP] $31.59
÷ Earnings [under HLP] 1.495
= P/E Ratio 21.130
PART 2 RECESSIONARY CASH FLOW ANALYSIS
6. Total fixed financial charges, FC, the firm would have to pay next year are computed
using the following formula:
FC = interest expense + sinking fund/year
where
LLP HLP
Proposed dollar amount of new bonds $2,000,000 $6,000,000
x Interest rate x 11% x 14%
= Interest expense $220,000 $840,000
Proposed dollar amount of new bonds $2,000,000 $6,000,000
x Sinking fund requirement/year x 10% x 10%
= Sinking fund/year $200,000 $600,000
thus,
FC = $420,000 $1,440,000
65
7. The cash balance at the end of the recessionary year, CB
r
, is computed using the
following formula:
CB
r
= C
0
+ (C
S
+ OR) - (P
a
+

RM + T
e
+ E
n
) - FC
where
LLP HLP
C
0
= Cash balance at beginning of period = $500,000 $500,000
C
S
= Cash collections from sales = $4,000,000 $4,000,000
OR = Miscellaneous cash receipts = $200,000 $200,000
P
a
= Payroll expenditures = $1,500,000 $1,500,000
RM = Raw material payments = $1,000,000 $1,000,000
T
e
= Estimated tax payments = $265,000 $54,000
E
n
= All other nondiscretionary cash outlays = $700,000 $700,000
FC (as computed) = $420,000 $1,440,000
thus, CB
r
= $815,000 $6,000
8. The firm prefers to maintain a cash balance of $500,000. Yet, the combined effect of
a recession and the costs associated with the proposed new debt would result in
recessionary cash balances of $815,000 and $6,000 for LLP and HLP, respectively.
Consequently, the lower leverage plan, LLP, is recommended over the higher
leverage plan, HLP.
Solutions to Problem Set B
16-1B.
The following formula can be used to solve for the amount of cash collections on
sales, C
S
, required to provide the desired end of year cash balance:
CB
r
= C
0
+ (C
S
+ OR) - (P
a
+

RM + E
n
) - FC
Solving for the required minimum cash receipts from sales:
C
S
= CB
r
- {C
0
+ OR - (P
a
+

RM + E
n
) - FC}
then, simplifying:
C
S
= CB
r
- C
0
- OR + P
a
+

RM + E
n
+ FC
66
where
CB
r
= desired cash balance at end of recessionary period = $400,000
C
0
= cash balance at beginning of period = $400,000
OR = other cash receipts (as percent of sales receipts) = 5%
P
a
= payroll expenditures (as percent of sales receipts) = 40%
RM = raw material payments (as percent of sales receipts) = 20%
E
n
= total nondiscretionary expenditures = $500,000
FC = fixed financial charges = $300,000
thus
C
S
= {CB
r
- C
0
+ E
n
+ FC} / {1 - (-OR% + P
a
% + RM%)}
C
S
=
} {
} { %) 20 % 40 % 5 ( 1
000 , 300 $ 000 , 5000 $ 000 , 400 $ 000 , 40 $
+ + − −
+ + −
= $1,777,778
PROOF:
CB
r
= C
0
+ (C
S
+ OR) - (P
a
+

RM + E
n
) - FC
CB
r
= $400,000 + ($1,777,778 + .05 x $1,777,778) - (.40 x $1,777,778
+ .20 x $1,777,778 + $500,000) - $300,000
CB
r
= $400,000 + $1,777,778 + $88,889 - $711,111 - $355,556 -
$500,000 - $300,000
CB
r
= $400,000
16-2B.
At the EBIT indifference level:
EPS (All Debt Plan) = EPS (Debt and Equity Plan)
that is,
AllDebt
S
SF] P t) I)(1 [(EBIT − − − −
=
Equity & Debt
S
SF] P t) I)(1 [(EBIT − − − −
100,000
$100,000] .35) 1 $200,000)( [(EBIT − − −
=
70,000) (100,000
$30,000] .35) $48,000)(1 [(EBIT
+
− − −
10
$230,000 .65EBIT −
=
17
$61,200 .65EBIT −
EBIT = $724,835
67
16-3B. (a)
shares 150,000
0.34) 0)(1 (EBIT − −
=
shares 50,000
0.34) 1 $220,000)( (EBIT − −
15
0.66EBIT
=
5
$145,200 0.66EBIT −
EBIT = $330,000
(b) Since $450,000 exceeds the indifference level of $330,000 from part (a), the
levered alternative (Plan B) will generate the higher EPS.
(c) Here we compute EPS for each financing plan, apply the relevant
price/earnings ratios, and, thereby, forecast a common stock price for each
plan. Thus, we have:
Plan A Plan B
EBIT $450,000 $450,000
Interest 0 220,000
EBT $450,000 $230,000
Taxes (34%) 153,000 78,200
NI $297,000 $151,800
P _______0 _______0
EAC $297,000 $151,800
÷ No. of common shares 150,000 50,000
EPS $ 1.98 $ 3.036
x P-E ratio 19 12.39
= Projected Stock Price $37.62 $37.62
The added riskiness of Plan B, owing to the use of financial leverage, is
reflected in the lower P-E ratio associated with Plan B (i.e., 12.39x versus
19x for Plan A). The rational investor will prefer Plan A (unlevered) as the
same projected stock price ($37.62) can be obtained with a lower level of risk
exposure.
16-4B. (a)
shares 80,000
0.34) 0)(1 (EBIT − −
=
shares 50,000
0.34) 1 $320,000)( (EBIT − −
80
.66EBIT
=
50
$211,200 .66EBIT −
EBIT = $853,333
(b) Plan A Plan B
EBIT $853,333 $853,333
Interest 0 320,000
EBT $853,333 $533,333
Taxes (34%) 290,133 181,333
EAC $563,200 $352,000
÷ No. of common shares 80,000 50,000
EPS $7.04 $7.04
68
16-5B.
(a)
shares 75,000
0.5) $0)(1 (EBIT − −
=
shares 50,000
0.5) 1 $140,000)( (EBIT − −
75
0.5EBIT
=
50
$70,000 0.5EBIT −
EBIT = $420,000
(b) Plan A Plan B
EBIT $420,000 $420,000
Interest 0 140,000
EBT $420,000 $280,000
Taxes (50%) 210,000 140,000
NI $210,000 $140,000
P 0 0
EAC $210,000 $140,000
÷ No. of Common Shares 75,000 50,000
EPS $ 2.80 $ 2.80
(c) Since $750,000 exceeds the calculated indifference level of $420,000, the
levered plan (Plan B) will generate the higher EPS.
(d) To solve this part of the problem, compute EPS under each financial
alternative. Then apply the relevant price-earnings ratio for each plan. An
associated common stock price for each plan can then be forecast. This
follows.
Plan A Plan B
EBIT $750,000 $750,000
Interest 0 140,000
EBT $750,000 $610,000
Taxes (50%) 375,000 305,000
NI $375,000 $305,000
P 0 0
EAC $375,000 $305,000
÷ No. of Common Shares 75,000 50,000
EPS $ 5.00 $ 6.10
× P-E Ratio 12 9.836
= Projected Stock Price $60.00 $60.00
Riskiness is reflected in a lower P-E ratio for Plan B of 9.836 versus that of 12
for Plan A (the all common equity plan). The decision now can logically shift
to Plan A (unlevered). The investors obtain the same stock price of $60.00
under both plans. There is less risk in Plan A, so it would be preferable.
69
16-6B. (a) FC = Interest + Sinking Fund
FC = ($11 million) (.16) +
20yr.
n) ($11millio
FC = $1,760,000 + $550,000 = $2,310,000
(b) CB
r
= CB
0
+ NCF
r
- FC
where: CB
0
= $500,000
FC = $2,310,000
and, NCF
r
= $3,800,000 - $3,600,000 = $200,000
so, CB
r
= $500,000 + $200,000 - $2,310,000
CB
r
= - $1,610,000
(c) We see that the company has a preference for a $500,000 cash balance. The
combination of the recessionary period and the proposed issue of bonds
would put the firm's recessionary cash balance (CB
r
) at -$1,610,000. The
combination of this negative number and the statement that the firm likes a
cash balance of $500,000 suggests strongly that the proposed bond issue be
postponed.
16-7B.(a)
75,000
0.4) $0)(1 (EBIT − −
=
55,000
0.4) 1 $240,000)( (EBIT − −
75
0.6EBIT
=
55
$144,000 0.6EBIT −
EBIT = $900,000
(b) Plan A Plan B
EBIT $900,000 $900,000
Interest 0 240,000
EBT $900,000 $660,000
Taxes (40%) 360,000 264,000
NI $540,000 $396,000
P 0 0
EAC $540,000 $396,000
EPS $ 7.20 $ 7.20
16-8B. (a)
s
S
P t) I)(1 (EBIT − − −
=
b
S
P t) I)(1 (EBIT − − −
1,200,000
0 0.5) $0)(1 (EBIT − − −
=
850,000
0 0.5) 1 $315,000)( (EBIT − − −
120
0.5EBIT
=
85
$157,500 0.5EBIT −
EBIT = $1,080,000
(b) Plan A Plan B
70
EBIT $1,080,000 $1,080,000
Interest 0 315,000
EBT $1,080,000 $ 765,000
Taxes (50%) 540,000 382,500
NI $ 540,000 $ 382,500
P 0 0
EAC $ 540,000 $ 382,500
EPS $ 0.45 $ 0.45
(c) Analysis chart follows.
(d) Since $1,500,000 exceeds $1,080,000, the levered plan (Plan B) will provide
for higher EPS.
$0.5 Mil. $1.0 Mil. $1.5 Mil. $2.0 Mil.
0.15
0.25
0.35
0.45
0.55
$0.65
$0.45 Indif. level
Plan A
Plan B
$1,080,000
$315,000
E
P
S
EBIT
0
71
16-9B.
(a) At EBIT of $1,500,000 the respective EPS amounts are:
Plan A = $0.63
Plan B = $0.70
The stock prices then are:
Plan A: ($0.63) (13) = $8.19
Plan B: ($0.70) (11) = $7.70
Plan A offers the higher stock price.
(b) ($0.70) (P/E) = $8.19
P/E =
70 . 0 $
19 . 8 $
= 11.7 times
(c) The penalized price/earnings ratio resulting from use of financial leverage
may well favor the unlevered financing plan when the ultimate effect on the
firm's stock price is considered.
16-10B.
(a) FC = Interest + Sinking Fund
FC = $600,000 + $300,000 = $900,000
(b) CB
r
= C
o
+ NCF
r
- FC
where: C
o
= $750,000
FC = $900,000
and, NCF
r
= $3,700,000 - $3,200,000 = $500,000
so, CB
r
= $ 750,000 + $500,000 - $900,000
CB
r
= $350,000
(c) The firm ordinarily carries a $750,000 cash balance. This analysis shows that
during a tight economic period the firm's cash balance (CB
r
) could fall to as
low as $350,000. Management might well decide not to issue the proposed
bonds.
16-11B.
(a) Firm C appears to be excessively levered. Both its debt ratio and burden
coverage ratio are unfavorable relative to the industry norm. The firm's
price/earnings ratio is significantly lower (5 versus 10) than the industry
norm.
(b) Firm B.
(c) The investing market place seems to place more weight on coverage ratios
than balance sheet financial leverage measures. Thus, Firm B's price/earnings
ratio exceeds that of Firm A.
72
16-12B.
(a) Firm Y seems to be most appropriately levered. Its price/earnings ratio
exceeds that of both Firms X and Z.
(b) The first financial leverage effect refers to the added variability in the
earnings-per-share stream caused by the firm's use of leverage-inducing
financial instruments. The second financial leverage effect concerns the level
of earnings per share at a specific EBIT associated with a specific capital
structure. Beyond some critical EBIT level, earnings per share will be higher
if more (rather than less) leverage is used. Based on the tabular data in this
problem, the market seems to be weighing the second leverage effect more
heavily. Thus, Firm Z seems to be underlevered.
16-13B.
(a) ($22) (1,000,000 shares) = $22,000,000
(b) K
c
=
o
t
P
D
=
o
t
P
E
=
22 $
75 . 4 $
= 21.59%
In the all equity firm K
c
= K
o
, thus, K
o
= 21.59%
(c) K
c
=
0 . 22 $
882 . 4 $
= 22.19%
(1) EBIT $4,750,000
- Interest 90,000
EAC $4,660,000
÷ 954,545
*

= D
t
$4.882
*$1,000,000 ÷ $22 = 45,455 shares retired
(2)
750 . 4
750 . 4 $ 882 . 4 $ −
= 0.0278 or 2.78%
(3)
% 59 . 21
% 59 . 21 % 19 . 22 −
= 0.0278 or 2.78%
(4)
) 19 . 22 (
000 , 000 , 1
545 , 954
+
) 00 . 9 (
000 , 000 , 1
455 , 45
= 21.59%
16-14B.
(a) ($38) (575,000 shares) = $21,850,000
(b) K
c
=
o
t
P
D
=
o
t
P
E
=
38 $
826 . 7 $
= 20.595%
In the all equity firm K
c
= K
o,
thus, K
o
= 20.595%
73
(c) K
c
=
00 . 38 $
095 . 8 $
= 21.3%
(1) EBIT $4,500,000
- Interest 165,000
EAC $4,335,000
÷ 535,526 shares
*
D
t
$8.095
*$1,500,000 ÷ $38 = 39,474 shares retired
(2)
826 . 7 $
826 . 7 $ 095 . 8 $ −
= 3.437%
(3)
% 595 . 20
% 595 . 20 % 3 . 21 −
= 3.423%
(4)
%) 3 . 21 (
000 , 575
526 , 535
+
%) 0 . 11 (
000 , 575
474 , 39
= 20.59%
16-15B.
(a) Plan B will always dominate Plan C, the preferred stock alternative, by 0.5
($5,000)/10,000 shares or $0.25 a share. Thus, only alternatives A versus B
and A versus C need be evaluated. Those calculations appear below.
Plan A versus Plan B
15,000
0 0.5) $0)(1 (EBIT − − −
=
10,000
0.5) $5,000)(1 (EBIT − −
EBIT = $15,000
Plan A versus Plan C
15,000
0 0.5) $0)(1 (EBIT − − −
=
10,000
$5,000 0.5) 0)(1 (EBIT − − −
EBIT = $30,000
(b) Since long-term EBIT is forecast to be $36,000, the data favor use of
financing alternative B, the bond plan. This is well above the A versus B
indifference level of $15,000.
Earnings per share
$1.20
A Plan
$1.55
B Plan
$1.55
B Plan
Earnings per share is highest under Plan B.

74
CHAPTER 17
Dividend Policy
and Internal Financing

CHAPTER ORIENTATION
In determining the firm's dividend policy, two issues are important: the dividend payout
ratio and the stability of the dividend payment over time. In this regard, the financial
manager should consider the investment opportunities available to the firm and any
preference that the company's investors have for dividend income or capital gains. Also,
stock dividends, stock splits, or stock repurchases can be used to supplement or replace cash
dividends.
CHAPTER OUTLINE
I. The trade-offs in setting a firm's dividend policy
A. If a company pays a large dividend, it will therefore:
1. Have a low retention of profits within the firm.
2. Need to rely heavily on a new common stock issue for equity
financing.
B. If a company pays a small dividend, it will therefore:
1. Have a high retention of profits within the firm.
2. Will not need to rely heavily on a new common stock issue for equity
financing. The profits retained for reinvestment will provide the
needed equity financing.
II. Impact of Dividend Policy on Stock Price
A. The importance of a firm's dividend policy depends on the impact of the
dividend decision on the firm's stock price. That is, given a firm's capital
budgeting and borrowing decisions, what is the impact of the firm's dividend
policies on the stock price?
75
B. Three views about the importance of a firm's dividend policy.
1. View 1: Dividends do not matter
a. Assumes that the dividend decision does not change the firm's
capital budgeting and financing decisions.
b. Assumes perfect capitals markets, which means:
(1) There are no brokerage commissions when investors
buy and sell stocks.
(2) New securities can be issued without incurring any
flotation costs.
(3) There are no personal or corporate income taxes.
(4) Complete information about the firm is free and
equally readily available to all investors.
(5) There are no conflicts of interest between management
and stockholders.
(6) Financial distress and bankruptcy costs are
nonexistent.
c. Under the foregoing assumptions, it may be shown that the
market price of a corporation's common stock is unchanged
under different dividend policies. If the firm increases the
dividend to its stockholders, it has to offset this increase by
issuing new common stock in order to finance the available
investment opportunities. If on the other hand, the firm
reduces its dividend payment, it has more funds available
internally to finance future investment projects. In either
policy, the present value of the resulting cash flows to be
accrued to the current investors is independent of the dividend
policy. By varying the dividend policy, only the type of return
is affected (capital gains versus dividend income), not the total
return.
2. View 2: High dividends increase stock value
a. Dividends are more predictable than capital gains because
management can control dividends, while they cannot dictate
the price of the stock. Thus, investors are less certain of
receiving income from capital gains than from dividend
income. The incremental risk associated with capital gains
relative to dividend income should therefore cause us to use a
higher required rate in discounting a dollar of capital gains
than the rate used for discounting a dollar of dividends. In so
doing, we would give a higher value to the dividend income
than we would the capital gains.
76
b. Criticisms of view 2.
(1) Since the dividend policy has no impact on the
volatility of the company's overall cash flows, it has no
impact on the riskiness of the firm.
(2) Increasing a firm's dividend does not reduce the basic
riskiness of the stock; rather, if dividend payment
requires management to issue new stock, it only
transfers risk and ownership from the current owners
to the new owners.
3. View 3: Low dividends increase value
Stocks that allow us to defer taxes (low dividends-high capital
gains) will possibly sell at a premium relative to stocks that
require us to pay taxes currently (high dividends-low capital
gains). Only then will the two stocks provide comparable
after-tax returns, which suggests that a policy to pay low
dividends, will result in a higher stock price. That is, high
dividends hurt investors, while low dividends-high retention
help the firm's investors.
But wait, then came 2003 and Congress again felt the need to
change the tax code as it pertained to both dividend income
and capital gains income. On May 28 President Bush signed
into law the “Jobs and Growth Tax Relief Reconciliation Act
of 2003.” Recall that part of the impetus for this Act was the
recession 2001.
In a nutshell this 2003 Act lowered the top tax rate on
dividend income to 15 percent from a previous top rate of 38.6
percent, and also lowered the top rate paid on realized long-
term capital gains to the same 15 percent from a previous 20
percent. Thus, you can see that the so-called investment
playing field was (mostly) leveled for dividend income
relative to qualifying capital gains. This rather dramatic
change in the tax code will immediately remind you of
Principle 8: Taxes Bias Business Decisions. In effect, a
major portion of the previous bias against paying cash
dividends to investors was mitigated. But, not all of it.
C. Additional thoughts about the importance of a firm's dividend policy.
1. Residual dividend theory: Because of flotation costs incurred in
issuing new stock, firms must issue a larger amount of securities in
order to receive the amount of capital required for investments. As a
result, new equity capital will be more expensive than capital raised
77
through retained earnings. Therefore, financing investments internally
(and decreasing dividends) instead of issuing new stock may be
favored. This is embodied in the residual dividend theory, where a
dividend would be paid only when any internally generated funds
remain after financing the equity portion of the firm's investments.
2. The clientele effect: If investors do in fact have a preference between
dividends and capital gains, we could expect them to seek out firms
that have a dividend policy consistent with these preferences. They
would in essence "sort themselves out" by buying stocks which satisfy
their preferences for dividends and/or capital gains. In other words,
there would be a "clientele effect," where firms draw a given clientele
based on their stated dividend policy. However, unless there is a
greater aggregate demand for a particular policy than is being
satisfied in the market, dividend policy is still unimportant, in that one
policy is as good as the other. The clientele effect only tells us to
avoid making capricious changes in a company's dividend policy.
3. Information effect.
a. We know from experience that a large, unexpected change in
dividends can have significant impact on the stock price.
Despite such "evidence," it is not unreasonable to hypothesize
that dividend policy only appears to be important, because we
are not looking at the real cause and effect. It may be that
investors use a change in dividend policy as a signal about the
firm's "true" financial condition, especially its earning power.
b. Some would argue that management frequently has inside
information about the firm that it cannot make available to the
investors. This difference in accessibility to information
between management and investors, called information
asymmetry, may result in a lower stock price than would be
realized if we had conditions of certainty. Dividends become a
means in a risky marketplace to minimize any "drag" on the
stock price that might come from differences in the level of
information available to managers and investors.
4. Agency costs: Conflicts between management and stockholders may
exist, and the stock price of a company owned by investors who are
separate from management may be less than the stock value of a
closely-held firm. The difference in price is the cost of the conflict to
the owners, which has come to be called agency costs. A firm's
dividend policy may be perceived by owners as a tool to minimize
agency costs. Assuming the payment of a dividend requires
management to issue stock to finance new investments, then new
investors will be attracted to the company only if management
78
provides convincing information that the capital will be used
profitably. Thus, the payment of dividends indirectly results in a
closer monitoring of management's investment activities. In this case,
dividends may provide a meaningful contribution to the value of the
firm.
5. Expectations theory: As the time approaches for management to
announce the amount of the next dividend, investors form
expectations as to how much the dividend will be. When the actual
dividend decision is announced, the investor compares the actual
decision with the expected decision. If the amount of the dividend is
as expected, even if it represents an increase from prior years, the
market price of the stock will remain unchanged. However, if the
dividend is higher or lower than expected, the investors will reassess
their perceptions about the firm and the value of the stock.
D. The empirical evidence about the importance of dividend policy
1. Statistical tests. To test the relationship between dividend payments
and security prices, we could compare a firm's dividend yield
(dividend/stock price) and the stock's total return, the question being,
"Do stocks that pay high dividends provide higher or lower returns to
the investors?" Such tests have been conducted using a variety of the
most sophisticated statistical techniques available. Despite the use of
these extremely powerful analytical tools involving intricate and
complicated procedures, the results have been mixed. However, over
long periods of time, the results have given a slight advantage to the
low-dividend stocks; that is, stocks that pay lower dividends appear to
have higher prices. The findings are far from conclusive, however,
owing to the relatively large standard errors of the estimates.
2. Reasons for inconclusive results from the statistical tests.
a. To be accurate, we would need to know the amount of
dividends investors expect to receive. Since these expectations
cannot be observed, we can only use historical data, which
may or may not relate to expectations.
b. Most empirical studies have assumed a linear relationship
between dividend payments and stock prices. The actual
relationship may be nonlinear, possibly even with
discontinuities in the relationship.
3. Since our statistical prowess does not provide us with any conclusive
evidence, researchers have surveyed financial managers about their
perceptions of the relevance of dividend policy. In such surveys, the
evidence favors the relevance of dividend policy, but not just
overwhelming so. For the most part, managers are divided between
believing that dividends are important and having no opinion in the
matter.
79
E. Conclusions about the importance of dividend policy
1. As a firm's investment opportunities increase, the dividend payout
ratio should decrease.
2. The firm's dividend policy appears to be important; however,
appearances may be deceptive. The real issue may be the firm's
expected earnings power and the riskiness of these earnings.
3. If dividends influence stock price, it probably comes from the
investor's desire to minimize and/or defer taxes and from the role of
dividends in minimizing agency costs.
4. If the expectations theory has merit, which we believe it does, it
behooves management to avoid surprising the investors when it
comes to the firm's dividend decision.
III. Dividend policy decisions
A. Other practical considerations
1. Legal restrictions
a. A corporation may not pay a dividend
(l) if the firm's liabilities exceed its assets
(2) if the amount of the dividend exceeds the accumulated
profits (retained earnings)
(3) if the dividend is being paid from capital invested in
the firm
b. Debtholders and preferred stockholders may impose restrictive
provisions on management, such as common dividends not
being paid from earnings prior to the payment of interest or
preferred dividends.
2. Liquidity position: The amount of a firm's retained earnings and its
cash position are seldom the same. Thus, the company must have
adequate cash available as well as retained earnings to pay dividends.
3. Absence or lack of other sources of financing: All firms do not have
equal access to the capital markets. Consequently, companies with
limited financial resources may rely more heavily on internally
generated funds.
4. Earnings predictability: A firm that has a stable earnings trend will
generally pay a larger portion of its earnings in dividends. If earnings
fluctuate significantly, a larger amount of the profits may be retained
to ensure that enough money is available for investment projects
when needed.
5. Ownership control: For many small firms, and certain large ones,
maintaining the controlling vote of common stock is very important.
80
These owners would prefer the use of debt and retained profits to
finance new investments rather than to issue new stock.
6. Inflation: Because of inflation, the cost of replacing equipment has
increased substantially Depreciation funds tend to become
insufficient. Hence, greater profit retention may be required.
B. Alternative dividend policies
1. Constant dividend payout ratio: The percentage of earnings paid out
in dividends is held constant. Therefore, the dollar amount of the
dividend fluctuates from year to year.
2. Stable dollar dividend per share: Relatively stable dollar dividend is
maintained. The dividend per share is increased or decreased only
after careful investigation by the management.
3. Small, regular dividend plus a year-end extra: Extra dividend is paid
out in prosperous years. Management's objective is to avoid the
connotation of a permanent dividend increase.
C. Basis for stable dividends
1. Stable dividend policy is most common of the three options.
2. Managers were found to be reluctant to change the amount of the
dividend, especially when it came to decreasing the amount.
3. Increasing-stream hypothesis of dividend policy states that dividend
stability is a smoothing of the dividend stream to minimize the effect
of other types of company reversals.
a. Corporate managers attempt to have a gradually increasing
dividend over the long-term.
b. If dividend reduction is necessary, it should be large enough to
reduce the probability of future cuts.
D. Dividend policy and corporate strategy: Things will change—even dividend
policy.
1. The recessions of 1990 to 1991 and 2001 induced a large number of
American corporations to revisit their broadest corporate strategies,
including adjusting dividend policies.
2. One firm that altered its dividend policy in response to new strategies
was the W.R. Grace & Co., headquartered in Columbia, Maryland.
3. Table 17-5 in the text reviews W.R. Grace’s actual dividend policies
over the 1992 to 1996 time frame. The firm’s payout ratio and the
absolute amount of the cash dividend paid per share declined in a
significant fashion over this period.
IV. Dividend payment procedures
A. Dividends are generally paid quarterly.
81
B. The declaration date is the date on which the firm's board of directors
announces the forthcoming dividends.
C. The date of record designates when the stock transfer books are to be closed.
Investors who own stock on this date are entitled to the dividend.
D Brokerage firms terminate the right of ownership to the dividend two
working days prior to the date of record. This date is called the ex-dividend
date.
E. Dividend checks are mailed on the payment date.
V. Stock dividends and stock splits
A. Both a stock dividend and a stock split involve issuing new shares of stock to
current stockholders.
B. The investor’s percentage ownership in the firm remains unchanged. The
investor is neither better nor worse off than before the stock split/dividend.
C. On an economic basis there is no difference between a stock dividend and a
stock split.
D. For accounting purposes, the stock split has been defined as a stock dividend
exceeding 25 percent of the number of shares currently outstanding.
E. Accounting treatment
1. For a stock dividend, the dollar amount of the dividend is transferred
from retained earnings to the capital accounts (par and paid-in
capital).
2. In the case of a split, the dollar amounts of the capital accounts do not
change. Only the number of shares is increased while the par value of
each share is decreased proportionately.
F. Rationale for a stock dividend or split
1. Shareholders benefit because the price of stock may not fall precisely
in proportion to the share increase; thus, the stockholders' value is
increased.
2. If a company is encountering cash problems, it can substitute a stock
dividend for a cash dividend. Investors will probably look beyond the
stock dividend to determine the underlying reasons for conserving
cash.
VI. Stock repurchases
A. A number of benefits exist justifying stock repurchases instead of dividend
payments. Included in these are:
1. to provide an internal investment opportunity
2. to modify the firm's capital structure
3. to impact earnings per share, thus increasing stock price
B. Share repurchase as a dividend decision
82
1. A firm may decide to repurchase its shares, increasing the earnings
per share, which should be reflected in a higher stock price.
83
2. The investor's choice
a. For tax purposes, the investor may prefer the firm to
repurchase stock in lieu of a dividend. Dividends formerly
were taxed as ordinary income, whereas any price appreciation
resulting from the stock repurchase would be taxed as a capital
gain, and can be deferred until the gain is realized.
b. The investor may prefer dividend payment because
(l) Dividends are viewed as being more dependable than
stock repurchases.
(2) The price the firm must pay for its stock may be too
high.
(3) Riskiness of the firm's capital structure may increase,
lowering the P/E ratio and thus the stock price.
C. Financing or investment decision
1. A stock repurchase effectively increases the debt-equity ratio towards
higher debt, thus repurchase is viewed as a financing decision.
2. When buying its own stock at depressed prices, a firm may consider
the repurchase as an investment decision. However, this action is not
a true investment opportunity; buying its own stock does not provide
the expected returns as other investments do.
D. The repurchase procedure
1. A public announcement should be made detailing the amount,
purpose and procedure for the stock repurchase.
2. Open market purchase – stock is bought at the current market price.
3. Tender offer - more formal offer where offer for stock is at a specified
price, usually above current market price.
4. Negotiated basis - repurchasing from specific, major shareholders at a
negotiated price.
VII. The Multinational firm: The Case of Low Dividend Payments
A. During economic prosperity, multinational firms look to international
markets for high net present value projects.
1. This provides diversification of country-related economic risks.
2. Firm can achieve cost advantages over its competitors.
B. U.S. multinational firms favor the UK and Canada for direct investments.
C. U.S. multinational firms concentrate investments in manufacturing industries
when investing internationally.
1. Firms can achieve lower labor costs by employing workers in a
foreign country.
84
2. Lower labor costs improve a firm’s competitive position.
VIII. How Financial Managers Use This Material
A. In the text, actual examples of dividend policy in action are presented that
deal with Coca-Cola and the Walt Disney Company.
B. And we are reminded that the differential tax treatment of cash dividends as
opposed to capital gains can give investors a preferential tax advantage when
shares are repurchased, as the capital gains can be deferred. This is not
possible with the receipt of cash dividends. The income tax has to be paid in
the year that the dividends are actually received by the investor.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
17-1. The dividend payout ratio indicates the amount of dividends paid relative to the
earnings available to common stockholders, or dividend-per-share divided by
earnings-per-share.
17-2. A firm's net profits are used to pay dividends and/or to finance new investments. As
larger dividends are paid, the retained earnings available for reinvestment are
reduced. Conversely, as a larger amount of profits is reinvested, the capital available
for common stockholders' dividends is reduced.
17-3. (a) In a perfect market, there are no brokerage commissions, no flotation costs,
no taxes, no information content assigned to a particular dividend policy,
complete information about a firm is available to every investor, no conflicts
of interest between management and stockholders and financial distress and
bankruptcy costs are nonexistent..
(b) A firm's dividend policy is irrelevant in a perfect market.
Management may choose between retaining profits and paying dividends without
affecting the value of the firm's security. Therefore, the only wealth-creating
activities in a perfect market are management's investment and financing decisions.
17-4. The existence of flotation costs eliminates the indifference between financing by
internal capital and new stock. Financing investments through retained earnings will
be preferred to avoid flotation costs and capital leakage. If no other perfect market
85
assumptions have been relaxed, new stock would be issued only after internally
generated funds have been exhausted.
17-5. (a) According to the residual dividend theory, dividends are paid only if retained
earnings are available after financing all acceptable investments.
(b) This theory may not be feasible in the short term because the year-to-
year variability in dividend payments is undesirable. The theory can be used in the
long term if management projects financing needs for several years. A target
dividend payout ratio for this planning horizon can be established that will distribute
the residual capital smoothly over the period.
86
17-6. Taxes on dividend income are paid when the dividend is received, while taxes on
capital gains are deferred until the stock is actually sold.
17-7. Statutory restrictions prevent a corporation from paying dividends if its liabilities
exceed its assets, the amount of the dividend exceeds retained earnings, or the
dividend is being paid from capital invested in the firm.
The restrictions in debt and preferred stock contracts may also limit dividends.
These contract provisions may stipulate that dividends are not to be paid from
earnings prior to the debt payment. Also, a certain amount of working capital may
be required. Finally, if any preferred dividends have gone unpaid, a provision may
restrict payment of common dividends.
17-8. Dividends are paid with cash. If there is little or no cash available, the firm will be
unable to pay dividends.
17-9. For many smaller companies, maintaining voting control of the common stock is
very important. Issuing new stock is unattractive to these firms if it results in a
dilution of the control of the current stockholders. Financing by debt and through
profits will be preferred. Thus, the firm's growth is limited to the amount of debt
capital available and the company's ability to generate profits.
17-10. (a) Corporate managers are reluctant to change dividends without being
confident that the change is reflective of the company's long-term earnings
prospects. This is why most managers avoid a change in dividends in
response to temporary fluctuations in earnings and are especially reluctant to
make a dividend cut. They would prefer instead to develop a gradually
increasing dividend series over time. This smoothing of the dividend stream
is done in an effort to minimize the effect of other types of company
reversals.
(b) Investors also prefer a stable dividend policy because they perceive a
change in the dividend payment to reflect management's view of the firm's long-term
earnings prospects. Also, many investors rely upon dividends for current income,
and this need is best satisfied by the stable dividend. Another reason for the
popularity of the stable dividend is the requirement of many states that financial
institutions invest only in companies with a regular dividend payment.
17-11. The declaration date is the date that the dividend is formally authorized by the board
of directors. Investors shown to own the stock on the date of record receive the
dividends. The ex-dividend date is two days prior to the record date. This date was
set by stock brokerage companies as the date when the right of ownership to the
dividend is terminated.
17-12. The stockholder is benefited only if the price of the stock does not fall in direct
proportion to the number of new shares issued. An advantage to the corporation is
the conservation of cash for investment opportunities.
17-13. A stock repurchase might be used by a firm to provide an alternative to cash
dividends, to provide an "internal" investment opportunity, to alter the firm's capital
structure, or any of a variety of other reasons stemming from a reduction of the
number of shares outstanding.
87
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
17-1A. Dividend Policies
a. Constant payout ratio of 40%
Year $ Dividend
Profits ×
payout/shares
1 0.40 1,000,000 × 0.4 / 1,000,000
2 0.80 2,000,000 × 0.4 / 1,000,000
3 0.64 1,600,000 × 0.4 / 1,000,000
4 0.36 900,000 × 0.4 / 1,000,000
5 1.20 3,000,000 × 0.4 / 1,000,000
b. Stable target payout of 40%
Target dividend =
5
0.4
1,000,000
8,500,000
×
= 0.68
c. Small regular dividend of $0.50 plus year-end extra
Base profits: 1,500,000
% of extra profits: 50%
Year $ Dividend Payout Calculation
1 0.50 0.50
2 0.75 0.5 + [(2,000,000 – 1,500 000 * 0.5 / 1,000,000]
3 0.55 0.5 + [(1,600,000 -,1,500,000) * 0.5 / 1,000,000]
4 0.50 0.50
5 1.25 0.5 + [(3,000,000 – 1,500,000) * 0.5 / 1,000,000]
17-2A. Number of shares to be issued:
15 $ 120 $
000 , 000 , 10 $

= 95,238 shares
Dollar size of the issue:
95,238 shares x $120 = $11,428,560
88
17-3A. Flotation Costs and Issue Size
Flotation costs 0.18
Stock price $85.00
Net to firm $5,800,000
Dollar issue size = $ 7,073,171 = $5,800,000/(1-.18)
Number of shares = $ 7,073,171 ÷ $85/share
83,214 shares
17-4A. Terra Cotta - Residual Dividend Theory
Total financing needed $640,000
Retained earnings $400,000
Debt ratio 0.4
Equity ratio 0.6
Equity financing needed $384,000 = $640,000(.6)
Dividends $ 16,000 = $400,000 - $384,000
17-5A. RCB - Stock Dividend
Before dividend
Shares outstanding 2,000,000
Net income $ 550,000
Price/Earnings 10
Stock dividend 20%
Investor's share 100
Current price $ 2.75= P/E x EPS = 10 ×
000 , 000 , 2
550,000
Value before dividend $ 275.00 = $2.75 x 100 shares
After dividend
Shares outstanding 2,400,000 = 2,000,000 x (1 + 0.2)
New price $2.29 = P/E x EPS=10 x
000 , 400 , 2
$550,000
Investor's shares 120 = 100 x 1.2
Value after dividend $ 275.00 = 120 x $2.29
Change $ 0.00 = $275 (before)
- $275 (after)
The value of the investors' holdings does not change because the price of the
stock reacted fully to the increase in the shares outstanding.
89
17-6A. Harris, Inc. - Dividends in Perfect Markets
Dividend Plans
Year Plan A Plan B
1996 $ 2.50 $ 4.25
1997 $ 2.50 $ 4.75
1998 $45.75 $40.66
Required rate of return 0.18
Value stock A $31.76 =
3 2
.18) (1
$45.75

.18) (1
$2.50

.18) (1
$2.50
+
+
+
+
+
Value stock B $31.76 =

.18) (1
$40.66

.18) (1
$4.75

.18) (1
$4.25
3 2
+
+
+
+
+
a. There is no effect on the value of the common stock.
b. An investor's preference for current income, tax consequences, informational
content, and transaction costs may change your answer.
17-7A. Stetson Manufacturing, Inc. - Long Term Dividend Policy
Debt ratio 0.35
Equity ratio 0.65
Shares outstanding 100,000
(A) (B) (C)
Equity
Funds Available Contribution
Year Investment Internally (A x .65)
1 $ 350,000 $ 250,000 $ 227,500
2 475,000 450,000 308,750
3 200,000 600,000 130,000
4 980,000 650,000 637,000
5 600,000 390,000 390,000
$2,340,000 $1,693,250
a. Residual Dividend
Year Dividend =
Shares 100,000
on Contributi Equity Available Funds −
1 $0.225
2 $1.41
3 $4.70
4 $0.13
5 $0.00
90
b. Target Dividend = $1.29 =
Shares 100,000
)/5 $1,693,250 0 ($2,340,00 −
c. The target dividend allows for consistency of income to the
stockholder and income in all years whereas the year-to-
year dividend would not pay a dividend in year five.
17-8A. Trexco Corporation - Stock Split
Market price $ 98.00
Split multiple 2
Shares outstanding 25,000
a. You own 0.05 x 25,000
Investor's shares = 1,250
Position before split $122,500 = 1,250 Shares x $98 per share
Price after split $ 49.00 = $98 ÷ 2
Your shares after split 2,500 = 1,250 x 2
Position after split $122,500 = 2,500 shares x $49 per share
Net gain $ 0
b. Price fall 0.4
Price after split $ 58.80 = $98.00 (1 - .4)
Position after split $147,000 = 2,500 Shares x $58.80 per share
Net gain $ 24,500 = $147,000 - $122,500
17-9A. Crystal Cargo, Inc. - Dividend Policies
Year Profits After Taxes
1 $1,400,000
2 2,000,000
3 1,860,000
4 900,000
5 2,800,000
Total Profits After Taxes $8,960,000
Shares Outstanding 1,000,000
a. Constant Payout Ratio of 50%
Year Dividend = Profits x Payout Ratio ÷ Shares
1 $0.70 = $1,400,000 (.5) ÷ 1,000,000
2 $1.00 = $2,000,000 (.5) ÷ 1,000,000
3 $0.93 = $1,860,000 (.5) ÷ 1,000,000
4 $0.45 = $ 900,000 (.5) ÷ 1,000,000
5 $1.40 = $2,800,000 (.5) ÷ 1,000,000
91
b. Stable target payout of 50%
Target dividend = $0.90 =
1,000,000
(.5)/5 $8,960,000
c. Small regular dividend of $0.50 plus year-end extra
Base profits $1,500,000
% of extra profits 50%
Year Dividend
1 0.50
2 0.75 = .50+[($2,000,000-$1,500,000)(.5)/1,000,000]
3 0.68 = .50+[($1,860,000-$1,500,000)(.5)/1,000,000]
4 0.50
5 1.15 = .50+[($2,800,000-$1,500,000)(.5)/1,000,000]
17-10A. Dunn Corporation - Repurchase of Stock
Proposed dividend $ 500,000
Shares outstanding 250,000
Earnings per share $ 5.00
Ex-dividend price $ 50.00
Proposed dividend/share $2.00
a. Repurchase price $ 52.00 = $50 + $2
b. Number of shares repurchased 9,615 = $500,000 ÷ ($50 + $2)
c. The capital gains to be received by the stockholder would not be equal to the
intended dividend, thus resulting in a dollar benefit or loss to the
stockholders.
d. Unless you have a need for current income, you would probably prefer the
stock repurchase plan.
17-11A. Number of shares to be issued
50 . 9 $ 95 $
000 , 000 , 14 $

= 163,743 share
Dollar size of the issue
163,743 shares x $95 = $15,555,585
92
17-12A. Martinez, Inc. - Residual Dividend Theory
Total financing needed $1,200,000
Retained earnings $450,000
Debt ratio 0.70
Equity ratio 0.30
Equity financing needed $360,000 = $1,200,000 (0.30)
**Dividends** $ 90,000 = $450,000 - $360,000
Thus, the firm would pay $90,000 dividends.
17-13A. Rainy Corporation - Stock Split
Market price $ 86.00
Split multiple 2
Shares outstanding 80,000
a. You own 16,000 shares = .20 x 80,000
Position before split $1,376,000 = 16,000 Shares x $86 per share
Price after split $ 43.00 = $86 ÷ 2
Your shares after split 32,000 = 16,000 x 2
Position after split $1,376,000 = 32,000 shares x $43 per share
Net gain $ 0
b. Price fall 0.45
Price after split $ 47.30 = $86.00 (1 - .45)
Position after split $1,513,600 = 32,000 Shares x $47.30 per share
Net gain $ 137,600 = $1,513,600 - $1,376,000
SOLUTION TO INTEGRATIVE PROBLEM
Burns’ main argument is that dividends are more important in some periods and less
important in others. His discussion certainly gives us the impression that “dividend policy
matters.” He also sounds like he believes the “bird in the hand is worth two in the bush”
theory. However, he fails to prove that a shareholder’s value is greater whether a dividend
is paid or whether it is not paid. Obviously, he is correct in saying that in some years more
of an investor’s returns come in the form of dividends, and in other years more is in the form
of capital gains. But that does not prove that a dividend payment is inherently good or bad.
It is simply a tradeoff between one form of return and another. Also of great importance, he
fails to acknowledge the fact that dividends (or any form of distribution to shareholders)
should be paid when the firm cannot earn its cost of capital and retained when it can earn
more than the cost of capital. Retaining profits and investing them in negative NPV projects
destroys shareholder value – period. Thus, the more important question is what can be done
with the money within the firm versus what the shareholder can do with the money apart
93
from the company, and not how much dividends contribute to a shareholder’s total returns in
a given year.
Solutions to Problem Set B
17-1B. Number of shares to be issued:
17 $ 115 $
000 , 000 , 12 $

= 122,449 shares
Dollar size of the issue:
122,449 shares x $115 = $14,081,635
17-2B. Flotation Costs and Issue Size
Flotation costs 0.14
Stock price $76.00
Net to firm $6,100,000
Dollar issue size = $7,093,023 = $6,100,000/(1-.14)
Number of shares = 93,329 shares ($7,093,023 ÷ $76/share)
17-3B. Steven Miller - Residual Dividend Theory
Total financing needed $650,000
Retained earnings $375,000
Debt ratio 0.35
Equity ratio 0.65
Equity financing needed $422,500 = $650,000(.65)
Dividends ($47,500) = $375,000 - $422,500
Thus, the firm would pay no dividends and would also have to issue $47,500
in stock.
17-4B. DCA - Stock Dividend
Before dividend
Shares outstanding 2,500,000
Net income $ 600,000
Price/Earnings 10
Stock dividend 18%
Investor's shares 120
Current price $ 2.40 = P/E x EPS=10 x
$2,500,000
$600,000
Value before dividend $ 288.00 = $2.40 x 120 shares
After dividend
Shares outstanding 2,950,000 = 2,500,000 x (1+.18)
New price $ 2.03 = P/E x EPS = 10 x
$2,950,000
$600,000
Investor's shares 141.6 = 120 (1.18)
Value after dividend $ 288.00 = 141.6 x $2.03
Change $ 0.00 = $288(before)
- $288 (after)
94
The value of the investors' holdings does not change because the price of the
stock reacted fully to the increase in the shares outstanding.
17-5B. Montford, Inc. - Dividends in Perfect Markets
Dividend Plans
Year Plan A Plan B
1997 $ 2.55 $ 4.35
1998 $ 2.55 $ 4.70
1999 $45.60 $40.62
Required rate of return 0.17
Value stock A $32.51 =
3 2
.17) (1
$45.60

.17) (1
$2.55

.17) (1
$2.55
+
+
+
+
+
Value stock B $32.51 =
3 2
.17) (1
$40.62

.17) (1
$4.70

.17) (1
$4.35
+
+
+
+
+
a. There is no effect on the value of the common stock.
b. An investor's preference for current income, tax consequences, informational
content, and transaction costs might change our conclusion.
17-6B. Wells Manufacturing, Inc. - Long Term Dividend Policy
Debt ratio 0.40
Equity ratio 0.60
Shares outstanding 125,000
(A) (B) (C)
Equity
Funds Available Contribution
Year Investment Internally (A x .60)
1 $ 360,000 $225,000 $ 216,000
2 450,000 440,000 270,000
3 230,000 600,000 138,000
4 890,000 650,000 534,000
5 600,000 400,000 360,000
$2,315,000 $1,518,000
a. Residual Dividend
Year Dividend =
Shares 125,000
on Contributi Equity Available Funds −
1 $0.07
2 $1.36
3 $3.70
4 $0.93
5 $0.32
95
b. Target Dividend = $1.28 =
res 125,000Sha
)/5 $1,518,000 0 ($2,315,00 −
c. The target dividend allows for consistency of income to the stockholder and
income in all years whereas the year-to-year dividend would result in wide
year-to-year variations.
17-7B. Standlee Corporation - Stock Split
Market price $ 98.00
Split multiple 2
Shares outstanding 30,000
a. You own 0.08 x 30,000
Investor's shares = 2,400
Position before split $235,200 = 2,400 Shares x $98 per share
Price after split $ 49.00 = $98 ÷ 2
Your shares after split 4,800 = 2,400 x 2
Position after split $235,200 = 4,800 shares x $49 per share
Net gain $ 0
b. Price fall 0.45
Price after split $ 53.90 = $98.00 (1 - .45)
Position after split $258,720 = 4,800 Shares x $53.90 per share
Net gain $ 23,520 = $258,720 - $235,200
17-8B. Carlson Cargo, Inc. - Dividend Policies
Year Profits After Taxes
1 $1,500,000
2 2,000,000
3 1,750,000
4 950,000
5 2,500,000
Total Profits After Taxes $8,700,000
Shares Outstanding 1,000,000
a. Constant Payout Ratio of 40%
Year Dividend = Profits x Payout Ratio ÷ Shares
1 $0.60 = $1,500,000 (.4) ÷ 1,000,000
2 $0.80 = $2,000,000 (.4) ÷ 1,000,000
3 $0.70 = $1,750,000 (.4) ÷ 1,000,000
4 $0.38 = $ 950,000 (.4) ÷ 1,000,000
5 $1.00 = $2,500,000 (.4) ÷ 1,000,000
b. Stable target payout of 40%
96
Target dividend = $0.70 =
000 , 000 , 1
5 / ) 4 (. 000 , 700 , 8 $
c. Small regular dividend of $0.50 plus year-end extra
Base profits 1,500,000
% of extra profits 50%
Year Dividend
1 0.50
2 0.75 = .50+[($2,000,000-$1,500,000)(.5)/1,000,000]
3 0.63 = .50+[($1,750,000-$1,500,000)(.5)/1,000,000]
4 0.50
5 1.00 = .50+[($2,500,000-$1,500,000)(.5)/1,000,000]
17-9B. B. Phillips Corporation - Repurchase of Stock
Proposed dividend $ 550,000
Shares outstanding 275,000
Earnings per share $ 6.00
Ex-dividend price $ 45.00
Proposed dividend/share $2.00
a. Repurchase price $ 47.00 = $45 + $2
b. Number of shares repurchased 11,702 = $550,000 ÷ ($45 + $2)
c. The capital gains to be received by the stockholder would not be equal to the
intended dividend, thus resulting in a dollar benefit or loss to the
stockholders.
d. Unless you have a need for current income, you would probably prefer the
stock repurchase plan.
17-10B. Number of shares to be issued
12 $ 100 $
000 , 000 , 16 $

= 181,819 share
Dollar size of the issue
181,818 shares x $100 = $18,181,800
17-11B. Maness, Inc. - Residual Dividend Theory
Total financing needed $ 1,500,000
Retained earnings $ 525,000
Debt ratio 0.65
Equity ratio 0.35
Equity financing needed $ 525,000 = $1,500,000 (0.35)
Dividends $ 0 = $525,000 - $525,000
Thus, the firm would pay no dividend, but it would also not have to issue any
stock.
97
17-12B. Star Corporation - Stock Split
Market price $ 90
Split multiple 2
Shares outstanding 90,000
a. You own 22,500 shares = 0.25 x 90,000
Position before split $2,025,000 = 22,500 shares x $90 per share
Price after split $ 45.00 = $90 ÷ 2
Your shares after split 45,000 = 22,500 x 2
Position after split $2,025,000 = 45,000 shares x $45 per share
Net gain $ 0
b. Price fall 0.45
Price after split $ 49.50 = $90 (1 - .45)
Position after split $2,227,500 = 45,000 Shares x $49.50 per share
Net gain $ 202,500 = $2,227,500 - $2,025,000

98
CHAPTER 18
Working-Capital Management and Short-Term Financing

CHAPTER ORIENTATION
In this chapter we introduce working-capital management in terms of managing the firm's
liquidity. Specifically, net working capital is defined as the difference in current assets and
current liabilities. The hedging principle is offered as one approach to addressing the firm's
liquidity problems. In addition, this chapter deals with the sources of short-term financing
that must be repaid within 1 year.
CHAPTER OUTLINE
I. Managing current assets
A. Like fixed assets, the firm's investment in current assets is determined by the
marginal benefits derived from investing in them compared with their
acquisition cost.
B. However, the mix of current and fixed assets of the firm's investment in total
assets is an important determinant of the firm's liquidity. That is, the greater
the firm's investment in current assets, other things remaining the same, the
greater the firm's liquidity. This is generally true since current assets are
usually more easily converted into cash.
C. The firm can invest in marketable securities to increase its liquidity.
However, such a policy involves committing the firm's funds to a relatively
low-yielding (in comparison to fixed assets) investment.
II. Managing the firm's use of current liabilities
A. The greater the firm's use of current liabilities, other things being the same,
the less will be the firm's liquidity.
B. There are a number of advantages associated with the use of current liabilities
for financing the firm's asset investments.
1. Flexibility. Current liabilities can be used to match the timing of a
firm's short-term financing needs exactly.
99
2. Interest cost. Historically, the interest cost on short-term debt has
been lower than that on long-term debt.
C. Following are the disadvantages commonly associated with the use of short-
term debt:
1. Short-term debt exposes the firm to an increased risk of illiquidity
because short-term debt matures sooner and in greater frequency, by
definition, than does long-term debt.
2. Since short-term debt agreements must be renegotiated from year-to-
year, the interest cost of each year's financing is uncertain.
III. Determining the appropriate level of working capital
A. Pragmatically, it is impossible to derive the "optimal" level of working
capital for the firm. Such a derivation would require estimation of the
potential costs of illiquidity which, to date, have eluded precise measurement.
B. However, the "hedging principle" provides the basis for the firm's working-
capital decisions.
1. The hedging principle, or rule of self-liquidating debt involves the
following: Those asset needs of the firm not financed by spontaneous
sources (i.e., payables and accruals) should be financed in accordance
with the following rule: Permanent asset investments are financed
with permanent sources and temporary asset investments are financed
with temporary sources of financing.
2. A permanent investment in an asset is one which the firm expects to
hold for a period longer than one year. Such an investment may
involve current or fixed assets.
3. Temporary asset investments comprise the firm's investment in
current assets that will be liquidated and not replaced during the year.
4. Spontaneous sources of financing include all those sources that are
available upon demand (e.g., trade credit--Accounts Payable) or that
arise naturally as a part of doing business (e.g., wages payable,
interest payable, taxes payable, etc.).
5. Temporary sources of financing include all forms of current or short-
term financing not categorized as spontaneous. Examples include
bank loans, commercial paper, and finance company loans.
6. Permanent sources of financing include all long-term sources such as
debt having a maturity longer than one year, preferred stock, and
common stock.
C. Although the hedging principle provides a useful guide to the firm's working-
capital decisions, no firm will follow its tenets strictly. At times a firm may
rely too much on temporary financing for its cash needs or it may have
excess cash as a result of excessive use of permanent financing.
100
IV. Determining the appropriate level of short-term financing
A. The hedging concept was presented as one basis for determining the firm's
use of short-term debt.
B. Hedging involves attempting to match temporary needs for funds with short-
term sources of financing and permanent needs with long-term sources.
V. Measuring the effectiveness of managing net working capital
A. The firm’s goal should be to minimize net working capital. This can be
accomplished by:
1. faster collection of cash from sales
2. increasing inventory turns
3. slowing down disbursements to suppliers
B. Cash conversion cycle (CCC) measures these three factors
1. CCC = Days of sales outstanding (DSO) + Days of sales in inventory
(DSI) – Days of payables outstanding (DPO)
2. Decreasing DSO or DSI or increasing DPO will lead to a shorter cash
conversion cycle.
VI. Selecting a source of short-term financing
A. In general, there are three basic factors that should be considered in selecting
a source of short-term financing:
1. The effective cost of the credit source
2. The availability of credit
3. The effect of the use of a particular source of credit on the cost and
availability of other sources
B. The basic procedure used in estimating the cost of short-term credit utilizes
the basic interest equation, i.e., interest = principal x rate x time.
C. The problem faced in assessing the cost of a source of short-term financing
involves estimating the annual percentage rate (APR) where the interest
amount, the principal sum, and the time for which financing will be needed is
known. Thus, the basic interest equation is "rearranged" as follows:
APR =
principal
interest
x
time
1
D. Compound interest was not considered in the simple APR calculation. To
consider compounding, the following relation is used:
APY =
m
m
i
1
,
_

¸
¸
+ - 1
where APY is the annual percentage yield, i is the nominal rate of interest per
year, and m is the number of compounding periods within one year. The
effect of compounding is thus to raise the effective cost of short-term credit.
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VII. Sources of short-term credit
A. The two basic sources of short-term credit are unsecured and secured credit.
1. Unsecured credit consists of all those sources that have as their
security only the lender's faith in the ability of the borrower to repay
the funds when due.
2. Secured funds include additional security in the form of assets that are
pledged as collateral in the event the borrower defaults in payment of
principal or interest.
B. There are three major sources of unsecured short-term credit: trade credit,
unsecured bank loans, and commercial paper.
1. Trade credit provides one of the most flexible sources of financing
available to the firm. To arrange for credit, the firm need only place
an order with one of its suppliers. The supplier then checks the firm's
credit and if the credit is good, the supplier sends the merchandise.
2. Commercial banks provide unsecured short-term credit in two basic
forms: lines of credit and transaction loans (notes payable). Maturities
of both types of loans are usually 1 year or less with rates of interest
depending on the credit-worthiness of the borrower and the level of
interest rates in the economy as a whole.
3. A line of credit is generally an informal agreement or understanding
between the borrower and the bank as to the maximum amount of
credit that the bank will provide the borrower at any one time. There
is no "legal" commitment on the part of the bank to provide the stated
credit. There is another variant of this form of financing referred to as
a revolving credit agreement whereby such a legal obligation is
involved. The line of credit generally covers a period of one year
corresponding to the borrower's "fiscal" year.
4. Transaction loans are another form of unsecured short-term bank
credit. The transaction loan, in contrast to a line of credit, is made for
a specific purpose.
5. Only the largest and most creditworthy companies are able to use
commercial paper, which consists of unsecured promissory notes sold
in the money market.
a. The maturities of commercial paper are generally six months
or less with the interest rate slightly lower than the prime rate
on commercial bank loans. The new issues of commercial
paper are either directly placed or dealer placed.
102
b. There are a number of advantages that accrue to the user of
commercial paper: interest rates are generally lower than rates
on bank loans and comparable sources of short-term
financing; no minimum balance requirements are associated
with commercial paper; and commercial paper offers the firm
with very large credit needs a single source for all its short-
term financing needs. Since it is widely recognized that only
the most creditworthy borrowers have access to the
commercial paper market, its use signifies a firm's credit
status.
c. However, a very important "risk" is involved in using this
source of short-term financing; the commercial paper market
is highly impersonal and denies even the most credit-worthy
borrower any flexibility in terms of repayment.
B. Secured sources of short-term credit have certain assets of the firm, such as
accounts receivable or inventories, pledged as collateral to secure a loan.
Upon default of the loan agreement, the lender has first claim to the pledged
assets.
1. Generally, a firm's receivables are among its most liquid assets. Two
secured loan arrangements are generally made with accounts
receivable as collateral:
a. Under the arrangement of pledged accounts receivable, the
amount of the loan is stated as a percentage of the face value
of the receivables pledged.
b. Factoring accounts receivable involves the outright sale of a
firm's accounts receivables to a factor.
2. Four secured loan arrangements are generally made with inventory as
collateral:
a. Under the floating lien agreement, the borrower gives the
lender a lien against all its inventories.
b. The chattel mortgage agreement involves having specific
items of inventory identified in the security agreement.
c. The field warehouse financing agreements means that the
inventories used as collateral are physically separated from the
firm's other inventories and are placed under the control of a
third-party field warehousing firm.
d. Terminal warehouse agreements involve transporting the
inventories pledged as collateral to a public warehouse that is
physically removed from the borrower's premises.
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ANSWERS TO
END-OF-CHAPTER QUESTIONS
18-l. Working capital has traditionally been defined as the firm's investment in current
assets. Current assets are comprised of all assets which the firm expects to convert
into cash within one year including: cash, marketable securities, accounts receivable,
and inventories. Net working capital refers to the difference in the firm's current
assets and its current liabilities, i.e., net working capital = current assets - current
liabilities.
18-2. The final composition of the firm's current and fixed asset investments is an
important determinant of the firm's liquidity since, other things remaining the same,
the greater the firm's investment in current assets the greater its liquidity.
The firm may choose to invest additional funds in cash and/or marketable securities
as a means of increasing its liquidity. However, this type of action involves a trade-
off between the risk of illiquidity and the firm's return on invested funds. By
increasing its investment in cash and marketable securities, the firm reduces its risk
of illiquidity. However, the firm has increased its investment in assets which earn
little or no return. The firm can reduce its risk of illiquidity only by reducing its
overall return on invested funds and vice versa.
18-3. Advantages of Short-Term Debt:
(1) The interest rate is usually lower (i.e., the term structure of interest rates is
generally upward sloping) for short-term debt.
(2) Funds are paid for only when they are used.
Disadvantages:
(1) Short-term debts must be repaid sooner; thus, there is a greater risk of
illiquidity.
(2) Interest costs on short-term debts vary from year-to-year, whereas long-term
debt agreements "lock in" the cost of funds to the firm.
18-4. The use of current liabilities, or short-term debt as opposed to long-term debt,
subjects the firm to a greater risk of illiquidity. That is, short-term debt by its very
nature must be repaid or "rolled over" more often than long-term debt. Thus, the
possibility that the firm's financial condition might deteriorate to a point where the
needed funds might not be available is enhanced where short-term debt is used.
18-5. The hedging principle involves matching the maturities of the sources of financing
for the firm's assets with the useful lives of the assets. To implement the hedging
principle, the firm must fund all its permanent assets investments not financed by
spontaneous sources (payables) with long-term sources of funds, and then, finance
all its temporary asset investments not funded by spontaneous sources with short-
term sources of funds.
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18-6. Definitions:
(1) A permanent asset investment is one which the firm expects to hold for a
period longer than one year.
(2) Temporary asset investments are comprised of the firm's investments in
current assets which will be liquidated and not replaced within the current
year.
(3) Permanent sources of financing include intermediate and long-term debt,
preferred stock, and common equity.
(4) Temporary sources of financing consist of the various sources of short-term
debt: including secured and unsecured bank loans, commercial paper, loans
secured by accounts receivable, and loans secured by inventories.
(5) Spontaneous sources of financing consist of the trade credit and other
accounts payable which arise "spontaneously" in the firm's day-to-day
operations. Examples include wages and salaries payable, accrued interest,
and accrued taxes.
18-7. The important factors in selecting a source of short-term credit are as follows:
(1) the effective cost of credit.
(2) the availability of credit.
(3) the effect of the use of a particular source of credit on the cost and
availability of other sources of credit.
18-8. The procedure used in estimating the cost of short-term credit relies on the use of the
basic interest equation:
i = P x R x T
The problem faced in assessing the cost of a source of short-term financing,
however, generally involves estimating the annual effective rate for which both the
interest amount, the principal sum, and the time for which financing will be needed
is known.
To find the effective rate of interest, we simply solve the interest equation for the
rate (APR), i.e.:
APR =
T x P
i
=
P
i
x
T
1
18-9. Compound interest was not considered in the simple APR calculation. To consider
the influence of compounding we can use the following relation:
APY = (1 + i/m)
m
- 1
where i is the nominal rate of interest per year and m is the number of compounding
periods within a year. This cost of credit relationship is frequently referred to as the
Annual Percentage Yield, or APY.
105
18-10. The trade credit term "2/10, net 30" means that a 2 percent discount is offered for
payment within 10 days or the full amount is due in 30 days: "4/20, net 60"--4
percent discount within 20 days, full amount due in 60 days; 3/15, net 45--3 percent
discount within 15 days, full amount due in 45 days.
18-11. (a) A line of credit is generally an informal agreement or understanding between
the borrower and the bank as to the maximum amount of credit which the
bank will provide the borrower at any one time.
(b) Commercial paper consists of unsecured promissory notes of firms that are
sold in the money market.
(c) Compensating balance is a minimum balance that a borrower must maintain
in a bank throughout a loan period.
(d) The prime rate represents the interest rate which a bank charges its most
creditworthy borrowers on short-term loans.
18-12. The four advantages of commercial paper are:
(1) Interest rate. Commercial paper rates are generally lower than rates on bank
loans and comparable sources of short-term financing.
(2) Compensating balance requirements. No minimum balance requirements are
associated with commercial paper.
(3) Amount of credit. Commercial paper offers the firm with very large credit
needs a single source for all its short-term financing needs.
(4) Prestige. Since it is widely recognized that only the most creditworthy
borrowers have access to the commercial paper market, its use signifies a
firm's credit status.
18-13. The "risk" involved with the firm's use of commercial paper as a source of short-term
debt relates to the fact that the commercial paper market is highly impersonal and
denies even the most credit-worthy borrower any flexibility in terms of repayment.
18-14. There are two basic procedures which can be used in arranging for financing on
receivables--pledging and factoring.
Under pledging, the borrower simply offers his accounts receivable as collateral for a
loan obtained from either a commercial bank or a finance company. The amount of
the loan is stated as a percent of the face value of the receivables pledged.
The primary advantage of pledging as a source of short-term credit relates to the
flexibility it provides the borrower. Financing is available on a continuous basis.
Furthermore, the lender may provide credit services which eliminate or reduce the
need for similar services within the firm.
Factoring receivables involves the outright sale of a firm's accounts to a factor. The
factor, in turn, bears the risk of collection and services the accounts for a fee. In
addition, the factor provides advances or loans to the borrower on which interest is
charged for the term of the advance.
106
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
18-1A. The financial statements for both firms are found below:
Firm A
Cash 100,000 Accounts Payable 200,000
Accounts Receivable 100,000 Notes Payable 200,000
Inventories 300,000 Bonds 600,000
Net Fixed Assets 1,500,000 Common Equity 1,000,000
Total 2,000,000 Total 2,000,000
Firm B
Cash 150,000 Accounts Payable 400,000
Accounts Receivable 50,000 Notes Payable 200,000
Inventories 300,000 Current Liabilities 600,000
Net Fixed Assets 1,500,000 Bonds 400,000
Total 2,000,000 Common Equity 1,000,000
Total 2,000,000
Financial measures of firm liquidity
Firm A Firm B
Working Capital 500,000 500,000
Net Working Capital 100,000 (100,000)
Current Ratio 1.25 0.83
Acid Test Ratio 0.5 0.33
Cash 100,000 150,000
Firm B is obviously the more aggressive of the two firms. Note the fact that it has negative
net working capital (current liabilities exceed current assets) and both its current ratio and
acid test ratio are lower. Notice that the higher level of cash for Firm B is more than offset
by it more aggressive use of current liabilities.
107
18-2A. The information contained in the problem provides the basis for the following:
Purchases = $480,000
Discount Period = 15 days
Cash Discount = 1%
Deferred Period = 30 days
Maximum Credit Period = 45 days
Purchases per day = 480,000 ÷ 360 = 1,333.33
a. Purchases/day x 15 day discount period = 20,000.00
b. Purchases/day x 45 day maximum credit period = 60,000.00
c. The Annual Percentage Rate for forgoing the discount = 12.12%
18-3A.First we calculate the interest expense for the three month loan as follows:
Interest = .12 x $100,000 x 3/12 = $3,000.
Assuming that Paymaster has to leave 10% of the loan idle in a compensating
balance the effective cost of credit can be calculated as follows:
APR = [$3,000/($100,000 - 10,000 - 3,000)] x (12/3) = 13.79%
If the company already has sufficient funds in the bank to satisfy the compensating
balance requirement then the cost of credit drops to 12.37%.
18-4A.
Interest expense for the commercial paper issue is calculated as follows:
Interest = .11 x $20 million x (270/360) = $1,650,000
The effective rate of interest to Burlington Western (including the issue fee of
$200,000) is calculated as follows:
APR = [($1,650,000 + 200,000)/($20 million - 1,650,000 - 200,000)] x (360/270) =
13.59%
Note that both the interest expense and the issue fee are prepaid.
18-5A.
(a)
98 . 0
02 . 0
x
360 / 20
1
= 0.36734 or 36.73%
(b)
97 . 0
03 . 0
x
360 / 15
1
= 0.74226 or 74.23%
108
(c)
97 . 0
03 . 0
x
360 / 30
1
= 0.37113 or 37.11%
(d)
98 . 0
02 . 0
x
360 / 45
1
= 0.16327 or 16.33%
18-6A.
Instructor’s Note: This problem can be easily solved using the exponent function
(y
x
) on a hand calculator. Simply let y = (1+r/m) and x = m, then solve for y
x
.
Finally subtract "1" to obtain the effective cost of credit with compounding of
interest.
APY = (1 + i/m
)m
- 1
i = Nominal interest rate
m = # of compounding periods in a year
(a) APY = (1 +
18
3673 . 0
)
18
- 1
= 1.4385 - 1
= .4385 or 43.85%
(b) APY = ( 1 +
24
7423 . 0
)
24
- 1
= 2.0773 - 1
= 1.0773 or 107.73%
(c) APY = (1 +
12
3711 . 0
)
12
- 1
= 1.4412 - 1
= .4412 or 44.12%
(d) APY = (1 +
8
1633 . 0
)
8
- 1
= 1.1755 - 1
= .1755 or 17.55%
109
18-7A.
(a)
Interest = .14 x $100,000
= $14,000
Therefore, the effective rate of interest on the loan is calculated as follows:
APR =
000 , 14 000 , 100 $
000 , 14 $

x
360 / 360
1
= .1628 or 16.28%
Dealer Financing Alternative
APR =
000 , 100 $
300 , 16 $
x
360 / 360
1
= .163 or 16.3%
Analysis. The costs of the two sources of financing are identical for practical
purposes. The final choice can now be made based upon other nonquantitative
factors. For example, the firm may find that using dealer financing is less time
consuming and allows the firm to leave its credit line within the bank unchanged.
Since bank credit can be used for a much wider array of financing needs than dealer
financing, R. Morin would find that using dealer financing leaves the firm with
greater flexibility in raising funds for its future needs.
(b) If the compensating balance becomes binding, then the effective rate on the
bank loan alternative will be
Interest = .14 x $100,000
= $14,000
Compensating Balance = .15 x $100,000
= $15,000
APR =
000 , 15 000 , 14 000 , 100 $
000 , 14 $
− −
x
= .197 or 19.7%
Thus, where the 15 percent compensating balance requirement is binding on R.
Morin, the cost of the bank loan rises to 19.7 percent. In this case, dealer financing
is clearly less costly.
Note that equipment dealers will frequently price their merchandise so as to
compensate them for offering "below market" rates of interest for financing. This
may well be the case here such that R. Morin should use the dealer financing unless
it can negotiate a price concession equal to the value of "bargain financing."
110
18-8A. Interest = .13 x 100,000
= $13,000
$1083/month -- interest
Compensating balance = 100,000 x .20
= $20,000
(a) APR =
000 , 100 $
000 , 13 $
x
360 / 360
1
= 0.13 or 13%
(b) APR =
000 , 20 000 , 100 $
000 , 13 $

x
360 / 360
1
= 0.1625 or 16.25%
Interest expense for the loan is $13,000; however, the firm gets the use
of only .8 x $100,000 = $80,000.
18-9A. (a) Interest = .1025 x $500,000 x 180/360 = 25,625
APR =
principal
interest
x
time
1
APR =
625 , 25 000 , 12 000 , 500 $
000 , 12 625 , 25 $
− −
+
x
360 / 180
1
= .1627 = 16.27%
(b) The risk involved with the issue of commercial paper should be considered.
This risk relates to the fact that the commercial paper market is highly
impersonal and denies even the most credit-worthy borrower any flexibility
in terms of when repayment is made.
In addition, commercial paper is a viable source of credit to only the most
credit-worthy borrowers. Thus, it may simply not be available to the firm.
18-10A.(a) Interest = P x R x T = (400,000 x .75) x .13 x 1 = $39,000
Fee = $200,000 x .01 x 12 = $24,000
APR =
principal
interest
x
time
1
APR =
.75 x 000 , 400 $
000 , 24 000 , 39 $ +
x
360 / 360
1
= .21 or 21%
111
(b) $300,000 x .15 = $45,000 (compensating balance)
Since Johnson maintains a balance of $80,000 normally with the bank, the
compensating balance requirement will not increase the effective cost of
credit.
Interest = 300,000 x (.11 + .03) x 1 = $42,000
000 , 300 $
000 , 42 $
x
360 / 360
1
= 0.14 or 14%
(c) Choose the line of credit since the effective interest is considerably lower.
Note, however, that the pledging arrangement may reduce credit services to
Johnson which would reduce Johnson's credit department expense. If this
were the case then these savings would reduce the effective cost of that
financing arrangement.
18-11A.(a) Maximum Advance
Face Value of Receivables
(2 months credit sales) $ 800,000
Less: Factoring Fee (1%) (8,000)
Reserve (9%) (72,000)
Interest (1 1/2% per month for 60 days)* (21,600 )
Loan Advance (less discount interest) $ 698,400
*Interest is calculated on the 90 percent of the factored accounts that can be
borrowed, (.90 x $800,000 x .015 x 2 months) = $21,600 or ($800,000 -
8,000 - 72,000) x .015 x 2 months = $21,600.
Thus, the effective cost of credit to MDM is calculated as follows:
APR =
400 , 698 $
* * 000 , 3 000 , 8 600 , 21 $ − +
x
) 360 / 60 (
1
= .2285 or 22.85%
**Credit department savings for 60 days equals 2 x $1500.
112
Calculated on an annual basis, the cost of credit would be:
APR =
400 , 698 $
000 , 18 000 , 48 600 , 129 $ − +
x
360 / 360
1
= .2285 or 22.85%
where interest = .015 x $720,000 x 12 = $129,600
factoring fee = .01 x $400,000 x 12 = $48,000
credit department savings = 12 x $1500 = $18,000
(b) Of particular concern here is the presence of any "stigma" associated with
factoring. In some industries, factoring simply is not used unless the firm's
financial condition is critical. This would appear to be the case here, given
the relatively high effective rate of interest on borrowing.
18-12A.
(a) Pledged Receivables (A/R):
0.80 A/R = $500,000 loan
A/R = $500,000/.80 = $625,000
Fee = (0.01) ($625,000) = $6,250
Interest Cost = (0.11) ($500,000) x 90/360 = $13,750
Effective Rate =
,
_

¸
¸

,
_

¸
¸ +
360 / 90
1
x
000 , 500 $
250 , 6 750 , 13 $
= .16 or 16%
(b) Warehousing cost = $2,000 x 3 months = $6,000
Interest cost = 0.09 x $500,000 x 90/360 = $11,250
Effective Rate =
,
_

¸
¸

,
_

¸
¸ +
360 / 90
1
x
000 , 500 $
250 , 11 000 , 6 $
= .138 or 13.8%
The inventory loan would be preferred since its cost is lower under the conditions
presented to S-J.
113
18-13A.
(a) Interest = $20,000 x .10 x 180/360
= $1,000
APR =
000 , 20 $
000 , 1 $
x
) 360 / 180 (
1
= .10 or 10%
(b) The net proceeds from the loan are now $20,000 - (.15 x $20,000) or
$17,000. Thus, the effective cost of credit is
APR =
000 , 17 $
000 , 1 $
x
360 / 180
1
= .1176 or 11.76%
We would have gotten the same answer by assuming that you borrow the
necessary compensating balance. In that case the amount borrowed (B) is
found as follows:
B - .15B = $20,000
.85B = $20,000
B = $20,000/.85
= $23,529.41
Interest = .10 x 180/360 x $23,529.41
= $1,176.47
APR =
000 , 20 $
47 . 176 , 1 $
x
360 / 180
1
= .1176 or 11.76%
(c) In this case we assess the impact of discounted interest and the 15 percent
compensating balance. As in part (b) the discounted interest serves to reduce
the loan proceeds:
APR =
000 , 1 000 , 3 000 , 20 $
000 , 1 $
− −
x
) 360 / 180 (
1
= .125 or 12.5%
114
If you borrowed enough to cover both the compensating balance requirement
and discounted interest, then you would borrow (B) such that
B - .15B - (.10 x 6/12)B = $20,000
.8B = $20,000
B = $25,000
Interest = .10 x 6/12 x $25,000
= $1,250
Compensating Balance = .15 x $25,000
= $3,750
Thus,
APR =
750 , 3 250 , 1 000 , 25 $
250 , 1 $
− −
x
360 / 180
1
= .125 or 12.5%
The cost of the bank loan rises once again in part (c) due to the reduction in
funds available to you from the loan as a result (this time) of discounted
interest.
18-14A.
Calculation of the Maximum Advance
Face Amount of Receivables Factored $300,000
Less: Fee (.02 x $300,000) (6,000)
Reserve (.20 x $300,000) (60,000)
Interest (.01 x $234,000 x 3 months) (7,020)
Maximum Advance $226,980
Calculation of the cost of credit
APR =
980 , 226 $
* 000 , 6 000 , 6 020 , 7 $ − +
x
3
12
= .0309 x 4 = .1237 or 12.37%
* Credit department expenses reduced by $2,000 per month for 3 months.
115
18-15A.
(a) Days of Sales Outstanding (DSO) =
Sales/365
Receivable Accounts
Days of Sales in Inventory (DSI) =
Sales/365
s Inventorie
1999 2000 2001 2002 2003
DSO 52.2 56.5 50.0 42.5 44
DSI 28.0 30.8 29.6 11.8 6.9
(b) Days of Payables Outstanding (DPO) =
Sales/365
Payable Accounts
Cash Conversion Cycle (CCC) = DSO + DSI - DPO
1999 2000 2001 2002 2003
DPO 35.9 47.0 32.1 48.9 48.7
CCC 44.22 40.3 47.5 5.4 2.2
Generally, DSO and DSI are decreasing and DPO is increasing. This signifies that
Mega PC is collecting receivables faster, turning inventory more rapidly, and paying
suppliers slower. Mega PC has achieved significant improvement in its working
capital management practices.
Solutions to Problem Set B
18-1B.
Firm A
Cash 200,000 Accounts Payable 400,000
Accounts Receivable 200,000 Notes Payable 400,000
Inventories 600,000 Bonds 1,200,000
Net Fixed Assets 3,000,000 Common Equity 2,000,000
Total 4,000,000 Total 4,000,000
Firm B
Cash 200,000 Accounts Payable 600,000
Accounts Receivable 400,000 Notes Payable 400,000
Inventories 400,000 Bonds 500,000
Net Fixed Assets 3,000,000 Common Equity 2,500,000
Total 4,000,000 Total 4,000,000
116
The preceding financial statements provide the information needed to compute the
following measures of liquidity for the two firms:
Firm A Firm B
Working Capital 1,000,000 1,000,000
Net Working Capital 200,000 0
Current Ratio 1.25 1
Acid Test Ratio .5 0.6
Cash 200,000 200,000
Firm B is the more aggressive of the two firms with respect to the management of its
working capital. Firm B has zero net working capital which is reflected in its lower
current ratio.
18-2B.
The information contained in the problem provides the basis for the following:
Purchases = 600,000
Discount Period = 30 days
Cash Discount = 2%
Deferred Period = 30 days
Maximum Credit Period = 60 days
Purchases per day = 600,000 ÷ 360 = 1,666.67
a. Purchases/day x 30 day discount period = 50,000.00
b. Purchases/day x 60 day maximum credit period = 100,000.00
c. The Annual Percentage Rate = 24.49%
18-3B.
First we calculate the interest expense for the three month loan as follows:
Interest = .14 x $125,000 x 3/12 = $4,375.
Assuming that Dee has to leave 10% of the loan idle in a compensating balance, the
effective cost of credit can be calculated as follows:
APR = [$4,375/($125,000 - 12,500 - 4,375)] x (12/3) = 16.18%
If the company already has sufficient funds in the bank to satisfy the
compensating balance requirement then the cost of credit drops
to 14.5%.
117
18-4B.Interest expense for the commercial paper issue is calculated as follows:
Interest = .12 x $15 million x (270/360) = $1,350,000
The effective rate of interest to Duro Auto Parts (including the issue fee of $150,000)
is calculated as follows:
APR = [($1,350,000 + 150,000)/($15 million - 1,350,000 - 150,000)] x (360/270) =
14.81%
Note that both the interest expense and the issue fee are prepaid.
18-5B.
(a)
99 . 0
01 . 0
x
360 / 20
1
= .1818 or 18.18%
(b)
98 . 0
02 . 0
x
360 / 15
1
= .4898 or 48.98%
(c)
98 . 0
02 . 0
x
360 / 30
1
= .2449 or 24.49%
(d)
97 . 0
03 . 0
x
360 / 45
1
= .2474 or 24.74%
18-6B. Instructor’s Note: This problem can be easily solved using the exponent function
(y
x
) on a hand calculator. Simply let y = (1+i/m) and x = m, then solve for y
x
.
Finally subtract "1" to obtain the effective cost of credit with compounding of
interest.
APY = (1 + i/m)
m
- 1
i = Nominal interest rate
m = # of compounding periods in a year
(a) APY = (1 +
18
1818 . 0
)
18
- 1
= .1983 or 19.83%
(b) APY = ( 1 +
24
4898 . 0
)
24
- 1
= .6240 or 62.40%
(c) APY = (1 +
12
2449 . 0
)
12
- 1
= .2744 or 27.44%
(d) APY = (1 +
8
2474 . 0
)
8
- 1
118
= .2759 or 27.59%
18-7B.
(a)
Interest = .15 x $150,000
= $22,500
Therefore, the effective rate of interest on the loan is calculated as follows:
APR =
500 , 22 000 , 150 $
500 , 22 $

x
360 / 360
1
= .1765 or 17.65%
Dealer Financing Alternative
APR =
000 , 150 $
000 , 30 $
x
360 / 360
1
= .20 or 20%
In this case bank financing is preferred.
(b) If the compensating balance becomes binding, then the cost of bank loan
alternative will be
Interest = .15 x $150,000
= $22,500
Compensating Balance = .16 x $150,000
= $24,000
APR =
000 , 24 500 , 22 000 , 150 $
500 , 22 $
− −
x
360 / 360
1
= .2174 or 21.74%
Thus, where the 16 percent compensating balance requirement is binding on
Vitra, the cost of the bank loan rises to 21.74 percent, and dealer financing is
preferred.
119
18-8B. Interest = 100,000 x .14 x 1
= $14,000
Compensating balance = 100,000 x .15 = 15,000
(a) APR =
000 , 100 $
000 , 14 $
x
360 / 360
1
= 0.14 or 14%
(b) APR =
000 , 5 1 - 000 , 100 $
000 , 14 $
x
360 / 360
1
= .1647 or 16.47%
Interest expense for the loan is $14,000; however, the firm gets the use of only .85 x
$100,000 = $85,000.
18-9B.
(a) APR =
principal
interest
x
time
1
Interest = .11 x $450,000 x 180/360 = $24,750
APR =
750 , 24 000 , 13 000 , 450 $
000 , 13 750 , 24 $
− −
+
x
= .1831 or 18.31%
(b) The risk involved with the issue of commercial paper should be considered.
This risk relates to the fact that the commercial paper market is highly
impersonal and denies even the most credit-worthy borrower any flexibility
in terms of when repayment is made.
In addition, commercial paper is a viable source of credit to only the most
credit-worthy borrowers. Thus, it may simply not be available to the firm.
18-10B.
Interest = ($500,000 x 0.80) x .13 x 1 = $52,000
Processing fee = (250,000 x .01 x 12) = $30,000
(a) APR =
.80 x 000 , 00 5 $
000 , 30 000 , 52 $ +
x = .205 or 20.5%
120
(b) Interest = $400,000 x .14 = $56,000
Compensating Balance = $400,000 x .15 = $60,000
Since the firm maintains a balance of $100,000 normally with the bank, the
compensating balance requirement will not increase the effective cost of
credit.
000 , 400 $
000 , 56 $
x
360 / 360
1
= 0.14 or 14%
(c) Choose the line of credit since the effective interest is considerable lower.
Note, however, that the pledging arrangement may reduce credit services to
the firm which would reduce its credit department expense. If this were the
case then these savings would reduce the effective cost of that financing
arrangement.
18-11B.
(a) Maximum Advance
Face Value of Receivables
(2 months credit sales) $ 600,000
Less: Factoring Fee (1%) (6,000)
Reserve (9%) (54,000)
Interest (1 1/2% per month
for 60 days)* (16,200 )
Loan Advance (less discount interest) $ 523,800
*Interest is calculated on the 90 percent of the factored accounts that can be
borrowed, (.90 x $600,000 x .015 x 2 months) = $16,200 or ($600,000 -
6,000 - 54,000) x .015 x 2 months = $16,200.
Thus, the effective cost of credit to Dal Molle is calculated as follows:
APR =
800 , 523 $
* * 800 , 2 000 , 6 200 , 16 $ − +
x
= .2222 or 22.22%
**Credit department savings for 60 days equals 2 months x $1,400/month.
(b) Of particular concern here is the presence of any "stigma" associated with
factoring. In some industries, factoring simply is not used unless the firm's
financial condition is critical. This would appear to be the case here, given
the relatively high effective rate of interest on borrowing.
121
18-12B.
Pledged Receivables (A/R):
0.80 A/R = $400,000 loan
A/R = $400,000/.80 = $500,000
Fee = (0.01) ($500,000) = $5,000
Interest Cost = (0.11) ($400,000) x 3/12 = $11,000
Effective Rate =
,
_

¸
¸

,
_

¸
¸ +
12 / 3
1
x
000 , 400 $
000 , 5 000 , 11 $
= .16 or 16%
Inventory Loan:
Warehousing cost = $2,000 x 3 months = $6,000
Interest cost = 0.09 x $400,000 x 3/12 = $9,000
Effective Rate =
,
_

¸
¸

,
_

¸
¸ +
12 / 3
1
x
000 , 400 $
000 , 9 000 , 6 $
= .15 or 15%
The inventory loan would be preferred since its cost is lower under the
conditions presented.
18-13B.
(a) Interest = $25,000 x .11 x 180/360
= $1,375
APR =
000 , 25 $
375 , 1 $
x
) 360 / 180 (
1
= .11 or 11%
(b) The net proceeds from the loan are now $25,000 - (.15 x $25,000) or
$21,250. Thus, the effective cost of credit is
APR =
250 , 21 $
375 , 1 $
x
360 / 180
1
= .1294 or 12.94%
122
We would have gotten the same answer by assuming that you borrow the
necessary compensating balance. In that case the amount borrowed (B) is
found as follows:
B - .15B = $25,000
.85B = $25,000
B = $25,000/.85
= $29,411.76
Interest = .11 x 180/360 x $29,411.76
= $1,617.65
Compensating Balance = .15 x 29,411.76 = 4,411.76
APR =
76 . 411 , 4 76 . 411 , 29 $
65 . 617 , 1 $

x
360 / 180
1
= .1294 or 12.94%
(c) In this case we assess the impact of discounted interest and the 15 percent
compensating balance. As in part (b) the discounted interest serves to reduce
the loan proceeds:
APR =
375 , 1 750 , 3 000 , 25 $
375 , 1 $
− −
x
) 360 / 180 (
1
= .1383 or 13.83%
18-14B.
Calculation of the Maximum Advance
Face Amount of Receivables Factored $450,000
Less: Fee (.02 x $450,000) (9,000)
Reserve (.15 x $450,000) (67,500)
Interest
( .13/12 x $373,500 x 3 months) (12,139 )
Maximum Advance $361,361
Calculation of the cost of credit
APR =
361 , 361 $
) 2000 x 3 ( 000 , 9 139 , 12 $ − +
x
3
12
= .1676 or 16.76%
18-15B
123
(a) Days of Sales Outstanding (DSO) =
Sales/365
Receivable Accounts
Days of Sales in Inventory (DSI) =
Sales/365
s Inventorie
1997 1998 1999 2000 2001
DSO 59.4 63.7 63.6 62.7 60.5
DSI 46.9 24.7 32.8 31.5 26.0
(b) Days of Payables Outstanding (DPO) =
Sales/365
Payable Accounts
Cash Conversion Cycle (CCC) = DSO + DSI - DPO
1997 1998 1999 2000 2001
DPO 26.5 18.9 20.2 19.4 22.6
CCC 79.8 79.5 76.2 74.8 63.9
Although there has been some improvement in DSO, DSI, and DPO during the last 5
years, there has been little change during the most recent 2 years. Allergan should
focus on collecting receivables faster and increasing inventory turns to reduce the
DSO and DSI measures. This will in turn reduce the cash conversion cycle.
Allergan should also try to obtain more favorable trade credit terms (i.e. lengthen
payment period).

CHAPTER 19
Cash and Marketable
124
Securities Management

CHAPTER ORIENTATION
This chapter initiates our study of cash management, focusing on the cash flow process and
the reasons why a firm holds cash balances. Cash management systems are explored, as is
the topic of investing excess cash in marketable securities.
CHAPTER OUTLINE
I. Why a company holds cash
A. Sound cash management techniques are based on a thorough understanding
of the cash flow process.
1. Cash holdings are increased from several external sources on an
irregular basis.
2. Irregular cash outflows reduce the firm's cash balance.
3. Other major sources of cash arising from internal operations occur on
a rather regular basis, i.e., accounts receivable collections.
B. Three motives for holding cash balances have been identified by Keynes.
1. The transactions motive
2. The precautionary motive
3. The speculative motive
II. Cash management objectives and decisions
A. The risk return trade-off
1. Strike an acceptable balance between holding too much cash and
holding too little cash.
2. A large cash investment minimizes insolvency, but penalizes
profitability.
3. A small cash investment frees excess balances for investment in more
profitable assets, which increase profitability.
B. The objectives
1. On-hand cash must be sufficient to meet disbursal needs.
2. Idle cash balances must be reduced to a minimum.
C. The decisions
1. How to speed up cash collections and slow down cash outflows?
125
2. What should be the composition of the marketable securities
portfolio?
3. How should the investment in liquid assets be split between actual
cash holdings and marketable securities?
D. Perspective on collection and disbursement procedures
III. Collection and disbursement procedures
A. Cash acceleration and deceleration techniques revolve around the concept of
float.
1. Mail float
2. Processing float
3. Transit float
4. Disbursing float
B. Float reduction can result in (l) usable funds that are released for company
use and (2) increased returns produced on these freed-up balances.
C. Several techniques are available to improve the management of the firm's
cash inflows and may also provide for a reduction in float.
1. The lock-box arrangement expedites cash gathering.
a. The objective is to reduce both mail and processing float.
b. The procedure includes rental of a local post office box and
authorization of a local bank, in which a demand deposit
account (DDA) is maintained, to pick up remittances from the
box.
c. The arrangement provides for (l) increased working cash, (2)
elimination of clerical functions, and (3) early knowledge of
dishonored checks.
d. Added costs must be evaluated.
2. Pre-authorized checks (PACs) also speed up the conversion of
receipts into working cash.
a. The objective is to reduce mail and processing float.
b. A PAC (l) is created with the individual's legal authorization,
(2) resembles an ordinary check, and (3) does not contain the
signature of the person on whose account it is being drawn.
c. PAC systems are most useful to firms that regularly receive a
large volume of payments of a fixed amount from the same
customers.
3. Depository transfer checks (DTCs) are used in conjunction with
concentration banking.
126
Major objectives of using DTCs are (1) elimination of excess cash balances held in
several regional banks and (2) reduction of float.
4. Wire transfers offer the fastest method for moving funds between
commercial banks. Two major communication facilities
accommodate wire transfers: (1) Bank Wire, and (2) Federal Reserve
Wire System.
D. Techniques used by firms that hope to improve the management of their cash
flow
1. Zero balance accounts (ZBAs) permit centralized control, but also
allow the firm to maintain disbursing authority at the local level. The
major objective is to achieve better control over cash payments. It
might also increase disbursement float.
2. Payable-through drafts (PTDs) have the physical appearance of
ordinary checks but they are drawn on and paid by the issuing firm
instead of the bank.
a. The objective of a PTD system is to provide for effective
control of field-authorized payments.
b. Stop payment orders can be initiated on any drafts considered
inappropriate.
c. Legal payment of individual drafts takes place after review
and approval of the drafts by the company. Disbursing float is
usually not increased by the use of drafts.
IV. Electronic funds transfer systems (EFT) reduce transit, mail, and processing float.
A. Transactions are immediately reflected on the books and bank accounts of
firms doing business.
B. This ideal has not yet been fully reached.
C. The purpose of the EFT is the elimination of the check as a method of
transferring funds.
D. Perspective on evaluating costs.
127
V. Evaluating the costs of cash management services
A. Whether a cash management system will provide an economic benefit can be
evaluated by:
added costs = added benefits
B. If the benefits exceed the costs, the system is economically feasible.
C. On a per unit basis, this relationship can be expressed as follows:
P = (D) (S) (i)
where P = increase in per-check processing cost, if new system is
adopted
D = days saved in the collection process
S = average check size in dollars
i = the daily, before-tax opportunity cost of carrying cash.
D. The product of (D) x (S) x (i) must exceed P for the system to be beneficial to
the firm.
E. Perspective on the marketable securities portfolio.
VI. Composition of marketable securities portfolio
A. Five factors to consider when selecting a proper marketable securities mix
1. Financial risk
2. Interest rate risk
3. Liquidity
4. Taxability of interest income and capital gains
5. Yield criterion
B. Marketable security alternatives
1. A Treasury bill is a direct obligation of the U.S. government.
a. May be purchased in denominations of $1,000 and higher
($10,000, $15,000, $50,000, $100,000, $500,000, and
$1,000,000).
b. Currently offered with maturities of 91, 182, and 365 days.
c. Since Treasury bills are sold on a discount basis, the investor
does not receive an actual interest payment.
d. The bills are considered risk-free and sell at lower yields than
other marketable securities of like maturity.
e. Income from Treasury bills is subject to the federal income tax
and is taxed as ordinary income.
128
2. Federal agency securities represent debt obligations of corporations
and agencies that have been created to manage the various lending
programs of the U.S. government.
3. Bankers' acceptances are drafts drawn on a specific bank by an
exporter in order to obtain payment for goods shipped to a customer
who maintains an account with that bank.
a. Maturities run mostly from 30 to 180 days.
b. Acceptances are sold on a discount basis.
c. Income generated is fully taxable at all levels.
d. Provide investors with a higher yield than do Treasury bills.
4. A negotiable certificate of deposit (CD) is a marketable receipt for
funds that have been deposited in a bank for a fixed time period at a
fixed interest rate.
a. CDs are offered in denominations ranging from $25,000 to
$10,000,000
b. Maturities range from 1 to 18 months.
c. Yields are higher than those of Treasury bills.
d. Income received is taxed at all governmental levels.
5. Commercial paper refers to short-term, unsecured promissory notes.
a. Paper ranges from $5,000 up to $5,000,000.
b. The notes are generally sold on a discount basis with
maturities ranging from 3 to 270 days.
c. Paper has no active trading in a secondary market.
d. Return received is taxable at all governmental levels.
6. Repurchase agreements involve the actual sale of securities by a
borrower to the lender, with a commitment on the part of the borrower
to repurchase the securities at the contract price plus a stated interest
charge.
a. These agreements are usually executed in sizes of $500,000 or
more.
b. There is a specified maturity date or time period.
c. Yields are higher than for Treasury bills and are taxable at all
governmental levels.
7. Money market mutual funds usually invest in a diversified portfolio
of short-term, high-grade debt instruments.
a. Shares are sold to a large number of small investors.
b. Funds offer a high degree of liquidity.
c. Returns are usually taxable at all governmental levels.
129
IX. Summary
ANSWERS TO
END-OF-CHAPTER QUESTIONS
19-1. The procedure by which funds generated from company activity are accommodated
(directed) through the firm from the time of their initial receipt until their ultimate
disposition. Over the long run, accounts receivable collections account for the
largest regular source of cash in the typical manufacturing company. Payment of
accounts payable, payroll expenses, and the distribution of income to the owners
(cash dividends) are the major forms of cash disbursal. Other sources of cash for a
company may include receipts from the sale of assets, assumption of additional debt,
issuance of new stock, or gains realized from investments. While these are important
sources of cash to a company, the proceeds are not available on a regular basis.
Major capital expenditure programs, new company acquisitions, and inventory
stockpiling are examples of irregular disbursals of cash outside the normal course of
everyday business.
19-2. The three classical motives for holding cash and near-cash balances are: (1) the
transactions motive; (2) the precautionary motive; (3) the speculative motive.
Transactions balances allow the firm to make payments that arise in the ordinary
course of doing business. Precautionary balances provide a buffer stock of liquid
assets that can be drawn down if unexpected demands for cash arise. Speculative
balances permit the economic unit to take advantage of future profit-making
situations.
19-3. Concentration banking involves the use of multiple cash collection centers and the
deposit of funds in regional banks located near the collection centers. Funds are then
transferred from the regional commercial banks to a concentration bank. A
concentration bank is one where the firm maintains a major cash disbursing account.
Concentration banking may permit the firm to: (1) operate with lower levels of
excess cash; (2) maintain more effective control over the firm's cash resources; (3)
make prudent decisions concerning marketable securities transactions. Moreover,
concentration banking will reduce both mail float and transit float.
19-4. The "regular" depository transfer check is a pre-printed form that is filled out and
mailed by a company employee in order to move demand deposit balances from one
bank to another. The automated depository transfer check (ADTC) eliminates the
mail delay associated with the "regular" depository transfer check. The deposit
information in this latter case is telephoned by a company employee to a regional
data collection center. The data collection center transmits the information to the
firm's concentration bank. Ordinarily, both of these systems are used in conjunction
with a concentration banking arrangement.
19-5. The firm which regularly receives a large volume of payments from the same
customers will find the pre-authorized check system a useful device. Common
examples are insurance companies, savings and loan associations, consumer credit
firms, leasing enterprises and charitable and religious organizations.
130
19-6. The firm must: (1) maintain adequate cash balances that will permit it to meet the
disbursal needs that occur in the course of doing business; (2) reduce idle cash
balances to a minimum.
19-7. (1) Choosing among various methods available for speeding up cash receipts,
slowing down cash payments, and providing for more effective control over
cash outflows.
(2) Splitting the firm's liquid asset holdings among cash and marketable
securities.
(3) Choosing the appropriate marketable securities mix.
19-8. (1) Mail float: this represents funds which are not usable to the firm because of
the time necessary for a customer's remittance check to travel through the
mails to a company collection center.
(2) Processing float: this represents funds tied up due to the time needed for the
company to process the remittance checks and get them ready for deposit in a
demand deposit account.
(3) Transit float: this represents funds tied up because of the time necessary for a
deposited check to clear through the commercial banking system and become
"good" funds to the firm.
(4) Disbursing float: this refers to funds available in the firm's demand deposit
account due to the time needed for a payment check to clear through the
banking system.
19-9. In the context of cash management, financial risk is the uncertainty of future returns
from a security caused by possible changes in the financial capability of the security-
issuer to make future payments to the security-owner. This is sometimes called
default risk. On the other hand the uncertainty related to the expected returns from a
financial asset caused by changes in interest rates is called interest rate risk.
19-10. Liquidity is the ability to change a security into cash. A money market instrument
that is highly liquid can be converted into cash quickly and at a price near its
prevailing market price.
19-11. Commercial paper
19-12. Bills--5.90%
Agencies--6.10%
Paper--6.25%
19-13. (1) Maturity periods on repurchase agreements can be individually tailored to the
needs of the investor.
(2) The price at which the repo will be liquidated is set at the time the contract is
finalized.
131
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
19-1A.
Average daily float =
Year in Days
Revenues Annual
=
365
000 , 000 , 40 $
=
$109,589
[(Average daily float) x (Number of days of float reduction)] = Amount that can be
invested
[($109,589) x (7)] = $767,123
[(Amount that can be invested) x Interest rate on investment)] = Annual interest
forgone
[($767,123) x (.05)] = $38,358
Thus, the cost of the Healthy Herbal's current billing system is:
Annual interest forgone $38,356
Plus: Clerical costs 35,000
Cost of current system $73,356
And, the net annual gain from adoption of the proposed concentration banking system is:
Cost of current system $73,356
Less: cost of concentration banking system 40,000
Net annual gain from proposed system $33,356
19-2A.
Analysis of the two alternatives requires that the net earnings be computed for each
alternative for each of the specified time periods as follows:
Invest in Money Market Fund:
Cash Interest Holding Annual Annual Net
Available Rate Period Earnings Cost Earnings
$750,000 0.05 1mo. $3,125 0 $3,125
$750,000 0.05 2 mo. 6,250 0 6,250
$750,000 0.05 6 mo. 18,750 0 18,750
$750,000 0.05 12 mo. 37,500 0 37,500
132
Invest directly in marketable securities:
Cash Interest Holding Annual Annual Net
Available Rate Period Earnings Cost Earnings
$750,000 0.075 1mo. $4,688 15000 -$10,312
$750,000 0.075 2 mo. 9,375 15000 -5,625
$750,000 0.075 6 mo. 28,125 15000 13,125
$750,000 0.075 12 mo. 56,250 15000 41,250
Accordingly, a comparison of the net earnings of the two alternatives indicates the following:
Money Market Fund Direct Investment Recommendation
1 mo. $3,125 -$10,312 Money Market Fund
2 mo. 6,250 -5,625 Money Market Fund
6 mo. 18,750 13,125 Money Market Fund
12 mo. 37,500 41,250 Direct Investment
19-3A.
Annual collection = ($6,232,375) (12 regions) = $74,788,500
Daily collections = $74,788,500 / 365 = $204,900
Use of the lock-box system will reduce Marino Rug Company's float by 3 days according to
the study done by National Bank of Miami. The value of the float reduction is found by
presuming the freed funds will be added to the marketable securities portfolio and will earn
the 9.75% yield noted in the text of the problem. The gross annual savings from the system
are:
($204,900) (3) (.0975) = $59,933
The annual cost of operating the lock-box system is:
($325 per month) (12 regions) (12 months) = $46,800
The net annual savings are:
($59,933) - ($46,800) = $13,133
Marino's management should approve the use of the proposed lock-box system and, thereby,
save $13,133 per year.
133
19-4A.
(a) The average accrued wages under the monthly payment system are:
2
) 000 , 675 ($ 4
= $1,350,000
This means the firm has, on average, $1,012,500 (i.e., $1,350,000 - $337,500)
more to invest. This provides an annual return of ($1,012,500) (.085) =
$86,063. Therefore, Mac's Tennis Racket should move to the monthly
payment system since it will generate $86,063 - $50,775 = $35,288 in net
annual savings.
(b) Let r = the break-even rate of return on the near cash portfolio:
$1,012,500 (r) = $50,775
r = 5.01%
A reasonable margin of safety favoring adoption of the monthly payment
proposal is present.
19-5A.
(a) Reduction in mail float:
(1.5 days) ($750,000) = $1,125,000
+ reduction in processing float:
(2.0 days) ($750,000) = 1,500,000
= Total Float Reduction $2,625,000
(b) The opportunity cost of maintaining the current banking arrangement is:
(.092) ($2,625,000) = $241,500
(c) The average number of checks to be processed each day through the lock-box
arrangement is:
size check Average
s remittance Daily
=
750 , 3 $
000 , 750 $
= 200 checks per day
Now we can calculate the cost of the lock-box system on an annual basis as
follows:
(200 checks) ($0.35) (270 days) = $18,900
Next, we compute the cost of the automated depository transfer check
(ADTC) system. Second National Bank will not contribute to the cost of the
ADTC arrangement because it is the lead concentration bank and, thereby,
receives the transferred data. Thus, James Waller will be charged for six
ADTCs (or, three locations @ 2 checks each) each business day. The cost of
the ADTC system is:
(6 daily transfers) ($27 each) (270 days) = $43,740
134
The total cost of the proposed system will be:
Lock-box cost $18,900
ADTC cost 43,740
Total cost $62,640
(d) Waller Nail Corp. should adopt the proposed system. The projected net
annual gain will be $178,860.
Projected return on freed balances $241,500
Less: Cost of new system 62,640
Net annual gain $178,860
19-6A. Initially, compute the firm's average remittance check size and daily opportunity cost
of carrying cash. The average check size is:
000 , 15
000 , 000 , 40 $
= $2,666.67
The daily opportunity cost of carrying cash is:
365
09 .
= .0002466 per day
Next, the days saved in the collection process can be evaluated according to this
format:
Added costs = Added benefits
or
P = (D) (S) (i)
$0.35 = (D) (2,666.67) (.0002466)
0.5322 days = D
We know Mountain Furniture will experience a financial gain if it adopts the lock-
box system and, thereby, speeds up its collections by more than 0.5322 days.
135
19-7A.
year in Days
revenues Annual
=
365
000 , 000 , 890 $
=
day per
sales $2,438,356
(0.096)
yield) (assumed
6) ($2,438,35
day) per (sales
= $234,082
19-8A. (a) First, it is necessary to compute Mustang's average remittance check size and
the daily opportunity cost of carrying cash. The average check size is:
000 , 6
000 , 000 , 12 $
= $2,000 per check.
The daily opportunity cost of carrying cash is:
365
07 . 0
= 0.0001918 per day
Second, the days saved in the collection process can be evaluated according to
the general format of
Added Costs = Added Benefits
or
P = (D) (S) (i)
0.20 = (D) ($2,000) (0.0001918)
0.5214 days = D.
Therefore, Mustang Ski-Wear will experience a financial gain if it adopts the
lock-box system and speeds up its collections by more than 0.5214 days.
(b) In this situation the daily opportunity cost of carrying cash is:
365
045 . 0
= 0.0001233 per day
For Mustang to break even should it choose to install the lock-box system, the
cash collections must be accelerated by 0.8110 days as follows:
$0.20 = (D) ($2,000) (0.0001233)
0.8110 days = D.
136
(c) The break-even cash acceleration period of 0.8110 days is
greater than the 0.5214 days found in part (a). This is due
to the lower yield available on near-cash assets (or 4.5
percent annually versus 7.0 percent). Since the
alternative rate of return on the freed-up balances is lower
in the second situation, more funds must be invested to
cover the costs of operating the lock-box system. The
greater cash acceleration period generates this increased
level of required funds.
19-9A. The value of one day of processing float is:
270
000 , 000 , 18 $
= $66,667
The annual savings at 8% are:
(2 days) ($66,667) (0.08) = $10,667
19-10A.
Annual collections = ($5,200,000) (12) = $62,400,000
Daily collections = $62,400,000/365 = $170,959
The opportunity cost of the mail and processing float is:
($170,959) (4.0) (0.09) = $61,545
19-11A.
This exercise attempts to illustrate that a change in the firm's accounts payable policy
can properly be viewed as a part of the overall problem of cash management. Before
evaluating the 45 day and 60 day payment alternatives it is necessary to calculate the
amount of purchases that are actually discounted and the value of the annual purchase
discount earned by Bradford Construction. These amounts are calculated below:
Purchases discounted
($37,500,000 annual purchases) (0.25) = $9,375,000
Purchase discounts earned
($9,375,000) (0.03) = $281,250
with $281,250 in purchase discounts earned. Bradford actually pays:
($9,375,000) - ($281,250) = $9,093,750, 10 days after purchase.
The annual amount not discounted is ($37,500,000) - ($9,375,000) = $28,125,000.
137
We are now in a position to evaluate first the 45 day proposal and, second, the 60 day
proposal.
45 day alternative:
(1) (2) (3) (4) = (1) x (2) x (3)
Principal Extra time Interest Interest
amount available rate earned

$ 28,125,000 15 days 0.12 ÷ 365 = $138,699
9,093,750 35 days 0.12 ÷ 365 = 104,640
Total added return $243,339
- $281,250 Lost discounts earned
+ 243,339 Total added return
$ 37,911 Loss to Bradford by stretching payables to 45 days.
60 day alternative:
(1) (2) (3) (4) =(1)x(2)x(3)
Principal Extra time Interest Interest
amount available rate earned

$28,125,000 30 days 0.12 ÷ 365 = $277,397
9,093,750 50 days 0.12 ÷ 365 = 149,486
Total added return $426,883
-$281,250 Lost discounts earned
+$426,883 Total added return
$145,633 Gained by Bradford by stretching payables to 60 days
Finally, we can evaluate the effect of the projected price increase to Bradford that is
associated with the 60 day alternative.
Price Increase:
$37,500,000 Purchases
.005
$ 187,500 Price increase
$187,500 Price increase
-145,633 Net added return
$ 41,867 Loss to Bradford
138
Ultimately, none of the proposed courses of action would benefit the firm.
139
19-12A.
(a) P =
T
18
1 T
(1.09)
$80


·
+
18
) 09 . 1 (
000 , 1 $
= $912.44
The bond can be sold for $912.44. This was developed as follows:
$80 (8.7556) + $1,000 (.21199) = $912.44
(b) $1,000 - $912.44 = $87.56
(c) First, we find the price of the 4-year bond, which now has 2 years remaining
to maturity:
P =
T
2
1 T
(1.09)
$80


·
+
2
) 09 . 1 (
000 , 1 $
= $982.41
Then we can determine the expected capital loss on the shorter-term bond as
follows:
$1,000 - $982.41 = $17.59
The capital loss on the shorter-term bond is much less than that suffered on
the longer-term instrument.
(d) Interest rate risk.
19-13A.The easiest way to visualize the appropriate responses to all three parts of this
problem is to calculate the income that would be generated if the entire $4,000,000
was invested in each separate maturity category. This is shown below:
Amount Yield Income Brokerage Net
1. $4,000,000 (.062) 1/12 $ 20,667 $10,000 $ 10,667
2. $4,000,000 (.064) 2/12 $ 42,667 $10,000 $ 32,667
3. $4,000,000 (.065) 3/12 $ 65,000 $10,000 $ 55,000
4. $4,000,000 (.067) 4/12 $ 89,333 $10,000 $ 79,333
5. $4,000,000 (.069) 5/12 $115,000 $10,000 $105,000
6. $4,000,000 (.070) 6/12 $140,000 $10,000 $130,000
From this table we can see that the $10,000 brokerage fee is exceeded by the
incremental return from the investment in all maturity categories. Since the available
yield rises with each successive increase in the maturity period, investment in longer
maturities increases return. Now, we can proceed to answer the specific parts of this
problem.
(a) Return from investing:
$2,000,000 for three months $32,500
$2,000,000 for six months $70,000
- brokerage fee $10,000
$92,500
By investing half of the excess for three months and half for six months the return
will be maximized at $92,500; this approach adheres to the wishes of the company
president.
140
(b) Under this circumstance all $4,000,000 should be invested in securities
with maturity periods of six months. The added income will be
$130,000.
(c) This solution is developed from the table above:
(1)
6
667 , 20
= $ 3,445
(2)
6
667 , 42
= $ 7,111
(3)
6
000 , 65
= $10,833
(4)
6
333 , 89
= $14,889
(5)
6
000 , 115
= $19,167
(6)
6
000 , 140
= $23,333
Total 78,778
Brokerage fee -10,000
Net $68,778
19-14A.
(a) The after-tax yield to Aggieland Fireworks on the BBB-rated bond is (0.09)
(1-0.46) = .0486 = 4.86%. Since the yield on the tax-exempt issue is
already stated on an after-tax basis, we can conclude the 5 1/2 percent return
on the municipal is preferable.
(b) r =
T) (1
* r

r =
) 46 . 0 1 (
055 . 0

=
54 . 0
055 . 0
= 10.185%
141
SOLUTION TO INTEGRATIVE PROBLEM
1. The amount of cash balances that will be freed if New Wave Surfing Stuff, Inc.
adopts the system proposed by the Bank of the U.S.:
Cash balances freed due to reduction in mail float:
[(Number of days eliminated) x (Average daily cash remittances)]
[(3.5) x ($100,000)] = $350,000
Cash balances freed due to reduction in processing float:
[(Number of days eliminated) x (Average daily cash remittances)]
[(4) x ($100,000)] = $400,000
Total float reduction $750,000
2. Opportunity cost of maintaining the current banking arrangement:
(Forecast yield on marketable securities portfolio) x (Total float reduction)
= (Opportunity Cost--Interest)
[(.06) x ($750,000)] = $45,000
Opportunity cost--interest $45,000
Opportunity cost--clerical expense 50,000
Total Opportunity cost $95,000
3. Projected annual cost of operating the proposed system:
Average number of checks to be processed each day through the lock-box
arrangement:
size check Average
s remittance Daily
=
000 , 1 $
000 , 100 $
= 100 checks
Resulting cost of lock-box system on an annual basis:
[(Average number of checks) x (Processing cost per check) x (Number of
business days per year)] = Cost
[(100) x ($0.25)x (270)] = $6,750
Next, the estimated cost of the ADTC system must be calculated. The Bank of the
U.S. will not contribute to the cost of the ADTC because it is the lead concentration
bank and thereby receives the transferred data. As a result, New Wave will be
charged for six ADTCs (three locations @ two checks each) each business day. The
ADTC system, therefore, costs:
142
[(No. of daily transfers) x (Cost per transfer) x (No. of business days per year)] =
Cost
[(6) ($25) x (270)] = $40,500
Accordingly, the total cost of the proposed system is:
Lock-box cost $ 6,750
ADTC cost 40,500
Total Cost $47,250
4. The net annual gain associated with adopting the proposed system is:
Opportunity cost of current system [from "2" above] $95,000
Less: Total cost of new system [from "3" above] 47,250
Net annual gain (loss) $47,750
As a result, the analysis suggests the company should adopt the proposed cash
receipts acceleration system.
Solutions to Problem Set B
19-1B.
Average daily float =
Year in Days
Revenues Annual
=
365
000 , 000 , 80 $
= $219,178
[(Average daily float) x (No. of days of float reduction)] = Amount that can be
invested
[($219,178) x (5)] = $1,095,890
[(Amount that can be invested) x (Interest rate on investment)] = Annual
interest forgone
[($1,095,890) x (.055)] = $60,274
Thus, the cost of the Sprightly Step's current billing system is:
Annual interest forgone $ 60,274
Plus: Clerical costs 50,000
Cost of current system $110,274
And, the net annual gain from adoption of the proposed concentration banking system is:
Cost of current system $110,274
Less: cost of concentration banking system 80,000
Net annual gain from proposed system $ 30,274
143
19-2B.
Analysis of the two alternatives requires that the net earnings be computed for each
alternative for each of the specified time periods as follows:
Invest in Money Market Fund:
Cash Interest Holding Annual Annual Net
Available Rate Period Earnings Cost Earnings
$1,100,000 0.055 1 mo. $5,042 0 $5,042
$1,100,000 0.055 2 mo. 10,083 0 10,083
$1,100,000 0.055 6 mo. 30,250 0 30,250
$1,100,000 0.055 12 mo. 60,500 0 60,500
Invest directly in marketable securities:
Cash Interest Holding Annual Annual Net
Available Rate Period Earnings Cost Earnings
$1,100,000 0.08 1 mo. $7,333 $15,000 -$7,667
$1,100,000 0.08 2 mo. 14,667 15,000 - 333
$1,100,000 0.08 6 mo. 44,000 15,000 29,000
$1,100,000 0.08 12 mo. 88,000 15,000 73,000
Accordingly, a comparison of the net earnings of the two alternatives indicates the
following:
Money Market Fund Direct Investment Recommendation
1 mo. $5,042 -$7,667 Money Market Fund
2 mo. 10,083 -333 Money Market Fund
6 mo. 30,250 29,000 Money Market Fund
12 mo. 60,500 73,000 Direct Investment
19-3B.
(a) Reduction in mail float:
(1.5 days) ($800,000) = $1,200,000
+ reduction in processing float:
(2.0 days) ($800,000) = 1,600,000
= Total Float Reduction $2,800,000
144
(b) The opportunity cost of maintaining the current banking arrangement is:
(.095) ($2,800,000) = $266,000
(c) The average number of checks to be processed each day through the lock-box
arrangement is:
size check Average
s remittance Daily
=
000 , 4 $
000 , 800 $
= 200 checks per day
Now we can calculate the cost of the lock-box system on an annual basis as
follows:
(200 checks) ($0.40) (270 days) = $21,600
Next, we compute the cost of the automated depository transfer check
(ADTC) system. First Citizens Bank will not contribute to the cost of the
ADTC arrangement because it is the lead concentration bank and, thereby,
receives the transferred data. Thus, Charles Kobrin will be charged for six
ADTCs (or, three locations @ 2 checks each) each business day. The cost of
the ADTC system is:
(6 daily transfers) ($30 each) (270 days) = $48,600
The total cost of the proposed system will be:
Lock-box cost $21,600
ADTC cost 48,600
Total cost $70,200
(d) Kobrin Door & Glass, Inc. should adopt the proposed system. The projected
net annual gain will be $195,800.
Projected return on freed balances $266,000
Less: Cost of new system (70,200 )
Net annual gain $195,800
19-4B. Annual collections = $10,000,000 (5 regions) = $50,000,000
Daily collections = $50,000,000/365 = $136,986
The value of the 3.0 days' float reduction is found by presuming the freed balances
will be added to the marketable securities portfolio and will earn 11.0% (see text of
problem). The gross annual savings from the system are:
($136,986) (3.0 days) (.11) = $45,205
145
The annual cost of operating the lock-box system is:
($600 per month) (5 regions) (12 months) = $36,000
The net annual savings are: $45,205
- 36,000
$9,205 Savings
The data indicate that Regency Components should adopt the lock-box system.
19-5B. Initially, compute the firm's average remittance check size and daily opportunity cost
of carrying cash. The average check size is:
000 , 20
000 , 000 , 50 $
= $2,500
The daily opportunity cost of carrying cash is:
365
09 .
= .0002466 per day
Next, the days saved in the collection process can be evaluated according to this
format:
Added costs = Added benefits
or
P = (D) (S) (i)
$0.37 = (D) (2,500) (.0002466)
0.6002 days = D
We know Hallmark Technology will experience a financial gain if it adopts the lock-
box system and, thereby, speeds up its collections by more than 0.6002 days.
19-6B.
year in Days
revenues Annual
=
365
000 , 000 , 900 $
=
day per
sales 2,465,753
(0.095)
yield) (assumed
3) ($2,465,75
day) per (sales
= $234,247
19-7B. (a) First, it is necessary to compute Colorado Comm's average remittance check
size and the daily opportunity cost of carrying cash. The average check size
is:
000 , 7
000 , 000 , 10 $
= $1,429 per check.
146
The daily opportunity cost of carrying cash is:
365
07 . 0
= 0.0001918 per day
Second, the days saved in the collection process can be evaluated according to
the general format of
Added Costs = Added Benefits
or
P = (D) (S) (i)
0.30 = (D) ($1,429) (0.0001918)
1.0946 days = D
Therefore, Colorado Comm will experience a financial gain if it adopts the
lock-box system and speeds up its collections by more than 1.0946 days.
(b) In this situation the daily opportunity cost of carrying cash is:
365
045 . 0
= 0.0001233 per day
For Colorado Comm to break even should it choose to install the lock-box
system, the cash collections must be accelerated by 1.7027 days as follows:
$0.30 = (D) ($1,429) (0.0001233)
1.7027 days = D
(c) The break-even cash acceleration period of 1.7027 days is greater than the
1.0946 days found in part (a). This is due to the lower yield available on
near-cash assets (or 4.5 percent annually versus 7.0 percent). Since the
alternative rate of return on the freed-up balances is lower in the second
situation, more funds must be invested to cover the costs of operating the
lock-box system. The greater cash acceleration period generates this
increased level of required funds.
19-8B.
The value of one day of processing float is:
270
000 , 000 , 17 $
= $62,963
The annual savings at 9% are:
(2 days) ($62,963) (0.09) = $11,333
147
19-9B. (a) The average accrued wages under the monthly payment system are:
2
) 000 , 500 ($ 4
= $1,000,000
This means that the firm has, on the average, $750,000 (i.e., $1,000,000 -
$250,000) more to invest. This provides an annual return of ($750,000)
(0.08) = $60,000. Therefore, Katz Jewelers should move to the monthly
payment system since it will generate $60,000 - $40,000 = $20,000 in net
annual savings.
(b) Let r = the break-even rate of return on the near-cash portfolio:
$750,000 (r) = $40,000
r = 5.33%
A reasonable margin of safety favoring adoption of the monthly payment
proposal is present.
19-10B.
Annual collections = ($5,000,000) (10) = $50,000,000
Daily collections = $50,000,000/365 = $136,986
The opportunity cost of the mail and processing float is:
($136,986) (4.0) (0.09) = $49,315
19-11B.
This exercise attempts to illustrate that a change in the firm's accounts payable policy
can properly be viewed as a part of the overall problem of cash management. Before
evaluating the 45 day and 60 day payment alternatives it is necessary to calculate the
amount of purchases that are actually discounted and the value of the annual purchase
discount earned by Meadowbrook. These amounts are calculated below:
Purchases discounted
($40,000,000 annual purchases) (0.25) = $10,000,000
Purchase discounts earned
($10,000,000) (0.03) = $300,000
with $300,000 in purchase discounts earned. Meadowbrook actually pays:
($10,000,000) - ($300,000) = $9,700,000, 10 days after purchase.
The annual amount not discounted is ($40,000,000) - ($10,000,000) =
$30,000,000.
We are now in a position to evaluate first the 45 day proposal and, second, the 60 day
proposal.
148
45 day alternative:
(1) (2) (3) (4) = (1) x (2) x (3)
Principal Extra time Interest Interest
amount available rate earned

$30,000,000 15 days 0.11 ÷ 365 = $135,616
9,700,000 35 days 0.11 ÷ 365 = 102,315
Total added return $237,931
- $300,000 Lost discounts earned
+ 237,931 Total added return
- $ 62,069 Loss to Meadowbrook by stretching payables to 45 days.
60 day alternative:
(1) (2) (3) (4) =(1)x(2)x(3)
Principal Extra time Interest Interest
amount available rate earned

$30,000,000 30 days 0.11 ÷ 365 = $271,233
9,700,000 50 days 0.11 ÷ 365 = 146,164
Total added return $417,397
-$300,000 Lost discounts earned
+$417,397 Total added return
$117,397 Gained by Meadowbrook by stretching payables to 60 days
Finally, we can evaluate the effect of the projected price increase to Meadowbrook
that is associated with the 60 day alternative.
Price Increase:
$40,000,000 Purchases
.005
$ 200,000 Price increase
$200,000 Price increase
-117,397 Net added return
-$ 82,603 Loss to Meadowbrook
Ultimately, none of the proposed courses of action would benefit the firm.
149
19-12B.
(a) P =
T
(1.09)
$80
18
1 T

·
+
18
) 09 . 1 (
000 , 1 $
= $912.44
The bond can be sold for $912.44. This was developed as follows:
$80 (8.7556) + $1,000 (.21199) = $912.44
(b) $1,000 - $912.44 = $87.56
(c) First, we find the price of the 4-year bond, which now has 2 years remaining
to maturity:
P =
T
(1.09)
$80
2
1 T

·
+
2
) 09 . 1 (
000 , 1 $
= $982.41
Then we can determine the expected capital loss on the shorter-term bond as
follows:
$1,000 - $982.41 = $17.59
The capital loss on the shorter-term bond is much less than that suffered on
the longer-term instrument.
(d) Interest rate risk.
19-13B.
The easiest way to visualize the appropriate responses to all three parts of this
problem is to calculate the income that would be generated if the entire $3,500,000
was invested in each separate maturity category. This is shown below:
Amount Yield Income Brokerage Net
1. $3,500,000 (.062) 1/12 $ 18,083 $15,000 $ 3,083
2. $3,500,000 (.064) 2/12 $ 37,333 $15,000 $ 22,333
3. $3,500,000 (.065) 3/12 $ 56,875 $15,000 $ 41,875
4. $3,500,000 (.067) 4/12 $ 78,167 $15,000 $ 63,167
5. $3,500,000 (.069) 5/12 $100,625 $15,000 $85,625
6. $3,500,000 (.070) 6/12 $122,500 $15,000 $107,500
From this table we can see that the $15,000 brokerage fee is exceeded by the
incremental return from the investment in all maturity categories. Since the available
yield rises with each successive increase in the maturity period, investment in longer
maturities increases return. Now, we can proceed to answer the specific parts of this
problem.
150
(a) Return from investing:
$1,750,000 for three months $28,438
$1,750,000 for six months $61,250
- brokerage fee $15,000
$74,688
By investing half of the excess for three months and half for six months the
return will be maximized at $74,688; this approach adheres to the wishes of
the company president.
(b) Under this circumstance all $3,500,000 should be invested in securities
with maturity periods of six months. The added income will be
$107,500.
(c) This solution is developed from the table above:
(1)
6
083 , 18
= $ 3,014
(2)
6
333 , 37
= $ 6,222
(3)
6
875 , 56
= $9,479
(4)
6
167 , 78
= $13,028
(5)
6
625 , 100
= $16,771
(6)
6
500 , 122
= $20,417
Total 68,931
Brokerage -15,000
Net $53,931
19-14B.
(a) The after-tax yield to Ward Grocers on the BBB-rated bond is (0.08) (1-0.46)
= .0432 = 4.32%. Since the yield on the tax-exempt issue is already stated
on an after-tax basis, we can conclude the 5 1/2 percent return on the
municipal is preferable.
(b) r =
T) (1
* r

r =
) 46 . 0 1 (
055 . 0

=
54 . 0
055 . 0
= 10.185%
151

CHAPTER 20
Accounts Receivable and
152
Inventory Management

CHAPTER ORIENTATION
The investment of funds in accounts receivable inventory involves a trade-off between
profitability and risk. For accounts receivable, this trade-off occurs as less creditworthy
customers with a higher probability of bad debts are taken on to increase sales. With respect
to inventory management, a larger investment in inventory leads to more efficient
production and speedier delivery, hence, increased sales. However, additional financing to
support the increase in inventory and increased handling and carrying costs is required. In
addition, the concept of total quality management and single-sourcing have had a major
impact on inventory purchasing.
CHAPTER OUTLINE
I. Accounts receivable
A. Typically, accounts receivable account for just over 20 percent of a firm's
assets.
B. The size of the investment in accounts receivable varies from industry to
industry and is affected by several factors including the percentage of credit
sales to total sales, the level of sales and the credit and collection policies,
more specifically the terms of sale, the quality of customers and collection
efforts.
C. Although all these factors affect the size of the investment, only the credit
and collection policies are decision variables under the control of the
financial manager.
D. The terms of sale are generally stated in the form a/b net c, indicating that the
customer can deduct a percentage if the account is paid within b days;
otherwise, the account must be paid within c days.
153
E. If the customer decides to forgo the discount and not pay until the final
payment date, the annualized opportunity cost of passing up this a% discount
and withholding payment until the c
th
day is determined as follows:
discount
the forgoing of cost
y opportunit annualized
=
a 1
a

x
b c
360

Example: Given the trade credit terms of 2/10, net 30, what is the annualized
opportunity cost of passing up the 2 percent discount and withholding
payment until the 30th day?
Solution: Substituting the values from the example, we get
36.73% =
02 . 0 1
02 . 0

x
10 30
360

F. A second decision variable in determining the size of the investment in
accounts receivable in addition to the trade credit terms is the type of
customer.
1. The costs associated with extending credit to lower-quality customers
include:
a. Increased costs of credit investigation
b. Increased probability of customer default
c. Increased collection costs
G. Analyzing the credit application is a major part of accounts receivable
management.
1. Several avenues are open to the firm in considering the credit rating
of an applicant. Among these are financial statements, independent
credit ratings and reports, bank references, information from other
companies, and past experiences.
2. One commonly used method for credit evaluation is called credit
scoring and involves the numerical evaluation of each applicant in
which an applicant receives a score based upon the answers to a
simple set of questions. The score is then evaluated relative to a
predetermined standard, its level relative to that standard determining
whether or not credit scoring should be extended to the applicant. The
major advantage of credit scoring is that it is inexpensive and easy to
perform.
H. The key to maintaining control over the collection of accounts receivable is
the fact that the probability of default increases with the age of the account.
1. One common way of evaluating the current situation is ratio analysis.
a. examining the average collection period
b. ratio of receivables to assets
154
c. ratio of credit sales to receivables (accounts receivable
turnover ratio)
d. amount of bad debts relative to sales over time
e. aging of accounts receivable schedule
I. Once delinquent accounts have been identified, the third and final variable is
determined by the firm’s collection policies. A direct trade-off does exist
between collection expenses and lost goodwill on one hand and noncollection
of accounts on the other, and this trade-off is always part of making the
decision.
J. Credit should be extended to the point that marginal profitability on
additional sales equals the required rate of return on the additional costs we
have to consider investment in inventories + receivables + change in cost of
cash discount to generate those sales.
II. Inventory
A. Typically, inventory accounts for about four to five percent of a firm's assets.
B. The purpose of carrying inventories is to uncouple the operations of the firm;
that is, to make each function of the business independent of each other
function.
C. As such, the decision with respect to the size of the investment in inventory
involves a basic trade-off between risk and return.
D. The risk comes from the possibility of running out of inventory if too little
inventory is held, while the return aspect of this trade-off results because
increased inventory investment costs money.
E. There are several general types of inventory.
1. Raw materials inventory consists of the basic materials that have been
purchased from other firms to be used in the firm's production
operations. This type of inventory uncouples the production function
from the purchasing function.
2. Work in process inventory consists of partially finished goods that
require additional work before they become finished goods. This type
of inventory uncouples the various production operations.
3. Finished goods inventory consists of goods on which the production
has been completed but the goods are not yet sold. This type of
inventory uncouples the production and sales function.
4. Stock of cash inventory, already discussed in some detail in preceding
chapters, serves to make the payment of bills independent of the
collection of accounts due.
F. In order to effectively manage the investment in inventory, two problems
must be dealt with: the order quantity problem and the order point problem.
G. The order quantity problem involves the determination of the optimal order
size for an inventory item given its expected usage, carrying, and ordering
costs.
155
H. The economic order quantity (EOQ) model attempts to determine the order
size that will minimize total inventory costs. The EOQ is given as
Q* =
where C = carrying cost per unit
O = ordering cost per order
S = total demand in units over the planning period
Q* = the optimal order quantity in units
I. The order point problem attempts to answer the following question: How low
should inventory be depleted before it is reordered?
J. In answering this question two factors become important:
1. What is the usual procurement or delivery time and how much stock is
needed to accommodate this time period?
2. How much safety stock does the management desire?
K. Modification for safety stocks is necessary since the usage rate of inventory
is seldom stable over a given timetable.
L. This safety stock is used to safeguard the firm against changes in order time
and receipt of shipped goods.
M. The greater the uncertainty associated with forecasted demand or order time,
the larger the safety stock.
1. The costs associated with running out of inventory will also determine
the safety stock levels.
2. A point is reached where it is too costly to carry a larger safety stock
given the associated risk.
N. Inflation can also have an impact on the level of inventory carried.
1. Goods may be purchased in large quantities in anticipation of price
rises.
2. The cost of carrying goods may increase, causing a decline in Q*, the
optimal order quantity.
O. The just-in-time inventory control system is more than just an inventory
control system; it is a production and management system.
1. Under this system, inventory is cut down to a minimum, and the time
and physical distance between the various production operations is
also minimized.
156
2. Actually the just-in-time inventory control system is just a new
approach to the EOQ model which tries to produce the lowest average
level of inventory possible.
3. Average inventory is reduced by locating inventory supplies in
convenient locations and setting up restocking strategies that cut time
and thereby reduce the needed level of safety stock.
III. TQM and Inventory Purchasing management.
A. The concept of total quality management has led to strong customer-supplier
relationships in an effort to increase quality.
B. In many cases firms that only a few years ago placed an upper limit of 10 or
20 percent on the purchases of any part from a single supplier now rely on a
single supplier using the single-sourcing relationship.
C. Single sourcing ties the interests of the supplier to the firm to which it
supplies and allows the supplier to provide input on production techniques
that might improve quality.
D. Financially, the TQM view argues that higher quality will result in increased
sales and market share and as a result the traditional economic analysis of
inventory management is flawed.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
20-1. The size of the investment in accounts receivable is determined primarily by these
factors:
(1) The percentage of credit sales to total sales. While this factor plays a major
role in determining the investment in accounts receivable, it is generally not
within the control of the financial manager. In essence, the nature of the
business tends to determine the blend between credit sales and cash sales.
(2) The level of sales. As sales increase, so will accounts receivable. Again, this
is not an effective decision tool.
(3) Credit and collection policies. Specifically the terms of sale, the quality of
customer, and collection efforts are determinants of the level of investment in
receivables that are under the control of the financial manager.
20-2. (a) 1/20 net 50 means a 1 percent discount can be taken if the account is paid
within 20 days; otherwise, it can be paid within 50 days.
(b) 2/30 net 60 means a 2 percent discount can be taken if the account is paid
within 30 days; otherwise, it must be paid within 60 days.
(c) Net 30 means there are no discounts offered and the account must be paid
within 30 days.
157
(d) 2/10, 1/30 net 60 means a two percent discount can be taken if the account is
paid within 10 days, and if paid after 10 days but before and up to 30 days, a
one percent discount can be taken; otherwise, the account must be paid within
60 days.
20-3. The purpose of an aging account is to provide a breakdown both in dollars and
percentage terms of the proportion of receivables that are past due. The same
function could essentially be handled through ratio analysis, provided accounts
receivable were broken down according to when they were due. However, an aging
account provides control over past due accounts in an extremely efficient manner.
20-4. If a credit manager experienced no bad debt losses over the past year, then credit was
probably not extended to enough customers. Ideally credit should be extended to the
point where marginal revenue from added sales due to increased credit is equal to the
marginal costs associated with increased bad debts, costs of investigation, costs of
collection, and increased required rate of return. Obviously the credit manager was
nowhere near this level if no bad debts were incurred.
20-5. Credit scoring involves the numerical evaluation of credit applicants based upon
their answers to simple questions. This score is then evaluated relative to a
predetermined standard, many times generated through the use of multiple
discriminant analysis; its level relative to the standard determining whether or not
credit should be extended to the applicant. The major advantage of credit scoring is
that it is inexpensive and easy to perform. Once standards are set, a computer or
clerical worker without specialized training can easily evaluate applicants.
20-6. The returns associated with a more liberal credit policy come from the fact that
extending credit to weaker customers or liberalizing the trade credit terms will
probably increase sales, resulting in a larger profit level. The risks involved largely
result from the increased possibility of extending credit that will eventually become
bad debts.
20-7. The logic behind marginal analysis is to examine the incremental or marginal
benefits, and incremental costs associated with any change in the credit policy; and if
this change produces more benefits than costs, the change should be made. If,
however, the incremental costs are greater than the incremental benefits, the
proposed change should be dropped.
20-8. The purpose of carrying inventories is to uncouple the operations of the firm; that is,
to make each function of the business independent of each other's function. By
uncoupling the various operations of the firm, delays or shutdowns in one area no
longer affect the production and sale of the final product. Raw materials inventory,
for example, uncouples the production function from the purchasing function. Work
in process inventory uncouples the various production operations.
20-9. Yes. The stock of cash carried by a firm is simply a special type of inventory. In
terms of uncoupling the various operations of the firm, the purpose of holding cash is
to make the payment of bills independent of the collection of accounts due.
158
20-10. In order to effectively control the investment in inventory, the firm must: (1)
determine the optimal order size for the inventory item, given its expected usage,
carrying, and ordering costs; (2) determine how low inventory should be allowed to
deplete before it is reordered.
20-11. The major assumptions of the EOQ model include:
(1) Constant or uniform demand.
(2) Constant unit price regardless of amount ordered.
(3) Constant carrying costs per unit.
(4) Constant ordering costs per order regardless of the size of the order.
(5) Instantaneous delivery.
(6) Independent orders.
20.12. The risk associated with the inventory investment is that if the level of inventory is
too low, the various functions of business will not be effectively uncoupled, and
delays in production and customer delivery will result. The return aspects of this
trade-off result because increased inventory investment costs money. As the size of
the inventory increases, the storage and handling cost, in addition to the required rate
of return on capital invested in inventory, will rise. Thus, the more inventory the
firm holds, the less risk they run of stocking out of inventory and the greater are their
inventory expenses.
20.13. Inflation affects the EOQ model by increasing carrying costs (C) which results in a
small EOQ level. In addition, if inflation is accompanied by major periodic price
increases, this may cause the EOQ model to lose its applicability and be replaced by
a policy of anticipatory buying; that is, buying in anticipation of a price increase in
order to secure the goods at a lower cost.
20-14. With single-sourcing, a company uses very few suppliers or, in many cases, a single
supplier as a source for a particular part or material. In this way the company has a
more direct influence and control over the quality performance of a supplier, since
the company accounts for a larger proportion of the supplier's volume. The company
and supplier can then enter into a partnership where the supplier agrees to meet the
quality standards of the customer. In this way the supplier can be brought into the
TQM program of the customer.
20-15. The TQM view argues that the traditional analysis is flawed in that it ignores the fact
that increased sales and market share result from better quality products and that this
increase in sales will more than offset the higher costs associated with increased
quality. In effect, it is argued that the benefits from quality improvement are
underestimated.
159
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
20-1A.
b c
360
x
a 1
a
− −
where a = amount of the discount
b = the discount period
c = the net period
02 . 0 1
02 . 0

x
10 50
360

= 18.37%
20-2A.
b c
360
x
a 1
a
− −
where a = amount of the discount
b = the discount period
c = the net period
02 . 0 1
02 . 0

x
20 30
360

= 73.47%
20-3A.
b c
360
x
a 1
a
− −
where a = amount of the discount
b = the discount period
c = the net period
(a)
01 . 0 1
01 . 0

x
10 20
360

= 36.36%
(b)
02 . 0 1
02 . 0

x
10 30
360

= 36.73%
(c)
03 . 0 1
03 . 0

x
10 30
360

= 55.67%
(d)
03 . 0 1
03 . 0

x
10 60
360

= 22.27%
160
(e)
03 . 0 1
03 . 0

x
10 90
360

= 13.92%
(f)
05 . 0 1
05 . 0

x
10 60
360

= 37.89%
20-4A.
Applicant #1
Z = 3.3(0.2) + 1.0(0.2) + 0.6(1.2) + 1.4(0.3) + 1.2(0.5)
Z = 0.66 + 0.2 + 0.72 + 0.42 + 0.6
Z = 2.6 < 2.7 thus, reject

Applicant #2
Z = 3.3(0.2) + 1.0(0.8) + 0.6(1.0) + 1.4(0.3) + 1.2(0.8)
Z = 0.66 + 0.8 + 0.6 + 0.42 + 0.96
Z = 3.44 > 2.7 thus, accept
Applicant #3
Z = 3.3(0.2) + 1.0(0.7) + 0.6(0.6) + 1.4(0.3) + 1.2(0.4)
Z = 0.66 + 0.7 + 0.36 + 0.42 + 0.48
Z = 2.62 < 2.7 thus, reject
Applicant #4
Z = 3.3(0.1) + 1.0(0.4) + 0.6(1.2) + 1.4(0.4) + 1.2(0.4)
Z = 0.33 + 0.4 + 0.72 + 0.56 + 0.48
Z = 2.49 < 2.7 thus, reject
Applicant #5
Z = 3.3(0.3) + 1.0(0.7) + 0.6(0.5) + 1.4(0.4) + 1.2(0.7)
Z = 0.99 + 0.7 + 0.30 + 0.56 + 0.84
Z = 3.39 > 2.7 thus, accept
Applicant #6
Z = 3.3(0.2) + 1.0(0.5) + 0.6(0.5) + 1.4(0.4) + 1.2(0.4)
Z = 0.66 + 0.5 + 0.30 + 0.56 + 0.48
Z = 2.5 < 2.7 thus, reject
20-5A.
(a)
Sales
sold goods of cost Sales −
= Gross Profit Margin
$600,000
sold goods of Cost $600,000 −
= 0.10
Cost of goods sold = $540,000
161
inventory Average
sold goods of Cost
= Inventory turnover ratio
inventory Average
$540,000
= 6
Average inventory = $90,000
(b) Inventory turnover ratio =
Period Collection Average
360
Inventory turnover =
Inventory turnover ratio = 9 times
inventory Average
sold goods of Cost
= 9 times
inventory Average
$480,000
= 9 times
Average inventory = $53,333
(c)
inventory Average
sold goods of Cost
= Inventory turnover ratio

inventory Average
$1,150,000
= 5
Average inventory = $230,000
(d) (1 - Gross profit margin) (Sales) = (0.86)($25,000,000)
Cost of Goods Sold = $21,500,000 cost of goods
Inventory turnover ratio =
45
360
= 8 times
inventory Average
0 $21,500,00
= 8 times
Average inventory = $ 2,687,500
20-6A. Step 1: Estimate the Change in Profit.
= ($1,000,000 x .20) - ($1,000,000 x .08)
= $200,000 - $80,000
162
= $120,000
Step 2: Estimate the cost of additional investment in accounts
receivable and inventory.
Estimate the additional investment in accounts receivable:
= ($6,000,000 / 360) x 90 - ($5,000,000 / 360) x 60
= $1,500,000 - $833,333
= $666,667
Additional accounts receivable and inventory times the required
rate of return:
= ($666,667 + $50,000) .15
= $107,500
Step 3: Estimate the change in the cost of the cash discount
= $0 (no change)
Step 4: Compare incremental revenues with incremental costs.
= Step 1 - (Step 2 + Step 3)
= $120,000 - $107,500
= $12,500
The policy should be adopted.
20-7A. Step 1: Estimate the Change in Profit.
= ($1,500,000 x .20) - ($1,500,000 x .09)
= $300,000 - $135,000
= $165,000
Step 2: Estimate the cost of additional investment in accounts
receivable and inventory.
Estimate the additional investment in accounts receivable:
= ($12,500,000 / 360) x 45 - ($11,000,000 / 360) x 30
= $1,562,500 - $916,667
= $645,833
Additional accounts receivable and inventory times the required
rate of return:
163
= ($645,833 + $75,000) .15
= $108,125
Step 3: Estimate the change in the cost of the cash discount
= $0 (no change)
Step 4: Compare the incremental revenues with the incremental costs.
= Step 1 - (Step 2 + Step 3)
= $165,000 - $108,125
= $56,875
The policy should be adopted.
20-8A.
(a) Q* =
C
2SO
=
10 . 0
10 ) 3000 ( 2
=
000 , 600
= 775 units
(b) Total costs =
,
_

¸
¸
2
Q
C +

,
_

¸
¸
Q
S
O
Order one time: =
,
_

¸
¸
2
3000
$.10 +
,
_

¸
¸
3000
3000
$10
= $150 + $10
= $160
Order four times: =
,
_

¸
¸
2
750
$.10 +
,
_

¸
¸
750
3000
$10
= $37.50 + $40
= $77.50
Order five times: =
,
_

¸
¸
2
600
$.10 +
,
_

¸
¸
600
3000
$10
164
= $30.00 + $50.00
= $80
Order ten times: =
,
_

¸
¸
2
300
$0.10 +
,
_

¸
¸
300
3000
$10
= $15.00 + $100
= $115
Order 15 times: =
,
_

¸
¸
2
200
$0.10 +
,
_

¸
¸
200
3000
$10
= $10 + $150
= $160
(c) (1) constant or uniform demand
(2) constant unit price
(3) constant carrying costs
(4) constant ordering costs
(5) instantaneous delivery
(6) independent orders
20-9A.
(a) Q* =
C
2SO
=
25 . 0
50 ) 000 , 20 ( 2
= 2828 boxes
(b) It assumes among other things that the rolls are not perishable. Other
assumptions include:
(1) constant or uniform demand
(2) constant unit price
(3) constant carrying costs
(4) constant ordering costs
(5) instantaneous delivery
(6) independent orders
165
20-10A.
(a) Q* =
C
2SO
=
75
500 ) 000 , 50 ( 2
= 816.4967 units or 816 units
(b) Total costs =
,
_

¸
¸
2
Q
C +

,
_

¸
¸
Q
S
O
=
,
_

¸
¸
2
816
$75 +
,
_

¸
¸
816
000 , 50
$500
= $30,600 + $30,637
= $61,237
Note that carrying cost ($30,600) differs from ordering cost ($30,637) due to a $37
rounding error. Recall that Q* was rounded down by .4967 units.
20-11A.
(a) Q* =
C
2SO
=
40 .
90 ) 000 , 500 ( 2
= 15,000 Units
(b)
000 , 15
000 , 500
= 33 1/3 orders per year
(c) Inventory order point = delivery time stock + safety stock
=
50
1
x 500,000 + 15,000
= 10,000 + 15,000
= 25,000 units
(d) Average inventory =
2
EOQ
+ safety time stock
=
2
000 , 15
+ 15,000
= 7,500 + 15,000
= 22,500 units
166
20-12A.
(a) EOQ =
C
2SO
=
50 .
) 100 )( 000 , 500 ( 2
= 14,142 units: but since orders must be placed in 200-unit
lots, the effective EOQ becomes 14,200 units
(b)
200 , 14
000 , 500
= 35.2 orders per year
(c) Inventory order point = Delivery time stock + safety stock
=
50
4
x 500,000 + 5,000
= 40,000 + 5,000
= 45,000 units
(d-a) EOQ =
5 . 2
) 100 )( 000 , 500 ( 2
= 6,324.5 = 6,325
= 6,325 units, but since orders must be placed in 200 unit
lots the effective EOQ becomes 6,400
(d-b)
400 , 6
000 , 500
= 78.1 orders per year
(d-c)
50
4
x 500,000 + 5,000
= 40,000 + 5,000
= 45,000 units
(d-d) Yes, as carrying costs rise the EOQ level drops and the number of orders per
year rises which means that on average less inventory will be kept on hand.
167
SOLUTION TO INTEGRATIVE PROBLEM
Accounts Receivable
1. The size of the investment in accounts receivable is determined primarily by these
factors:
(a) The percentage of credit sales to total sales. While this factor plays a major
role in determining the investment in accounts receivable, it is generally not
within the control of the financial manager. In essence, the nature of the
business tends to determine the blend between credit sales and cash sales.
(b) The level of sales. As sales increase, so will accounts receivable. Again, this
is not an effective decision tool.
(c) Credit and collection policies. Specifically the terms of sale, the quality of
customer, and collection efforts are determinants of the level of investment in
receivables that are under the control of the financial manager.
2. (a)
b c
360
x
a 1
a
− −
where a = amount of the discount
b = the discount period
c = the net period
x = 18.18%
3. (a)
b c
360
x
a 1
a
− −
where a = amount of the discount
b = the discount period
c = the net period
x = 24.49%
4. Step 1: Estimate the Change in Profit.
= ($1,000,000 x .25) - ($1,000,000 x .08)
= $250,000 - $80,000
= $170,000
5. Step 2: Estimate the cost of additional investment in account receivable and
inventory.
Estimate the additional investment in accounts receivable:
= ($8,000,000 / 360) x 75 - ($7,000,000 / 360) x 60
= $1,666,667 - $1,166,667
= $500,000
168
Additional accounts receivable and inventory times the required rate of
return:
= ($500,000 + $50,000) .15
= $82,500
6. Step 3: Estimate the change in the cost of the cash discount
= ($8,000,000 x .02 x .50) - ($7,000,000 x .01 x .50)
= $80,000 - $35,000
= $45,000
7. Step 4: Compare the incremental revenues with the incremental costs.
= Step 1 - (Step 2 + Step 3)
= $170,000 - ($82,500 + $45,000)
= $42,500
The policy should be adopted.
Inventory Management
1. EOQ =
C
2SO
=
1
100 ) 000 , 250 ( 2
= 7,071 units or 7,100 units
2.
100 , 7
000 , 250
= 35.2 orders per year
3. Inventory order point = Delivery time stock + safety stock
=
50
1
x 250,000 + 5,000
= 5,000 + 5,000
= 10,000 units
4. Average inventory =
2
EOQ
+ Safety stock
=
2
100 , 7
+ 5,000
= 8,550 units
169
5. EOQ =
1
100 ) 000 , 500 ( 2
= 10,000 units
sales in double
a respect to
with EOQ
of Elasticity
=
Sales Δ %
EOQ Δ %
=
Sales
Sales Δ
EOQ
EOQ Δ
=

,
_

¸
¸ −
100 , 7
100 , 7 000 , 10
/

,
_

¸
¸ −
000 , 250
000 , 250 000 , 500
=
0 . 1
4085 .
= .4085 or 40.85%
6. EOQ =
2
100 ) 000 , 250 ( 2
= 5,000
costs carrying
in double
a respect to
with EOQ
of Elasticity
=
Costs Carrying %
EOQ %


=
1
1 2
100 , 7
100 , 7 000 , 5


= -29.58%
7. EOQ =
1
200 ) 000 , 250 ( 2
= 10,000
costs ordering
in double
a respect to
with EOQ
of Elasticity
=
Costs Ordering %
EOQ %


=
100
100 200
100 , 7
100 , 7 000 , 10


= 40.85%
170
8. The selling price of the item does not enter the EOQ equation and does not affect the
level of EOQ. The EOQ equation attempts to minimize costs and as such the selling
price does not enter into its calculation; thus the elasticity of EOQ with respect to the
selling price is 0.
9. The major assumptions of the EOQ model include:
(1) Constant or uniform demand.
(2) Constant unit price regardless of amount ordered.
(3) Constant carrying costs per unit.
(4) Constant ordering costs per order regardless of the size of the order.
(5) Instantaneous delivery.
(6) Independent orders.
10. Inflation affects the EOQ model by increasing carrying costs (C) which results in a
small EOQ level. In addition if inflation is accompanied by major periodic price
increases this may cause the EOQ model to lose its applicability and be replaced by a
policy of anticipatory buying, that is, buying in anticipation of a price increase in
order to secure the goods at a lower cost.
11. A decrease in the average delivery time decreases the inventory order point.
Inventory can be ordered when there is a lower level of inventory. Safety stock may
also be reduced. The total level of inventory held will decrease in this situation.
12. If ordering costs decrease, then it is more economical to order more often and the
EOQ decreases. This in turn means that less inventory on average will be held.
Solutions to Problem Set B
20-1B.
b c
360
x
a 1
a
− −
where a = amount of the discount
b = the discount period
c = the net period
02 . 0 1
02 . 0

x
10 60
360

= 14.69%
171
20-2B.
b c
360
x
a 1
a
− −
where a = amount of the discount
b = the discount period
c = the net period
x = 36.73%
20-3B.
b c
360
x
a 1
a
− −
where a = amount of the discount
b = the discount period
c = the net period
(a)
01 . 0 1
01 . 0

x
5 20
360

= 24.24%
(b)
02 . 0 1
02 . 0

x
20 90
360

= 10.50%
(c)
01 . 0 1
01 . 0

x
20 100
360

= 4.55%
(d)
04 . 0 1
04 . 0

x
10 50
360

= 37.50%
(e)
05 . 0 1
05 . 0

x
20 100
360

= 23.68%
(f)
05 . 0 1
05 . 0

x
30 50
360

= 94.74%
172
20-4B. Applicant #1
Z = 3.3(0.3) + 1.0(0.4) + 0.6(1.2) + 1.4(0.3) + 1.2(0.5)
Z = 0.99 + 0.4 + 0.72 + 0.42 + 0.6
Z = 3.13 > 2.7 thus, accept
Applicant #2
Z = 3.3(0.2) + 1.0(0.6) + 0.6(1.3) + 1.4(0.4) + 1.2(0.3)
Z = 0.66 + 0.6 + 0.78 + 0.56 + 0.36
Z = 2.96 > 2.7 thus, accept
Applicant #3
Z = 3.3(0.2) + 1.0(0.7) + 0.6(0.6) + 1.4(0.3) + 1.2(0.2)
Z = 0.66 + 0.7 + 0.36 + 0.42 + 0.24
Z = 2.38 < 2.7 thus, reject
Applicant #4
Z = 3.3(0.1) + 1.0(0.5) + 0.6(1.8) + 1.4(0.5) + 1.2(0.4)
Z = 0.33 + 0.5 + 1.08 + 0.7 + 0.48
Z = 3.09 > 2.7 thus, accept
Applicant #5
Z = 3.3(0.5) + 1.0(0.7) + 0.6(0.5) + 1.4(0.4) + 1.2(0.6)
Z = 1.65 + 0.7 + 0.30 + 0.56 + 0.72
Z = 3.93 > 2.7 thus, accept
Applicant #6
Z = 3.3(0.2) + 1.0(0.4) + 0.6(0.2) + 1.4(0.4) + 1.2(0.4)
Z = 0.66 + 0.4 + 0.12 + 0.56 + 0.48
Z = 2.22 < 2.7 thus, reject
173
20-5B. (a)
Sales
sold goods of cost Sales −
= Gross Profit Margin
$550,000
sold goods of Cost $550,000 −
= 0.10
Cost of goods sold = $495,000
inventory Average
sold goods of Cost
= Inventory turnover ratio
inventory Average
$495,000
= 5
Average inventory = $99,000
(b) Inventory turnover ratio =
Period Collection Average
360
Inventory turnover =
35
360
Inventory turnover ratio = 10.286 times
inventory Average
sold goods of Cost
= 10.286 times
inventory Average
$480,000
= 10.286 times
Average inventory = $46,665.37
(c) = Inventory turnover ratio
inventory Average
$1,250,000
= 6
Average inventory = $208,333
174
(d) (1 - Gross profit margin) (Sales) = cost of goods
(0.85)($25,000,000) = $21,250,000
Inventory turnover ratio = = 7.2 times
inventory Average
0 $21,250,00
= 7.2 times
Average inventory = $ 2,951,389
20-6B. Step 1: Estimate the Change in Profit.
= ($1,000,000 x .20) - ($1,000,000 x .08)
= $200,000 - $80,000
= $120,000
Step 2: Estimate the cost of additional investment in accounts receivable and
inventory.
Estimate the additional investment in accounts receivable:
= ($7,000,000 / 360) x 90 - ($6,000,000 / 360) x 40
= $1,750,000 - $666,667
= $1,083,333
Additional accounts receivable and inventory times the required rate of
return:
= ($1,083,333 + $40,000) .15
= $168,500
Step 3: Estimate the change in the cost of the cash discount
= $0 (no change)
Step 4: Compare the incremental revenues with the incremental costs.
= Step 1 - (Step 2 + Step 3)
= $120,000 - $168,500
= - $48,500
The policy should not be adopted.
175
20-7B. Step 1: Estimate the Change in Profit.
= ($1,000,000 x .20) - ($1,000,000 x .08)
= $200,000 - $80,000
= $120,000
Step 2: Estimate the cost of additional investment in accounts receivable and
inventory.
Estimate the additional investment in accounts receivable:
= ($18,000,000 / 360) x 50 - ($17,000,000 / 360) x 30
= $2,500,000 - $1,416,667
= $1,083,333
Additional accounts receivable and inventory times the required rate of
return:
= ($1,083,333 + $60,000) .15
= $171,500
Step 3: Estimate the change in the cost of the cash discount
= $0 (no change)
Step 4: Compare the incremental revenues with the incremental costs.
= Step 1 - (Step 2 + Step 3)
= $120,000 - $171,500
= - $51,500
The change should not be made.
20-8B.
(a) Q* =
C
2SO
=
2 . 0
9 ) 3500 ( 2
=
000 , 315
= 561.2 units
176
(b) Total costs =
,
_

¸
¸
2
Q
C +

,
_

¸
¸
Q
S
O
Order one time: =
,
_

¸
¸
2
3500
$.20 +
,
_

¸
¸
3500
3500
$9
= $350 + $9
= $359
Order four times: =
,
_

¸
¸
2
875
$.20 +
,
_

¸
¸
875
3500
$9
= $87.50 + $36
= $123.50
Order five times: =
,
_

¸
¸
2
700
$.20 +
,
_

¸
¸
700
3500
$9
= $70.00 + $45.00
= $115
Order ten times: =
,
_

¸
¸
2
350
$0.20 +
,
_

¸
¸
350
3500
$9
= $35.00 + $90
= $125
Order 15 times: =
,
_

¸
¸
2
234
$0.20 +
,
_

¸
¸
234
3500
$9
= $23.40 + $134.62
= $158.02
(c) (1) constant or uniform demand
(2) constant unit price
(3) constant carrying costs
(4) constant ordering costs
(5) instantaneous delivery
(6) independent orders
20-9B. (a) Q* =
C
2SO
=
20 . 0
55 ) 000 , 21 ( 2
= 3,398.5 boxes
177
(b) It assumes among other things that the rolls are not perishable. Other
assumptions include:
(1) constant or uniform demand
(2) constant unit price
(3) constant carrying costs
(4) constant ordering costs
(5) instantaneous delivery
(6) independent orders
20-10B.
(a) Q* =
C
2SO
=
70
500 ) 000 , 55 ( 2
= 886.40 units or 886 units
(b) Total costs =
,
_

¸
¸
2
Q
C +

,
_

¸
¸
Q
S
O
=
,
_

¸
¸
2
886
$70 +
,
_

¸
¸
886
000 , 55
$500
= $31,010 + $31,038.37
= $62,048.37
Note that carrying cost ($31,010) differs from ordering cost ($31,038.37)
due to a $37 rounding error.
20-11B.
(a) Q* =
C
2SO
=
45 .
90 ) 000 , 600 ( 2
= 15,492 units or 15,400 units
(b)
400 , 15
000 , 600
= 38.96 orders per year (or about 39 orders)
(c) Inventory order point = delivery time stock + safety stock
= x 600,000 + 15,000
= 12,000 + 15,000
= 27,000 units
(d) Average inventory =
2
EOQ
+ safety time stock
178
=
2
400 , 15
+ 15,000
= 7,700 + 15,000
= 22,700 units
20-12B.
(a) EOQ =
C
2SO
=
45 .
) 75 )( 000 , 500 ( 2
= 12,909.90 units: but since orders must be
placed in 200 unit lots, the effective EOQ
becomes 13,000 units
(b)
000 , 13
000 , 500
= 38.5 orders per year
(c) Inventory order point = Delivery time stock + safety stock
=
50
4
x 500,000 + 5,000
= 40,000 + 5,000
= 45,000 units
(d-a) EOQ =
5 . 2
) 75 )( 000 , 500 ( 2
= 5,477 units, but since orders must be placed in 200 unit lots
the effective EOQ becomes 5,400
(d-b)
400 , 5
000 , 500
= 93 orders per year
(d-c)
50
4
x 500,000 + 5,000
= 40,000 + 5,000
= 45,000 units
(d-d) Yes. As carrying costs rise the EOQ level drops and the number of orders
per year rises which means that on average less inventory will be kept on
hand.

CHAPTER 21
179
Risk Management

CHAPTER ORIENTATION
The purpose of this chapter is to look at futures, options, and currency swaps and explain
how they are used by financial managers to control risk.
CHAPTER OUTLINE
I. Futures and options can be used by the financial manager to reduce the risks
associated with interest rates, and exchange rates, and commodity price fluctuations.
A. A futures contract is a contract to buy or sell a stated commodity (such as
soybeans or corn) or a financial claim (such as U.S. Treasury bonds) at a
specified price at some future specified time.
1. A futures contract is a specialized form of a forward contract
distinguished by: (l) an organized exchange, (2) a standardized
contract with limited price changes and margin requirements, (3) a
formal clearinghouse and (4) daily resettlement of contracts.
a. An organized exchange provides a central trading place and
encourages confidence in the futures market by allowing for
effective regulation of trading.
b. Standardized contracts lead to greater liquidity in the
secondary market for that contract, which in turn draws more
traders into the market.
c. The futures clearinghouse serves to guarantee that all trades
will be honored. This is done by having the clearinghouse
interpose itself as the buyer to every seller and the seller to
every buyer.
d. Under the daily resettlement process, maintenance margins
must be maintained.
2. For the financial manager financial futures provide an excellent way
of controlling risk in interest rates, foreign exchange rates, and stock
fluctuations.
180
B. There are two basic types of options: puts and calls. A call option
gives its owner the right to purchase a given number of shares of
stock or some other asset at a specified price over a specified time
period. A put gives its owner the right to sell a given number of shares
of common stock or some other asset at a specified price over a given
time period.
1. The popularity of options can be explained by their leverage, financial
insurance, and investment alternative expansion features.
a. The leverage feature allows the financial manager the chance
for unlimited capital gains with a very small investment.
b. When a put with an exercise price equal to the current stock
price is purchased, it insures the holder against any declines in
the stock price over the life of the put. This is the financial
insurance feature of options and can be used by portfolio
managers to reduce risk exposure in portfolios.
c. From the point of view of the investor, the use of puts, calls,
and combinations of them can materially increase the set of
possible investment alternatives available.
2. Recently, five new variations of the traditional option have appeared:
the stock index option, the interest rate option, the foreign currency
option, the Treasury bond futures option, and leaps.
a. Stock index options are merely options with the underlying
asset being the value or price of an index of stocks -- for
example, the S&P 100.
b. Interest rate and foreign exchange currency options are also
merely options with the underlying asset being the Treasury
bonds or a specific foreign currency.
c. Options on Treasury bond futures are different from other
bond options in that they involve the acquisition of a futures
position rather than the delivery of actual bonds. The buyer of
an option on a futures contract achieves immunization against
any unfavorable price movements, whereas the buyer of a
futures contract achieves immunization against any price
movements regardless of whether they are favorable or
unfavorable.
II. Currency Swaps are another technique for controlling exchange rate risk available to
the financial manager. Whereas options and futures contracts generally have a fairly
short duration, a currency swap provides the financial manager with the ability to
hedge away exchange rate risk over longer periods. It is for that reason that currency
swaps have gained in popularity.
A. A currency swap is simply an exchange of debt obligations in different
currencies. Interest rate swaps are used to provide long-term exchange rate
181
risk hedging. Actually, a currency swap can be quite simple, with two firms
agreeing to pay each other's debt obligation.
B. The nice thing about a currency swap is that it allows the firm to engage in
long-term exchange rate risk hedging since the debt obligation covers a
relatively long time period.
C. One of the more popular is the interest rate currency swap where the principal
is not included in the swap. That is, only interest payment obligations in
different currencies are swapped.
D. The key to controlling risk is to get an accurate estimate on the net exposure
level the firm is subjected to. Then, the firm must decide whether it feels it is
prudent to subject itself to the risk associated with possible exchange rate
fluctuations.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
21-1. Commodity and financial futures are the same other than the type of item specified in
the contract, that is the item to be delivered. With a commodity future, the item to be
delivered is an article of commerce such as soybeans, or wheat, while with a financial
future the item to be delivered is a financial instrument such as a certificate of deposit
or Eurodollars.
21-2. A manufacturer of electronic equipment might need copper in a few months and feel
that the price of copper in the futures market is extremely low. As a result it might
purchase a futures contract for delivery of copper in five months. If the price of
copper goes up, the futures contract has saved the company money; however, if the
price of copper drops, the futures contract does not allow the company to participate
in the price drop. Thus, the futures contract eliminates the effect of any future price
change.
21-3. A financial manager planning on issuing debt one month from now who was
concerned about possible interest rate rises might wish to write a futures contract on
Treasury bonds. If interest rates went up, the money made on the futures contract
would offset the increase costs associated with having to issue the debt at a higher
interest rate. On the other hand, if interest rates fell, the losses on the futures
contracts would be offset by the gains associated with the fact that the debt could
now be issued at a lower rate. In effect, the futures contract serves to lock in the
current interest rate.
21-4. A call option is the option to buy stock or some other asset at a specified price over a
specified time period.
21-5. A put is the option to sell a stock or some other asset at a specified price over a
specified time period.
21-6. (a) Standardization of the options contracts.
182
(b) Creation of a regulated central marketplace.
(c) Creation of the Options Clearinghouse Corporation.
183
(d) Trading was made certificateless, allowing for up-to-date and continuous
records of trader's positions.
(e) The result of all this has been the creation of a liquid secondary market with
dramatically decreased transactions costs.
21-7. An option on a futures contract is exactly what it sounds like. An example is an
option on Treasury Bond futures. While the purchaser of a futures contract on
Treasury bonds benefits from any decreases in interest rates, the purchaser is
negatively affected by any increases in interest rates. With an option on Treasury
Bond futures, the futures contract will only be exercised if the holder makes money.
Thus, with a futures contract there is the potential for both favorable and unfavorable
price movements, whereas with an option on a futures contract unfavorable price
movements are limited to the cost of the option.
21-8. With either buying a call or writing a put the investor is "betting" that the stock price
will rise. In the case of buying a call the purchaser has the right to purchase a given
number of shares of stock at a set price. Thus, the purchaser only makes money if the
stock rises in price, and the potential profits are unlimited. In the case of writing a
put, the put writer receives a premium when he or she sells the put. Then if the stock
price rises the put becomes worthless and the put writer profits by the amount of the
premium. In this case the maximum potential profits are the premium.
21-9. A currency swap provides the financial manager with the ability to hedge away
exchange rate risk over longer periods. It is for that reason that currency swaps have
gained in popularity. A currency swap is simply an exchange of debt obligations in
different currencies. Interest rate swaps are used to provide long-term exchange rate
risk hedging.
184
ANSWERS TO
END-OF-CHAPTER PROBLEMS
21-1A. (a) Purchasing a call with an exercise price of $65 with a $9 premium.
20
15
10
5
0
-5
-10
P
r
o
f
i
t

o
r

L
o
s
s

Stock Price at Option Expiration
10 20 30 40 50 60 70 75


Maximum loss = $9
Breakeven Point = $74
-9
Maximum
Profits =
Unlimited
Exercise or Striking
Price = $65
(b) Purchase a call with an exercise price of $70 with a $6 premium.
185
40
30
20
10
0
-10
-20
Pr
ofit
or
Lo
ss
10 20 30 40 50 60 70 80
}
Maximum loss = $6
Maximum
Profits =
Unlimited
Breakeven Point = $76
Exercise or Striking
Price = $70
186
21-2A. (a) Profit or loss graph for a call writer for a call with an exercise price of $65
and a premium of $9.
10
0
-10
-20
-30
-40
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80
}
Maximum Profits = $9
Maximum
Loss =
$ Unlimited
Breakeven Point
(Exercise Price +
Premium) = $74
Exercise or Striking
Price = $65
(b) Profit or loss graph for a call writer for a call with an exercise price of $70
and a premium of $6.
10
0
-10
-20
-30
-40
-50
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80
}
Maximum Profits = $6
Maximum
Loss =
$ Unlimited
Exercise or Striking
Price = $70
Breakeven Point
(Exercise Price +
Premium) = $76
187
21-3A. A Profit or loss graph for the purchase of a put with an exercise price of $45 and
a premium of $5.
60
50
40
30
20
10
0
P
r
o
f
i
t

o
r

L
o
s
s

10 20 30 40 50 60 70 80 90
}
MaximumLoss = $5
Maximum
Profits = $40
Breakeven Point
(Exercise Price -
Premium) = $40
Exercise or Striking Price = $45
-
-
-10
21-4A. A Profit or loss graph for writing a put with an exercise price of $45 and a
premium of $5.
10
0
-10
-20
-30
-40
-50
-60
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80 90
Maximum Profits = $5
Maximum
Loss = $40
Exercise or Striking Price = $45
Breakeven Point
(Exercise Price -
Premium) = $40
}
188
Solutions to Chapter Problems
21-1B. (a) Purchasing a call with an exercise price of $50 with a $5 premium.
20
15
10
5
0
-5
-10
P
r
o
f
i
t

o
r

L
o
s
s
Stock Price at Option Expiration
10 20 30 40 50 60 70 80
}
Maximum loss = $5
Maximum
Profits =
Unlimited
Breakeven Point = $55
Exercise or Striking
Price = $50
(b) Purchase a call with an exercise price of $55 with a $6 premium.
40
30
20
10
0
-10
-20
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80
}
Maximum loss = $6
Maximum
Profits =
Unlimited
Breakeven Point = $61
Exercise or Striking
Price = $55
189
190
21-2B. (a) Profit or loss graph for a call writer for a call with an exercise price of $50
and a premium of $5.
10
0
-10
-20
-30
-40
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80
}
Maximum Profits = $5
Exercise or
Striking
Price = $50
Maximum Loss =
$ Unlimited
Breakeven Point
(Exercise Price +
Premium) = $55
(b) Profit or loss graph for a call writer for a call with an exercise price of $55
and a premium of $6.
10
0
-10
-20
-30
-40
-50
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80
}
Maximum Profits = $6
Exercise or
Striking
Price = $55
Breakeven Point (Exercise
Price + Premium) = $61
Maximum loss
= $ Unlimited
191
21-3B. A Profit or loss graph for the purchase of a put with an exercise price of $60 and
a premium of $4.
60
50
40
30
20
10
0
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80 90
}
-
-
-10
Exercise or Striking Price = $60
Maximum loss = $4
Breakeven Point
(Exercise Price –
Premium) = $56
Maximum
Profits = $56
21-4B. A Profit or loss graph for writing a put with an exercise price of $60 and a
premium of $4.
10
0
-10
-20
-30
-40
-50
-60
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80 90
}
Maximum Loss = $56
Maximum Profits
= $4
Breakeven Point
(Exercise Price –
Premium) = $56
Exercise or Striking Price = $60
192
SOLUTION TO INTEGRATIVE PROBLEM
1. Derivative securities allow the financial manager to eliminate the effects of interest
rate, foreign exchange, and commodity price fluctuations. For example, a
manufacturer of electronic equipment might need copper in a few months and feel
that the price of copper in the futures market is extremely low. As a result it might
purchase a futures contract for delivery of copper in five months. If the price of
copper goes up, the futures contract has saved the company money; however, if the
price of copper drops, the futures contract does not allow the company to participate
in the price drop. Thus, the futures contract eliminates the effect of any future price
change.
2. Interest rate futures can be used to eliminate the effects of interest rate movements.
For example, a financial manager planning on issuing debt one month from now who
was concerned about possible interest rate rises might wish to write a futures contract
on Treasury bonds. If interest rates went up, the money made on the futures contract
would offset the increased costs associated with having to issue the debt at a higher
interest rate. On the other hand, if interest rates fell, the losses on the futures
contracts would be offset by the gains associated with the fact that the debt could
now be issued at a lower rate. In effect, the futures contract serves to lock in a future
interest rate. In a similar manner foreign exchange futures can be used to lock in
exchange rates while stock index futures can be used to lock in stock prices.
3. Foreign currency options can be used to lock in the exchange rate on a foreign
exchange rate like the British Pound or the Japanese Yen. Currency swaps can also
be used to control exchange rate risk over longer periods of time.
4. With a futures contract, all exchange rate movements, both favorable and unfavorable
are eliminated. With an option, it is only exercised if it is in the best interests of the
option holder. In effect, the buyer of an option on a futures contract can achieve
immunization against any unfavorable price movements, whereas the buyer of a
futures contract can achieve immunization against any price movements regardless of
whether they are favorable or unfavorable.
5. An option on a futures contract is exactly what it sounds like. An example is an
option on Treasury Bond futures. While the purchaser of a futures contract on
Treasury bonds benefits from any decreases in interest rates, the purchaser is
negatively affected by any increases in interest rates. With an option on Treasury
Bond futures, the futures contract will only be exercised if the holder makes money.
Thus, with a futures contract there is the potential for both favorable and unfavorable
price movements, whereas with an option on a futures contract unfavorable price
movements are limited to the cost of the option.
193
6. Purchasing a call with an exercise price of $25 with a $6 premium.
20
15
10
5
0
-5
-10
P
r
o
f
i
t

o
r

L
o
s
s
Stock Price at Option Expiration
10 20 30 40 50 60 70 75
-6
Maximum Loss = $6
Exercise or Striking
Price = $25
Breakeven Point
= $31
Maximum Profits = Unlimited
7. Profit or loss graph for a call writer for a call with an exercise price of $25 and a
premium of $6.
10
0
-10
-20
-30
-40
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80
}
6
Exercise or Striking
Price = $25
Maximum
Loss =
$ Unlimited
Breakeven Point
(Exercise Price +
Premium) = $31
Maximum Profits = $6
194
8. A Profit or loss graph for the purchase of a put with an exercise price of $30 and a
premium of $5.
60
50
40
30
20
10
0
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80 90
}
-
-
-10
Breakeven Point
(Exercise Price –
Premium) = $25
Maximum Profits = $25
Maximum Loss = $5
Exercise or Striking Price = $30
9. A Profit or loss graph for writing a put with an exercise price of $30 and a premium
of $5.
10
0
-10
-20
-30
-40
-50
-60
P
r
o
f
i
t

o
r

L
o
s
s
10 20 30 40 50 60 70 80 90
}
Maximum Loss = $25
Breakeven Point
(Exercise Price –
Premium) = $25
Maximum Profits = $5
Exercise or Striking Price = $30
195
10. A currency swap provides the financial manager with the ability to hedge away
exchange rate risk over longer periods. It is for that reason that currency swaps have
gained in popularity. A currency swap is simply an exchange of debt obligations in
different currencies. Interest rate swaps are used to provide long-term exchange rate
risk hedging. If I am an American firm with much of my income coming from sales
in England, I might enter in a currency swap with an English firm. The nice thing
about a currency swap is that it allows the firm to engage in long-term exchange rate
risk hedging since the debt obligation covers a relatively long time period.
196

Appendix to Chapter 21
Convertible Securities and
Warrants

APPENDIX ORIENTATION
The purpose of this appendix is to explain the use of convertibles and warrants and to
describe the terminology associated with them and their valuation.
CHAPTER OUTLINE
I. A convertible security is a bond or preferred stock that can be exchanged for a stated
number of common shares at the option of the holder.
A. The conversion ratio is the stated number of shares that the security can be
converted into.
B. The conversion price is the face or par value of the security divided by the
conversion ratio.
C. The conversion value equals the conversion ratio times the market price of
the stock when one converts.
D. The security value of a convertible is the price the convertible debenture (or
preferred stock) would sell for in the absence of its conversion feature.
E. The conversion premium is the difference between the market price of the
convertible and the higher of the security value or the conversion value.
F. There are several reasons generally given for issuing convertibles:
1. As a sweetening to long-term debt to make the security attractive
enough to ensure a market for it
2. As a method of delayed common stock financing
a. No dilution of earnings occurs at time of issuance.
b. Companies expect them to be converted sometime in the
future.
197
c. Less dilution of earnings occurs in the future because the
conversion price is greater than the common stock price at
time of issuance.
3. The interest rate associated with convertible debt is, to an extent,
indifferent to the risk level of the issuing firm.
G. There are two ways in which a company can stimulate conversion:
1. Include an acceleration clause, which periodically increases the
conversion price and results in a lower conversion ratio over time.
2. Force conversion by calling the convertible.
H The value of the convertible security is twofold.
1. The value of the common stock into which it can be converted is the
first component.
2. The value of the bond or preferred stock provides a cushion or a floor
value in case the stock price does not rise significantly (Provided
interest rates do not increase).
security value =
t
N
1 t i) (1
$I

+

·
+
N
i) (1
$M
+
where I = annual dollar interest paid to the investor each year
i = market yield to maturity on straight bond of same company
and with same seniority & maturity
N = number of years to maturity
M = maturity value or par value of the debt
I. The market price of a convertible security is frequently above the higher of
security value and conversion value; this difference is called the premium.
J. Unless the conversion feature is considered worthless, the security will sell
for a premium-over-security value (i.e., above the value of the security solely
as a bond or preferred stock).
K. In comparing the two premiums, one finds an inverse relationship between
them. In the extremes, the convertible security is selling either as a common
stock or a bond equivalent.
II. Warrants are a "sweetener" added to a bond or debt issue. Warrants entitle the holder
to purchase a specified number of shares of stock at a stated price.
A. The exercise price can be either fixed or "stepped up" over time.
B. A warrant usually has a fixed expiration date.
C. A detachable warrant can be sold separately in the marketplace.
D. A nondetachable warrant can only be exercised by the bondholder and cannot
be sold on its own.
198
E. Warrants are issued for two major reasons:
1. Warrants are attached to debt issues as sweeteners to increase the
marketability of these issues.
2. Warrants provide an additional cash inflow when they are exercised.
Convertible securities do not.
F. The minimum price of a warrant is equal to the price of the common stock
less the exercise price times the exercise ratio.
G. The premium on a warrant is the amount above the minimum price for which
the warrant sells.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
21A-1. (a) The conversion ratio is the number of shares of common stock for which the
convertible security can be exchanged.
(b) The conversion value of a convertible security is the market value of the
common stock for which the convertible can be exchanged.
(c) The conversion premium is the difference between the convertible's market
price and the higher of its security value or its conversion value.
21A-2. The major reason for issuing convertibles is, that interest rates on convertibles are
indifferent to the issuing firm’s risks level. Several reasons why firms choose to issue
convertibles include "sweetening" the long-term debt issue to make it more attractive,
delayed equity financing, raising temporarily inexpensive funds, and financing
corporate mergers.
21A-3. Investors are willing to pay a premium over value in order to have the possibility of
capital gains from stock price advances, coupled with the security of the fixed interest
payments associated with a debenture.
21A-4. If the price of the underlying common stock goes up, the convertible will be valued as
common stock, while if the price of the underlying common stock goes down, the
convertible will be valued as a bond and not fall accordingly. Graphically this is
illustrated in Figure 21A.1. If interest rates rise, the security value will fall, lowering
the bond floor on the convertible. On the other hand, if interest rates fall, the security
value will rise, increasing the value of the convertible as a bond.
21A-5. If the convertible is never exercised, then the cost of the convertible will be lower
than nonconvertible debt. If the convertible is converted, its cost becomes interest
payments while it was not converted and dividends after it is. In this case, the cost of
the convertible depends upon the conversion ratio, the common stock dividends, and
the time at which the security is converted. In any case, while the cost of convertibles
many times is less than the nonconvertible debt, the limitations it imposes on the
firm's financing flexibility must also be considered. Thus, the issuance of
convertibles involves a trade-off between cost and future financing flexibility.
199
21A-6. A convertible security is a debenture or preferred stock that can be converted into
common stock at the owner's discretion. A warrant, on the other hand, is similar to a
long-term right, in that it is merely an option to purchase common stock at a stated
price. When a convertible is exercised, it is exchanged directly for common stock;
however, with a warrant, both money and the warrant are exchanged for the common
stock.
21A-7. The minimum price of a warrant is equal to zero until the price of the stock rises
above the warrant's exercise price. After that, the warrant's minimum price takes on
positive values. The degree to which the warrant price rises with increases in the
common stock price depends upon the exercise ratio. In addition, investors are
willing to pay a premium for warrants because only a small loss is possible, in that the
warrant price is less than that of the common stock and has large return possibilities.
21A-8. Several factors affect the size of the warrant premium including:
(1) The stock price/exercise price-ratio. As the ratio of the stock price to the
exercise price climbs, the warrant premium falls, because the leverage ability
of the warrant declines.
(2) The time left to the warrant expiration date. As the expiration date approaches
the size of the warrant premium shrinks.
(3) Investors' expectations concerning the capital gains potential of the stock. If
investors feel favorably about the stock, the warrant premium is larger.
(4) The degree of price volatility on the underlying common stock. The more
volatile the common stock, the higher the warrant premium.
SOLUTIONS TO
END-OF-APPENDIX PROBLEMS
Solutions To Set A
21A-1A.
(a) Conversion ratio =
price conversion
security e convertibl of Par value
=
40 $
000 , 1 $
= 25 shares
200
(b) Conversion value = (Conversion ratio) x

,
_

¸
¸
stock common
the of pershare
ue Market val
= 25 shares x $27.25/share
= $681.25
(c) =
t
20
1 t 0.09) (1
$60

+

·
+
20
0.09) (1
$1,000
+
= $60 (9.129) + $1,000(0.178)
= $547.74 + $178
= $725.74
(d)
dollars absolute
in premium
Conversion
=

,
_

¸
¸
bond
e convertibl the
of price Market
-

,
_

¸
¸
value conversion
and alue security v
the of Higher
= $840.25 - $725.74
= $114.51
21A-2A.
(a) Conversion ratio =
price conversion
security e convertibl of Par value
=
27 $
25 $
= 0.9259
(b) Conversion value = (Conversion ratio) x

,
_

¸
¸
stock common
the of share per
ue Market val
= (0.9259) x ($13.25)
= $12.27
201
(c) Value as straight preferred stock =
08 . 0
25 . 1 $
= $15.63
dollars) absolute (in
premium Conversion
=

,
_

¸
¸
stock preferred
e convertibl the
of price Market
-

,
_

¸
¸
value
conversion and value
security the of Higher
= $17.75 - $15.63
= $2.12
21A-3A.
(a) Minimum price =
,
_

¸
¸

price
Exercise

stock common
of price Market
x
,
_

¸
¸
ratio
Exercise
= ($25 - $30) x 1.0
= -$5
Thus, the minimum price on this warrant is considered to be zero,
because things simply do not sell for negative prices.
(b) Warrant premium = Market price of warrant - Minimum price of warrant
= $4 - $0
= $4
21A-4A.
(a) Minimum price =
,
_

¸
¸

price
Exercise
stock common
of price Market
x
,
_

¸
¸
ratio
Exercise
= ($10.00 - 11.71) x 1.0
= -$1.71
Thus, the minimum price on this warrant is considered to be zero, because
things simply do not sell for negative prices.
Warrant premium = Market price of warrant - Minimum price of
warrant
202
= $3 - 0
= $3
(b) Minimum price =
,
_

¸
¸

price
Exercise

stock common
of price Market
x

,
_

¸
¸
ratio
Exercise
= ($16.375 - $11.71) x 1.0
= $4.665
Warrant premium =
,
_

¸
¸
warrant of
price Minimum
-
warrant of
price Market
= $9.75 - $4.665
= $5.085
21A-5A.
Minimum price =
,
_

¸
¸

price
Exercise
stock common
of price Market
x
,
_

¸
¸
ratio
Exercise
= ($7.25 - $22.94) x 3.1827
= (-$15.69) (3.1827)
= -$49.94
Thus, the minimum price on this warrant is considered zero, because things
simply do not sell for negative prices.
Warrant premium =
,
_

¸
¸

warrant of
price Minimum

warrant of
price Market
= $6.25 - 0
= $6.25
21A-6A. The gain on the warrants is
100($7.50-$3.00) = $450 for a return of
300
450 $
= 150%
If $300 had been invested in stock, 7.5 shares could have been purchased and those
shares would have risen in price by $5 per share for a return of $37.50 or 12.50%.
203
204
Solutions to Problem Set B
21A-1B.
(a) Conversion ratio =
price conversion
security e convertibl of Par value
=
45 $
000 , 1 $
= 22.22 shares
(b) Conversion value = (Conversion ratio) x

,
_

¸
¸
stock common
the of share per
ue Market val
= 22.22 shares x $26.00/share
= $577.72
(c)
Value
Security
=
t
20
1 t 0.09) (1
$70

+

·
+
20
) 09 . 0 1 (
000 , 1 $
+
= $70 (9.129) + $1,000(0.178)
= $639.03 + $178
= $817.03
(d)
dollars absolute
in premium Conversion
=

,
_

¸
¸
bond
e convertibl the
of price Market
-

,
_

¸
¸
value conversion
and alue security v
the of Higher
= $840.25 - $817.03
= $23.22
21A-2B.
(a) Conversion ratio =
price conversion
security e convertibl of Par value
=
28 $
25 $
= 0.8929
205
(b) Conversion value = (Conversion ratio) x

,
_

¸
¸
stock common
the of share per
ue Market val
= (0.8929) x ($14.00)
= $12.50
(c) Value as straight preferred stock =
= $18.75
dollars) absolute (in
premium Conversion
=

,
_

¸
¸
stock preferred
e convertibl the
of price Market
-

,
_

¸
¸
value
conversion and value
security the of Higher
= $20.00 - $18.75
= $1.25
21A-3B.
(a) Minimum price =
,
_

¸
¸

price
Exercise

stock common
of price Market
x

,
_

¸
¸
ratio
Exercise
= ($24 - $32) x 1.0
= -$8
Thus, the minimum price on this warrant is considered to be zero, because
things simply do not sell for negative prices.
(b) Warrant premium =
,
_

¸
¸

warrant of
price Minimum

warrant of
price Market
= $5 - $0
= $5
206
21A-4B.
(a) Minimum price =
,
_

¸
¸

price
Exercise

stock common
of price Market
x
,
_

¸
¸
ratio
Exercise
= ($9.00 - 11.75) x 1.0
= -$2.75
The minimum price on this warrant is considered to be zero, because things simply
do not sell for negative prices.
Warrant premium =
,
_

¸
¸

waranet of
price Minimum

warrant of
price Market
= ($4.00 - 0)
= $4.00
Minimum price =
price
Exercise

stock common
of price Market

= ($15.375 - $11.75) × 1.0
= $3.625
Warrant premium =
,
_

¸
¸

waranet of
price Minimum

warrant of
price Market
= ($7.00 - $3.625)
= $3.375
21A-5B
Minimum price Minimum price =

,
_

¸
¸
×

,
_

¸
¸

ratio
Exercise

price
Exercise

stock common
of price Market
= ($8.00 - $22.94)
= $63.60
The minimum price on this warrant is considered to be zero because things simply
do not sell for negative prices.
Warrant premium =
,
_

¸
¸

ofwarrant
ce Minimumpri
ofwarrant
e Marketpric
207
= ($6.75 – 0)
= $6.75
21A-6B.
The gain on the warrants is
100($6.75-$2.75) = $400 for a return of
275
400 $
= 145.45%
If $275 had been invested in stock, 7.86 shares could have been purchased and
those shares would have increased in value by $5 each for a gain of $39.30 or
14.29%.

CHAPTER 22
208
International Business Finance

CHAPTER ORIENTATION
This chapter introduces some of the financial techniques and strategies necessary to the
efficient operations of an international business. Problems inherent to these firms include
multiple currencies, differing legal and political environments, differing economic and
capital markets, and internal control problems. The difficulties arising from multiple
currencies are stressed here, including the dimensions of foreign exchange risk and
strategies for reducing this risk. We also cover multinational working capital management
and direct foreign investment for international firms.
CHAPTER OUTLINE
I. The globalization of product and financial markets
A. World trade has grown faster over the last few decades than has aggregate
world GNP.
B. In less-developed countries, long-run overseas investments of the United
States' companies have yielded high returns.
C. Many American multinational corporations (MNC) have significant assets,
sales, and profits attributable to foreign investments.
D. Many foreign MNCs have significant operations in the United States.
E. Many firms, investment companies, and individuals invest in the capital
markets of foreign companies to receive
1. Higher returns than those available in domestic capital markets
2. Reduced portfolio risk through international diversification
F. Companies are increasingly turning to the Eurodollar market to raise funds.
209
II. Exchange rates
A. Recent history of exchange rates
1. Exchange rates between the major currencies were fixed from 1949
and 1970.
2. Countries were required to set a parity rate with the U.S. dollar,
around which the daily exchange rate could narrowly fluctuate.
3. In order to effect a major adjustment, a currency either had to undergo
a devaluation (reducing the cost relative to the dollar) or an up-
valuation/revaluation (increasing the cost relative to the U.S. dollar).
4. Since 1973, a floating rate international currency system has operated,
wherein the currencies are allowed to fluctuate freely.
5. Two major types of transactions now occur in the foreign exchange
markets: spot and forward transactions.
B. The Euro
1. Beginning January 1, 1999, 11 countries in the European Union
introduced a single currency, the Euro.
2. This should make it easier for goods and services to cross borders,
and, as a result, economies should flourish.
3. It also eliminates the uncertainty associated with currency
fluctuations.
4. For the United States, it also means that competition should be
stronger.
C. Spot exchange rates
1. The rate at which one currency can be immediately exchanged for
another currency
2. Direct quote expresses the exchange rate in the units of home
currency required to buy one unit of foreign currency. For example,
1.4845 U.S. dollars per pound.
3. Indirect quotes indicate the number of foreign currency units needed
to purchase one unit of home currency. For example, .6691 pounds
per U.S. dollar.
EXAMPLE
Using the rates listed above, how many dollars would a U.S.
manufacturer pay for a part costing 250 pounds?
250 (pounds) x 1.4845 ($/pound) = $371.13
210
4. The direct and indirect quotes should have a reciprocal relationship.
In formula
Direct Quote =
Quote Indirect
1
or
Indirect Quote =
Quote Direct
1
5. When these quotes are not equal, arbitrage will occur, where a trader
(or arbitrager) makes a riskless profit, by exchanging currency in two
markets.
6. The asked rate is the rate which the bank or foreign exchange trader
"asks" the buyer to pay for the foreign currency.
7. The bid rate is the rate which the bank or foreign exchange trader
buys the foreign currency from the customer.
8. The spread is the difference in the bid and the asked rates.
9. The narrower the spread, the greater is the efficiency in the spot
exchange market.
10. A cross rate is the result of an indirect computation of one currency's
exchange rate from the exchange rate of two other currencies. For
example, the calculation of marks per pound from U.S. dollars per
pound and marks per U.S. dollars.
11. Triangular arbitrage will occur when the cross rates calculated are not
equal to the exchange rates offered.
D. Forward exchange rates
1. A forward exchange rate specifies today the rate at which currencies
will be exchanged at in the future, usually 30, 90, or 180 days from
today.
2. Rates are quoted in both the direct and indirect form.
3. Forward rates are often quoted at a premium or a discount to the
existing spot rate. This is also referred to as the forward-spot
differential.
4. These differentials may be stated either in absolute terms or as an
annualized percent premium or discount.
5. The use of forward contracts allows for risk reduction in that future
cash outlays are known with certainty.
211
III. The interest parity theory
A. Theorem states that the forward premium or discount should be equal and
opposite in sign to the difference in the national interest rates for securities of
the same maturity (except for the effects of small transaction costs).
Notationally, this is expressed as
P(or D) = - =
where
P(or D) = the percent-per-annum premium or discount on
the forward rate
I
f
= the annual interest rate on a foreign instrument
having the same maturity as the forward
contract
I
d
= the annualized interest rate on a domestic
instrument having the same maturity as the
forward contract
EXAMPLE
The premium (P) on 30-day forward mark contracts is 4.368 percent. If the
30-day T-Bill is yielding 10 percent, what must the 30-day German
instrument yield?
P =
f
d

f
I 1
I I
+

.04368 =
f

f
I 1
.10 I
+

I
f
= .1502 or 15.02%
B If the forward differentials are not those predicted by the interest parity
theorem, then covered interest arbitrage can occur and be profitable at no
risk.
IV. Purchasing power parity
A. According to purchasing power parity, exchange rates will adjust over time
so that the currencies of different countries will have the same purchasing
power. The exchange rates will adjust to cover the inflation rate differential
between the two countries.
212
B. Purchasing power parity can be demonstrated by the equation
S
t
+ 1 = S
t
(l + P
d
) / (l + P
f
)
n
= S
t
( 1 + P
d
- P
f
)
n
where
S
t
= units of domestic currency per unit of the foreign
currency at time t
P
f
= the foreign inflation rate
P
d
= the domestic inflation rate
n = the number of time periods
EXAMPLE
The inflation rate in Great Britain is 6% and in the United States it is 10%. The
current spot rate of the pound is $2.00. According to purchasing power parity,
what will be the expected value of the pound at the end of the year?
S = $2.00 (1 + .10 + -.06)
1
= $2.00 (l.04)
1
= $2.08
C. The law of one price
The law of one price underlies purchasing power parity. This law suggests
that where there are no transportation costs or barriers to trade, the same good
sold in different countries should sell for the same price if all the different
prices are expressed in terms of the same currency.
D. International Fisher effect
1. According to the Fisher effect, interest rates reflect not only the real
rate of return but the expected inflation rate.
2. The Fisher effect can be expressed as
I = P + I
r
+ (P) (I
r
)
where
I = the nominal interest rate
I
r
= the real rate of return
P = the expected inflation rate
213
3. The international Fisher effect suggests that the exchange rate adjusts
to cover the interest rate differential between two countries.
4. This theory suggests that in efficient markets, with rational
expectations, the forward rate is an unbiased forecast of the future
spot rate.
IV. Exchange Rate Risk
A. Risk arises from not knowing the value of the future spot rate today.
B. Types of exchange risk
1. Risk in international trade contracts—when an agreement exists to
purchase some good at a future date in foreign currency, uncertainty
exists as to the future cash outlay.
2. Risk in foreign portfolios - because of exchange rate fluctuations in
foreign securities the returns are more variable and thus more risky
than investment in domestic securities.
3. Risk in direct foreign investment (DFI)—the balance sheet and
income statement are denominated in foreign currency. Thus, for the
parent company, risk arises from both the fluctuations in the asset's
value and the profit streams.
C. Exposure to exchange rate risk
1. Transaction exposure refers to the net total foreign currency
transactions whose monetary value was fixed at a time different from
when the transactions are actually completed. Examples of
transactions exposed to this kind of risk are receivables, payables, and
fixed price sales or purchase contracts. Fluctuations in exchange rates
can affect the value of these assets and liabilities.
2. Translation exposure is actually a paper gain or loss. Translation
exposure refers to gains or losses caused by the translation of foreign
currency assets and liabilities into the currency of the parent company
for accounting purposes.
3. Economic exposure refers to the extent to which the economic value
of a company can decline due to exchange rate changes. It is the
overall impact of exchange rate changes on the value of the firm. A
decline in value can be attributed to an exchange rate induced decline
in the level of expected cash flows and/or by an increase in the
riskiness of these cash flows.
D. Hedging strategies
1. The standard procedure to hedge is to match the amount and the
duration of the asset (liability) position.
2. The money market hedge offsets the exposed position in a foreign
currency by borrowing or lending in the foreign and domestic money
markets. This may be costly for small or infrequent users.
214
3. The forward market hedge matches the asset (liability) position with
an offsetting forward contract of equal value and maturity. Generally,
this is less costly than the money market hedge.
4. Foreign currency futures contracts and foreign currency options are
two relatively new instruments used for hedging. Futures contracts are
similar to forward contracts in that they provide a fixed price for the
required delivery of foreign currency. Options, on the other hand,
permit a fixed price anytime before their expiration date. Options and
futures both differ from forward contracts in that they are traded in
standardized amounts with standardized maturity dates and are traded
through organized exchanges and individual dealers. The difference
between the futures contract and the currency option is that the option
requires delivery only if it is exercised. The option can be exercised
any time before its maturity date; this can provide additional
flexibility for a company.
V. Multinational working capital management
A. The MNC must be careful to make decisions concerning working capital
management that are optimal for the corporation as a whole and not just the
best for the individual entities.
B. Leading and lagging are important risk reduction techniques for a MNC's
working capital management.
1. When holding an asset in a:
a. Strong (appreciating) currency, we should lag (delay)
conversion to the domestic currency.
b. Weak (depreciating) currency, we should lead (expedite)
conversion to the domestic currency.
2. When holding a liability in a:
a. Strong currency, we should lead (expedite) payment of the
liability.
b. Weak currency, we should lag (delay) payment of the liability.
C. Cash management
1. A MNC may wish to position funds in a specific subsidiary in another
country such that the foreign exchange exposure and the tax liability
of the MNC are minimized as a whole. This strategy may not,
however, be the optimal strategy for the specific subsidiary.
2. The transfer of funds is effected by royalties, fees, and transfer-
pricing. The transfer price is the price charged for goods or services
transferred from a subsidiary or parent company to another
subsidiary.
215
VI. International Financing Decisions
A. A multinational corporation (MNC) may have a lower cost of capital than a
domestic firm due to its ability to tap a larger number of financial markets.
1. A multinational company has access to financing sources in the
countries in which it operates.
2. Host countries often provide access to low-cost subsidized financing
to attract foreign investment.
3. A MNC may enjoy preferential credit treatment due to its size and
investor preference for its home currency.
4. A MNC may be able to access third country capital markets.
5. A MNC has access to external currency markets variously known as
Eurodollar, Eurocurrency, or Asian dollar markets. These markets are
unregulated and because of their lower spread, can offer attractive
rates for financing and investment.
B. To increase their visibility in foreign capital markets, MNCs are increasingly
listing their stocks in the foreign capital markets.
C. A MNC's capital structure should reflect its wider access to financial markets,
the ability to diversify economic and political risks, and several of its other
advantages over domestic firms.
VII. Direct foreign investment
A. Risk in international capital budgeting
1. Political risk arises from operating a business in a different and
possibly less stable business climate than the United States.
2. Exchange risk incorporates changes in the future earnings stream
because of currency fluctuations, possibly in both foreign and
domestic currencies.
3. Business risk is affected by the response of business and the MNC to
economic conditions within the foreign country.
4. Financial risk arises from the financial structure of the firm and its
effect on the profit stream.
B. Cash flows must be estimated considering the potential effects of exchange
rate changes, governmental policy, and other items that determine product
demand and sales.
C. A foreign investment can be evaluated from either a parent or a local firm
perspective. If a firm uses a local perspective the initial investment and all of
its cash flows should be discounted at a rate that reflects the local inflation
rate and the riskiness of the project. When using the parent company
perspective, the discount rate should reflect the expected inflation rate in the
parent currency and foreign currency cash flows should be converted to the
parent currency cash flows using projected exchange rates.
216
D. The net present value (NPV) must be calculated using the above factors.
1. If NPV is greater than zero, generally accept direct foreign
investments.
2. If NPV is less than zero, the MNC may decide to
a. Reject direct foreign investment.
b. Establish a sales office in the foreign country.
c. License a local company to manufacture the product, where
the MNC receives royalty payments.
VIII How financial managers use this material.
IX. Summary.
ANSWERS TO
END-OF-CHAPTER QUESTIONS
22-1. The additional factors that must be considered in international finance relate to:
multiple currencies, different legal requirements, institutional restrictions, and
internal control problems. These issues are discussed in the introduction to the
chapter.
22-2. The different types of businesses that operate in the international environment are:
one time (or occasional) exporters and importers, exporters and importers that do
business (continually) with one foreign country, exporters and importers that conduct
business in many countries, companies that have a production plant or subsidiary
abroad and multinational corporations with many subsidiaries in different countries.
The techniques and strategies open to these firms differ mainly due to the differing
exposure to risk. Firms with plants abroad are subject to political risk of
expropriation. Firms doing import or export business do not have much risk of
expropriation. The ideas of exchange risk apply to all these firms. The relevant
measures of exchange risk differ between businesses due to the amount of foreign
exchange diversification that they have.
22-3. Arbitrage profits are the riskless profits made without investing funds. These profits
are generated when certain assets are not priced according to an equilibrium
relationship. For example, arbitrage profits are possible in the spot and forward
exchange markets if the indirect quote or cross quote relationships are out of line.
The respective arbitrage processes are called simple and triangular arbitrage.
Arbitrage opportunities exist if the money market rates differ from the forward
market rates. This is referred to as: Covered Interest Arbitrage.
22-4.(a) Simple Arbitrage is possible when the quoted rates in a foreign market for a
single currency are not the inverse of the rates quoted in the home market.
For example, the dollar quote in Frankfurt should be the inverse of the DM
quote in New York. Otherwise, arbitrage opportunities would prevail. See
Problem 22-5 and its solution in this regard. Simple arbitrage is also possible
217
in the forward quotes.
(b) Triangular Arbitrage is possible when the cross rate is out of line. For
example, if the pound rate in Frankfurt (quoted as DM/pound) is different
from the
,
_

¸
¸
$
DM
x
,
_

¸
¸
Pound
$
rate, then an arbitrageur could sell and buy
different currencies in Frankfurt, London, and New York to turn an arbitrage
profit.
22-5. Purchasing power parity suggests that exchange rates will adjust so that each
currency will have the same purchasing power. Differences in forward and spot
rates are explained by differences in inflation rates between two countries.
Interest-rate parity theory suggests that current spot rates and forward rates differ
because of an interest-rate differential between two countries.
The Fisher effect contends that the nominal interest rate is a function of the real rate
of interest and an expected inflation rate. Thus, spot and forward rates between
countries will differ depending on the inflation rate and the real rate of return in
those countries.
22-6. (a) Exchange Risk: Refers to the change in value of a profit stream or the
economic value of an asset due to changes in the exchange rate.
(b) Political Risk: Refers to the risks associated with direct foreign investment
due to changes in political climate or structure in the foreign country. These
risks are due to expropriation, lack of compensation or other unanticipated
governmental controls that are imposed on the multinational corporation.
22-7. The proper measurement of exchange risk involves the measurement of economic
exposure. This is difficult to measure. However, the net asset (liability) exposure in
a currency measures the exchange risk (at least, of short-term assets) quite well.
22-8. Exposure to foreign currency losses is often placed into three categories as follows:
(a) Transaction Exposure: This is the net total of foreign currency transactions
whose monetary value was fixed at a time different from when the given
transactions were actually completed. Accounts receivable and payable are
typical examples of such transactions.
(b) Translation Exposure: This is the net total of exposed assets less exposed
liabilities. The asset or liability is exposed in this sense if the foreign
currency value is to be translated (i.e., altered) into the parent company
currency using the exchange rate in effect on the balance sheet date. This is
primarily a bookkeeping exercise with no impact on taxable income.
(c) Economic Exposure: This is the extent to which the economic value of a
company can decline because of exchange rate fluctuations.
For practical purposes it is fair to say that these risks can be managed, but they
should not be reduced to zero. For example, economic exposure could only be
reduced to zero by doing business in the domestic country and, thereby, giving up
the potential benefits of operating in the foreign environment.
218
22-9. Short-term exchange risk can be covered by the money market or the forward market
hedge. The hedge should be constructed so that the net asset (liability) position in a
foreign currency is zero. In addition to the amount of hedge, the maturity of the
hedge should also be matched. This ensures that the risk of foreign exchange
exposure is eliminated.
22-10. The money market hedge is implemented by borrowing or lending in the home or the
foreign money market against the foreign currency asset or liability position.
In the forward market hedge a forward contract is bought or sold to exactly offset the
foreign currency net asset or liability position.
The hedges differ in the markets utilized for covering the exposed positions. The
types of hedge may also differ in the costs of hedge. The money market hedge may
be cheaper for the hedge on large amounts of exposure.
22-11. Since the forward market for the Indian Rupee does not exist, a trader can effect a
hedge via the money markets in the U.S. and India. Other ways of covering an
exposed position in rupees are by bilateral swap arrangements with other companies
in India.
22-12. A forward exchange contract requires delivery, at a specified future date, of one
currency for a specified amount of another currency. The exchange rate for the
future transaction is agreed upon today. The physical transaction takes place at the
future date.
Futures contracts (like forward exchange contracts) provide fixed prices for the
required delivery of a foreign currency at maturity.
Options, on the other hand, permit fixed (strike) price foreign currency transactions
anytime prior to maturity.
Futures contracts and options are traded in standardized amounts with standardized
maturity dates. These instruments are traded on organized security exchanges. The
individual traders deal with the exchange-based clearing organization rather than the
direct parties to the foreign currency transaction.
Forward contracts are quite different. Typically they are written by banks and the
firm deals directly with the banking institution rather than the organized security
exchange.
22-13. Leading and lagging are two useful working capital management techniques.
Leading and lagging techniques are useful because they reduce the exchange risk.
Leading and lagging are not useful as hedging techniques, since exchange risk
cannot be totally eliminated by these techniques. Leading and lagging techniques are
profitable when the potential appreciation (depreciation) in the foreign currency is
correctly anticipated.
219
22-14. The multinational corporation enjoys access to more financing sources than the
domestic company.
Specifically the MNC:
a. May have access to low-cost subsidized financing provided by the host
country.
b. May enjoy preferential credit standards.
c. May tap third-country capital markets.
d. May tap the (1) Eurodollar, (2) Eurocurrency, or (3) Asian dollar markets.
Probably the MNC operates at a lower cost of capital because of the financing
flexibility available to it.
22-15. The risks associated with direct foreign investment are: business risk, financial risk,
exchange risk, and political risk. The direct foreign investment has the additional
factors of exchange and political risk compared to domestic investment. The
exchange risk is due to the fact that the profit stream and the value of the subsidiary
fluctuate due to changes in the exchange rate. The political risk arises from the fact
that the political system and laws in many foreign countries are not as stable as in the
U.S.
22-16. The direct foreign investment problem is a capital budgeting problem. All the
relevant risks like business risk, financial risk, exchange risk and political risk are to
be considered. The cash flow estimates should take into account the risks and
demand related factors. The choice of the appropriate discount rate should include
the following: the risks of the investment, and the choice of the "correct" component
costs of financing. Finally, the net present value of the project is calculated and the
project is accepted if the NPV is positive.
22-17. If direct foreign investment is not a profitable way of entering a foreign market, a
corporation has the choice of establishing either a sales office or a licensing
arrangement. Typically, if the sales volume is expected to be low, then a sales office
is profitable. Production is done elsewhere and the finished product is exported to
the foreign country for sales. If the sales volume is expected to be large, but not
large enough to support DFI, then a licensing arrangement is beneficial.
22-18. A sales office is an acceptable alternative when the volume of sales is not very high.
This corresponds to a low cash flow situation. A licensing arrangement is beneficial
when the affiliate's required return is less than the MNC's required rate of return.
This situation arises since the affiliate typically faces less political and exchange risk
than a subsidiary. Consequently, the required return for the owner of the licensing
company is less than that of the MNC.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
220
Solutions to Problem Set A
22-1A.
(a) 10,000 (Canadian $) x . 8437 (U.S. $/Canadian $) = $8,437
(b) 2,000,000 (Yen) x .004684 ($/Yen) = $ 9,368
(c) 50,000 (Swiss-franc) x .5139 ($/Swiss franc) = $25,695.
22-2A.
(a) 10,000 ($) x 1/.004684 (Yen/$) = 2,134,927.41 Yen
(b) 15,000 ($) x 1/.5139 (Swiss franc/$) = 29,188.56 Swiss franc
(c) 20,000 ($) x 1/.8437 (Canadian $/U.S. $) = 23,705.11 Canadian $.
22-3A. Recall that the indirect quote = (1/Direct Quote). The results are tabulated below:
Foreign Currency/$
Canadian - dollar Spot 1.1853
30 day 1.1881
90 day 1.1912
Japan - Yen Spot 213.4927
30 day 211.9992
90 day 209.1613
Swiss - franc Spot 1.9459
30 day 1.9346
90 day 1.8815
22-4A. Recall that the direct asked quote is greater than the direct bid quote. Consequently,
the direct bid quote for Yen is 98% of the asked quote. The bid quotes for Canadian
dollars and Swiss francs are, respectively, 97% and 95% of the selling quotes. The
results are tabulated below:
$/Foreign
Bid Quotes for Foreign Currency Currency
Canadian - dollar Spot .8437 × .97 = .8184
30 day .8417 × .97 = .8165
90 day .8395 × .97 = .8143
Japan - Yen Spot .004684 × .98 = .004590
30 day .004717 × .98 = .004623
90 day .004781 × .98 = .004685
Swiss - franc Spot .5139 × .95 = .4882
30 day .5169 × .95 = .4910
90 day .5315 × .95 = .5049
221
222
22-5A. The Tokyo rate is 216.6743 Yen/$
The (indirect) New York rate is 1/.004684 = 213.4927 Yen/$.
Assuming no transaction costs, the rate between Tokyo and New York are out of
line. Arbitrage profits are possible.
Yen is cheaper in Tokyo. Buy Yen for $10,000.
$10,000 x 216.6743 = 2,166,743 Yen.
Sell the Yen in New York at the prevailing rate.
2,166,743 x .004684 = $10,149.02
Your net gain is $10,149.02 - $10,000 = $149.02
22-6A.
(a) (Canadian dollar/Yen) = ($/Yen) ×

,
_

¸
¸
dollar U.S.
dollar Canadian
= .004684 × (1/.8437)
= .00555
(b) (Yen/Swiss franc) = ($/Swiss franc) ×

,
_

¸
¸
$
Yen
= .5139 × (1/.004684)
= 109.7139
SOLUTIONS TO INTEGRATIVE PROBLEM
1.. The additional factors that must be considered in international finance relate to:
multiple currencies, different legal requirements, institutional restrictions, and
internal control problems. These issues are discussed in the introduction to the
chapter.
2. Arbitrage profits are the riskless profits made without investing funds. These profits
are generated when certain assets are not priced according to an equilibrium
relationship. For example, arbitrage profits are possible in the spot and forward
exchange markets if the indirect quote or cross quote relationships are out of line.
The respective arbitrage processes are called simple and triangular arbitrage.
Arbitrage opportunities exist if the money market rates differ from the forward
market rates. This is referred to as: Covered Interest Arbitrage.
223
3. Short-term exchange risk can be covered by the money market or the forward market
hedge. The hedge should be so constructed that the net asset (liability) position in a
foreign currency is zero. In addition to the amount of hedge, the maturity of the
hedge should also be matched. This ensures that the risk of foreign exchange
exposure is eliminated.
4. A forward exchange contract requires delivery, at a specified future date, of one
currency for a specified amount of another currency. The exchange rate for the
future transaction is agreed upon today. The physical transaction takes place at the
future date.
Futures contracts (like forward exchange contracts) provide fixed prices for the
required delivery of a foreign currency at maturity.
Options, on the other hand, permit fixed (strike) price foreign currency transactions
anytime prior to maturity.
Futures contracts and options are traded in standardized amounts with standardized
maturity dates. These instruments are traded on organized security exchanges. The
individual traders deal with the exchange-based clearing organization rather than the
direct parties to the foreign currency transaction.
Forward contracts are quite different. Typically, they are written by banks and the
firm deals directly with the banking institution rather than the organized security
exchange.
5. (a) 15,000 (Canadian $) x . 8450 (U.S. $/Canadian $) = $12,675
(b) 1,500,000 (Yen) x .004700 ($/Yen) = $ 7,050
(c) 55,000 (Swiss-franc) x .5150 ($/Swiss franc) = $28,325.
6. (a) 20,000 ($) x 1/.004700 (Yen/$) = 4,255,319.15 Yen
(b) 5,000 ($) x 1/.5150 (Swiss franc/$) = 9,708.74 Swiss franc
(c) 15,000 ($) x 1/.8450 (Canadian $/U.S. $) = 17,751.48 Canadian $.
7. Recall that the indirect quote = (1/Direct Quote). The results are tabulated below:
Foreign Currency / $
Canadian - dollar Spot 1.1834
30 day 1.1884
90 day 1.1919
8. The Tokyo rate is 216.6752 Yen/$.
The (indirect) New York rate is 1/.004700 = 212.7660 Yen/$.
Assuming no transaction costs, the rate between Tokyo and New York are out of
line. Arbitrage profits are possible.
Yen is cheaper in Tokyo. Buy Yen for $10,000.
224
$10,000 x 216.6752 = 2,166,752 Y.
Sell the Yen in New York at the prevailing rate.
2,166,752 x .004700 = $10,183.73
Your net gain is $10,183.73 - $10,000 = $183.73
9. (Canadian dollar/Yen) = ($/Yen) ×

,
_

¸
¸
dollar U.S.
dollar Canadian
= .004700 × (1/.8450)
= .00556
Solutions to Problem Set B
22-1B.
(a) 15,000 (Canadian $) x . 8439 (U.S. $/Canadian $) = $12,65850
(b) 1,500,000 (Yen) x .004680 ($/Yen) = $ 7,020
(c) 55,000 (Swiss-franc) x .5140 ($/Swiss franc) = $28,270.
22-2B. (a) 20,000 ($) x 1/.004680 (Yen/$) = 4,273,504.27 Yen
(b) 5,000 ($) x 1/.5140 (Swiss franc/$) = 9,728.63 Swiss franc
(c) 15,000 ($) x 1/.8439 (Canadian $/U.S. $) = 17,774.62 Canadian $.
22-3B. Recall that the indirect quote = (1/Direct Quote). The results are tabulated below:
Foreign Currency/$
Canadian - dollar Spot 1.1850
30 day 1.1891
90 day 1.1919
Japan - Yen Spot 213.6752
30 day 211.8644
90 day 208.8991
Swiss - franc Spot 1.9455
30 day 1.9309
90 day 1.8744
225
22-4B. Recall that the direct asked quote is greater than the direct bid quote. Consequently,
the direct bid quote for Yen is 96% of the asked quote. The bid quotes for Canadian
dollars and Swiss francs are, respectively, 97% and 94% of the selling quotes. The
results are tabulated below:
&/Foreign
Bid Quotes for Foreign Currency Currency
Canadian - dollar Spot .8439 × .97 = .8186
30 day .8410 × .97 = .8158
90 day .8390 × .97 = .8138
Japan - Yen Spot .004680 × .96 = .004493
30 day .004720 × .96 = .004531
90 day .004787 × .96 = .004596
Swiss - franc Spot .5140 × .94 = .4832
30 day .5179 × .94 = .4868
90 day .5335 × .94 = .5015
22-5B. The Tokyo rate is 216.6752 Yen/$
The Yen rate in New York is 0.00468 $/Yen.
Assuming no transaction costs, the rate between Tokyo and New York are out of
line. Arbitrage profits are possible.
Buy Yen for $10,000.
$10,000 x 216.6752 = 2,166,752 Yen.
Sell the Yen in New York at the prevailing rate.
2,166,752 x .004680 = $10,140.40
Your net gain is $10,140.40 - $10,000 = $140.40
22-6B. (a) (Canadian dollar/Yen) = ($/Yen) ×

,
_

¸
¸
dollar U.S.
dollar Canadian
= .004680 × (1/.8439)
= .0055457
(b) (Yen/Swiss franc) = ($/Swiss franc) ×

,
_

¸
¸
$
Yen
= .5140 × (1/.004680)
= 109.8291

226
CHAPTER 23
Corporate Restructuring:
Combinations and Divestitures

CHAPTER ORIENTATION
Corporate restructuring comes through combining assets (mergers and acquisitions) and
uncombining assets (divestitures). This chapter examines how mergers and acquisitions can
create shareholder wealth and the methods used to value a potential merger candidate.
Firms may also increase shareholder wealth by divesting themselves of some portion of its
current operations. This chapter discusses the different divestiture options available to a
firm.
CHAPTER OUTLINE
I. There are two principal ways by which a firm may grow:
A. Internally, through the acquisition of specific assets which are financed by
the retention of earnings and/or external financing, or
B. Externally, through the combination with another company. We turn now to a
discussion of external growth through mergers with, and acquisition of, other
firms.
II. There have been five identifiable time periods where the number and amount of
mergers and acquisitions were particularly accentuated.
A. End of the 19th century and beginning of the 20th century. During this
time, many industries were merged. The resulting firms had enormous
economic power. Example firms include U.S. Steel, American Tobacco, and
Standard Oil.
B. The decade of the 1920s. This merger wave was closely related to the
creation of oligopolies (industries dominated by a few firms), such as IBM,
General Foods, and Allied Chemical. During this time, the developments in
transportation, communications, and merchandising fostered the growth.
227
C. Between the 1950s and the 1970s. No longer permitted by the Federal Trade
Commission to acquire firms in their own industry, companies actively began
acquiring companies outside their own industries. The bringing together of
these dissimilar firms into one corporate entity came to be known as the
conglomerate.
1. The creation of a conglomerate was thought to be an efficient way of
monitoring individual businesses by subjecting them to regular
quantitative evaluations by the central office.
2. With hindsight we now see that conglomerate acquisitions have, for
the most part, proven unsuccessful.
D. The 1980s. In this period, the pattern became that of acquiring a
conglomerate, breaking it up into its individual business units, and selling off
the segments to large corporations in the same businesses. The 1980s merger
activity came to an end, however, largely because the huge amounts of debt
financing used to fund many of the acquisitions dried up.
E. The 1990s. During the 90s the financial services and telecommunication
industries went through a period of consolidation resulting in some of the
largest mergers ever recorded.
III. Why mergers create value. For a merger to create wealth it has to provide
shareholders with something they get for free by merely holding the individual
shares of the two firms. Such benefits might include:
A. Tax benefits: If a merger were to result in a reduction of taxes that is not
otherwise possible, then wealth is created by the merger. This can be the
case with a firm that has lost money and thus generated tax credits, but does
not currently have a level of earnings sufficient to utilize those tax credits.
B. Reduction of agency costs: An agency problem is a result of the separation
of management and the ownership in the firm. A merger, particularly when
it results in a holding company or conglomerate organizational form may
reduce the significance of this problem, because top management is created
to monitor the management of the individual companies making up the
conglomerate. Alternatively, it can be argued that the creation of a
conglomerate might result in increased agency costs. This might occur as
shareholders in conglomerates feel they have less control over the firm's
mangers, as a result of the additional layers of management between them
and the decision makers.
C. The release of free cash flows to the owners: A merger can create wealth by
allowing the new management to distribute the free cash flow out to the
shareholders, thus allowing them to earn a higher return on these cash flows
than would have been earned by the firm.
D. Economies of scale: Wealth can be created in a merger through economies of
scale. Redundant functions of the combined firms, such as accounting,
computer operations, and management, provide opportunities to reduce
staffing and its associated costs or to increase productivity.
228
E. Unused debt potential: Assuming the acquired firm has unused debt
capacity, a new management can increase debt financing, and reap the tax
benefits associated with the increased debt.
F. Complementary financial slack: It may be possible to create wealth by
combining cash-rich bidders and cash-poor targets, with wealth being created
as a result of the positive NPV projects taken by the merged firm that the
cash-poor firm would have passed up.
G. Removal of ineffective management: If a firm with ineffective management
can be acquired, it may be possible to replace the current management with a
more efficient management team, and thereby create wealth.
H. Increased market power: The merger of two firms can result in an increase in
the market or monopoly power of the two firms. While this can result in
increased wealth, it may also be illegal.
I. Reduction in bankruptcy costs: Presuming that bankruptcy costs exist, a
merger that reduces the possibility of bankruptcy creates wealth.
J. The creation of "chop shop" value: It may be less expensive to purchase
assets through an acquisition than it is to obtain those assets in any other way.
IV. Determining a firm's value
A. The value of a firm depends not only on its earnings capabilities but also on
the operating and financial characteristics of the acquired firm. To determine
an acceptable price of a corporation, a number of factors must be carefully
evaluated. The final objective of this valuation process is to maximize the
stockholders' wealth (stock price) of both firms.
B. The value of a firm may be represented in a number of ways including (l)
book value, (2) appraisal value, (3) chop-shop value, and (4) the free cash
flow value.
1. The book value of a firm's net worth is the depreciated value of the
company's assets less its outstanding liabilities. Book value alone is
not a significant measure of the worth of a company but should be
used as a starting point to be compared with other analyses.
2. Appraisal value, acquired from an independent appraisal firm, may be
useful in conjunction with other methods. Advantages include
a. The reduction of accounting goodwill by increasing the
recognized worth of specific assets.
b. A test of the reasonableness of results obtained through other
evaluation methods.
c. The discovery of strengths and weaknesses that otherwise
might not be recognized.
229
3. The "chop shop" approach to valuation attempts to identify multi-
industry companies that are undervalued and would be worth more if
separated into their parts. As such, this approach encompasses the
idea of attempting to buy assets below their replacement cost.
4. The free cash-flow approach to merger valuation requires that we
estimate the incremental net cash flows available to the bidding firm
as a result of the merger or acquisition. The present value of these
cash flows will then be determined, and this will be the maximum
amount that should be paid for the target firm. The initial outlay can
then be subtracted out to calculate the net present value from the
merger.
V. Divestitures
A. Divestitures, or "reverse mergers," have become an important factor in
restructuring corporations.
B. A successful divestiture allows the firm's assets to be used more efficiently,
and therefore, be assigned a higher value by the market forces.
C. The different types of divestitures may be summarized as follows:
1. Selloff. A selloff is the sale of a subsidiary, division, or product line
by one company to another.
2. Spinoff. A spinoff involves the separation of a subsidiary from its
parent, with no change in the equity ownership.
3. Liquidation. A liquidation in this context is not a decision to shut
down or abandon an asset. Rather, the assets are sold to another
company and the proceeds are distributed to the stockholders.
4. Going private. Going private results when a company, whose stock is
traded publicly, is purchased by a small group of investors and the
stock is no longer bought and sold on a public exchange.
5. Leveraged buyout. The leveraged buyout is a special case of going
private. The existing shareholders sell their shares to a small group of
investors. The purchasers of the stock use the firm's unused debt
capacity to borrow the funds to pay for the stock.
230
ANSWERS TO
END-OF-CHAPTER QUESTIONS
23-1. Clearly, for a merger to create wealth it would have to provide shareholders with
something they could not get for free by merely holding the individual shares of
the two firms. Restating the question: What benefits are there to shareholders
from mergers and acquisitions? Potential benefits would include the following:
a. If a merger were to result in a reduction of taxes that is not otherwise
possible, then wealth is created by the merger.
b. As a result of agency problems, stockholders and bondholders impose a
premium on funds supplied to the firm to compensate them for this
inefficiency in management. A merger, particularly when it results in a
holding company or conglomerate organizational form, may reduce the
significance of this problem, because top management is created to monitor
the management of the individual companies making up the conglomerate.
As a result, management of the individual companies can be effectively
monitored without any forced public announcement of proprietary
information, such as new product information that might aid competitors.
If investors recognize this reduction in the agency problem as being
material in scope, they may provide funds to the firm at a reduced cost, no
longer charging as large of an "agency problem premium."
Alternatively, it can be argued that the creation of a conglomerate might
result in increased agency costs. This might occur as shareholders in
conglomerates feel they have less control over the firm's mangers, as a
result of the additional layers of management between them and the
decision makers.
c. Free cash flow should be paid out to shareholders; otherwise it would be
invested in projects returning less than the required rate of return.
Unfortunately, managers may not wish to pass these funds to the
shareholders, because they may feel that their power would be reduced.
Moreover, if they return these surplus funds they may, at a later date, be
forced to go outside for financing if more profitable investment
opportunities are identified. This situation is a form of the agency problem,
but these actions may be more a result of the corporate management culture
than of any attempt by the managers to maintain their own position as
opposed to maximizing shareholder wealth. A merger can create wealth
by allowing the new management to pay this free cash flow out to the
shareholders, thus allowing them to earn a higher return on this excess than
would have been earned by the firm.
d. Wealth can be created in a merger through economies of scale. For
example, administrative expenses including accounting, computing, or
simply top-management costs, may fall as a percent of total sales as a result
of sharing these resources.
231
e. Some firms simply do not exhaust their debt capacity. If a firm with
unused debt potential is acquired, the new management can then increase
debt financing, and reap the tax benefits associated with the increased debt.
f. It may be possible to create wealth by combining cash-rich bidders and
cash-poor targets, with wealth being created as a result of the positive NPV
projects taken by the merged firm that the cash-poor firm would have
passed up.
g. If a firm with ineffective management can be acquired, it may be possible
to replace the current management with a more efficient management team,
and thereby create wealth.
h. The merger of two firms can result in an increase in the market or
monopoly power of the two firms. While this can result in increased
wealth, it may also be illegal.
i. Firm diversification, when the earnings from the two firms are less than
perfectly positively correlated, can reduce the chance of bankruptcy. Since
costs are associated with bankruptcy, reduction of the chance of bankruptcy
has a very real value to it.
23-2. The basic function of book value is to establish the costs as set forth by accounting
principles, not to determine value. These costs may bear little relationship to the
value of the organization or to its ability to produce earnings.
23-3. The advantages of an independent appraisal include:
(1) Accounting goodwill may be reduced by increasing the recognized worth of
specific assets.
(2) The reasonableness of the results obtained through other valuation methods
are tested.
(3) Strengths and weaknesses may be uncovered that otherwise might not be
recognized.
23-4. The "chop-shop" approach to valuation attempts to identify multi-industry
companies that are undervalued and would be worth more if separated into their
parts. As such, this approach encompasses the idea of attempting to buy assets
below their replacement cost.
23-5. The NPV, or free cash flow valuation model, is familiar to us, since it merely
involves finding the present value of cash flows, as we did in our studies in capital
budgeting. Using the cash-flow approach to merger valuation requires that we
estimate the incremental net cash flows available to the bidding firm as a result of
the merger or acquisition. The present value of these cash flows will then be
determined, and this will be the maximum amount that should be paid for the target
firm. The initial outlay can then be subtracted out to calculate the net present value
from the merger. While this is very similar to what was proposed when we
examined the capital budgeting problem, there are differences, particularly when
estimating the initial outlay.
232
23-6. Types of divestitures include:
(1) Selloff. A selloff is the sale of a subsidiary, division, or product line by one
company to another.
(2) Spinoff. A spinoff involves the separation of a subsidiary from its parent
with no change in the equity ownership.
(3) Liquidation. A liquidation in this context is not a decision to shut down or
abandon an asset. Rather, the assets are sold to another company, and the
proceeds are distributed to the stockholders.
(4) Going private. Going private results when a company whose stock is
traded publicly is purchased by a small group of investors, and the stock is
no longer bought and sold on a public exchange.
(5) Leveraged buyout. The leveraged buyout is a special case of going private.
The existing shareholders sell their shares to a small group of investors.
The purchasers of the stock use the firm's unused debt capacity to borrow
the funds to pay for the stock.
SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
Solutions to Problem Set A
23-1A. Aramus, Inc. - Chop shop valuation (In Thousands)
Business Capital-to- Segment Theoretical
Segment Sales Sales Values
Sunglasses distribution 1.0 3,500 $3,500
Reading glasses distribution 0.9 2,000 1,800
Technical products 1.2 6,500 7,800
Total Value $13,100
Business Capital-to- Segment Theoretical
Segment Assets Sales Values
Sunglasses distribution 0.8 1,000 $ 800
Reading glasses distribution 0.8 1,500 1,200
Technical products 1.0 8,500 8,500
Total Value $10,500
233
Business Capital-to- Segment Theoretical
Segment Operating Income Sales Values
Sunglasses distribution 8.0 350 $2,800
Reading glasses distribution 10.0 250 2,500
Technical products 7.0 1,200 8,400
Total Value $13,700
Average Theoretical Value $12,433
23-2A. Argo Corporation (numbers expressed in millions)
Beyond
Year 2004 2005 2006 2007 2007
Sales $200.00 $225.00 $240.00 $250.00 $275.00
Cost of goods sold 120.00 135.00 144.00 150.00 165.00
Admin. & selling costs 15.00 20.00 27.00 28.00 30.00
Depreciation 10 .00 15 .00 17 .00 20 .00 24 .00
Earnings before taxes $55.00 $55.00 $52.00 $52.00 $56.00
Taxes (34%) 18 .70 18 .70 17 .68 17 .68 19 .04
Earnings after taxes $36.30 $36.30 $34.32 $34.32 $36.96
Depreciation 10.00 15.00 17.00 20.00 24.00
Capital expenditures 12 .00 13 .00 15 .00 17 .00 20 .00
Free cash flows $34 .30 $38 .30 $36 .32 $37 .32 $40 .96
Weighted cost of capital: (.30) x 8% + (.70) x 18% = 15%
$29 .83 $28 .96 $23 .88 $21 .34 $156 .13
*

Total present value $260.14
Cost of acquisition 290 .00
($250 paid + $40 debt assumed)
Net present value -$29 .86
*
=
,
_

¸
¸
15 .
96 . 40 $
/(1+.15)
4
= $156.13
234
23-3A. Prime Corporation - Free cash flow valuation (In Millions)
Beyond
Year 2004 2005 2006 2007 2007
Sales $300.00 $335.00 $370.00 $400.00 $425.00
Cost of Goods 180.00 201.00 222.00 240.00 255.00
Sold
Admin.& selling 40.00 50.00 58.00 62.00 65.00
Depreciation 25 .00 30 .00 35 .00 38 .00 40 .00
Earnings before tax $55.00 $54.00 $55.00 $60.00 $65.00
Taxes (34%) 18 .70 18 .36 18 .70 20 .40 22 .10
Earnings after tax. $36.30 35.64 $36.30 $39.60 $42.90
Depreciation 25.00 30.00 35.00 38.00 40.00
Capital expenditures 30 .00 37 .00 45 .00 48 .00 50 .00
Free Cash Flows $31 .30 $28 .64 $26 .30 $29 .60 $32 .90
Weighted Cost of Capital . 4(10%) + .6(20%) = 16%
$26 .98 $21 .28 $16 .85 $16 .35 $113 .56
*

Total Present Value $195.02
Cost of Acquisition 180 .00
($150 paid + $30 debt assumed)
Net Present Value $15 .02
*
=
,
_

¸
¸
16 .
90 . 32 $
/(1+.16)
4
= $113.56
235
Solutions to Problem Set B
23-1B. Cornutt, Inc. - Chop-shop valuation (In Thousands)
Business Capital-to- Segment Theoretical
Segment Sales Sales Values
Consumer wholesale 0.75 $1,500 $1,125
Specialty services 1.10 800 880
Retirement centers 1.00 2,000 2,000
Total value $4,005
Business Capital-to- Segment Theoretical
Segment Assets Assets Values
Consumer wholesale 0.60 $750 $450
Specialty services 0.90 700 630
Retirement centers 0.60 3,000 1,800
Total value $2,880
Business Capital-to- Segment Theoretical
Segment Operating Income Income Values
Consumer wholesale 10.00 $100 $1,000
Specialty services 7.00 150 1,050
Retirement centers 6.00 600 3,600
Total value $5,650
Average theoretical value $4,178
23-2B Wrongway, Inc. - Chop-shop valuation (In Thousands)
Business Capital-to- Segment Theoretical
Segment Sales Sales Values
Sunglasses distribution 0.8 2,200 1,760
Reading glasses distribution 1.2 1,000 1,200
Technical products 1.2 3,500 4,200
Total value $7,160
Business Capital-to- Segment Theoretical
Segment Assets Assets Values
Sunglasses distribution 1.0 600 600
Reading glasses distribution 0.9 700 630
Technical products 1.1 5,000 5,500
Total value $6,730
Business Capital-to- Segment Theoretical
Segment Operating Income Income Values
Sunglasses distribution 8.0 200 1,600
Reading glasses distribution 10.0 150 1,500
Technical products 12.0 500 6,000
Total Value $9,100
236
Average Theoretical Value $7,663
237
23-3B. Brown Corporation. - Free cash flow valuation (In Millions)
Beyond
Year 2004 2005 2006 2007 2007
Sales $260.00 $265.00 $280.00 $290.00 $300.00
Cost of goods sold (50%) 130.00 132.50 140.00 145.00 150.00
Admin. & selling costs 25.00 25.00 25.00 30.00 30.00
Depreciation 15 .00 17 .00 18 .00 23 .00 30 .00
Earnings before taxes $90.00 $90.50 $97.00 $92.00 $90.00
Taxes (34%) 30 .60 30 .77 32 .98 31 .28 30 .60
Earnings after taxes $59 .40 $59 .73 $64 .02 $60 .72 $59 .40
Depreciation 15.00 17.00 18.00 23.00 30.00
Capital expenditures 22 .00 18 .00 18 .00 20 .00 22 .00
Free cash flows $52 .40 $58 .73 $64 .02 $63 .72 $67 .40
Weighted average cost of capital = .25 x 8% + .75 x 22% = 18.50%
$44 .22 $41 .82 $38 .47 $32 .32 $184 .76
*

Total present value $341.59
Cost of acquisition ($225 paid plus $75 debt assumed) 300 .00
Net present value $41 .59
*
=
,
_

¸
¸
185 .
40 . 67 $
/(1+.185)
4
= $184.76
238
23-4B. Little Corporation - Free cash flow valuation (In Millions)
Beyond
Year 2004 2005 2006 2007 2007
Sales $200.00 $220.00 $245.00 $275.00 $300..00
Cost of goods sold 140.00 154.00 171.50 192.50 210.00
Admin. & selling 30.00 35.00 38.00 40.00 45.00
Depreciation 18 .00 20 .00 22 .00 25 .00 30 .00
Earnings before tax $12.00 $11.00 $13.50 $17.50 $15.00
Taxes (34%) 4 .08 3 .74 4 .59 5 .95 5 .10
Earnings after tax $7.92 $7.26 $8.91 $11.55 $9.90
Depreciation 18.00 20.00 22.00 25.00 30.00
Capital expend. 20 .00 22 .00 25 .00 28 .00 30 .00
Free Cash Flows $5 .92 $5 .26 $5 .91 $8 .55 $9 .90
Weighted Cost of Capital:
.5 (15%) + .5 (25%) = 20%
$4 .93 $3 .65 $3 .42 $4 .12 $23 .87
**

Total Present Value $39.99
Cost of Acquisition 37 .00
($25 paid + $12 debt assumed)
Net Present Value $2 .99

CHAPTER 24
**
=
,
_

¸
¸
20 .
90 . 9 $
/(1+.20)
4
= $23.87
239
Term Loans and Leases

CHAPTER ORIENTATION
The first section of this chapter provides an overview of the major sources of term loans and
their characteristics. The second section of the chapter provides an overview of lease
financing, including a discussion of leasing arrangements, the accounting treatment of
financial leases, the lease versus purchase decision, and the potential benefits from leasing.
CHAPTER OUTLINE
I. Term loans
A. In general, term loans have maturities from one to 10 years and
are repaid in periodic installments over the life of the
loan. Term loans are usually secured by a chattel
mortgage on equipment or a mortgage on real property.
The principal suppliers of term credit include commercial
banks, insurance companies and, to a lesser extent,
pension funds.
B. The common attributes of term loans include the following:
1. The maturities of term loans are usually as follows:
a. Commercial banks: 1 to 5 years.
b. Insurance companies: 5 to 15 years.
c. Pension funds: 5 to 15 years.
2. The collateral backing term loans:
a. Shorter maturity loans are usually secured with a chattel
mortgage on machinery and equipment or securities such as
stocks and bonds.
b. Longer maturity loans are frequently secured by mortgages on
real estate.
240
3. In addition to collateral, the lender on a term loan agreement will
often require restrictive covenants that are designed to maintain the
borrower's financial condition on a par with that which existed at the
time the loan was made.
a. Working capital restrictions involve maintaining a minimum
current ratio that reflects the norm for the borrower's industry,
as well as the lender's desires.
b. Additional borrowing restrictions prevent the borrower from
increasing the amount of debt financing outstanding without
the lender's approval.
c. A third covenant that is very popular requires that the
borrower supply periodic financial statements to the lender.
d. Term loan agreements often include a key-man provision that
the borrower requires that the lender approve major personnel
changes and insure the lives of "key" personnel with the
lender named as the beneficiary.
4. Term loans are generally repaid in periodic installments in accordance
with repayment schedules established by the lender. Each installment
includes both an interest and a principal component.
5. Frequently a bank will have demand for loans that exceeds its lending
capacity. In order to satisfy the demand, the bank will share the loan
demand with other participating banks. The participating banks
receive a certificate of participation and a commitment from the lead
bank to pay a portion of the loan cash flows as they are received.
6. Eurodollar loans are intermediate term loans made by major
international banks to businesses based on foreign deposits
denominated in dollars. The rate of the loan is an amount greater than
the London Interbank Offered Rate. The Eurodollar loan market is
governed by a limited number of regulations.
II. Leasing
A. There are three major lease agreements: direct leasing, sale and leaseback,
and leveraged leasing.
1. In a direct lease the firm acquires the services of an asset it did not
previously own. Direct leasing is available through a number of
financial institutions, including manufacturers, banks, finance
companies, independent leasing companies, and special-purpose
leasing companies. Basically, direct leasing involves the purchase of
the asset by the lessor from a vendor and leasing the asset to the
lessee.
2. A sale and leaseback arrangement occurs when a firm sells land,
buildings, or equipment that it already owns to a financial institution
and simultaneously enters into an agreement to lease the property
241
back for a specified period under specific terms. The lessee firm
receives cash in the amount of the sales price of the asset sold and the
use of the asset over the term of the lease. In return, the firm must
make periodic rental payments throughout the term of the lease to the
lessor.
3. In a leveraged lease a third participant is added who finances the
acquisition of the asset to be leased for the lessor. From the lessee's
standpoint, this lease is no different from the two lease arrangements
discussed above. But with a leveraged lease, specific consideration is
given to the financing arrangement used by the lessor in acquiring the
asset to be leased.
B. The accounting profession through Financial Accounting Statement No. 13
requires the capitalization of any lease that meets one or more of the
following criteria:
1. The lease transfers ownership of the property to the lessee by the end
of the lease term.
2. The lease contains a bargain repurchase option.
3. The lease term is equal to 75 percent or more of the estimated
economic life of the leased property.
4. The present value of the minimum lease payments equals or exceeds
90% of the excess of the fair value of the property over any related
investment tax credit retained by the lessor.
C. The lease–versus-purchase decision requires a standard capital budgeting
type of analysis, as well as an analysis of two alternative "packages" of
financing. Two models are used to evaluate the lease versus purchase
decision.
1. The first model computes the net present value of the purchase option which
can be defined as follows:
NPV (P) =

·
+
n
t
t
t
1
K ) ( 1
A C F
- IO
where ACF
t
= the annual after-tax cash flow resulting from the
asset’s purchase in period t
K = the firm's cost of capital applicable to the project
being analyzed and the particular mix of financing
used to acquire the project
IO = the initial cash outlay required to purchase the asset
in period zero (now)
n = the productive life of the project
242
2. In the second model a net advantage to lease (NAL) over purchase
equation is used that indicates the more favorable (least expensive)
method of financing. The equation used to arrive at NAL is as
follows:
NAL =

·
+
n
t
t
b
t t t t
1
) r ( 1
T D - T I - T ) - ( 1 R - T ) - ( 1 O
-
n
s
n
) K (1
V
+
+ IO
where O
t
= any operating cash flows incurred in period t that are
incurred only when the asset is purchased. Most often
this consists of maintenance expenses and insurance that
would be paid by the lessor.
R
t
= the annual rental for period t.
T = the marginal tax rate on corporate income.
I
t
= the tax deductible interest expense foregone in period t if
the lease option is adopted. This level of interest expense
was set equal to that which would have been paid on a
loan equal to the full purchase price of the asset.
D
t
= depreciation expense in period t for the asset.
V
n
= the after-tax salvage value of the asset expected in year
n.
K
s
= the discount rate used to find the present value of V
n
.
This rate should reflect the risk inherent in the estimated
V
n
. For simplicity, the after-tax cost of capital is often
used as a proxy for this rate.
IO = the purchase price of the asset which is not paid by the
firm in the event the asset is leased.
r
b
= the after-tax rate of interest on borrowed funds. This rate
is used to discount the relatively certain after-tax cash
flow savings accruing through leasing the asset.
If NAL is positive, there would be a positive cost advantage to lease
financing. If NAL is negative, then purchasing the asset and financing
with a debt plus equity package would be the preferred alternative.
However, we would lease or purchase the asset in accordance with the
value of NAL in only two circumstances:
243
a. If NPV(P) is positive, then the asset should be acquired
through the preferred financing method as indicated by NAL.
b. If NPV(P) is negative, then the asset's services should be
acquired via the lease alternative only if NAL is positive and
greater in absolute value than NPV(P). That is, the asset
should be leased only if the cost advantage of leasing (NAL)
is great enough to offset the negative NPV(P). In effect, if a
positive NAL were to more than offset a negative NPV(P),
then the net present value through lease would be positive.
D. Over the years a number of potential benefits have been offered for lease
financing. Some of the more frequently cited advantages are enumerated and
commented upon here.
1. Flexibility and convenience. It is often argued that lease financing is
more convenient than other forms of financing because smaller
amounts of funds can be raised at lower cost. In addition, it is often
argued that lease payment schedules can be made to coincide with
cash flows generated by the asset. These may or may not be real
advantages. It depends on the actual circumstances faced by the lessee
firm.
2. Lack of restrictions. It has been argued that leases require fewer
restrictions on the lessee than do debt agreements.
3. Avoiding the risk of obsolescence. This argument is generally
conceded to be fallacious because the lessor includes his or her
estimated cost of obsolescence in the lease terms.
4. Conservation of working capital. Here it is argued that leasing
involves no down payment. However, the borrower could obtain the
same effect by borrowing the down payment.
5. 100-percent financing. The lease involves 100% financing but
purchasing the asset would surely involve some equity. As we noted
above, the down payment could be borrowed to produce 100%
financing via a loan. In addition, it is not clear that 100% lease
financing is desirable because it represents 100% non-owner
financing. Finally the lease agreement does not entitle the lessee to
the asset's salvage value. Thus, the lease provides 100% financing for
the "use value" of the asset but not its "salvage value."
6. Tax savings. The difference in tax shelters between leasing and other
forms of financing can only be evaluated by using a net advantage of
lease model as we discussed earlier.
7. Ease of obtaining credit. Lease financing may be more or less difficult
to obtain than other forms of financing. This advantage (or
disadvantage) can only be evaluated on a case-by-case basis.
244
ANSWERS TO
END-OF-CHAPTER QUESTIONS
24-1. Intermediate-term financing includes all those financing arrangements with final
maturities longer than one year and with a maximum of ten years. Short-term
financing is for a period of less than one year and long-term financing generally
involves a period of more than ten years.
24-2. The major types of restrictions usually found in the covenants of term loan
agreements include:
(1) Working capital requirement. This restriction involves maintaining a
minimum amount of working capital. Very often this restriction takes the
form of a minimum current ratio such as 2 to 1 or 3 1/2 to 1, or a minimum
level of net working capital such as $200,000.
(2) Additional borrowing. Generally, this type of restriction will require the
approval of the lender before any additional debt is issued. The restriction is
often extended to long-term lease agreements.
(3) Periodic financial statements. A standard covenant in most term-loan
agreements involves supplying the lender with periodic financial statements.
These usually include annual or quarterly-income statements and balance
sheets.
(4) Management. Term-loan agreements will sometimes include a provision
requiring prior approval by the lender of major personnel changes. In
addition, the borrower may be required to insure the lives of certain "key"
personnel with the lender named as beneficiary.
24-3. (1) In a direct leasing agreement the firm acquires the services of an asset it did
not previously own. The lease basically involves purchase of the asset by the
lessor from a vendor and leasing it to the lessee.
(2) Sale and leaseback arrangements arise when a firm sells land, buildings, or
equipment which it already owns to a financial institution and simultaneously
enters into an agreement to lease the property back for a specified period
under specific terms.
(3) A net-net lease requires that the lessee maintain the leased asset and return it
to the lessor at the end of the lease term with a value equal to a pre-
established amount.
(4) An operating lease constitutes a cancelable contractual commitment on the
part of the firm leasing the asset (the lessee) to make a series of payments to
the firm which actually owns the asset (the lessor) for use of the asset.
245
24-4. Prior to January, 1977, most financial leases were not included in the balance sheets
of lessee firms. They were instead reported in the footnotes to the balance sheet in
accordance with APB Opinions 5 and 31. In November, 1976, the accounting
profession reversed its long standing position with Statement of Financial Account
Standards No. 13 entitled "Accounting for Leases." Specifically, Statement 13
requires that any lease which meets one or more of the following criteria be included
in the body of the balance sheet of the lessee:
(1) The lease transfers ownership of the property to the lessee by the end of the
lease term.
(2) The lease contains a bargain repurchase option.
(3) The lease term is equal to 75 percent or more of the estimated economic life
of the leased property.
(4) The present value of the minimum lease payments equals or exceeds 90
percent of the excess of the fair value of the property over any relate