Chapter 1

1. Question: Describe business analysis and identify its objectives.

Business analysis is the evaluation of a company’s prospects and risks for

business decisions. Applicable business decisions include, among others,
equity and debt valuation, credit risk assessment, earnings prediction, audit
testing, compensation negotiations, and countless other decisions. The
objective of business analysis is to aid with decision making by helping to
structure the decision task, including an evaluation of a company’s business
environment, its strategies, and its financial position and performance. As a
result, the decision-maker will make a more informed decision.

2. Question: Explain the claim: Financial statement analysis is an integral part

of business analysis

Business analysis is the evaluation of a company’s prospects and risks for

business decisions. Financial statements are the most comprehensive source
of information about a company. As a result, financial statement analysis is
an integral part of business analysis.

3. Question: Describe the different types of business analysis. Identify the

category of users of financial statements that applies to each different type of
business analysis.

Some major types of business analysis include credit analysis, equity

analysis, management and control, analysis of mergers and acquisitions, and
others. Credit analysis is the evaluation of the ability of a company to honor
its financial obligations (i.e., pay all of its debts). Current and potential
creditors and debt investors perform credit analysis. Equity analysis supports
equity investment decisions. Equity investment decisions involve buying,
holding, or selling the stock of a company. Current and potential investors
perform equity analysis.

Managers perform business analysis to optimize their managerial activities.

From business analysis, managers are better prepared to recognize
challenges and opportunities and respond appropriately.

Business analysis is also a part of a company’s restructuring decisions.

Before a merger, acquisition, or divestiture is completed, managers and
directors perform business analysis to decide whether the contemplated
action will increase the combined value of the firm. Business analysis
 supports financial decisions by financial managers. Business analysis helps
assess the impact of financing decisions for both future profitability and risk.

External auditors perform business analysis to support their assurance

function. Directors of a company use business analysis to support their
activities as overseer of the operations of the company. Regulators use
business analysis to support the performance of regulatory activities. Labor
union representatives use business analysis to support collective bargaining
activities. Lawyers use business analysis to provide evidence regarding
litigation matters.

4. Question: What are the main differences between credit analysis and equity
analysis? How do these impact the financial statement information that is
important for each type of analysis?

Credit analysis supports the lending decision. As such, credit analysis

involves determining whether a company will be able to meet financial
obligations over a given time horizon. Equity analysis supports the decision
to buy, hold, or sell a stock. As such, equity analysis involves the
identification of the optimal portfolio of stocks for wealth maximization.

5. None
6. None

7. Question: Describe the importance of accounting analysis for financial

analysis.

Accounting analysis is crucial to effective financial analysis. The limitations

of financial analysis in the absence of accounting analysis include:
 Lack of uniformity in accounting principles applied by different
companies can impede the reliability of financial analysis. The seeming
comparability of accounting data is sometimes illusory.
 Lack of information in the aggregate financial data to inform the analyst
on how the accounting of the company was applied. The analyst needs to
analyze the explanatory notes for this information.
 Increased frequency of “anomalies” in financial statements such as the
failure to change previous years' data for stock splits, missing data, etc.
 Retroactive changes cannot be made accurately because companies only
change final figures.
 Certain comparative analyses (leases and pensions) cannot be done since
all companies do not provide full information in the absence of analytical
accounting adjustments.
8. Question: Describe financial statement analysis and identify its objectives.
The financial statements of a company are one of the richest sources of
information about a company. Financial statement analysis is a collection of
analytical processes that are an important part of overall business analysis.
These processes are applied to the financial statement information to produce
useful information for decision making. The objective of financial statement
analysis is to use the information provided in the statements to produce
quantified information to support the ultimate equity, credit, or other
decision of interest to the analyst.

9. Question: Identify at least five different internal and external users of

financial statements.

Internal users: Owners, managers, employees, directors, internal auditors;

External users: Current and potential equity investors, current and potential
debt investors, current and potential creditors, current and potential
suppliers, current and potential customers, labor unions members and
representatives, regulators, and government agencies.

10.Question: Identify and discuss the four major activities of a business

enterprise.

A business pursues four major activities in a desire to provide a saleable

product and/or service and to yield a satisfactory return on investment. These
activities are:

Planning activities. A company implements specific goals and objectives. A

company's goals and objectives are captured in its business plans (or
strategies)—that describe the company's purpose, strategy, and tactics. The
business plan assists managers in focusing their efforts and identifying
expected opportunities and obstacles.

Financing Activities. A company requires financing to carry out its business

plan. Financing activities are the means companies use to pay for these
ventures. A company must take care in acquiring and managing its financial
resources because of both their magnitude and their potential to determine
success or failure. There are two main sources of business financing: equity
investors (referred to as owner financing) and creditors (referred to as non-
owner financing).

Investing Activities. Investing activities are the means a company uses to

acquire and maintain investments for purchasing, developing, and selling
products and services. Financing provides the funds necessary for acquisition
 of investments needed to carry out business plans. Investments include land,
buildings, equipment, legal rights (patents, licenses, and copyrights),
inventories, human capital (managers and employees), accounting systems,
and all components necessary for the company to operate.

Operating Activities. Operating activities represent the carrying out of the

business plan, given necessary financing and investing. These activities
involve several basic functions such as research, purchasing, production,
marketing, and labor. Operating activities are a company's primary source of
income. Income measures a company's success in buying from input markets
and selling in output markets. How well a company does in devising
business plans and strategies, and with decisions on elements comprising the
mix of operating activities, determines its success or failure.

11.Question: Explain how financial statements reflect the business activities of

a company.
Business activities—planning, financing, investing, and operating—can be
synthesized into a cohesive picture of how businesses function in a market
economy. Step one is the company's formulation of plans and strategies.
Next, a company obtains necessary financing from equity investors and
creditors. Financing is used to acquire investments in resources to produce
goods or services. The company uses these investments to undertake
operating activities.

At the end of a period of time—typically quarterly or annually—financial

statements are prepared and reported. These statements list the amounts
associated with financing and investing activities, and summarize operating
activities for the most recent period(s). This is the role of financial
statements—the object of analysis. The financial statements listing of
financing and investing activities is at a point in time, whereas the reporting
of operating activities cover a period of time.

12.Question: Identify and discuss the four primary financial statements of a

business.
The four primary financial statements are the balance sheet, the income
statement, the statement of shareholders’ (owner’s) equity, and the statement
of cash flows.

Balance Sheet. The accounting equation is the basis of the balance sheet:
Assets = Liabilities + Equity.
The left-hand side of this equation relates to the economic resources
controlled by the firm, called assets. These resources are valuable in the
sense that they represent potential sources of future revenues. The company
uses these resources to carry out its operating activities. In order to engage in
its operating activities, the company must obtain funds to fund its investing
activities. The right-hand side of the accounting equation details the sources
of these funds. Liabilities represent funds obtained from creditors. These
amounts represent obligations or, alternatively, the claims of creditors on
assets. Equity, also referred to as shareholders' equity, encompasses two
different financing sources: (1) funds invested or contributed by owners,
called "contributed capital", and (2) accumulated earnings since inception
and in excess of distributions to owners (dividends), called "retained
earnings". From the owners' viewpoint, these amounts represent their claim
on assets. It often is helpful for students to rewrite the accounting equation in
terms of the underlying business activities:
Investing Activities = Financing Activities.
Recognizing the two basic sources of financing, this can be rewritten as:
Investments = Creditor Financing + Owner Financing.

Income Statement. The income statement is designed to measure a

company's financial performance between balance sheet dates—hence, it
refers to a period of time. An income statement lists revenues, expenses,
gains, and losses of a company over a period. The "bottom line" of an
income statement, net income, measures the increase (or decrease) in the net
assets of a company (i.e., assets less liabilities), before consideration of any
distributions to owners. Most contemporary accounting systems, the U.S.
included, determine net income using the accrual basis of accounting. Under
this method, revenues are recognized when earned, independent of the
receipt of cash. Expenses, in turn, are recognized when incurred (or matched
with its related revenue), independent of the payment of cash.

Statement of Cash Flows. Under the accrual basis of accounting, net income
equals net cash flow only over the life of the firm. For periodic reporting
purposes, accrual performance numbers nearly always differ from cash flow
numbers. This creates a demand for periodic reporting on both income and
cash flows. The statement of cash flows details the cash inflows and
outflows related to a company's operating, investing, and financing activities
over a period of time.

Statement of Shareholders' Equity. The statement of shareholders' equity

reports changes in the component accounts comprising equity. The statement
is useful in identifying the reasons for changes in owners' claims on the
assets of the company. In addition, accepted practice excludes certain gains
and losses from net income which, instead, are directly reported in the
statement of shareholders' equity.
13.Question: Explain why financial statements are important to the decision-
making process in financial analysis. Also, identify and discuss some of their
limitations for analysis purposes.
Financial statements are one of the most reliable of all publicly available
data for financial analysis. Also, financial statements are objective in
portraying economic transactions and events, they are concrete, and they
quantify important business activities. Moreover, since financial statements
express transactions and events in a common monetary unit, they enable
users to readily work with the data, to relate them to other data, and to deal
with them in different arithmetic ways. These attributes contribute to the
usefulness of financial statements, both historical and projected, in business
decision-making.

On the other hand, one must recognize that accounting is a social science
subject to human decision making. Moreover, it is a continually evolving
discipline subject to revisions and improvements, based on experience and
emerging business transactions. These limitations sometimes frustrate certain
users of financial statements such that they look for substitute data.
However, there is no equivalent substitute. Double-entry accounting is the
only reliable system for the systematic recording, classification, and
summarization of most business transactions and events. Improvement lies in
the refinement of this time-tested system rather than in substitution.
Accordingly, any serious analyst of a company’s financial position and
results of operations, learns the accounting framework and its terminology,
conventions, as well as its imperfections in financial analysis.

14.Question: Identify at least seven additional sources of financial reporting

information (beyond financial statements) that are useful for analysis.
Financial statements are not the sole output of the financial reporting system.
Additional financial information is communicated by companies through the
following sources:

Management's Discussion and Analysis (MD&A). Companies with publicly

traded debt and equity securities are required by the SEC to provide a report
of their financial condition and results of operations in a MD&A section of
its financial reports.

Management Report. The management report sets out the responsibilities of

management in preparing the company's financial statements.

Audit Report. The external auditor is an independent certified public

accountant hired by management to assess whether the company's financial
statements are prepared in conformity with generally accepted accounting
 principles. Auditors provide an important check on financial statements prior
to their release to the public.

Explanatory Notes. Notes are an integral part of financial statements and are
intended to communicate additional information regarding items included in,
and excluded from, the statements.

Supplementary Information. Certain supplemental schedules are required by

accounting regulatory agencies. These schedules can appear in notes to
financial statements or, in the case of companies with publicly held
securities, in exhibits to regulatory filings such as the Form 10-K that is filed
with the Securities and Exchange Commission.

Social Responsibility Reports. Companies increasingly recognize their need

for social responsibility. While reports of socially responsible activities are
increasing, there is no standard format or accepted standard.
Proxy Statements. A proxy statement is a document containing information
necessary to assist shareholders in voting on matters for which the proxy is
solicited.

15.Question: Identify and discuss at least two areas of financial analysis

Financial analysis includes analysis of the profitability of a company, the
risk of the company, and the sources and uses of funds for the company.
Profitability analysis is the evaluation of a company’s return on investment.
It focuses on a company’s sources and levels of profits, and involves
identifying and measuring the impact of various drivers of profitability.
Profitability analysis includes evaluation of two sources of profitability:
margins and turnover. Risk analysis is the evaluation of a company’s
riskiness and its ability to meet its commitments. Risk analysis involves
assessing the solvency and liquidity of a company along with its earnings
variability. An analysis of sources and uses of funds is the evaluation of
how a company is obtaining and deploying funds. This analysis provides
insights into a company’s future financing implications.

16.None
17.None
18.None
19.None
20.None
21.None
22.None
23.None
24.Question: What is a necessary condition for usefulness of a ratio of financial
numbers? Explain.
A ratio expresses a mathematical relation between two quantities. To be
meaningful (useful in analysis), a ratio of financial numbers must capture an
important economic relation. Certain items in financial statements have no
logical relation to each other and, therefore, would not be amenable to ratio
analysis.

Also, some type of benchmark or norm must exist for interpretation of the
ratio. One can draw minimal inference from being told that the return on
assets for a certain firm is .02. However, if the analyst is told that the
company’s return on assets is .02 and the industry average is .08, the ratio
becomes more useful for interpretation purposes.

25.Question: Identify and describe limitations of ratio analysis.

Since not all relations have meaning and not all ratios are useful for all
analytical purposes, the analyst must be careful in selecting ratios that are useful
for the particular task at hand. Unfortunately, ratios are too often misunderstood
and their significance overrated. Ratios can provide an analyst with clues and
symptoms of underlying conditions. Ratios also can highlight areas that require
further investigation and inquiry. Still, ratios, like all other analysis tools,
cannot predict the future. Moreover, the usefulness of insights obtained from
ratios depends on their skillful interpretation by the analyst. Of these several
limitations on ratio analysis, two are especially problematic:

Changing Price Levels. Different items on financial statement are valued at

different times, with the result that ratios can change over time even though
underlying factors do not. For example, a plant constructed in 1980 and
running at full capacity ever since might be blindly compared to, say, year
2002 dollar sales in computing a sale to gross plant ratio. Moreover, once we
begin multiplying ratios, it becomes more difficult (if not impossible) to
view everything in comparable real dollar terms.

Diverse Underlying Businesses. For most diversified companies, even one

reporting limited diversification of sales and earnings, the ratios calculated
from financial statements reflect composites or approximations of operations
and financial condition. This means they can obscure what may be
significant differences by product or service line. For example, a utilization
ratio may conceal markedly different levels of facility utilization for
different products. Yet, the overall utilization ratio might show a balanced
picture with no serious problems.
26.Question: Ratio analysis is an important tool in financial analysis. Identify at
least four ratios using:
a. Balance sheet data exclusively.
b. Income statement data exclusively.
c. Both balance sheet and income statement data.

a. Current ratio; Acid-test (quick) ratio; Cash ratio; Total debt ratio; Total
debt to equity ratio; Long-term debt to equity; Financial leverage ratio;
Book value per share

b. Times interest earned; Gross margin ratio; Operating profit margin ratio;
Pretax profit margin ratio; Net profit margin ratio; Effective tax rate

c. Inventory turnover; Days' sales in receivables; Return on total assets;

Return on equity; Cash turnover; Accounts receivable turnover; Sales to
inventory; Working capital turnover; Fixed asset turnover; Total assets
turnover; Equity growth rate

Exercise 1-1—continued

To avoid the potential for misleading inferences from these factors, we must
carefully examine footnotes, explanations, and qualifications that are disclosed as
part of financial reporting. Our comparative analysis must be adjusted for such
possibilities. Also, changing price levels for the periods of analysis can distort
comparative financial statements. For example, even items on a comparative balance
sheet or income statement that pertain to a single year are not all expressed in
dollars having the same purchasing power. Namely, in an era of rising prices, a
given year's depreciation represents older dollars having greater purchasing power
compared with most other income statement items. Further, inventory methods
other than LIFO can add to the inflationary distortion of the income statement.
Similarly, balance sheet items for a given year are expressed in dollars of varying
purchasing power.

Beyond these vertical distortions that exist within individual years covered by
comparative financial statements, are horizontal distortions in the trends and
relations of corresponding items across years. For example, an upward trend in sales
may actually reflect a constant level of, or even decline in, actual sales volume
because of increases in prices. Because of the potential for misleading inferences
from comparative analysis during periods of changing price levels, its usefulness as
an analytical and interpretative tool is severely restricted. This is because price level
changes can limit the comparability of the data in financial statements across time.
Of course, analysis of price-level adjusted financial statements can restore the
comparability of these statements across time and, thereby, enhance their usefulness
as tools of analysis and interpretation.
Exercise 1-2 (25 minutes)

2006 2005
Sales................................................ 100.0% 100.0%
Cost of goods sold.......................... 66.0 52.4
Gross profit.................................... 34.0% 47.6%
Operating expenses........................ 21.0 19.4
Net income...................................... 13.0% 28.2%

Analysis and Interpretation: This situation appears to be unfavorable. Both cost of

goods sold and operating expenses are taking a larger percent of each sales dollar in
year 2006 compared to the prior year. Also, even though sales volume increased, net
income both decreased in absolute terms and declined to only 13.0% of sales as
compared to 28.2% in the year before.
Exercise 1-3 (25 minutes)

a. Current ratio:

2006: $30,800 + $88,500 + $111,500 + $9,700

$128,900
= 1.9 to 1

2005: $35,625 + $62,500 + $82,500 + $9,375

$75,250
= 2.5 to 1

2004: $36,800 + $49,200 + $53,000 + $4,000

$49,250
= 2.9 to 1

b. Acid-test ratio:

2006: $30,800 + $88,500 = 0.9 to 1

$128,900

2005: $35,625 + $62,500 = 1.3 to 1

$75,250

2004: $36,800 + $49,200 = 1.7 to 1

$49,250

Analysis and Interpretation: Mixon's short-term liquidity position has weakened over
this two-year period. Both the current and acid-test ratios show declining trends.
Although we do not have information about the nature of the company's business, the
acid-test ratio shift from ‘1.7 to 1’ down to ‘0.9 to 1’ and the current ratio shift from
‘2.9 to 1’ down to ‘1.9 to 1’ indicate a potential liquidity problem. Still, we must
recognize that industry standards may show that the 2004 ratios were too high (instead
of 2006 ratios as too low).
Exercise 1-4 (20 minutes)

Mixon Company
Common-Size Comparative Balance Sheet
December 31, 2004-2006
2006 2005* 2004*
Cash................................................................................ 5.9% 8.0% 9.9%
Accounts receivable, net............................................... 17.1 14.0 13.2
Merchandise inventory................................................. 21.5 18.5 14.2
Prepaid expenses........................................................... 1.9 2.1 1.1
Plant assets, net ............................................................ 53.6 57.3 61.6
Total assets ................................................................... 100.0% 100.0% 100.0%

Accounts payable.......................................................... 24.9% 16.9% 13.2%

Long-term notes payable secured by
mortgages on plant assets ......................................... 18.8 23.0 22.1
Common stock, $10 par value...................................... 31.4 36.5 43.6
Retained earnings ........................................................ 24.9 23.5 21.0
Total liabilities and equity............................................ 100.0% 100.0% 100.0%
*
Column does not equal 100.0 due to rounding.
Exercise 1-5 (25 minutes)

a. Days' sales in receivables:

2006: $88,500 x 360 = 47 days

$672,500

2005: $62,500 x 360 = 42 days

$530,000

b. Accounts receivable turnover:

2006: $672,500 = 8.9 times

($88,500 + $62,500)/2

2005: $530,000 = 9.5 times

($62,500 + $49,200)/2

c. Inventory turnover:

2006: $410,225 = 4.2 times

($111,500 + $82,500)/2

2005: $344,500 = 5.1 times

($82,500 + $53,000)/2

d. Days’ sales in inventory:

2006: $111,500 x 360 = 98 days

$410,225

2005: $82,500 x 360 = 86 days

$344,500

Analysis and Interpretation: The number of days' sales uncollected has increased and
the accounts receivable turnover has declined. Also, the merchandise turnover has
decreased and days’ sales in inventory has increased. While none of these changes in
ratios that occurred from 2005 to 2006 appear dramatic, it seems that Mixon is
becoming less efficient in managing its inventory and in collecting its receivables.
Exercise 1-6 (25 minutes)

a. Total debt ratio (solution also includes the equity ratio):

2006 2005
Total liabilities (and debt ratio):
$128,900 + $97,500......................... $226,400 43.7%
$75,250 + $102,500......................... $177,750 39.9%
Total equity (and equity ratio):
$162,500 + $129,100....................... 291,600 56.3
$162,500 + $104,750....................... _______ 267,250 60.1
Total liabilities and equity................. $518,000 100.0% $445,000 100.0%

b. Times interest earned:

2006: ($34,100 + $8,525 + $11,100)/$11,100 = 4.8 times

2005: ($31,375 + $7,845 + $12,300)/$12,300 = 4.2 times

Analysis and Interpretation: Mixon added debt to its capital structure during 2006,
with the result that the debt ratio increased from 39.9% to 43.7%. However, the book
value of pledged assets is well above secured liabilities (2.8 to 1 in 2006 and 2.5 to 1 in
2005), and the increased profitability of the company allowed it to increase the times
interest earned from 4.2 to 4.8 times. Apparently, the company is able to handle the
increased debt. However, we should note that the debt increase is entirely in current
liabilities, which places a greater stress on short-term liquidity.
Exercise 1-7 (30 minutes)

a. Net profit margin:

2006: $34,100/$672,500 = 5.1%

2005: $31,375/$530,000 = 5.9%

b. Total asset turnover:

2006: $672,500 = 1.4 times

($518,000 + $445,000)/2

2005: $530,000 = 1.3 times

($445,000 + $372,500)/2

c. Return on total assets:

$34,100
2006: =
($518,000 + $445,000)/2
7.1%

$31,375
2005: = 7.7%
($445,000 + $372,500)/2

Analysis and Interpretation: Mixon's operating efficiency appears to be declining

because the return on total assets decreased from 7.7% to 7.1%. While the total asset
turnover favorably increased slightly from 2005 to 2006, the profit margin unfavorably
decreased from 5.9% to 5.1%. The decline in profit margin indicates that Mixon's
ability to generate net income from sales has declined.
Exercise 1-8 (20 minutes)

a. Return on common stockholders' equity:

2006: $34,100 = 12.2%

($291,600 + $267,250)/2

2005: $31,375 = 12.4%

($267,250 + $240,750)/2

b. Price earnings ratio, December 31:

2006: $15/$2.10 = 7.1

2005: $14/$1.93 = 7.3

c. Dividend yield:

2006: $.60/$15 = 4.0%

2005: $.30/$14 = 2.1%

Exercise 1-9 (25 minutes)

Answer: Net income decreased.

Supporting calculations: When the sums of each year's common-size cost of goods sold
and expenses are subtracted from the common-size sales percents, net income percents
are as follows:

2004: 100.0 - 58.1 - 14.1 = 27.8% of sales

2005: 100.0 - 60.9 - 13.8 = 25.3% of sales
2006: 100.0 - 62.4 - 14.3 = 23.3% of sales

Also notice that if 2003 sales are assumed to be $100, then sales for 2004 are $103.20 and
the sales for 2005 are $104.40. If the income percents for the years are applied to these
amounts, the net incomes are:

2004: $100.00 x 27.8% = $27.80

2005: $103.20 x 25.3% = $26.12
2006: $104.40 x 23.3% = $24.33
This case shows that the company’s net income decreased over the three-year period.

Exercise 1-11 (20 minutes)

Year 5 Year 4 Year 3 Year 2 Year 1

Sales......................................... 188 180 168 156 100
Cost of goods sold................... 190 181 171 158 100
Accounts receivable................ 191 183 174 162 100
The trend in sales is positive. While this is better than no growth, one cannot
definitively say whether the sales trend is favorable without additional information
about the economic conditions in which this trend occurred such as inflation rates and
competitors’ performances.
Given the trend in sales, the comparative trends in cost of goods sold and accounts
receivable both appear to be somewhat unfavorable. In particular, both are increasing
at slightly faster rates (indexes for cost of goods sold is 190 and accounts receivable is
191) than sales (index is 188).

Exercise 1-12 (15 minutes)

Dollar Percent
Change Base Amount Change
Short-term investments............ $52,800 $165,000 32%
Accounts receivable.................. (5,880) 48,000 -12%
Notes payable............................ 57,000 0 (not calculable)

Exercise 1-13 (10 minutes)

a. Bond price = Present value (PV) of cash flows (both interest payments and principal
repayment)

Present value of interest payments:

Payment = $100 x 10% = $10 per year at end of each year (ordinary annuity)
PVint = $10 x PV factor for an ordinary annuity (n=5, i=14%)
= $10 x 3.43308
= $34.33

Present value of principal repayment:

PVprin = $100 x PV factor for a lump sum (n=5, i=14%)
= $100 x 0.51937
= $51.94

Price = PV of interest payments + PV of principal repayment

= $34.33 + $51.94
= $86.27

b. Interest payments ($1,000 x 8% = $80 annually):

PVint = $80 x Present value factor for an ordinary annuity (n=5; i=6%)
= $80 x 4.21236
= $336.99

Principal repayment ($1,000 in 5 years hence):

PVprin = $1,000 x Present value factor for a lump sum (n=5; i=6%)
= $1,000 x 0.74726
= $747.26

Price = $336.99 + $747.26

 = $1,084.25

c. Interest payments ($1,000 x 8% x (1/2)= $40):

PVint = $40 x Present value factor for an ordinary annuity (n=10; i=3%)
= $40 x 8.53020
= $341.21

Principal repayment ($1,000 in 5 years hence):

PVprin = $1,000 x Present value factor for a lump sum (n=10; i=3%)
= $1,000 x .74409
= $744.09

Price = $341.21 + $744.09

= $1085.30
Exercise 1-14 (10 minutes)

a. Interest payments ($10,000 x 8% x (1/2) = $400 semiannually):

PVint = $400 x Present value factor for an ordinary annuity (n=20;
i=3%)
= $400 x 14.87747
= $5,950.99

Principal repayment ($10,000 in 10 years hence):

PVprin = $10,000 x Present value factor for a lump sum (n=20; i=3%)
= $10,000 x 0.55368
= $5,536.80

Price = $5,950.99 + $5,536.80

= $11,488

b. Interest payments ($10,000 x 8% x (1/2) = $400):

PVint = $400 x Present value factor for an ordinary annuity (n=20;
i=5%)
= $400 x 12.46221
= $4,984.88

Principal repayment ($10,000 in 10 years hence):

PVprin = $10,000 x Present value factor for a lump sum (n=20; i=5%)
= $10,000 x 0.37689
= $3,768.90

Price = $4,984.88 + $3,768.90

= $8,754

c. Risk is the possibility that Colin Company will not make all of the interest and principal payments
that are called for in the debt agreement. The higher that an investor perceives the risk of non-
payment to be, the more the investor should discount the cash flows. Thus, a higher risk of
repayment is reflected in a higher discount rate. By using the higher discount rate, the amount that
the investor is willing to pay for the bonds is lower.