FinanceSolutions Manual of FM

8/13/2019 FinanceSolutions Manual of FM

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Solutions Manual

FINANCIAL

MANAGEMENTPrinciples and Practice

Fourth Edition

Timothy J. GallagherColorado State University

Joseph D. Andrew, Jr.Webster University

2006 Freeload Press, Madison Wisconsin


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(Insert publication data on this page)


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Solutions Manual

to accompany

Financial Management: Principles and Practice

4rd Edition

by Timothy J. Gallagher and Joseph D. Andrew, Jr.

This solutions manual provides the answers to all the review questions and end-of-chapter problemsinFinancial Management: Principles and Practice, by Gallagher and Andrew. The answers and the stepstaken to obtain the answers are shown.

We remind our readers that in finance there is often more than one answer to a question or to aproblem, depending on ones viewpoint and assumptions. We provide one answer to each question and showone approach to solving each problem. Other answers and approaches may be equally valid, or judged evenbetter according to each individuals preference.


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TABLE OF CONTENTS

Chapter 1 Solutions................................................................................................................... 5

Chapter 2 Solutions................................................................................................................... 9

Chapter 3 Solutions................................................................................................................. 13







Chapter 10 Solutions............................................................................................................... 67



Chapter 13 Solutions............................................................................................................. 103










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Chapter 1 Solutions

Answers to Review Questions

1. How is finance related to the disciplines of accounting and economics?

Financial management is essentially a combination of accounting and economics. First, financialmanagers use accounting informationbalance sheets, income statements, and so onto analyze,plan, and allocate financial resources for business firms. Second, financial managers use economicprinciples to guide them in making financial decisions that are in the best interest of the firm. In otherwords, finance is an applied area of economics that relies on accounting for input.

2. List and describe the three career opportunities in the field of finance.

Finance has three main career paths: financial management, financial markets and institutions, and

investments.

Financial management involves managing the finances of a business. Financial managerspeoplewho manage a business firm's financesperform a number of tasks. They analyze and forecast afirm's finances; assess risk, evaluate investment opportunities, decide when and where to find moneysources and how much money to raise, and decide how much money to return to the firm's investors.

Bankers, stockbrokers, and others who work in financial markets and institutions focus on the flow ofmoney through financial institutions and the markets in which financial assets are exchanged. Theytrack the impact of interest rates on the flow of that money.

People who work in the field of investments locate, select, and manage income-producing assets. For

instance, security analysts and mutual fund managers both operate in the investment field.

3. Describe the duties of the financial manager in a business firm.

Financial managers measure the firm's performance, determine what the financial consequences willbe if the firm maintains its present course or changes it, and recommend how the firm should use itsassets. Financial managers also locate external financing sources and recommend the most beneficialmix of financing sources, and they determine the financial expectations of the firm's owners.

All financial managers must be able to communicate, analyze, and make decisions based on

information from many sources. To do this, they need to be able to analyze financial statements,forecast and plan, and determine the effect of size, risk, and timing of cash flows.

4. What is the basic goal of a business?

The primary financial goal of the business firm is to maximize the wealth of the firm's owners.Wealth, in turn, refers to value. If a group of people owns a business firm, the contribution that firmmakes to that group's wealth is determined by the market value of that firm.


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5. List and explain the three financial factors that influence the value of a business.

The three factors that affect the value of a firm's stock price are cash flow, timing, and risk.

The Importance of Cash Flow: In business, cash is what pays the bills. It is also what the firm

receives in exchange for its products and services. Cash is therefore of ultimate importance, and theexpectation that the firm will generate cash in the future is one of the factors that gives the firm itsvalue.

The Effect of Timing on Cash Flows: Owners and potential investors look at when firms can expectto receive cash and when they can expect to pay out cash. All other factors being equal, the soonercompanies expect to receive cash and the later they expect to pay out cash, the more valuable thefirm and the higher its stock price will be.

The Influence of Risk: Risk affects value because the less certain owners and investors are about afirm's expected future cash flows, the lower they will value the company. The more certain ownersand investors are about a firm's expected future cash flows, the higher they will value the company.In short, companies whose expected future cash flows are doubtful will have lower values thancompanies whose expected future cash flows are virtually certain.

6. Explain why accounting profits and cash flows are not the same thing.

Stock value depends on future cash flows, their timing, and their riskiness. Profit calculations do notconsider these three factors. Profit, as defined in accounting, is simply the difference between salesrevenue and expenses. It is true that more profits are generally better than less profits, but when thepursuit of short-term profits adversely affects the size of future cash flows, their timing, or theirriskiness, then these profit maximization efforts are detrimental to the firm.

7. What is an agent? What are the responsibilities of an agent?

An agent is a person who has the implied or actual authority to act on behalf of another. The ownerswhom the agents represent are the principals. Agents have a legal and ethical responsibility to makedecisions that further the interests of the principals.

8. Describe how society's interests can influence financial managers.

Sometimes the interests of a business firm's owners are not the same as the interests of society. Forinstance, the cost of properly disposing of toxic waste can be so high that companies may be temptedto simply dump their waste in nearby rivers. In so doing, the companies can keep costs low andprofits high, and drive their stock prices higher (if they are not caught). However, many peoplesuffer from the polluted environment. This is why we have environmental and other similar laws:So that society's best interests take precedence over the interests of individual company owners.

When businesses take a long-term view, the interests of the owners and society often (but not always)coincide. When companies encourage recycling, sponsor programs for disadvantaged young people,


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run media campaigns promoting the responsible use of alcohol, and contribute money to worthwhilecivic causes, the goodwill generated as a result of these activities causes long-term increases in thefirm's sales and cash flows, which translate into additional wealth for the firm's owners.

9. Briefly define the termsproprietorship,partnership, and corporation.

A proprietorship is a business owned by one person.

Two or more people who join together to form a business make up a partnership. This can be done onan informal basis without a written partnership agreement, or a contract can spell out the rights andresponsibilities of each partner.

A limited liability company is a hybrid between a partnership and a corporation. Profits and lossespass through to the members. Members generally enjoy limited liability.

Corporations are legal entities separate from their owners. To form a corporation, the owners specifythe governing rules for the running of the business in a contract known as the articles ofincorporation. They submit the articles to the government of the state in which the corporation isformed, and the state issues a charter that creates the separate legal entity.

10. Compare and contrast the potential liability of owners of proprietorships, partnerships (generalpartners), and corporations.

The sole proprietor has unlimited liability for matters relating to the business. This means that thesole proprietor is responsible for all the obligations of the business, even if those obligations exceedthe amount the proprietor has invested in the business.

Each partner in a partnership is usually liable for the activities of the partnership as a whole. Even if

there are a hundred partners, each one is technically responsible for all the debts of the partnership.If ninety-nine partners declare personal bankruptcy, the hundredth partner still is responsible for allthe partnership's debts.

A corporation is a legal entity that is liable for its own activities. Stockholders, the corporation'sowners, have limited liability for the corporation's activities. They cannot lose more than the amountthey paid to buy the corporations stock.

Answers to End-of-Chapter Problems

1. An accountant prepares financial statements while a financial analyst interprets them.

2. A financial managers role in a publicly traded company is to make financial decisions so as tobest serve the principal stockholders.


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3. a. The value of the firm would go down due to the increase in the amount of time it takes toreceive the cash inflows.

b. The value of the firm would go up due to the increase in expected cash inflows.

c. If expected future cash flows do not change the value of the firm would go down due to theincreased riskiness of the firm.

4. This practice obviously takes advantage of people who are in a difficult financial situation. Thistransaction is voluntary, however, and high risk loans have high interest rates.

5. LLCs have a small number of members like partnerships and each of these members is likely tohave an active voice in the company like a partnership. The LLC is taxed like a partnership.Unlike a partnership, and more like a corporation, the owners generally enjoy limited liability.


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Chapter 2 Solutions


1. What are financial markets? Why do they exist?

Financial markets are where financial securities are bought and sold. They exist primarily to bringdeficit economic units (those needing money) and surplus economic units (those having extra money)together.

2. What is a security?

Securities are claims on financial assets. They can be described as claim checks that give theirowners the right to receive funds in the future. Securities are traded in both the money and capital

markets. Money market securities include Treasury bills, negotiable certificates of deposit,commercial paper, and bankers acceptances. Capital market securities include bonds and stock.

3. What are the characteristics of an efficient market?

The term market efficiency refers to the ease, speed, and cost of trading securities. In an efficientmarket, securities can be traded easily, quickly, and at low cost. Markets lacking these qualities areconsidered to be inefficient.

4. How are financial trades made on an organized exchange?

Each exchange-listed security is traded at a specified location on the trading floor called the post. Thetrading is supervised by specialists who act either as brokers (bringing together buyers and sellers) oras dealers (buying or selling the stock themselves). Prominent international securities exchangesinclude the New York Stock Exchange (NYSE) and major exchanges in Tokyo, London,Amsterdam, Frankfurt, Paris, Hong Kong, and Mexico.

5. How are financial trades made in an over-the-counter market? Discuss the role of a dealer in the OTCmarket.

In contrast to the organized exchanges, which have physical locations, the over-the-counter markethas no fixed location,or more correctly, it is everywhere. The over-the-counter market, or OTC, is a

network of dealers around the world who maintain inventories of securities for sale. If you wanted tobuy a security that is traded OTC, you would call your broker, who would then shop amongcompeting dealers who have the security in their inventory. After locating the dealer with the bestprice, your broker would buy the security on your behalf.


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The role of dealers: Dealers make their living buying securities and reselling them to others. Theyoperate just like car dealers who buy cars from manufacturers for resale to others. Dealers makemoney by buying securities for one price (called the bid price) and selling them for a higher price,(called the ask price). The difference, or spread, between the bid price and the ask price represents

the dealers fee.

6. What is the role of a broker in security transactions? How are brokers compensated?

Brokers handle orders to buy or sell securities. Brokers are agents who work on behalf of an investor.When investors call with an order, brokers work on their behalf to find someone to take the other sideof the proposed trade. If investors want to buy, brokers find sellers. If investors want to sell, brokers

find buyers. Brokers are compensated for their services when the person whom they represent, the

investor, pays them a commission on the sale or purchase of securities.

7. What is a Treasury bill? How risky is it?

Treasury bills are short-term debt instruments issued by the U.S. Treasury that are sold at a discountand pay face value at maturity. They are very nearly risk-free as they are backed by the U.S.Government which could, if need by, print money to pay their holders at maturity.

8. Would there be positive interest rates on bonds in a world with absolutely no risk (no default risk,maturity risk, and so on)? Why would a lender demand, and a borrower be willing to pay, a positiveinterest rate in such a no-risk world?

Yes, there would be a positive rate of interest in a risk-free world. This is because regardless of risk,lenders of money must postpone spending during the time the money is loaned. Lenders, then, losethe opportunity to invest their money for that period of time. To compensate for the cost of losing

investment opportunities while they postpone their spending, lenders demand, and borrowers pay, abasic rate of return, the real rate of interest.

Answers to End of Chapter Problems

2-1. a. Surplus economic units have income that exceeds their expenditures. Wealthy families in thehousehold sector and most states (which have balanced budget requirements) are surplus economicunits.

b. Deficit economic units have expenditures that exceed their incomes. Home buyers and collegestudents are likely to be deficit economic units.

2.2. a. falseb. falsec. falsed. false


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2-3. a. 2 3 4 1

b. The money market is dominated by large institutional traders and there is much competition. TheNew York Stock Exchange tends to have larger more actively traded stocks. The over-the-countermarket tends to have smaller less actively traded securities. The real estate market has very hightransaction costs and trades take months.

2.4. a. A money market security is short term and actively traded.

b. Treasury bills and commercial paper are both traded in the money market.

2-5. $66.25/$1,000 = 6 5/8 % coupon rate

2-6. The yield on a Bonds-R-Us bond:

Real rate of interest...................... 2%Inflation premium........................ 3%Default risk premium................... 1%Liquidity risk premium................ 1%Maturity risk premium................. 1%

Total yield on Bonds-R-Us Bond: 8%

(reference figure 2-2)

2-7. Treasury Yield Curve:

Given:

Treasury Security Yields:Maturity in Years (for Chart)

Three-month T-bills 4.50% 0.25

Six-month T-bills 4.75% 0.5

One-year T-notes 5.00% 1

Two-year T-notes 5.25% 2

Three-year T-bonds 5.50% 3

Five-year T-bonds 5.75% 5

Ten-year T-bonds 6.00% 10

Thirty-year T-bonds 6.50% 30

Chart: (see next page)


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Implications:

a. For borrowers: Borrowers tend to look for the low point of the curve, which indicates the leastexpensive loan maturity. In this case the low point is 3 months, leading the borrower to seek a short-term loan. However, if a firm borrows long-term and obtains the higher interest rate, that rate islocked in for the life of the loan (30 years in this case). If interest rates rise the borrower may be gladhe/she locked in the long-term rate.

b. Lenders face the opposite situation. Granting short-term-term loans at relatively low interest ratesmay look unattractive now; but if short-term rates rise, the lenders will be able to roll overinvestments at higher and higher rates.


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Chapter 3 Solutions


1. Define intermediation.

The financial system makes it possible for surplus and deficit economic units to come together,exchanging funds for securities, to their mutual benefit. When funds flow from surplus economicunits to a financial institution to a deficit economic unit, the process is known as intermediation. Thefinancial institution acts as an intermediary between the two economic units.

2. What can a financial institution often do for a surplus economic unit that it would have difficultydoing for itself if the surplus economic unit (SEU) were to deal directly with a deficit economic unit(DEU)?

Surplus economic units do not usually have the expertise to determine whether deficit economic unitscan and will make good on their obligations, so it is difficult for them to predict when a would-bedeficit economic unit will fail to pay what it owes. Such a failure is likely to be devastating to asurplus economic unit that has lent a proportionately large amount of money. In contrast, a financialinstitution is in a better position to predict who will pay and who won't. It is also in a better position,having greater financial resources, to occasionally absorb a loss when someone fails to pay. (This isjust one example of the beneficial things financial institutions do for SEUs)

3. What can a financial institution often do for a deficit economic unit (DEU)that it would havedifficulty doing for itself if the DEU were to deal directly with an SEU?

SEUs typically want to supply a small amount of funds, while DEUs typically want to obtain a largeamount of funds. Thus it is often difficult for surplus and deficit economic units to come together ontheir own to arrange a mutually beneficial exchange of funds for securities. A financial institutioncan step in and save the day. A bank, savings and loan, or insurance company can take in smallamounts of funds from many individuals, form a large pool of funds, and then use that large pool topurchase securities from individual businesses and governments. (This is just one example of thebeneficial things financial institutions do for DEUs)

4. What are a bank'sprimary reserves? When the Fed sets reserve requirements, what is its primary

goal?

Vault cash and deposits in the bank's account at the Fed are used to satisfy these reserverequirements; they are calledprimary reserves. These primary reserves are non-interest-earningassets held by financial institutions.

The Federal Reserve requires all commercial banks to keep a minimum amount of reserves on handto meet the withdrawal demands of its depositors and to pay other obligations as they come due.


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Many would argue, however, that the reserve requirement is set more with monetary policy in mindthan to ensure that banks meet their depositors' withdrawal requests.

5. Compare and contrast mutual and stockholder-owned savings and loan associations.

Some savings and loan associations are owned by stockholders, just as commercial banks and other

corporations are owned by their stockholders. Other S&Ls, called mutuals, are owned by theirdepositors. When a person deposits money in an account at a mutual S&L, that person becomes apart owner of the firm. The mutual S&L's profits (if any) are put into a special reserve account fromwhich dividends are paid from time to time to the owner/depositors.

6. Who owns a credit union? Explain.

Credit unions are owned by their members. When credit union members put money in their creditunion, they are not technically "depositing" the money. Instead, they are purchasing shares of thecredit union. In general, credit unions exist to pay interest on shares bought by, and collect intereston loans made to, the members.

7. Which type of insurance company generally takes on the greater risks: a life insurance company or aproperty and casualty insurance company?

The risks protected against by property and casualty companies are much less predictable than are therisks insured by life insurance companies. Hurricanes, fires, floods, and trial judgments are all muchmore difficult to predict than the number of sixty-year-old females who will die this year among alarge number in this risk class. This means that property and casualty insurance companies mustkeep more liquid assets than do life insurance companies.

8. Compare and contrast a defined benefitand a defined contributionpension plan.

In a defined benefitplan, retirement benefits are determined by a formula that usually considers theworker's age, salary, and years of service. The employee and/or the firm contribute the amountsnecessary to reach the goal. In a defined contributionplan, the contributions to be made by theemployee and/or employer are spelled out, but retirement benefits depend on the total accumulationin the individual's account at the retirement date.

9. Special security software is used such that customers who enter their identification and passwordinformation can keep sensitive information out of the hands of hackers.


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3-1. a) If there were no financial institutions the SEUs and the DEUs would find that the amount ofmoney needed by a given DEU did not match the amount of money available by a given SEU. Themoney available would not be put to work and the economic activity that would have otherwise takenplace would not.

b) If financial institutions were available in this society they could position themselves between theSEUs and DEUs. The financial institution could pool the $1,000 available (100 SEUs times $10each) and pass that money along in $100 increments to the DEUs. This could be done via either adebt or equity claim that the financial institution would accept from the DEU in return for the money.

3-2. a) .10 rate on loans made - .05 rate paid to depositors = .05 = 5% interest rate spread

b) (.5 x .10) + (.5 x .12) = .11 = 11% weighted average loan rate(.5 x .05) + (.5 x .07) = .06 = 6% weighted average deposit rate11% - 6% = 5% interest rate spread

3-3. ($48,300,000 - $7,800,000) x .03) + (($60,000,000 - $48,300,000) x .10) + ($20,000,000 x 0) +($10,000,000 x 0) = $6,732,000

3-4. a) The FOMC should buy government securities in the open market. This would increase thereserves of the banking system and would put downward pressure on the federal funds rate.

b) The Feds trader at the New York Federal Reserve Bank would contact various governmentsecurities dealers and would buy the Treasury securities from them. Payment would be made bycrediting the accounts at the Fed of these dealers. This would make more funds available and wouldtend to put downward pressure on the cost of these funds, the federal funds rate.

3-5. a) ($1,000,000 x .08)($1,000,000 x .07) = $10,000 a profit of $10,000

b) ($1,000,000 x .08)($1,000,000 x .09) = -$10,000 a loss of $10,000


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Chapter 4 Solutions


1. Why do total assets equal the sum of total liabilities and equity? Explain.

Assets = Liabilities + Equity

Assets are the items of value a business owns. Liabilities are claims on the business by non-owners,and equity is the owners' claim on the business. The sum of the liabilities and equity is the totalcapital contributed to the business, which, by definition, equals the total value of the assets.

2. What are the time dimensions of the income statement, the balance sheet, and the statement of cashflows? Hint: Are they videos or still pictures? Explain.

The income statement is like a video: It measures a firm's profitability over a period of time (whichcan be a week, a month, a year, or any other time period).

The balance sheet is like a still photograph. The balance sheet shows the firm's assets, liabilities, andequity at a given point in time.

This cash flow statement like the income statement, can be compared to a video: It shows how cashflows into and out of a company over a given period of time.

3. Define depreciation expense as it appears on the income statement. How does depreciation affect

cash flow?

Accounting depreciation is the allocation of an asset's initial cost over time. Depreciation expense on

an income statement is the amount of the asset=s initial cost allocated to the period covered by the

income statement.

Depreciation expense is not a cash flow. Depreciation as an expense category affects cash flow,however, because it is tax-deductible. Depreciation expense lowers a companys taxable incomeand, therefore its income tax liability. In this way depreciation reduces cash outflows..

4. What are retained earnings? Why are they important?

Retained earnings represents the sum of all the earnings available to common stockholders of abusiness during its entire history, minus the sum of all the common stock dividends which it has everpaid. Those earnings that were not paid out were, by definition, retained.

Retained earnings are important because they represent amounts reinvested in a company on behalf

of the companys owners instead of being paid out in the form of dividends.


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5. Explain how earnings available to common stockholders and common stock dividends paid from thecurrent income statement affect the balance sheet item retained earnings.

The change in the retained earnings account from one balance sheet to the next equals net incomeless preferred stock dividends (which is the amount of earnings available to common stockholders)less common stock dividends.

6. What is accumulated depreciation?

Depreciation is the allocation of an asset's initial cost over time. Accumulated depreciation is thetotal of all the depreciation expense that has been recognized to date.

7. What are the three major sections of the statement of cash flows?

Cash flows from OperationsCash flows from investing activities

Cash flows from financing activitiesNet change in cash balanceCash balance at beginning of periodCash balance at end of period

8. How do financial managers calculate the average tax rate?

Average tax rates are calculated by dividing tax dollars paid by earnings before taxes (EBT).

9. Why do financial managers calculate the marginal tax rate?

Financial managers use marginal tax rates to estimate the future after-tax cash flows frominvestments. Since they are interested in how much of the next dollar earned from new investmentswill have to be paid in taxes, they use the marginal tax rate (rather than the average tax rate) tocalculate the tax liability.

10. Identify whether the following items belong on the income statement or the balance sheet.

a. Interest Expense IS l. Cash BSb. Preferred Stock Dividends Paid IS m. Capital in Excess of Par BSc. Plant and Equipment BS n. Operating Income ISd. Sales IS o. Depreciation Expense ISe. Notes Payable BS p. Marketable Securities BSf. Common Stock BS q. Accounts Payable BSg. Accounts Receivable BS r. Prepaid Expenses BSh. Accrued Expenses BS s. Inventory BSi. Cost of Goods Sold IS t. Net Income ISj. Preferred Stock BS u. Retained Earnings BSk. Long-Term Debt BS


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11. Indicate in which section the following balance items belong (current assets, fixed assets, currentliabilities, long-term liabilities, or equity).

a. Cash CA h. Capital in Excess of Par EQb. Notes Payable CL i. Marketable Securities CAc. Common Stock EQ j. Accounts Payable CLd. Accounts Receivable CA k. Prepaid Expenses CA

e. Accrued Expenses CL l. Inventory CAf. Preferred Stock EQ m. Retained Earnings EQg. Plant and Equipment FA


4-1.CASE A CASE B

Revenues 200,000 110,000Expenses 160,000 70,000Net Income 40,000 40,000Retained Earnings, Jan 1 300,000 100,000Dividends Declared 70,000 30,000Retained Earnings, Dec 31 270,000 110,000Current Assets, Dec 31 80,000 230,000Non-current Assets, Dec 31 850,000 180,000Total Assets, Dec 31 930,000 410,000Current Liabilities, Dec 31 40,000 60,000Non-current Liabilities, Dec 31 100,000 140,000Total Liabilities, Dec 31 140,000 200,000CS & Cap. in Excess of Par, Dec 31 520,000 100,000Total Stockholders Equity, Dec 31 790,000 210,000

4-2.CASE A CASE B

Sales 500,000 250,000COGS 200,000 100,000Gross Profit 300,000 150,000Operating Expenses 60,000 60,000Operating Income (EBIT) 240,000 90,000

Interest Expense 10,000 10,000Earnings Before Taxes (EBT) 230,000 80,000Tax Expense (40%) 92,000 32,000Net Income 138,000 48,000

4-3. a) 15%; $48,000 X 0.15 = $7,200b) $7,200/$48,000 = 0.15 or 15%


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4-4. a) Tax = $50,000 X 0.15 + $25,000 X 0.25 + $25,000 X 0.34 + $50,000 X 0.39= $41,750

b) Effective tax rate = $41,750/$150,000 = 0.2783 or 27.83%

4-5. The marginal tax rate is the tax rate applied to the next dollar of income. Therefore, the marginal tax

rate is 34%.

The average tax rate is 34%50,000 * .15 = 7,50025,000 * .25 = 6,25025,000 * .34 = 8,500235,000 * .39 = 91,6502,865,000 * .34 = 974,100

$1,088,000$1,088,000/$3,200,000 = 34%

4-6. $1 + $400,000/200,000 = $3.00 per share

4-7. Sales $10,000,000- Operating Costs 5,200,000- Interest Expense 200,000= EBT $4,600,000- Taxes (40%) 1,840,000Net after-tax income $2,760,000

Simons net after-tax income was $2,760,000 for the year.

4-8. Depreciation expense in 2006 = $70,000 - $60,000 = $10,000.

4-9a) Cash + Marketable Securities + Inventory + Accounts Receivable + Prepaid expenses.

(11,000,000 + 9,000,000 + 11,000,000 + 3,000,000 + 1,000,000) = 35,000,000Current Assets = $35,000,000

b) Fixed assetsdepreciation30,000,0008,000,000 = 22,000,000

Net Fixed Assets = $22,000,000

c) Notes Payable + Accrued Expenses4,000,000 + 2,000,000 = 6,000,000Current Liabilities = $6,000,000


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d) Current AssetsCurrent Liabilities(11,000,000 + 9,000,000 + 11,000,000 + 3,000,000 + 1,000,000)(4,000,000 + 2,000,000)35,000,0006,000,000 = 29,000,000

Net Working Capital = $29,000,000

4-10. a ) Gross Profit $440,000 - $200,000 = $240,000

b ) Operating Income (EBIT) $240,000 - $40,000 - 85,000 = $115,000c ) Earning Before Taxes (EBT) $ 115,000 - $40,000 = $75,000d ) Income Taxes $ 75,000 X 0.4 = $30,000e ) Net Income $75,000 - $30,000 = $45,000

4-11 $1,500,000$200,000 = $1,300,000Simon and Pieman had a net worth of $1,300,000 at the end of the year.

4-12 a ) 2006 Depreciation Expense for this process line

($131,000 + $12,000) X (0.245) = $35,035

b ) Amount of tax savings due to this investment.

$35,035 X 0.4 = $14,014

4-13. Operating Income (EBIT) = $768,000+ Depreciation = $42,000+ Amortization = $15,000

$825,000

Target Telecoms EBITDA = $825,000.

4-14 a ) The company's 2006 taxable income = ($400,000 - $130,000 X 0.2)

= $374,000

b ) Income tax = $374,000 X 0.34 = $127,160

4-15. a) Earnings = [($600,000 - 50,000) X (1 - .34) - $63,000] = $300,000

Earnings per share = $300,000 / 100,000 = $3 per share

b) Addition to Retained Earnings = $300,000 - 100,000 = $200,000


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4-16. a ) Current Assets: 2005: $5,534 + 14,745 + 10,733 + 952 + 3,234 = $35,1982006: $9,037 + 15,943 + 11,574 + 1,801 + 2,357=$40,712

b ) Total Assets: 2005: $35,198+(57,340 - 29,080)+1,010+2,503 = $66,9712006: $40,712+(60,374 - 32,478)+1,007+4,743 = $74,358

c ) Current Liabilities: 2005: $3,253 + 6,821 = $10,0742006: $2,450 + 7,330 = $9,780

d ) Total Liabilities: 2005: $10,074 + 2,389 = $12,463

2006: $9,780 + 2,112 = $11,892e ) Total Stockholders' Equity: 2005: $8,549 + 45,959 = $54,508

2006: $10,879 + 51,587 = $62,466

4-17. 2005: $12,463 TL + $54,508 EQ = $66,971 TA

2006: $11,892 TL + $62,466 EQ = $74,358 TA

4-18. (Dollars)a ) Accumulated Depreciation 3,398 Inflowb ) Accounts Receivable (net) 1,198 Outflowc ) Inventories 841 Outflowd ) Prepaid Expenses 877 Inflowe ) Accounts Payable 803 Outflowf ) Accrued Expenses 509 Inflowg ) Plant and Equipment (gross) 3,034 Outflowh ) Marketable Securities 849 Outflowi ) Land 3 Inflow

j ) Long Term Investments 2,240 Outflowk ) Common Stock 2,330 Inflowl ) Bonds Payable 277 Outflow

4-19. Pinewood Company and SubsidiariesStatement of Cash FlowsFor the year 2006

Operations: Net Income 10,628Add: Depreciation Exp. 3,398

Decrease in Prepaid Expenses 877Increase in Accrued Expenses 509

Less: Increase in A/C Receivable (1,198)Increase in Marketable Securities ( 849)Increase in Inventories ( 841)Decrease in A/C Payable ( 803)

Total Cash Flow from Operations $11,721Investments:

Add: Decrease in Land 3Less: Increase in Plant and Equipment (3,034)

Increase in Long Term Investment (2,240)Total Cash Flow from Investments ($5,271)


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Financing:Add: Increase in Common Stock 2,330Less: Common Stock Dividends (5,000)

Decrease in Bonds Payable ( 277)Cash Flow from Financing ($2,947)

Net Cash Flow $3,503

4-20. $3,503 = $9,037 end of 02 cash - $5,534 end of 01 cash Yes, the net cash flow figure fromproblem #16 gives the same answer as calculating the change in the cash figures from the end of 2005 to theend of 2006 balance sheets.

4-21. Sales 900,000COGS 300,000Gross Profit 600,000Operating Expenses 200,000

Operating Income (EBIT) 400,000Interest Expense 100,000Income before taxes (EBT) 300,000Tax Expense (30%) 90,000Net Income $210,000

4-22. Retained Earnings end of 2006 $8,700,000Retained Earnings end of 2005 8,000,000Addition to retained earnings 2006 700,000Earnings Available to Common Stockholders $1,500,000-Addition to Retained Earnings -700,000

Dividends paid to Common Stockholders 2006 = $ 800,000

4-23. Year Deprec. % * Depreciable Base = Depreciation

1 10% $385,000 $38,500

2 18% $385,000 $69,300

3 14.4% $385,000 $55,440

4 11.5% $385,000 $44,275

5 9.2% $385,000 $35,420

6 7.4% $385,000 $28,490

7 6.6% $385,000 $25,410

8 6.6% $385,000 $25,4109 6.5% $385,000 $25,025

10 6.5% $385,000 $25,025

11 3.3% $385,000 $12,705

4-24. Basis = $1,000,000 + $100,000 + $50,000 = $1,150,000Year 3 depreciation = $1,150,000 * .148 = $170,200


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4-25. Year 1 $7,000,000 * .1 = $700,000Year 2 $7,000,000 * .18 = $1,260,000Year 3 $7,000,000 * .144 = $1,008,000Year 4 $7,000,000 * .115 = $805,000Year 5 $7,000,000 * .092 = $644,000Year 6 $7,000,000 *.074 = $518,000Year 7 $7,000,000 * .066 = $462,000

Year 8 $7,000,000 * .066 = $462,000Year 9 $7,000,000 * .065 = $455,000Year 10 $7,000,000 * .065 = $455,000Year 11 $7,000,000 * .033 = $231,000


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Chapter 5 Solutions


1. What is a financial ratio?

A financial ratio is a number that expresses the value of one financial variable relative to another.Put more simply, a financial ratio is the result you get when you divide one financial number byanother. Calculating an individual ratio is simple, but each ratio must be analyzed carefully toeffectively measure a firm's performance.

2. Why do analysts calculate financial ratios?

Ratios are comparative measures. Because the ratios show relative value, they allow financial

analysts to compare information that could not be compared in its raw form. For example, ratios maybe used to compare one ratio to a related ratio, a firm's performance to management's goals, a firm'spast and present performance, or a firm's performance to similar firms

3. Which ratios would a banker be most interested in when considering whether to approve anapplication for a short-term business loan? Explain.

Bankers and other lenders use liquidityratios to see whether to extend short-term credit to a firm.Liquidity ratios measure the ability of a firm to meet its short-term obligations. These ratios areimportant because failure to pay such obligations can lead to bankruptcy. Generally, the higher theliquidity ratio, the more able a firm is to pay its short-term obligations.

4. Which ratios would a potential long-term bond investor be most interested in? Explain.

Current and potential lenders of long-term funds, such as banks and bondholders, are interested indebtratios. When a business's debt ratios increase significantly, bondholder and lender risk increasesbecause more creditors compete for that firm's resources if the company runs into financial trouble.

5. Under what circumstances would market to book value ratios be misleading? Explain.

The Market to Book ratio is useful, but it is only a rough approximation of how liquidation and goingconcern values compare. This is because the Market to Book ratio uses accounting-based bookvalues. The actual liquidation value of a firm is likely to be different than the book value. Forinstance, the assets of a firm may be worth more or less than the value at which they are currentlycarried on the company's balance sheet. In addition, the current market price of the company's bondsand preferred stock may also differ from the accounting value of these claims.


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6. Why would an analyst use the Modified Du Pont system to calculate ROE when ROE may becalculated more simply? Explain.

Actually, an analyst would notuse the Modified Du Pont equation to calculate ROE for precisely thereason stated above. What an analyst woulduse the Modified Du Pont equation for is to help analyzethe factors that contribute to a firm's ROE. In other words, analysts use the Modified Du Pont systemto take apart ROE to see what factors are influencing it.

7. Why are trend analysis and industry comparison important to financial ratio analysis?

Trend analysis helps financial managers and analysts see whether a company's current financialsituation is improving or deteriorating.

Cross-sectional analysis, or industry comparison, allows analysts to put the value of a firm's ratios inthe context of its industry.


5-1. a) Gross Profit Margin = Gross Profit/Sales20,000,000/35,000,000 = .5714Gross Profit margin = 57.14%

b) Operating Profit Margin = EBIT/Sales16,000,000/35,000,000 = .4571Operating Profit Margin = 45.71%

c) Net Profit Margin = Net Income/Sales8,100,000/35,000,000 = .2314Net Profit Margin = 23.14%

5-2. Current Ratio = Total Current Assets/Total Current Liabilities(5,000) / (500 +850 + 600) = 2.56Current Ratio = 2.56

Quick Ratio = (Total Current Assets - Inventory)/Total Current Liabilities(5,000900)/(500 + 850 + 600) = 2.10

Quick Ratio = 2.10

5-3. Average Daily Credit Sales = Annual credit sales/3655,000,000/365 = $13,698.63

Average Collection Period = Accounts Receivable/Average Daily Credit Sales$500,000/13,698.63 = 36.5Average Collection Period = 36.5 days


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5-4. Inventory Turnover = Sales/Inventory35,000,000/2,400,000 = 14.58Inventory Turnover = 14.58 X

Total Asset Turnover = Sales/Total Assets35,000,000/(15,000,000 + 20,000,000) = 1Total Asset Turnover = 1 X

5-5. a) Book value per shareBook price per share = Common Stock Equity/Number of shares Outstanding$4,500,000/650,000 =$6.92BPS = $6.92

b) Market to book value ratioMarket to book value ratio = Market price per share/Book value per share$25.00/$6.92 = 3.61Market to book value ratio = 3.61

5-6. a) Gross profit margin: $47,378/$94,001 = 50.40%b) Operating profit margin $12,941/$94,001 = 13.77%c) Net profit margin $8,620/$94,001 = 9.17%d) Return on assets $8,620/$66,971 = 12.87%e) Return on equity $8,620/$54,508 = 15.81%

While the Net profit margin is higher than the industry average, the Return on assets is lower. Pinewoodmay consider increasing its debt to leverage profits.

5-7. a) Current assets = $5,534 + $14,745 + $10,733 + $952 + $3,234 = $35,198Current ratio = $35,198/$10,074 = 3.494

b) Quick ratio = ($35,198 - $10,733)/$10,074 = 2.429Pinewood seems highly capable of paying off short-term debts.

5-8. a) Total debt = $3,253 + $6,821 + $2,389 = $12,463Debt to total assets = $12,463/$66,971 = 18.61%

b) Times interest earned = $12,941/$48 = 270 times

Yes. The Pinewood has very low debt and its earnings are extremely high compared to its interestexpense.

5-9. a. Average collection period $14,745/($94,001 / 365) = 57.25 daysb. Inventory turnover $94,001/$10,733 = 8.76c. Total asset turnover $94,001/$66,971 = 1.404

We would need to know the industry averages for these figures, and also know about Pinewoodscredit and inventory management practices to comment meaningfully on the above figures.


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5-10. Modified Du Pont: ROE = Net Profit Margin X Total Asset Turnover X Assets over Equity= 0.0917 X 1.404 X $66,971/$54,508 = 15.82%

5-11. a) EVA = EBIT (1- tax rate)(invested capital * investors required rate of return) EVA = $12,941,000 * (1 - 0.35)($77,389,000 * 0.10) = $672,750

b) Pinewood has a true economic profit of $672,750. This is the amount by which itsearnings exceed the returned expected by the firms investors.

c) MVA = Total market valueinvested capitalMVA = ($75,000,000 + $2,389,000)($54,508,000 + $2,389,000) = $20,492,000

d) Pinewood has a total market value that is $20,492,000 greater that the amount of capitalinvested in the firm.

5-12. a) EVA = EBIT (1Tax Rate)(invested capital * investors required rate of return)EVA = $8,000 (.65)($33,000 * .12)

= $5,200$3,960EVA = $1,240

b) The economic value is positive; therefore, Eversharp earned a sufficient amount during theyear to provide more than the expected rate of return from the investors and lenders whocontributed to the capital of the company.

c) MVA = Total market valueinvested capitalMVA = $33,000 - $21,000 = $12,000

d) Eversharps total market value exceeds its invested capital by $12,000.

5-13.EVA & MVA Calculation:

Income tax rate 35%Cost of Capital 12% KaStock Price (ref) $9Number of shares outstanding (ref) 3,000Market Value of Common Equity (ref) $27,000Book Value of Common Equity $15,210Debt Capital (ref) $6,630 (Notes payable + Long-Term Debt )Total Invested Capital (ref) $33,630 (Debt + Common)

EVAMVA

a. EVA $189 EBIT(1-Tr) - (Invested Capital * Ka)

b. Comment on EVA: This year T & J earned enough to exceed the return expected by thecontributors of the firm's capital by $189.


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5-14. a. Du Pont: ROA = Net Profit Margin X Total Asset Turnover= (80/1,000) X (1,000/500) = 16%

Modified Du Pont: ROE = Net Profit Margin X Total Asset Turnover X Assets overEquity

= ($80/$1,000) X ($1,000/$500) X (1/(1-0.5) = 32%

b. ROE = ($80/$1,000) X ($1,000/$500) X (1/(1-0.7) = 53.3%

c. ROE = ($80/$1,000) X ($1,000/$500) X (1/(1-0.9) = 160%

d. ROE = ($80/$1,000) X ($1,000/$500) X (1/(1-0.1) = 17.78%

5-15.Assets Liabilities + Equity

Cash $6,000 Accounts Payable $6,000Accounts Receivable 15,068 Notes Payable 2,739Inventory 6,667 Accrued Expenses 600Prepaid Expenses 282 Total Current Liabilities 9,339Total Current Assets 28,017 Bonds Payable 15,661Fixed Assets 34,483 Common Stock 16,000

Retained Earnings 21,500Total Assets $62,500 Total Liabilities + Equity $62,500

Total Assets = Sales / Total Asset Turnover = $100,000/1.6 = $62,500Fixed Assets = Sales / Fixed Asset Turnover = $100,000/2.9 = $34,483Total Current Assets = $62,500 - $34,483 = $28,017Accounts Receivable = Sales/day X Ave. Collection Period = ($100,000/365) X 55 = $15,068Inventory = Sales / Inventory Turnover = $100,000/15 = $6,667Prepaid Expenses = $28,017 - ($15,068 + $6,667 + $6,000) = $282

Total Debt = Total Assets X Debt to Asset Ratio = $62,500 X 0.4 = $25,000Total Current Liabilities = Total Current Assets / Current Ratio = $28,017/3 = $9,339Bonds Payable = Total Debt - Total Current Liabilities = $25,000 - $9,339 = $15,661Retained Earnings = $62,500 - ($16,000 + $25,000) = $21,500Notes Payable = $9,339 - ($600 + $6,000) = $2,739

5-16. NI/$5,000 = 0.10NI = $500TE = TA - TL = $10,000 - $6,000 = $4,000ROE = $500/$4,000 = .125 = 12.5%

5-17. Current Liability = $20,000 - $18,000 = $2,000Current Ratio = $5,000/$2,000 = 2.5 times

5-18. Return on Assets = Net Profit Margin X Total Asset Turnover0.12 = 0.04 X Total Asset TurnoverTotal Asset Turnover = 0.12/0.04 = 3


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5-19. Gross Profit = 0.50 X $5,000,000 = $2,500,000

5-20. EBIT = $2,500,000 - $200,000 - $50,000 = $2,250,000Operating Profit Margin = $2,250,000/$5,000,000 = .45 = 45%

5-21. Net Income = 0.20 X $5,000,000 = $1,000,000

5-22. Net Income = 0.20 X $5,000,000 = $1,000,000ROA = $1,000,000/$20,000,000 = .05 = 5%

5-23. Net Income = 0.10 X $15,000,000 = $1,500,000

5-24. Current Ratio = (20,000,000 - 2,000,000)/4,000,000 = 4.5

5-25. Quick Ratio = ($20,000,000 - $2,000,000 - $3,000,000)/$4,000,000 = 3.75 times

5-26. Total Debt = 0.30 X $20,000,000 = $6,000,000Debt to Equity ratio = $6,000,000/$14,000,000 = 0.43

5-27. Inventory Turnover = 5,000,000/3,000,000 = 1.67

5-28. Return on Assets = 0.20 X 0.25 = 0.05 = 5%

5-29. a) Du Pont: ROA = Net Profit Margin X Total Asset Turnover= ($200/$2,000) X ($2,000/$1,000) = .20 = 20%

Modified Du Pont: ROE = Net Profit Margin X Total Asset Turnover X Assets over Equity= ($200/$2,000) X ($2,000/$1,000) X (1/(1-0.6)) = .50 = 50%

b) ROE = ($200/$2,000) X ($2,000/$1,000) X (1/(1-0.8)) = 100%

c) ROE = ($200/$2,000) X ($2,000/$1,000) X (1/(1-0.2)) = 25%

5-30. Notoriously Niagara Niagaras Notions

a) NPM = $100,000/$500,000 = 0.20 NPM = $10,000/$500,000 = 0.02

b) TATO = $500,000/$500,0000 = 0.10 TATO = $500,000/$500,000 = 1.0

c) ROA = 0.20 X 0.10 = 0.02 ROA = 0.02 X 1.0 = 0.02


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d) Notoriously Niagara must have a higher net profit margin because their asset turnover is lowcompared to that of Niagaras Notions even though they have the same ROA. Niagras Notions has a highasset turnover but a low net profit margin.

5-31. a ) $2,250,000/1,750,000=$1.29b ) $40/$1.29 = 31

c ) $15,000,000/1,750,000 = $8.57d ) $40/$8.57 = 4.67e ) Yes, the market seems to believe that the company has going-concern value as evidenced by

the market to book ratio greater than 1.

5-32. Net Profit Margin Current Ratio Total Asset TurnoverYear NI/Sales CA/CL Sales/TA

2004 10.00% .94 1.052005 9.44% 1.02 1.152006 9.36% 1.08 1.18

Golden ProductsIndustry averages: 9.42% 1.13 2.00

The NPM is about average, although it is deteriorating. The liquidity, as measured by the currentratio, is below average but improving. Asset utilization, as measured by the total asset turnover is way belowaverage.

5-33. The Industry averages are:

Fixed Asset Turnover Return on Assets Debt to Assets Ratio Return on equity

1.33 11.00% 0.60 26%

YEAR PM CR TATO FATO ROA D/A ROE

2004 10.00% 0.94 1.05 1.21 10.53% 0.68 33.33%

2005 9.44% 1.02 1.15 1.33 10.90% 0.64 30.36%

2006 9.36% 1.08 1.18 1.36 11.00% 0.60 27.50%

Golden Products has an improving ROA that now equals that of the industry norm. The ROE hasslipped a little, but is still above the industry norm in spite of the fact that Golden has a little less debtin its capital structure in 2006. Overall, Johnny should be pleased.

5-34. ( Figures in $ '000) Mining Smelting Rolling Extrusion Whole CompanyNPM 3.3% 8.7% 11.7% 10.0% 9.7%ROA 4.2% 10.4% 17.9% 13.9% 13.4%


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5-35.National Glass Company

Income Statement (in $ 000's) Ratios:2006

ACP 48.7 daysSales $45,000 Inventory Turnover 9 XCost of Goods Sold 23,000 Debt to Assets 40%

Gross Profit 22,000 Current Ratio 1.6250

Selling and Admin Expenses 13,000 Total Asset turnover 1.50

Depreciation 3,000 Fixed Asset Turnover 2.6471Operating Income 6,000 Return on Equity 19.33%

Interest Expense 200 Return on Assets 11.6%

Earnings Before Tax 5,800 Operating Profit Margin 13.33%

Income Taxes 2,320 Gross Profit Margin 48.89%Net Income $3,480

Preferred Dividends $0Earnings Available to Common $3,480

Balance Sheet (in $ 000's)As of Dec 31

2006

AssetsCurrent Assets:Cash $2,000

Accounts Receivable 6,000

Inventory 5,000

Total Current Assets 13,000

Plant & Equipment, Net 16,000

Land 1,000Total Assets $30,000

Liabilities & EquityCurrent Liabilities:Accounts Payable $2,000

Notes Payable 3,000

Accrued Expenses 3,000

Total Current Liabilities 8,000Bonds Payable 4,000

Total Liabilities 12,000Common Stock 4,000Retained Earnings 14,000

Total Stockholders' Equity 18,000Total Liabilities & Equity $30,000

5-36.a.) (Industry) Kingston, 2006 Kingston, 2007

i. Gross Profit Margin (50%) 48.9% 48.9%

ii. Operating Profit Margin (15%) 15.1% 13.3%iii. Net Profit Margin (8%) 8.5% 7.5%iv. Return on Assets (10%) 11.56% 9.97%v. Return on Equity (20%) 19.3% 16.3%vi. Current Ratio (1.5) 1.63 1.62vii. Quick Ratio (1.0) 1.00 1.04viii. Debt to Total Asset (0.5) .4 .39ix. Times Interest Earned (25) 15.5X 14.6X


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x. Average Collection Period (45 days) 53.5days 61.6daysxi. Inventory Turnover (8) 8.18X 8.62Xxii. Total Asset Turnover (1.6) 1.4X 1.3X

b.) Kingston has about the same net profit margin and return on equity as the industry norm. The return onassets ratio for Kingston is about the same as than the industry norm.

c.) Determine the sources and uses of funds and prepare a statement of cash flows for 2007.

(1) Sources and Uses of Funds:Change,

2006 to 2007Balance SheetSources Uses

Net Income $3,353Dividends paid $733Depreciation $3,000

Cash ($200) $200Accounts Receivable, Net $1,600 $1,600Inventory $220 $220

Property, Plant & Equipment, Gross $5,000 $5,000Land $0Accounts Payable $600 $600Notes Payable $300 $300

Accrued expenses $100 $100Bonds Payable $0Common Stock $0

Totals $7,553 $7,553

(2) Statement of Cash Flows:Kingston Tool Company

Statement of Cash Flows for the year 2007( in $ 000s)

Cash Flows from Operations:Net Income $3,353

Depreciation 3,000Decrease(Increase) in Accounts Receivable (1,600)

Decrease(Increase) in Inventory (220)Increase(Decrease) in Accounts Payable 600

Increase(Decrease) in Notes Payable 300Increase(Decrease) in Accrued Expenses 100

Total Cash Flows from Operations $5,533Cash Flows from Investments:

New Property, Plant, & Equipment ($5,000)Total Cash Flows from Investments ($5,000)

Cash Flows from Financing: Dividends Paid ($733)Total Cash Flows from Financing (733)

-

Net Cash Flow ($200)

Beginning Cash Balance $2,000Ending Cash Balance $1,800


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d.) Profit margins are eroding and generally a little below the industry norm. Liquidity is about average.Debt is low, but interest coverage is below the industry norm in spite of the low debt load. Inventoryturnover is way below average. The negative cash flow of $200,000 came mainly from the buildup ofaccounts receivable and plant & equipment.

e.) The current ratio, quick ratio, and times interest earned would get the most scrutiny from loan officers.

5-36b. EVA = EBIT * (1tax rate)(invested capital * investors required rate of return)EVA = ($4,000 * 0.60)($60,000 * 0.10) = -$3,600EVA = -$3,600

MVA = Total market valueinvested capitalMVA = $50,000 - $60,000 = -$10,000MVA = -$10,000

5.37. a) Accounts Receivable/Average Daily Credit Sales$564,000.00 / ($3,814,000 / 365)= 53.71 = 54 days

b)Super Dot Com was more profitable in 2006 than it was in 2004.

2004 2006_________$519,000/$2,100,000 $1,115,000/$3,814,000

Net Profit Margin 24.71% 29.23%

$519,000/$2,859,000 $1,115,000/$5,316,000Return on Assets 18.15% 20.97%

Both the NPM and ROA ratios were better in 2006.

c)Super Dot Com was less liquid at the end of 2006 than it was at the end of 2004.

2004 2006_________$981,000/$245,000 $1,720,000/$623,000

Current Ratio 4.00 2.76

($981,000 - $307,000)/$245,000 ($1,720,000 - $960,000)/$623,000

Quick Ratio 2.75 1.22


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Chapter 6 Solutions


1. Why do businesses spend time, effort, and money to produce forecasts? Explain.

Businesses succeed or fail depending on how well prepared they are to deal with the situations theyconfront in the future. Therefore they expend considerable sums making estimates (forecasts) ofwhat the future situation is likely to be. Businesses develop new products, set production quotas, andselect financing sources based on forecasts about the future economic environment and the firm'scondition. If economists predict interest rates will be relatively high, for example, firms may plan tolimit borrowing and defer expansion plans.

2. What is the primary assumption behind the experience approach to forecasting?

The experience approach to forecasting is based on the assumption that things will happen a certainway in the future because they happened that way in the past. For instance, if it has always taken youfifteen minutes to drive to the grocery store, then you will probably assume that it will take you aboutfifteen minutes the next time you drive to the store. Similarly, financial managers often assume sales,expenses, or earnings will grow at certain rates in the future because they grew at that rate in the past.

3. Describe the sales forecasting process.

Sales forecasting is a group effort. Sales and marketing personnel usually provide assessments ofdemand and the competition. Production personnel usually provide estimates of manufacturing

capacity and other production constraints. Top management will make strategic decisions affectingthe firm as a whole. Financial managers coordinate, collect, and analyze the sales forecastinginformation. Figure 6-1 in the text shows a diagram of the process.

4. Explain how the cash budget and the capital budget relate topro formafinancial statements.

The cash budget shows the projected flow of cash in and out of the firm for specified time periods.The capital budget shows planned expenditures for major asset acquisitions. Forecasters incorporatedata from these budgets into pro forma financial statements under the assumption that the budgetfigures will, in fact, occur.

5. Explain how management goals are incorporated intopro formafinancial statements.

Management sets a target goal, and forecasters produce pro forma financial statements under theassumption that the goal will be reached. For example, if managements goal is to pay off all short-term notes during the coming year, forecasters would incorporate this into thepro formabalancesheet by setting Notes Payable to zero.


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6. Explain the significance of the term additional funds needed.

When the pro forma balance sheet is completed, total assets and total liabilities and equity will rarelymatch. The discrepancy between forecasted assets and forecasted liabilities and equity results wheneither too little or too much financing is projected for the amount of asset growth expected. Thediscrepancy is called additional funds needed(AFN) when forecast assets exceed forecast liabilitiesand equity, and excess financingwhen forecast liabilities and equity exceed forecast assets.

7. What do financial managers look for when they analyzepro formafinancial statements?

After thepro formafinancial statements are complete, financial managers analyze the forecast todetermine (1) what current trends suggest what will happen to the firm in the future, (2) what effectmanagement's current plans and budgets will have on the firm, and (3) what actions to take to avoidproblems revealed in thepro formastatements

8. What action(s) should be taken if analysis ofpro formafinancial statements reveals positive trends?Negative trends?

When analyzing thepro formastatements, managers often see signs of emerging positive or negativeconditions. If forecasters discover positive indicators, they will recommend that current plans becontinued. If forecasters see negative indicators, they will recommend corrective action.


6-1.

Sales Record for The Miniver Corporation

Sales in 2007 is expected to be approximately $215,000 following the trend of the last six years as shownabove.

$0

$50,000

$100,000

$150,000

$200,000

$250,000

1997 1998 1999 2000 2001 2002 2003


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6-2.This year Next Year Forecasting Assumption

Sales 100 120 Sales will grow 20%(100 X 1.2)- Variable Costs 50 60 Constant % of sales(120 X 0.5)- Fixed Costs 40 40 Remains same= Net Income 10 20 (120 - 60 - 40)

Dividends 5 10 Keep 50% Payout Ratio(20 X 0.5)

Current Assets 60 72 Constant % of sales(120 X 0.6)Fixed Assets 100 100 Remains sameTotal Assets 160 172 (100 + 72)

Current Liabs. 20 24 Constant % of sales (120 X 0.2)Long-term Debt 20 20 Remains sameCommon Stock 20 20 Remains sameRetained Earns. 100 110 (100+20-10)Tot Liabs & Eq 160 174

AFN = 172-174= -2 (Negative AFN means there are excess funds.)

6-3. Jolly Joe's Pizza, Inc.Financial Status and Forecast

2006 Est. for 2007

Sales $10,000 20,000COGS 4,000 8,000

Gross Profit 6,000 12,000Fixed Expenses 3,000 3,000Before-Tax Profit 3,000 9,000Tax @ 33.33% 1,000 3,000Net Profit $2,000 6,000

Dividends $0 0

Current Assets $25,000 50,000Net Fixed Assets 15,000 15,000Total Assets $40,000 65,000

Current Liabilities $17,000 34,000Long-term debt 3,000 3,000Common Stock 7,000 7,000Retained Earnings 13,000 19,000Total Liabs & Eq $40,000 63,000

Joe will need $2,000 in additional funds in 2007 ($65,000 - $63,000).


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6-4. Sugar Cane AlleyFinancial Status and Forecast

2006 Est. for 2007

Sales $90,000 110,000COGS 48,000 58,667

Gross Profit 42,000 51,333Selling andmarketing expenses 13,000 15,889General and admini-strative expenses 5,000 5,000Depreciation Expense 2,000 2,000

Operating Income 22,000 28,444Interest Expense 800EBT 27,644Tax @ 30% 8,293Net Profit 19,351

Dividends 10,000

Addition to RE 9,351

6-5. a ) Cash .111111 X $110,000 = $12,222Accounts Receivable .024667 X $110,000 = $2,713Inventory .088889 X $110,000 = $9,778

b ) Property and Equipment, gross $25,000

Accumulated Depreciation $6,000Property and Equipment, net $19,000Total Assets $19,000 + $12,222 + $2,713 + $9,778 = $43,713

c ) Accounts Payable .015333 X $110,000 = $1,687

d ) Total Liabilities = $8,000 + $1,687 = $9,687

e ) Total Liabilities and Equity = $9,687 + $9,351 + $5,000 + $26,840= $50,878

f ) Total Assets = $12,222 + $2,713 + $9,778 + $19,000 = $43,713AFN = $43,713 - $50,878 = -$7,165There are excess funds of $7,165.

g ) 2006: Net Profit Margin = $14,840/$90,000 = 16.49%2007: Net Profit Margin = $19,351/$110,000 = 17.6%


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6-6.Assets 2006 2007 Liabilities 2006 2007

Cash $10,000 $12,500 Accounts Payable $10,500 $13,125Acct Rec. 25,000 31,250 Notes Payable 10,000 12,500Inventory 20,000 25,000 Accrued Expenses 11,000 13,750Prepaid Exp 2,000 2,500 Long Term Debt 15,000 15,000

Total Current Common Equity 38,500 38,500Assets 57,000 71,250 Total LiabilitiesFixed Assets 32,000 32,000 Equity 85,000 $92,875Depreciation 4,000 4,000Total Assets 85,000 $99,250

*Net Sales for 2007 = $150 million * 1.25 = $187.5 millionAdditional funds needed = $99,250 - $92,875 = $6,375

6-7.

2006 2007

Sales 1,000 1,250Variable Costs 500 562.50Fixed Costs 160 160Net Income 340 527.50Dividends 136 290.13

6-8. Pro Forma Balance SheetsEnd of Year

Assets 2006 2007 Liabilities + Equity 2006 2007Cash $4,000 4,400 Accounts Payable $4,400 4,840Accounts Rec 10,000 11,000 Notes Payable 4,000 4,400Inventory 13,000 14,300 Accrued Expenses 5,000 5,500Prepaid Exp 400 440 Tot.Current Liabilities13,400 14,740Current Assets27,400 30,140 Bonds Payable 6,000 6,000Fixed Assets 11,000 11,000 Common Equity 19,000 21,468

Total Assets $38,400 $41,140 Tot.Liab. + Equity $38,400 $42,208

In 2007 there would be $1,068 ($42,208-$41,140) in excess funds. This assumes, as the problem states, thatnotes payable would increase by 10% along with other current liabilities. Notes payable usually does notincrease with sales.

Year Total Sales PBT NI Addition to RE2007 $85,000 X 1.1 $93,500 X .11 $10,285 X .6 $6,171 X .40

= $93,500 = $10,285 = $6,171 = $2,468


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6-9.Compute the following ratios for 2006 and 2007:

2006 2007Current Ratio 3 3Debt to Assets Ratio 25% 25.3%Sales to Assets Ratio 62.5% 66.27%Net Profit Margin 10% 13.64%

Return on Assets 6.25% 9.04%Return on Equity 8.33% 12.10%

Liquidity seems strong and stable. Debt is modest and stable. Asset utilization is improving slightly whileall the profit margins calculated show marked improvement.

6-10.BRIGHT FUTURE CORPORATION

Historical and Projected Income Statements

Historical Projected2006 2007

Sales $10,000,000 $12,000,000Cost of goods Sold $4,000,000 $4,800,000Gross Profit $6,000,000 $7,200,000Selling & Admin. Expenses $800,000 $960,000Depreciation Expense $2,000,000 $2,000,000Operating Income (EBIT) $3,200,000 $4,240,000Interest Expenses $1,350,000 $1,350,000Earnings Before Tax (EBT) $1,850,000 $2,890,000Income Tax (40%) $740,000 $1,156,000Net Income (NI) $1,110,000 $1,734,000

Common Stock Dividends paid $400,000 $400,000Addition to Retained earnings $710,000 $1,334,000

Earnings per Share (1,000,000 shares) $1.11 $1.73

BRIGHT FUTURE CORPORATIONHistorical and Projected Balance Sheets

Projection with AFNHistorical Projected Excess Financing

Dec 31, 2006 Dec 31, 2007 IncorporatedASSETSCurrent Assets:

Cash $9,000,000 $10,800,000 $10,800,000Marketable Securities $8,000,000 $9,600,000 $9,600,000Accounts Receivable (gross) $1,200,000 $1,440,000 $1,440,000

Less: Allowance for bad Debts $200,000 $240,000 $240,000Accounts Receivable (Net) $1,000,000 $1,200,000 $1,200,000Inventory $20,000,000 $24,000,000 $24,000,000

Prepaid Expenses $1,000,000 $1,200,000 $1,200,000Total Current Assets $39,000,000 $46,800,000 $46,800,000Plant and Equipment (gross) $20,000,000 $20,000,000 $20,000,000

Less: Accumulated Depreciation $9,000,000 $11,000,000 $11,000,000Plant and equipment (net) $11,000,000 $9,000,000 $9,000,000TOTAL ASSETS $50,000,000 $55,800,000 $55,800,000

LIABILITIES AND EQUITYCurrent Liabilities:Accounts payable $12,000,000 $14,400,000 $14,400,000Notes Payable $5,000,000 $5,000,000 $5,000,000


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Accrued Expenses $3,000,000 $3,600,000 $3,600,000Total Current Liabilities $20,000,000 $23,000,000 $23,000,000L-T Debt (Bonds Payable, 5%, due 2015) $20,000,000 $20,000,000 $21,466,000Total Liabilities $40,000,000 $43,000,000 $44,576,000Common Stock (1,000,000 shares, $1 par) $1,000,000 $1,000,000 $1,000,000Capital in Excess of Par $4,000,000 $4,000,000 $4,000,000Retained Earnings $5,000,000 $6,334,000 $6,334,000Total Equity $10,000,000 $11,224,000 $11,224,000TOTAL LIABILITIES AND EQUITY $50,000,000 $54,224,000 $55,800,000

Question 2a. Excess Financing (Additional Funds Needed) $1,466,000

AFN is incorporated in L-T debt. If $1,466,000 of new L-T debt is issued the financing need will be met.Other financing sources could be used but we chose new L-T debt in this illustration.

Question 2, Ratios:2006 2007

b. Current Ratio 1.95 2.03

c. Total Asset Turnover 0.20 0.22Inventory Turnover 0.50 0.50

d. Total Debt to Assets 0.80 0.77

e. Net Profit Margin 11.10% 14.45%Return on Assets 2.22% 3.11%Return on Equity 11.10% 15.30%

Question 3, Comments on liquidity, asset productivity, debt management, and profitability:

Liquidity is improving. Debt is high but stable. Inventory and overall asset utilization are stable. The netprofit margin appears healthy. The return on assets ratio is much lower than the net profit margin because ofthe low asset turnover. The return on equity ratio is much higher than the return on assets because of the

high debt load.

Question 4, Recommendations:

A 20% projected increase in sales is quite impressive. Management should prepare now, however, to raisethe $1,466,000 that will be needed in 2007 to support the necessary new investments if the projected salesincrease is to be achieved.


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Chapter 7 Solutions


1. What is risk aversion? If common stockholders are risk averse, how do you explain the fact that theyoften invest in very risky companies?

Risk aversion is the tendency to avoid additional risk. Risk-averse people will avoid risk if they can,unless they receive additional compensation for assuming that risk. In finance, the addedcompensation is a higher expected rate of return.

People are not all are equally risk averse. For example, some people are willing to buy risky stocks,while others are not. The ones that do, however, almost always demand an appropriately highexpected rate of return for taking on the additional risk.

2. Explain the riskreturn relationship.

The relationship between risk and required rate of return is known as the riskreturn relationship. Itis a positive relationship because the more risk assumed, the higher the required rate of return mostpeople will demand.

Risk aversion explains the positive riskreturn relationship. It explains why risky junk bonds carry ahigher market interest rate than essentially risk-free U.S. Treasury bonds.

3. Why is the coefficient of variation often a better risk measure when comparing different projects than

the standard deviation?

Whenever we want to compare the risk of investments that have different means, we use thecoefficient of variation (CV). The CV represents the standard deviation's percentage of the mean.Because the CV is a ratio, it adjusts for differences in means, while the standard deviation does not.therefore the CV provides a standardized measure of the degree of risk that can be used to comparealternatives.

4. What is the difference between business risk and financial risk?

Business risk refers to the uncertainty a company has with regard to its operating income (alsoknown as earnings before interest and taxes or EBIT). Business risk is brought on by sales volatilityand intensified by the presence of fixed operating costs.

Financial risk is the additional volatility of net income caused by the presence of interest expense.Firms that have only equity financing have no financial risk because they have no debt on which tomake fixed interest payments. Conversely, firms that operate primarily on borrowed money areexposed to a high degree of financial risk.


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5. Why does the riskiness of portfolios have to be looked at differently than the riskiness of individualassets?

The riskiness of portfolios has to be looked at differently than the riskiness of individual assetsbecause the weighted average of the standard deviations of returns of individual assets does not resultin the standard deviation of a portfolio containing the assets. There is a reduction in the fluctuationsof the returns of portfolios which is called the diversification effect.

6. What happens to the riskiness of a portfolio if assets with very low correlations (even negativecorrelations) are combined?

How successfully diversification reduces risk depends on the degree of correlation between the twovariables in question. When assets with very low or negative correlations are combined in portfolios,the riskiness of the portfolios (as measured by the coefficient of variation) is greatly reduced.

7. What does it mean when we say that the correlation coefficient for two variables is -1? What does itmean if this value were zero? What does it mean if it were +1?

Correlation is measured by the correlation coefficient, represented by the letter r. The correlationcoefficient can take on values between +1.0 (perfect positive correlation) to -1.0 (perfect negativecorrelation). The closer r is to +1.0, the more the two variables will tend to move with each other atthe same time. The closer r is to -1.0, the more the two variables will tend to move opposite eachother at the same time. An r value of zero indicates that the variables values aren't related at all.This is known as statistical independence.

8. What is nondiversifiable risk? How is it measured?

Unless the returns of one-half the assets in a portfolio are perfectly negatively correlated with theother halfwhich is extremely unlikelysome risk will remain after assets are combined into aportfolio. The degree of risk that remains is nondiversifiable risk, the part of a portfolio's total riskthat can't be eliminated by diversifying.

Nondiversifiable risk is measured by a term called beta (). The ultimate group of diversified assets,the market, has a beta of 1.0. The betas of portfolios, and individual assets, relate their returns tothose of the overall stock market. Portfolios with betas higher than 1.0 are relatively more risky thanthe market. Portfolios with betas less than 1.0 are relatively less risky than the market. (Risk-freeportfolios have a beta of zero.)

9. Compare diversifiable and nondiversifiable risk. Which do you think is more important to financialmanagers in business firms?

Diversifiable risk can be dealt with by, of course, diversifying. Nondiversifiable risk is generallycompensated for by raising ones required rate of return. Both types of risk are important to financialmanagers.


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10. How do risk-averse investors compensate for risk when they take on investment projects?

Because of risk aversion, people demand higher rates of return for taking on higher-risk projects.

11. Given that risk-averse investors demand more return for taking on more risk when they invest, howmuch more return is appropriate for, say, a share of common stock, than is appropriate for a Treasury

bill?

Although we know that the riskreturn relationship is positive, the question of much return isappropriate for a given degree of risk is especially difficult. Unfortunately, no one knows the answerfor sure. One well-known model used to calculate the required rate of return of an investment, givenits degree of risk, is the Capital Asset Pricing Model (CAPM).

12. Discuss risk from the perspective of the Capital Asset Pricing Model (CAPM).

The Capital Asset Pricing Model, or CAPM, can be used to calculate the appropriate required rate of

return for an investment project given its degree of risk as measured by beta (). A project's betarepresents its degree of risk relative to the overall stock market. In the CAPM, when the beta term ismultiplied by the market risk premium term, the result is the additional return over the risk-free ratethat investors demand from that individual project. High-risk (high-beta) projects have high requiredrates of return, and low-risk (low-beta) projects have low required rates of return.


7-1.

Cash Flow ProbabilityEstimate of Occurrence

CF P CF x P CF - mean (CF - mean)2P x (CF - mean)

2

$10,000 5.00% $500 ($9,000) $81,000,000 $4,050,000

$13,000 10.00% $1,300 ($6,000) $36,000,000 $3,600,000

$16,000 20.00% $3,200 ($3,000) $9,000,000 $1,800,000

$19,000 30.00% $5,700 $0 $0 $0

$22,000 20.00% $4,400 $3,000 $9,000,000 $1,800,000

$25,000 10.00% $2,500 $6,000 $36,000,000 $3,600,000

$28,000 5.00% $1,400 $9,000 $81,000,000 $4,050,000

Sum of (R x P) = mean: $19,000

Sum of P x (CF- mean)2= variance: $18,900,000

Square root of variance = standard deviation of the variance: $4,347

Coefficient of Variation = std.dev./mean = 22.88%


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7-2.

EXPECTED VALUE, STANDARD DEVIATION AND COEFFICIENT OF VARIATION OF OPERATING INCOME

Operating

Sales Variable Fixed Income Prob.

Estimate Expenses Expenses Estimate of Occurrence

CF P CF x P CF - mean (CF - mean)2 Px(CF - mean2

$500 $250 $250 $0 2.00% $0 ($350) $122,500 $2,450

$700 $350 $250 $100 8.00% $8 ($250) $62,500 $5,000

$1,200 $600 $250 $350 80.00% $280 $0 $0 $0

$1,700 $850 $250 $600 8.00% $48 $250 $62,500 $5,000

$1,900 $950 $250 $700 2.00% $14 $350 $122,500 $2,450

a. Sum of (R x P) = mean: $350

Sum of (CF- mean)2x P= variance $14,900

b. Square root of variance = standard deviation: $122

c. Coeff. of Variation = std.dev/mean: 34.88%

d. New expected value, standard deviation, and coefficient of variation based on revised sales forecast:

Operating

Sales Variable Fixed Income Probability


CF P CF x P CF - mean (CF - mean)2 Px(CF - mean)

2

$500 $250 $250 $0 10.00% $0 ($350) $122,500 $12,250

$700 $350 $250 $100 15.00% $15 ($250) $62,500 $9,375

$1,200 $600 $250 $350 50.00% $175 $0 $0 $0

$1,700 $850 $250 $600 15.00% $90 $250 $62,500 $9,375

$1,900 $950 $250 $700 10.00% $70 $350 $122,500 $12,250


Sum of P x (CF - mean)2

= variance: $43,250b. Square root of variance = standard deviation: $208

c. Coeff. of Variation = std. dev./mean: 59.43%

e. Comments: Note how the increased possibilities that sales will be other than $1,200 caused the standard deviationand coefficient of variation of operating income to nearly double.

7-3. Mean:.10(1,000) + .2(5,000) + .45(10,000) + .15(15,000) + .10(20,000) =100 + 1,000 + 4,500 + 2,250 + 2,000Mean = $9,850

Standard Deviation:2 = .1(1,0009,850)2+ .2(5,0009,850)2+ .45(10,0009,850)2+ .15(15,0009,850)2+.1(20,0009,850)22 = 7,832,250 + 4,704,500 + 10,125 + 3,978,375 + 10,302,2502= 26,827,500 = 26,827,500 = 5,179.53Standard deviation = 5,179.53


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7-4.

I. EQUITY EDDIE'S COMPANY:

Operating

Income Interest Before-Tax Net Probability

Estimate Expense Income Taxes Income of Occurrence

CF P CF x P CF - mean (CF - mean)2

Px(CF -mean)

2

$100 $0 $100 $28 $72 5.00% $4 ($216) $46,656 $2,333

$200 $0 $200 $56 $144 10.00% $14 ($144) $20,736 $2,074

$400 $0 $400 $112 $288 70.00% $202 $0 $0 $0

$600 $0 $600 $168 $432 10.00% $43 $144 $20,736 $2,074

$700 $0 $700 $196 $504 5.00% $25 $216 $46,656 $2,333


Sum of P x (CF - mean)2= variance: $8,813

b. Square root of variance = standard deviation: $94

c. Coeff. of Variation = std. dev./mean: 32.60%

II. BARRY BORROWER'S COMPANY:

Operating

Income Interest Before-Tax Net Probability

Estimate Expense Income Taxes Income of Occurrence

CF P CF x P CF - mean (CF - mean)2

Px(CF -mean)

2

$110 $40 $70 $19.6 $50.4 5.00% $2.52 ($237.60) $56,453.76 $2,822.69

$220 $40 $180 $50.4 $129.6 10.00% $12.96 ($158.40) $25,090.56 $2,509.06

$440 $40 $400 $112.0 $288.0 70.00% $201.60 $0.00 $0.00 $0.00

$660 $40 $620 $173.6 $446.4 10.00% $44.64 $158.40 $25,090.56 $2,509.06

$770 $40 $730 $204.4 $525.6 5.00% $26.28 $237.60 $56,453.76 $2,822.69

a. Sum of (R x P) = mean: $288.00

Sum of P x (CF - mean)

2

= variance: $10,663.49b. Square root of variance = standard deviation= $103.26

c. Coeff. of Variation = std. dev./ mean: 35.86%

e. Comments: Note how Barry Borrower's use of debt financing causes his company to have a higherstandard deviation and coefficient of variation of net income than Equity Eddie's.

7-5.

STANDARD DEVIATION AND COEFFICIENT OF VARIATION OF CASH FLOWS FOR THE GO-RILLA PROJECT

Cash Flow Probability

Estimate of Occurrence

CF P CF x P CF - mean (CF - mean)2 P x (CF - mean)

2

$20,000 1.00% $200 ($6,000) $36,000,000 $360,000

$22,000 12.00% $2,640 ($4,000) $16,000,000 $1,920,000

$24,000 23.00% $5,520 ($2,000) $4,000,000 $920,000

$26,000 28.00% $7,280 $0 $0 $0

$28,000 23.00% $6,440 $2,000 $4,000,000 $920,000


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$30,000 12.00% $3,600 $4,000 $16,000,000 $1,920,000

$32,000 1.00% $320 $6,000 $36,000,000 $360,000

Sum of (R x P) = mean: $26,000

Sum of P x (CF - mean)2= variance: $6,400,000

a. Square root of variance = standard deviation: $2,530

b. Coefficient of Variation = std. dev./mean: 9.73%

c. Comment: Given that the average coefficient of variation of George's other product lines is 12%, we wouldsay that the Go-Rilla project is LESS risky than average

7-6.

Effect of Adding Asset B to Existing Portfolio A

Correlation coefficient r between existing portfolio A and new asset B: 0

Amount invested in Portfolio A: $700,000

Amount invested in Asset B: $200,000

Total value of combined portfolio: $900,000

Weight of existing assets in combined portfolio: 77.8%

Weight of new asset B in combined portfolio: 22.2%

Expected Return of existing portfolio A: 9.00%

Standard deviation of existing portfolio A: 3.00%

Coefficient of variation of existing portfolio A: 33.33%

Expected Return of new asset B: 12.00%

Standard deviation of new asset B: 4.00%

Coefficient of variation of new asset B: 33.33%

Expected Return of combined portfolio per equation 7-1: 9.67%

Standard deviation of combined portfolio per equation 7-5: 2.50%

Coefficient of Variation of combined portfolio: 25.83%

a. Comparison of standard deviations of existing portfolio A and the new combined portfolio:

Standard deviation of existing portfolio A: 3.00%Standard deviation of combined portfolio: 2.50%

a. Comparison of coefficients of variation of existing portfolio A and the new combined portfolio:

Coefficient of variation of existing portfolio A: 33.33%

Coefficient of variation of combined portfolio: 25.83%


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7-7. Coefficient of variation (CV) = Standard Deviation/Mean288/1,200 = .24CVzazzle = 24%

7-8. Total Portfolio = $10,000Weights: Stock A: 4,000/10,000 = .4

Stock B: 6,000/10,000 = .6.4(13) + .6(9) = 10.6%

Expected Rate of Return = 10.6%

7-9. p = (0.3)2 * (0.05)2 + (0.7)2* (0.02)2+ ( 2 * 0.3 * 0.7 * 0.6 * 0.05 * 0.02)

p = 0.000673p = 0.0259p = 2.59%

7-10.

Effect of Adding PROJ1 to Existing Portfolio

Expected Return of existing portfolio: 11.00%

Standard deviation of existing portfolio: 4.00%

a. Coefficient of variation of existing portfolio: 36.36%

Expected Return of new PROJ1: 13.00%

Standard deviation of new PROJ1: 5.00%

b. Coefficient of variation of new PROJ1: 38.46%

Amount invested in existing portfolio: $820,000

Amount invested in PROJ1: $194,000

Total value of combined portfolio: $1,014,000

c. Weight of existing assets in combined portfolio: 80.9%

d. Weight of new PROJ1 in combined portfolio: 19.1%

Correlation coefficient r between existing portfolio and new PROJ1: 0

e. Standard deviation of combined portfolio: 3.37%

(lower than existing portfolio)

: Expected Return of combined portfolio per equation 7-1 11.38%

f.: Coefficient of Variation of combined portfolio 29.63%

(lower than existing portfolio)

g. Firm's risk decreases with the addition of PROJ1 to the portfolio


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7-11.

Required Rate of Return per the CAPM

Risk free rate (kRF) 5.0%

Expected rate of return on the market (km) 15.0%

Beta 1.2

Required rate of return on stock per the CAPM: 17.0%

(equation 7-6)

7-12. kl= 4.5 + .5(12.5) = 10.75%ka= 4.5 + 1.0(12.5) = 17%kh = 4.5 + 1.6(12.5) = 24.5%

7-13.

Effect on CAPM Required Rate of Return of Adding a New Project

Risk free rate (kRF) 5.0%

Expected rate of return on the market (km) 15.0%

Existing firm's Beta 1.5

New Project's Beta 0.8

a. Required rate of return on company per the CAPM: 20.0%

b. Required rate of return on new project per the CAPM: 13.0%

Weight of new project in firm's portfolio: 20.0%

Weight of firm's other assets: 80.0%

c. Beta of firm with new project 1.36

7-14.

STANDARD DEVIATION AND COEFFICIENT OF VARIATION OF PSC SALES REVENUE

Sales Probability

Estimate of Occurrence

CF P CF x P CF - mean (CF - mean)2P x (CF - mean)

2

$800 2.00% $16 ($1,200) $1,440,000 $28,800

$1,000 8.00% $80 ($1,000) $1,000,000 $80,000

$1,400 20.00% $280 ($600) $360,000 $72,000

$2,000 40.00% $800 $0 $0 $0

$2,600 20.00% $520 $600 $360,000 $72,000

$3,000 8.00% $240 $1,000 $1,000,000 $80,000

$3,200 2.00% $64 $1,200 $1,440,000 $28,800

Sum of (R x P) = exp val: $2,000


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Sum of P x (CF - mean)2= variance: $361,600

Square root of variance = standard deviation: $601

Coefficient of Variation = std. dev./mean: 30.07%

7-15.

COEFFICIENT OF VARIATION OF PSC'S OPERATING INCOME

Operating

Sales Variable Fixed Income Probability


CF P CF x P CF - mean (CF - mean)2Px(CF - mean)

2

$800 $480 $0 $320 2.00% $6 ($480) $230,400 $4,608

$1,000 $600 $0 $400 8.00% $32 ($400) $160,000 $12,800

$1,400 $840 $0 $560 20.00% $112 ($240) $57,600 $11,520

$2,000 $1,200 $0 $800 40.00% $320 $0 $0 $0

$2,600 $1,560 $0 $1,040 20.00% $208 $240 $57,600 $11,520

$3,000 $1,800 $0 $1,200 8.00% $96 $400 $160,000 $12,800

$3,200 $1,920 $0 $1,280 2.00% $26 $480 $230,400 $4,608

Sum of (R x P) = mean: $800

Sum of P x (CF - mea

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