SOLUTIONS TO END-OF-CHAPTER PROBLEMS

2-1 Corporate yield = 9%; T = 35.5%

AT yield = 9%(1 - T)
= 9%(0.645) = 5.76%.

2-2 Corporate bond yields 8%. Municipal bond yields 6%.

Equivalent pretax yield Yield on muni

=
on taxable bond (1−T )
6%
8%=
(1−T )
0.08−0 .08 T=0 .06
−0 .08T =−0. 02
T =25 %.

2-3 NI = $6,000,000; EBIT = $13,000,000; T = 40%; Interest = ?

Need to set up an income statement and work from the bottom up.

EBIT $13,000,000
Interest 3,000,000 $6,000,000 $6,000,000
EBT $10,000,000 EBT = =
(1−T ) 0.6
Taxes (40%) 4,000,000
NI $6,000,000

Interest = EBIT – EBT = $13,000,000 – $10,000,000 = $3,000,000.

2-4 EBITDA = $8,000,000; NI = $2,400,000; Int = $2,000,000; T = 40%; DA = ?

EBITDA $8,000,000
DA 2,000,000 EBITDA – DA = EBIT; DA = EBITDA – EBIT
EBIT $6,000,000 EBIT = EBT + Int = $4,000,000 + $2,000,000
Int 2,000,000 (Given) $2,400,000 $2,400,000
EBT $4,000,000 =
Taxes (40%) 1,600,000 (1−T ) 0.6
NI $2,400,000 (Given)

2-5 NI = $3,100,000; DEP = $500,000; AMORT = 0; NCF = ?

NCF = NI + DEP and AMORT = $3,100,000 + $500,000 = $3,600,000.
2-6 NI = $70,000,000; R/EY/E = $900,000,000; R/EB/Y = $855,000,000; Dividends = ?

R/EB/Y + NI – Div = R/EY/E

$855,000,000 + $70,000,000 – Div = $900,000,000
$925,000,000 – Div = $900,000,000
$25,000,000 = Div.

2-7 Income $365,000

Less Interest deduction (50,000)
Plus: Dividends receiveda 4,500
Taxable income $319,500
a
For a corporation, 70% of dividends received are excluded from taxes; therefore, taxable
dividends are calculated as $15,000(1 - 0.70) = $4,500.

Tax = $22,250 + ($319,500 - $100,000)(0.39) = $22,250 + $85,605 = $107,855.

After-tax income:

Taxable income $319,500

Taxes (107,855)
Plus Non-taxable dividends receivedb 10,500
Net income $222,145
b
Non-taxable dividends are calculated as $15,000 x 0.7 = $10,500.

The company’s marginal tax rate is 39 percent. The company’s average tax rate is
$107,855/$319,500 = 33.76%.

2-8 a. Tax = $3,400,000 + ($10,500,000 - $10,000,000)(0.35) = $3,575,000.

b. Tax = $1,000,000(0.35) = $350,000.

c. Tax = ($1,000,000)0.30(0.35) = $105,000.

2-9 A-T yield on FLA bond = 5%.

A-T yield on AT&T bond = 7.5% - Taxes = 7.5% - 7.5%(0.35) = 4.875%.

Check: Invest $10,000 @ 7.5% = $750 interest.

Pay 35% tax, so A-T income = $750(1 - T) = $750(0.65) = $487.50.

A-T rate of return = $487.50/$10,000 = 4.875%.

A-T yield on AT&T preferred stock:

A-T yield = 6% - Taxes = 6% - 0.3(6%)(0.35) = 6% - 0.63% = 5.37%.

Therefore, invest in AT&T preferred stock. We could make this a harder problem by
asking for the tax rate that would cause the company to prefer the Florida bond or the
AT&T bond.

2-10 EBIT = $750,000; DEP = $200,000; 100% Equity; T = 40%

NI = ?; NCF = ?; OCF = ?

First, determine net income by setting up an income statement:

EBIT $750,000
Interest 0
EBT $750,000
Taxes (40%) 300,000
NI $450,000

NCF = NI + DEP = $450,000 + $200,000 = $650,000.

2-11 a. Income Statement
Sales revenues $12,000,000
Costs except
depreciation 9,000,000
Depreciation 1,500,000
EBT $ 1,500,000
Taxes (40%) 600,000
Net income $ 900,000
Add back depreciation 1,500,000
Net cash flow $ 2,400,000

b. If depreciation doubled, taxable income would fall to zero and taxes would be zero.
Thus, net income would decrease to zero, but net cash flow would rise to $3,000,000.
Menendez would save $600,000 in taxes, thus increasing its cash flow:

∆CF = T(∆Depreciation) = 0.4($1,500,000) = $600,000.

c. If depreciation were halved, taxable income would rise to $2,250,000 and taxes to
$900,000. Therefore, net income would rise to $1,350,000, but net cash flow would
fall to $2,100,000.

d. You should prefer to have higher depreciation charges and higher cash flows. Net
cash flows are the funds that are available to the owners to withdraw from the firm
and, therefore, cash flows should be more important to them than net income.
2-12 a.
EBIT $1,260
x (1-Tax rate) 60.0%
Net operating profit after taxes
(NOPAT) $756

b.
2013 2012
Cash $550 $500
+ Accounts receivable 2,750 2,500
+ Inventories 1,650 1,500
Operating current assets $4,950 $4,500

Accounts payable $1,100 $1,000

+ Accruals 550 500
Operating current liabilities $1,650 $1,500

Operating current assets $4,950 $4,500

- Operating current liabilities 1,650 1,500
Net operating working capital
(NOWC) $3,300 $3,000

c.
2011 2010
Net operating working capital
(NOWC) $3,300 $3,000
+ Net plant and equipment 3,850 3,500
Total net operating capital $7,150 $6,500

d.
2013
NOPAT $756
- Investment in total net operating
capital 650
Free cash flow $106

e.
2013
NOPAT $756
÷ Total net operating capital 7,150
Return on invested capital
(ROIC) 10.57%
 f.
Uses of FCF 2011
After-tax interest payment = $72
Reduction (increase) in debt = -$284
Payment of dividends = $220
Repurchase (Issue) stock = $88
Purchase (Sale) of short-term
investments = $10
Total uses of FCF = $106

2-13 Prior Years 2011 2012

Profit earned $150,000 $150,000
Carry-back credit 150,000 150,000
Adjusted profit $ 0 $ 0
Tax previously
paid (40%) 60,000 60,000
Tax refund: Taxes
previously paid $ 60,000 $ 60,000

Total check from U.S. Treasury = $60,000 + $60,000 = $120,000.

Future Years 2014 2015 2016 2017 2018

Estimated
profit $150,000 $150,000 $150,000 $150,000 $150,000
Carry-forward
credit 150,000 150,000 50,000 0 0
Adjusted
profit $ 0 $ 0 $100,000 $150,000 $150,000
Tax (at 40%) 0 $ 0 $ 40,000 $ 60,000 $ 60,000
3-1 DSO = 20 days; ADS = $20,000; AR = ?

AR
DSO =
S
365
AR
20 =
$20, 000
AR = $ 400,000 .

3-2 TA = $200 million, notes payable =$5 million, and LT debt = $25 million.

Total debt $5 + $25

Debt ratio = Debt-to-assets ratio = Total assets = $200 = 15%.

3-3 TA = $10,000,000,000; CL = $1,000,000,000; LT debt = $3,000,000,000; CE =

$6,000,000,000; Shares outstanding = 800,000,000; P0 = $75; M/B = ?
$6, 000 ,000 ,000
Book value per share = 800,000,000 = $7.50.
$75.00
M/B = $7.50 = 10.

3-4 EPS = $1.50; CFPS = $3.00; P/CF = 8.0; P/E = ?

P/CF = 8.0
P/$3.00= 8.0
P = $24.00.

P/E = $24.00/$1.50 = 16.0.

3-5 PM = 3%; EM = 2.0; Sales = $100,000,000; Assets = $50,000,000; ROE = ?

ROE = PM  TATO  EM
= NI/S  S/TA  A/E
= 3%  $100,000,00/$50,000,000  2
= 12%.

3-6 ROA = 12%; PM = 5%; ROE = 20%; S/TA = ?; A/E = ?

ROA = NI/A; PM = NI/S; ROE = NI/E

ROA = PM  S/TA
NI/A = NI/S  S/TA
 12% = 5%  S/TA
S/TA = 2.40.

ROE = PM  S/TA  TA/E

NI/E = NI/S  S/TA  TA/E
20% = 5% 2.4 TA/E
20% = 12%  TA/E
TA/E = 1.67.

CA CA - I
3-7 CA = $3,000,000; CL = 1.5; CL = 1.0;

CL = ?; I = ?

CA
= 1.5
CL
$3,000,000
= 1 .5
CL
1.5CL = $3,000,000
CL = $2,000,000.
CA - Inv
= 1.0
CL

$3,000,000 - Inv
= 1. 0
$2,000,000
$3,000,000 - Inv = $2,000,000
I nv = $1,000,000.
3-8 We are given ROA = 4%, ROE = 7%, and TAT = Sales/Total assets = 1.2.

From Du Pont equation:ROA = Profit margin  Total assets turnover

4% = Profit margin (1.2)
Profit margin = 4%/1.2 = 3.33%.

We can also calculate the company’s liabilities-to-assets (L/TA) ratio in a similar

manner, given the facts of the problem. We are given ROA = NI/TA and ROE= NI/E.
We begin by finding the percentage of assets financed by equity, E/TA:

E NI E 1
TA
= ( )( )
TA NI
= ROA
ROE ( )
= ROA/ROE
E
TA = ROA/ROE = 4%/7% = 57.14%.

By definition, L + E = Total liabilities & Equity = TA. Therefore, the percentage of the
firm financed by liabilities is equal to 1 minus the percentage financed by equity:

L E
TA = 1 − TA = 1 −57.14% = 42.86%.

To find the debt-to-total asset (i.e., the debt ratio), begin with the total liabilities-to-assets
ratio of 42.86%. We are given that half of the liabilities are debt, so the debt ratio is:

Debt ratio = Debt-to-total assets = (0.5)(L/TA) = (0.5)(42.86%) = 21.43%.

 $1,312,500
3-9 Present current ratio = $525,000 = 2.5.

$1,312,500 + ΔNP
Minimum current ratio = $525,000 + ΔNP = 2.0.

$1,312,500 + ∆NP = $1,050,000 + 2∆NP

∆NP = $262,500.

Short-term debt can increase by a maximum of $262,500 without violating a 2 to 1

current ratio, assuming that the entire increase in notes payable is used to increase current
assets. Since we assumed that the additional funds would be used to increase inventory,
the inventory account will increase to $637,500, and current assets will total $1,575,000.

Quick ratio = ($1,575,000 - $637,500)/$787,500 = $937,500/$787,500 = 1.19.

3-10 TIE = EBIT/INT, so find EBIT and INT.

Interest = $600,000  0.08 = $48,000.
Net income = $3,000,000  0.03 = $90,000.
Pre-tax income = $90,000/(1 - T) = $90,000/0.6 = $150,000.

EBIT = $150,000 + $48,000 = $198,000.

TIE = $198,000/$48,000 = 4.125.

The loan will not be renewed and they will go bankrupt!

3-11 1. Sales = (1.5)(Total assets) = (1.5)($400,000) = $600,000.

2. Cost of goods sold = (Sales)(1 - 0.25) = ($600,000)(0.75)

= $450,000.

3. Accounts receivable = (Sales/365)(DSO) = ($600,000/365)(36.5)

= $60,000.
4. Inventory = COGS/3.75 = $450,000/3.75 = $120,000.

5. TL = (0.40)(Total assets) = (0.40)($400,000) = $160,000.

6. Accounts payable = TL – Long-term debt = $160,000 - $50,000

= $110,000

7. Common stock =- TL - Retained earnings

= $400,000 - $160,000 - $100,000 = $140,000.

8. Cash + Accounts receivable = (0.80)(Accounts payable)

Cash + $60,000 = (0.80)($110,000)
Cash = $88,000 - $60,000 = $28,000.

9. Fixed assets = Total assets - (Cash + Accts rec. + Inventories)

= $400,000 - ($28,000 + $60,000 + $120,000) = $192,000.

$810,000
3-12 1. = 3.0 Current liabilities = 3.0

Current liabilities = $810,000/3 = $270,000.

$810,000 - Inventories
2. = 1.4 $270,000 = 1.4

Inventories = $810,000 – (1.4)($270,000) = $432,000.

Current = Cash + ¿ Marketable + ¿ Accounts + Inventories¿

3. assets Securities receivable

$810,000 = $120,000 + Accounts receivable + $432,000

Accounts receivable = $810,000 − $120,000 − $432,000 = $258,000.

Accounts receivable $258,000

5. DSO = Sales/365 36.5= Sales/365
 Sales = ($258,000 365)/36.5 = $2,580,000.

3-13 a. (Dollar amounts in thousands.)

Industry
Firm Average

$2,925,000
= $1,453,500 = 2.01 2.0

Accounts receivable $1,575,000

Sales/36 5 = $20,548 = 77 days 35 days

COGS $6,375,000
Inventory = $1,125,000 = 5.67 6.7

Sales $7,500,000
Fixed assets = $1,350,000 = 5.56 12.1

Sales $ 7,500,000
Total assets = $ 4,275 ,000 = 1.75 3.0

Net income $113 ,022

Sales = $7,500,000 = 1.5% 1.2%

Net income $113,022

Total assets = $ 4,275 ,000 = 2.6% 3.6%

Net income $113,022

Common equity = $1,752,750 = 6.4% 9.0%

$ 1,395,384
= $ 4,275 ,000 = 33% 30%

$2,522,250
= $ 4,275 ,000 = 59% 60.0%
 b. For the firm,

$ 4,275 ,000
ROE = PM  T.A. turnover  EM = 1.51%  1.75 $1,752,750 = 6.45%.
For the industry, ROE = 1.2%  3  2.5 = 9%.

Note: To find the industry ratio of assets to common equity, recognize that 1 minus
theLiabilities-to-assets ratio = common equity/total assets. So, common equity/total
assets = 1 – 60% = 40%, and 1/0.40 = 2.5 = total assets/common equity.

c. The firm’s days sales outstanding is more than twice as long as the industry average,
indicating that the firm should tighten credit or enforce a more stringent collection
policy. The total assets turnover ratio is well below the industry average so sales
should be increased, assets decreased, or both. While the company’s profit margin is
higher than the industry average, its other profitability ratios are low compared to the
industry--net income should be higher given the amount of equity and assets.
However, the company seems to be in an average liquidity position and financial
leverage is similar to others in the industry.

3-14 Here are the firm’s base case ratios and other data as compared to the industry:

Firm Industry Comment

Quick $511,000/$602,000 = 0.8 1.0 Weak
Current $1,405,000/$602,000 = 2.3 2.7 Weak
Inventory turnover $3,739,000/$894,000 = 4.2 7.0 Poor
Days sales outstanding $439,000/$11,753 = 37 days 32 days Poor
Fixed assets turnover $4,290,000/$431,000 = 10.0 13.0 Poor
Total assets turnover $4,290,000/$1,836,000 = 2.3 2.6 Poor
Return on assets $108,408/$1,836,000 = 5.9% 9.1% Bad
Return on equity $108,408/$829,710 = 13.1% 18.2% Bad
Profit margin on sales $108,408/$4,290,000 = 2.5% 3.5% Bad
Debt ratio $504,290/$1,836,000 = 27.5% 21.0% High
Liabilities-to-assets $1,006,290/$1,836,000 = 54.8% 50.0% High
EPS $4.71 n.a. --
Stock Price $23.57 n.a. --
P/E ratio $23.57/$4.71 = 5.0 6.0 Poor
P/CF ratio $23.57/$11.63 = 2.0 3.5 Poor
M/B ratio $23.57/$36.07 = 0.65 n.a. --

The firm appears to be badly managed--all of its ratios are worse than the industry
averages, and the result is low earnings, a low P/E, P/CF ratio, a low stock price, and a
low M/B ratio. The company needs to do something to improve.