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What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant.
What are the four primary disadvantages of the sole proprietorship and partnership forms of business organization? What benefits are there to these types of business organization as opposed to the corporate form?
What are the primary disadvantages of the corporate form of organization? Name at least two advantages of corporate organization?
In response to the Sarbanes-Oxley Act, many small firms in the United States have opted to go dark delist their stock. Why might a company choose this route? What are the costs of going dark?
In a large corporation what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance?
What goal should always motivate the actions of a firm’s financial manager?
Who owns a corporation? Describe the process whereby the owners control the form’s management. What is the main reason that an agency relationship exist in the corporate forms of organization? In this context, what kinds of problems can arise?
You’ve probably noticed coverage in the financial press of an initial public offering (IPO) of a company’s securities. Is an IPO a primary market transaction or a secondary market transaction?
What does it mean when we say the New York Stock Exchange is an auction market? How are auction markets different from dealer markets? What kind of market is NASDAQ?
Suppose you were the financial manager of a not-for-profit business (a not-for-profit hospital, perhaps). What kind of goals do you think would be appropriate?
Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits.
Can our goal of maximizing the value of the stock conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, the environment, and the general good of society fit in this framework, or are they essentially ignored? Think of some specific scenarios to illustrate your answer?
Would our goal of maximizing the value of the stock be different if we were thinking about financial management in a foreign country? Why or why not?
Suppose you own stock in a company. The current price per share is $25. Another company has just announced that it wants to buy your company and will pay $35 per share to acquire all the outstanding stock. Your company’s management immediately begins fighting off this hostile bid. Is management acting in the shareholders best interests? Why or why not?
Corporate ownership varies around the world. Historically individuals have owned the majority of shares in public corporations in the United States. In Germany and Japan, however, banks, other large financial institutions, and other companies own most of the stock in public corporations. Do you think agency problems are likely to be more or less severe in Germany and Japan than in the United States? Why? In recent years, large financial institutions such as mutual funds and pension funds have been becoming the dominant owners of stock in the United States, and these institutions are becoming more active in corporate affairs. What are the implications of this trend for agency problems and corporate control?
Critics have charged that compensation to top managers in the Units States is simply too high and should be cut back. For example, focusing on large corporations, Larry Ellison of Oracle has been one of the best-compensated CEOs in the United States, earning about $46 million in 2005 alone and $868 million over the 2001-2005 period. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as Tiger Woods, top entertainers such as Tom Hanks and Oprah Winfrey, and others are the top of their respective fields earn at least as much, if not a great deal more.
What does liquidity measure? Explain the trade-off a firm faces between high liquidity and low liquidity levels.
Why might the revenue and cost figures shown on a standard income statement not be representative of the actual cash inflows and outflows that occurred during a period?
In preparing a balance sheet, why do you think standard accounting practice focuses on historical cost rather than market value?
In comparing accounting net income and operating cash flow, name two items you typically find in net income that are not in operating cash flow. Explain what each is and why it is excluded in operating cash flow.
Under standard accounting rules, it is possible for a company’s liabilities to exceed its assets. When this occurs, the owners’ equity is negative. Can this happen with market values? Why or why not?
Suppose a company’s cash flow from assets is negative for a particular period. Is this necessarily a good sign or a bad sign?
Suppose a company’s operating cash flow has been negative for several ye running. Is this necessarily a good sign or a bad sign?
Could a company’s change in NWC be negative in a given year? Explain how this might come about. What about net capital spending?
Could a company’s cash flow to stockholders be negative in a given year? Explain how this might come about. What about cash flow to creditors?
Referring back to the Merrill Lynch example used at the beginning of the chapter, note that we suggested that Merrill Lynch’s stockholders probably didn’t suffer as a result of the reported loss. What do you think was the basis for our conclusion?
A firm’s enterprise value is equal to the market value of its debt and equity, less the firm’s holdings of cash and cash equivalents. This figure is particularly relevant to potential purchasers of the firm. Why?
Companies often try to keep accounting earnings growing at a relatively steady pace, thereby avoiding large swings in. earnings from period to period. They also try to me earnings targets. To do so they use a variety of tactics. The simplest way is to control the timing of accounting revenues and costs, which all firms can do to at least some extent. For example, if earnings are looking too low this quarter, then some accounting costs can be deferred until next quarter. This practice is called earnings management. It is common, and it raises a lot of questions. Why do firms do it? Why are firms even allowed to do it under GAAP? Is it ethical? What are the implications for cash flow and shareholder wealth?
Building Balance Sheet Predator Pucks, Inc., has current assets of $4,000, net fixed assets of $22,500, current liabilities of $3,400, and long-term debt of $6,800. What is the value of the shareholders’ equity account for this firm? How much is net working capital?
Building an Income Statement Mama Roach Exterminators, inc., has sales of $634,000, costs of $305,000, depreciation expense of $46,000, interest expense of $29,000, and a tax rate of 35 percent. What is the net income for this firm?
Dividends and Retained Earnings Suppose the firm in Problem 2 paid out $86,000 in cash dividends. What is the addition to retained earnings?
Per-Share Earnings and Dividends suppose the firm in Problem 3 had 30,000 shares of common stock outstanding. What are the earnings per share, or EPS, figure? What are the dividends per share figure?
Market Values and Book Values Klingon Widgets, Inc., purchased new cloaking machinery three years ago for $7 million. The machinery can be sold to the Romulans today for $3.7 million. Klingon’s current balance sheet shows net fixed assets of $2.6 million, current liabilities of $1.3 million, and net working capital of $410,000. If all the current assets were liquidated today, the company would receive $1.8 million cash. What is the book value of Klingon’s assets today? What is the market value?
Calculating Taxes The Baryla Co. had $325,000 in 2007 taxable income. Using the rates from Table 2.3 in the chapter, calculate the company’s 2007 income taxes.
Tax Rates In Problem 6, what is the average tax rate? What is the marginal tax rate?
Calculating OCF Prather, Inc., has sales of $14,200, costs of $5,600, depreciation expense of $1,200, and interest expense of $680. If the tax rate is 35 percent, what is the operating cash flow, or OCF?
Calculating Net Capital Spending Kahne Driving School’s 2006 balance sheet showed net fixed assets of $4.6 million, and the 2007 balance sheet showed net fixed assets of $5.2 million. The company’s 2007 income statement showed a depreciation expense of $875,000. What was net capital spending for 2007?
Calculating Additions to NWC The 2006 balance sheet of Rock ‘N’ Roll Records, Inc., showed current assets of $1,400 and current ‘liabilities of $870 the 2007 balance sheet showed current assets of $1,650 and current liabilities of $920. What was the company’s 2007 change in’4net working capital, or NWC?
Cash Flow to Creditors The 2006 balance sheet of Maria’s Tennis Shop, Inc., showed long-term debt of $3.1 million, and the 2007 balance sheet showed long-term debt of $3.3 million. The 2007 income statement showed an interest expense of $280,000. What was the firm’s cash flow to creditors during 2007?
Cash Flow to Stockholders the 2006 balance sheet of Maria’s Tennis Shop, Inc., showed $860,000 in the common stock account and $6.9 million in the additional paid-in surplus account. The 2007 balance sheet showed $885,000 and $7.7 million in the same two accounts, respectively. If the company paid out $600,000 in cash dividends during 2007, what was the cash flow to stockholders for the year?
Calculating Total Cash Flows Given the information for Maria’s Tennis Shop, Inc., in Problems 11 and 12, suppose you also know that the firm’s net capital spending for 2007 was $760,000, and that the firm reduced its net working capital investment by $165,000. What was the firm’s 2007 operating cash flow, or OCF?
Calculating Total Cash Flows Bedrock Gravel Corp. shows the following information on its 2007 income statement: sales $162,000; costs = $93,000; other expenses = $5,100: depreciation expense = $8,400; interest expense = $16,500; taxes = $14,820; dividends $9,400. In addition, you’re told that the firm issued $7,350 in new equity during 2007 and redeemed $6,400 in outstanding long-term debt.
a. What is the 2007 operating cash flow?
b. What is the 2007 cash flow to creditors?
c. What is the 2007 cash flow to stockholders?
d. If net fixed assets increased by $12,000 during the year, what was the addition to NWC?
Using Income Statements Given the following information for Mama Mia Pizza Co., calculate the depreciation expense: sales = $34,000; costs = $16,000; addition to retained earnings = $4,300; dividends paid = $1,200: interest expense = $2,300; tax rate = 35 percent.
Preparing a Balance Sheet Prepare a 2007 balance sheet for Haltiwanger Corp. based on the following information: cash = $210,000; patents and copyrights $720,000; accounts payable = $430,000; accounts receivable = $149,000; tangible net fixed assets = $2,900,000; inventory = $265,000; notes payable = $180,000; accumulated retained earnings = $1,865,000; long-term debt = $1,430,000.
Residual Claims Clapper’s Clippers, Inc., is obligated to pay its creditors $6,100 during the year. a. What is the market value of the shareholders’ equity if assets have a market value of $6,700? b. What if assets equal $5,900?
Marginal versus Average Tax Rates (Corporation Growth has $82,000 in taxable income, and Corporation Income has $8.200,000 in taxable income.
a. What is the tax bill for each firm?
b. Suppose both firms have identified a new project that will increase taxable income by $10,000. How much in additional taxes will each firm pay? Why is this amount the same?
Net Income and OCF During 2007, Raines Umbrella Corp. had sales of $840,000. Cost of goods sold, administrative and selling expenses, and depreciation expenses were $625,000, $120,000, and $130,000, respectively. In addition, the company had an interest expense of $85,000 and a tax rate of 35 percent. (Ignore any tax loss carry-back or carry forward provisions.)
a. What is Raines’s net income for 2007?
b. What is its operating cash flow?
c. Explain your results in (a) and (b).
Accounting Values versus Cash Flows in Problem 19, suppose Raines Umbrella Corp. paid out $30,000 in cash dividends. Is this possible? If spending on net fixed asset and net working capital was zero, and if no new stock was issued during the year, what do you know about the firm’s long- term debt account?
Calculating Cash Flows Brewer industries had the following operating results for 2007: sales = $15,200; cost of goods sold = $11,400; depreciation expense = 2,700; interest expense $520; dividends paid = $600. At the beginning of the year, net fixed assets were $9,100, current assets were $3,200, and current liabilities were $1,800. At the end of the year, net fixed assets were $9,700, current assets were $3,850, and current liabilities were $2,100. The tax rate for 2007 was 34 percent.
a. What is net income for 2007?
b. What is the operating cash flow for 2007?
c. What is the cash flow from assets for 2007? Is this possible? Explain.
d. If n o new debt was issued during the year, what is the cash flow to creditors?
What is the cash flow to stockholders? Explain and interpret the positive and negative signs of your answers in (a) through (d).
Calculating Cash Flows Consider the following abbreviated financial statements for Parrot head
a. What is owners’ equity for 2006 and 2007?
b. What is the change in net working capital for 2007?
c. In 2007, Parrot head Enterprises purchased $1,500 in new fixed assets. How much in fixed assets did Parrot head Enterprises sell? What is the cash flow from assets for the year? (The tax rate is 35 percent.)
d. During 2007, Parrot head Enterprises raised $300 in new long-term debt. How much long-term debt must Parrot head Enterprises have paid off during the year? What is the cash flow tocreditors?
Net Fixed Assets and Depreciation On the balance sheet, the net fixed assets (NFA) account is equal to the gross fixed assets (FA) account (which records the acquisition cost of fixed assets) minus the accumulated depreciation (AD) account (which records the total depreciation taken by the firm against its fixed assets). Using the fact that NFA = FA – AD, show that the expression given in the chapter for net capital spending, NFA end – NFA beg + D (where D is the depreciation expense during the year), is equivalent to FA end FA beg.
Tax rates refer to the corporate marginal tax rate information in Table 2.3.
a. Why do you think the marginal tax rate jumps up from 34 percent to 39 percent at a taxable income of $100,001, and then falls back to a 34 percent marginal rate at a taxable income of $335,001?
b. Compute the average tax rate for a corporation with exactly $335,001 in taxable income. Does this confirm your explanation in part (a)? What is the average tax rate for a corporation with exactly $18,333,334? Is the same thing happening here?
c. The 39 percent and 38 percent tax rates both represent what is called a tax “bubble.” Suppose the government wanted to lower the upper threshold of the 39 percent marginal tax bracket from $335,000 to $200,000. What would the new 39 percent bubble rate have to be?
Use the following information for Taco Swell, Inc., for Problems 25 and 26 (assume the tax rate is 34percent).
Financial Statements draw up an income statement and balance sheet for this company for 2006 and 2007.
Calculating Cash Flow for 2007, calculate the cash flow from assets, cash flow to creditors, and cash flow to stockholders.
Current Ratio What effect would the following actions have on a firm’s current ratio assume that net working capital is positive.
a. Inventory is purchased.
b. A supplier is paid.
c. A short-term bank loan is repaid.
d. A long-term debt is paid off early.
e. A customer pays off a credit account.
f. Inventory is sold at cost.
g. Inventory is sold for a profit.
Current Ratio and Quick Ratio In recent years, Dixie Co. has greatly increased its current ratio. At the same time, the quick ratio has fallen. What has happened? Has the liquidity of the company improved?
Current Ratio Explain what it means for a firm to have a current ratio equal to .50. Would the firm be better off if the current ratio were 1.50? What if it were 15.0? Explain your answers.
Financial Ratios fully explain the kind of information the following financial ratios provide about a firm:
a. Quick ratio.
b. Cash ratio.
c. Total asset turnover.
d. Equity multiplier.
e. Long-term debt ratio.
f. Times interest earned ratio.
g. Profit margin,
h. Return on assets.
i. Return on equity.
j. Price—earnings ratio.
Standardized Financial Statements What types of information do common-size financial statements reveal about the firm? What is the best use for these common-size statements? What purpose do common—base year statements have? When would you use them?
Peer Group Analysis Explain what peer group analysis is. As a financial manager, how could you use the results of peer group analysis to evaluate the performance of your firm? How is a peer group different from an aspirant group?
Du Pont Identity Why is the Du Pont identity a valuable tool for analyzing the performance of a firm discuss the types of information ii reveals compared to ROE considered by itself.
Industry-Specific Ratios Specialized ratios are sometimes used in specific industries, For example, the so-called book-to-bill ratio is closely watched for semiconductor manufacturers. A ratio of .93 indicates that for every $100 worth of chips shipped over some period, only $93 worth of new orders was received. In February 2006, the semiconductor equipment industry’s book-to-bill ratio reached 1.01, compared 16.98 during the month of January. The book-to-bill ratio reached a low of .78 during October 2002. The three-month average of worldwide bookings in January 2006 was $1.30 billion, an increase of 6 percent over January, while the three-month average of billings was $1.29 billion, a 2 percent increase from January. What is this ratio intended to measure? Why do you think it is so closely followed?
Industry-Specific Ratios So-called same-store sales are a. very important measure for companies as diverse as McDonald’s and Sears. As the name suggests, examining same-store sales means comparing revenues from the same stores or restaurants at two different points in time. Why might companies focus on same-store sales rather than total sales?
Industry-Specific Ratios there are many ways of using standardized financial information beyond those discussed in this chapter. The usual goal is to put firms on an equal footing for comparison purposes. For example, for auto manufacturers, it is common to express sales, costs, and profits on a per-car basis. For each of the following industries, give an example of an actual company and discuss one or more potentially useful means of standardizing financial information:
a. Public utilities.
b. Large retailers.
d. Online services
f. College textbook publishers.
Statement of Cash Flows In recent years, several manufacturing companies have reported the cash flow from the sale of Treasury securities in the cash from operations section of the statement of cash flows. What is the problem ‘with this practice? Is there any situation in which this practice would be acceptable?
Statement of Cash Flows Suppose a company lengthens the time it takes to pay suppliers. How would this affect the statement of cash flows? How sustainable is the change in cash flows from this practice?
Calculating Liquidity Ratios SDJ, Inc., has net working capital of $l,570 current liabilities of $4,380, and inventory of $1,875. What is the current ratio? What is the quick ratio?
Calculating Profitability Ratios Country Boy, Inc., has sales of $24 million, total assets of $18 mil lion, and total debt of $7 million. If the profit margin is 8 percent, what is net income? What is ROA? What is ROE?
Calculating the Average Collection Period Pujols Lumber Yard has a current accounts receivable balance of $387,615. Credit sales for the year just ended were $2,945,600. What is the receivables turnover? The days’ sales in receivables how long did it take on average for credit customers to pay off their accounts during the past year?
Calculating Inventory Turnover The Mississippi Moon Corporation has ending inventory of $324,600, and cost of goods sold for the year just ended was $2,987,165. What is the inventory turnover? The days’ sales in inventory how long on average did a unit of inventory on the shelf before it was sold?
Calculating Leverage Ratios Star Lakes, Inc., has a total debt ratio of .29. What is its debt-equity ratio? What is its equity multiplier?
Calculating Market Value Ratios Baryca Corp. had additions to retained earnings for the year just ended of $350,000. The firm paid out $160,000 in cash dividends, and it has ending total equity of $4.1 million. If the company currently has 210,000 shares of common stock- outstanding, what are earnings per share? Dividends per share book value per share if the stock currently sells for $58 per share, what is the market-to-book ratio the price—earnings ratio? If the company had sales of $3.9 million, what is the price—sales ratio?
Du Pont Identity If Roten Rooters, Inc., has an equity multiplier of 1.35, total asset turn-over of 1.30, and a profit margin of 8.5 percent, what is its ROE?
Du Pont Identity Braam Fire Prevention Corp. has a profit margin of 8.70 percent. Total asset turnover of 1.45, and ROE of 18.67 percent. What is this firm’s debt-equity ratio?
Sources and Uses of Cash Based only on the following information for Angkaw Corp., did cash go up or down? By how much classify each event as a source or use of cash.
Decrease in inventory $400
Decrease in accounts payable 160
Increase in notes payable 580
Decrease in accounts receivable 210
Calculating Average Payables Period Minnow, Inc., had a cost of goods sold of $21.587. At the end of the year, the accounts payable balance was $5,832. How long on average did it take the company to pay off its suppliers during the year? What might a large value for this ratio imply?
Cash Flow and Capital Spending For the year just ended, Ratter man Frozen Yogurt shows an increase in its net fixed assets account of $625. The company took $170 in depreciation expense for the year. How much did the company spend on new fixed assets? Is this a source or use of cash?
Equity Multiplier and Return on Equity Bettles Fried Chicken Company has a debt-equity ratio of 0.80. Return on assets is 9.2 percent, and total equity is $520,000. What is the equity multiplier? Return on equity net income? Just Dew It Corporation reports the following balance sheet information for 2006 and 2007. Use this information to work Problems 13 through 17.
Preparing Standardized Financial Statements prepare the 2006 and 2007 common-size balance sheets for Just Dew It.
Preparing Standardized Financial Statements prepare the 2007 common—base year balance sheet for Just Dew It.
Preparing Standardized Financial Statements Prepare ‘the 2007 combined common-size, common—base year balance sheet for Just Dew It.
Sources and Uses of Cash For each account on this company’s balance sheet show the change in the account during 2007 and note whether this change was a source or use of cash. Do your numbers add up and make sense? Explain your answer for total assets as compared to your answer for total liabilities and owners’ equity.
Calculating Financial Ratios Based on the balance sheets given for Just Dew It, calculate the following financial ratios for each year:
a. Current ratio.
b. Quick ratio
c. Cash ratio.
d. NWC to total assets ratio.
e. Debt—equity ratio and equity multiplier.
f. Total debt ratio and long-term debt ratio.
Using the Du Pont Identity Y3K, Inc., has sales of $4,800, total assets of $2,685, and a debt—equity ratio of 1.20. If its return on equity is 16 percent, what is its net income?
Days’ Sales in Receivables a company has net income of $195,000, a profit margin of 9.40 percent, and an accounts receivable balance of $106,851. Assuming 75 percent of sales are on credit, what are the company’s days’ sales in receivables?
Ratios and Fixc4 Assets The Richmond Company has a long-term debt ratio of .60 and a current ratio of 1:30. Current liabilities are $980, sales are $5,105, profit margin is 95 percent, and ROE is 18.5 percent what is the amount of the firm’s net fixed assets?
Profit Margin hi response to complaints about high prices, a grocery chain runs the following advertising campaign: “If you pay your child $2 to go buy $50 worth of groceries, then your child makes twice as much on the trip as we do.” You’ve collected the following information from the grocery chain’s financial statements:
Evaluate the grocery chain’s claim. What is the basis for the statement? Is this claim misleading? Why or why not?
Return on Equity Firm A and firm B have debt—total asset ratios of 55% and 45% and returns on total assets of 20% and 28%, respectively. Which firm has a greater return on equity?
Calculating the Cash Coverage Ratio Kat Inc.’s net income for the most recent year was $1 0,157. The tax rate was 34 percent. The firm paid $3,405 in total interest expense and deducted $2, 186 in depreciation expense. What was the cash coverage ratio for the year?
Cost of Goods Sold Holliman Corp. has current liabilities of $410,000, a quick ratio of 1.8, inventory turnover of 4.2, and a current ratio of 3.3. What is the cost of goods sold for the company?
Ratios and Foreign Companies Prince Albert Canning PLC had a net loss off 18,465 on sales off 151,387 (both in thousands of pounds). What was the company’s profit margin? Does the fact that these figures arc quoted in a foreign currency make any difference? Why? In dollars; sales were $269,566. What was the net loss in dollars? Some recent financial statements for Smolira Golf Corp. follow.
Du Pont Identity Construct the Du Pont identity for Smolira Golf Corp.
Statement of Cash Flows Prepare the 2007 statement of cash flows for Smolira Golf Corp
Tobin’s Q what is Tobin’s Q for Smolira Golf? What assumptions are you making about the book value of debt and the market value of debt? What about the book value of assets and the market value of assets? Are these assumptions realistic? Why or why not?
Sales Forecast Why do you think most long-term financial planning begins with sales forecasts? Put differently, why are future sales, the key input?
Sustainable Growth In the chapter, we used Rosengarten Corporation to demonstrate how to calculate EFN. The ROE for Rosengarten is about 7.3 percent, and the plowback ratio is about 67 percent. If you calculate the sustainable growth rate for Rosengarten, you will find it is only 5.14 percent. In our calculation for EFN, we used a growth rate of 2 percent. Is this possible?
External Financing Needed Testaburger, Inc., uses no external financing and maintains a positive retention ratio. When sales grow by 15 percent, the firm has a negative projected EFN. What does this tell you about the firm’s internal growth rate? How about the sustainable growth rate? At this same level of sales growth, what will happen to the projected EFN if the retention ratio is increased? What if the retention ratio is decreased? What happens to the projected EFN if the firm pays out all of its earnings in the form of dividends?
EFN and Growth Rates Broslofski Co, maintains a positive retention ratio and keeps its debt-equity ratio constant every year when sales grow by 20 percent, the firm has a negative projected EFN: What does this tell you about the firm’s sustainable growth rate? Do you know, with certainty, if the internal growth rate is greater than or less than 20 percent? Why? What happens to the projected EFN if the retention ratio is increased? What If the retention ratio is decreased? What if the retention ratio is zero? Use the following information to answer the next six questions: A small business called The Grandmother Calendar Company began selling personalized photo calendar kits. The kits were a hit, and sales soon sharply exceeded forecasts. The rush of orders created a huge backlog, so the company leased more space and expanded capacity; but it still could not keep up with demand. Equipment failed from overuse and quality suffered. Working capital was drained to expand production, and, at the same time, payments from customers were often delayed until the product was shipped. Unable to deliver on orders, the company became so strapped for cash that employee paychecks began to bounce. Finally, out of cash, the company ceased operations entirely three years later.
Product Sales Do you think the company would have suffered the same fate if its product had been less popular? Why or why not?
Cash Flow The Grandmother Calendar Company clearly had a cash flow problem. In the context of the cash flow analysis we developed in Chapter 2, what was the impact of customers not paying until orders were shipped?