SOLUTIONS MANUAL for Financial Management Theory & Practice 17th Edition by Eugine and Michael by digitaldownload87

TABLE OF CONTENTS 1. Chapter 1. An Overview of Financial Management and the Financial Environment 2. Chapter 2. Financial Statements, Cash Flow, and Taxes 3. Chapter 3. Analysis of Financial Statements 4. Chapter 4. Time Value of Money 5. Chapter 5. Bonds, Bond Valuation, and Interest Rates 6. Chapter 6. Risk and Return 7. Chapter 7. Corporate Valuation, Stock Valuation, and Stock Market Equilibrium Rates 8. Chapter 8. Financial Options and Applications in Corporate Finance 9. Chapter 9. The Cost of Capital 10. Chapter 10. The Basics of Capital Budgeting: Evaluating Cash Flows 11. Chapter 11. Cash Flow Estimation and Risk Analysis 12. Chapter 12. Corporate Valuation and Financial Planning 13. Chapter 13. Corporate Governance 14. Chapter 14. Distributions to Shareholders: Dividends and Repurchases 15. Chapter 15. Capital Structure Decisions 16. Chapter 16. Supply Chains and Working Capital Management 17. Chapter 17. Multinational Financial Management 18. Chapter 18. Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

19. Chapter 19. Lease Financing 20. Chapter 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles 21. Chapter 21. Dynamic Capital Structures and Corporate Valuation 22. Chapter 22. Mergers and Corporate Control 23. Chapter 23. Enterprise Risk Management 24. Chapter 24. Bankruptcy, Reorganization, and Liquidation 25. Chapter 25. Portfolio Theory and Asset Pricing Models

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

SOLUTION MANUAL Financial Management Theory and Practice 17th EditionEugene F. Brigham, Michael C. Ehrhardt

Solution and Answer Guide CHAPTER 1: AN OVERVIEW OF FINANCIAL MANAGEMENT AND THE FINANCIAL ENVIRONMENT

TABLE OF CONTENTS ANSWERS TO END-OF-CHAPTER QUESTIONS ............................................................................... 1 MINI CASE ................................................................................................................................................. 5

ANSWERS TO END-OF-CHAPTER QUESTIONS 1-1

Define each of the following terms: a. Proprietorship; partnership; corporation; charter; bylaws b. Limited partnership; limited liability partnership; professional corporation c. Stockholder wealth maximization d. Money market; capital market; primary market; secondary market e. Private markets; public markets; derivatives f. Investment bank; financial services corporation; financial intermediary g. Mutual fund; money market fund h. Open outcry auction; dealer market; automated trading platform i. Production opportunities; time preferences for consumption j. Foreign trade deficit k. Algorithmic trading; high-frequency trading Answer: a. A proprietorship, or sole proprietorship, is a business owned by one individual. A partnership exists when two or more persons associate to conduct a business. In contrast, a corporation is a legal entity created by a state. The corporation is separate and distinct from its owners and managers. A company must file a charter to become a corporation. A charter includes the following information: (1) name of the proposed corporation, (2) types of activities it will pursue, (3) amount of capital stock, (4) number of directors, and (5) names and addresses of directors. The bylaws are a set of rules drawn up by the founders of the corporation. Included are such points as: (1) how directors are to be elected (all elected each year or perhaps one-third each year for 3-year terms), (2) whether the existing stockholders will have the first right to buy any new shares the firm issues, and (3) procedures for changing the bylaws themselves, should conditions require it.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

In a limited partnership, limited partners’ liabilities, investment returns and control are limited, while general partners have unlimited liability and control. In limited partnership, at least one partner is liable for all the debts in the partnership. A limited liability partnership (LLP), sometimes called a limited liability company (LLC), combines the limited liability advantage of a corporation with the tax advantages of a partnership. A professional corporation (PC), known in some states as a professional association (PA), has most of the benefits of incorporation but the participants are not relieved of professional (malpractice) liability.

Stockholder wealth maximization is the appropriate goal for management decisions. The risk and timing associated with expected earnings per share and cash flows are considered in order to maximize the price of the firm’s common stock. Maximizing shareholder’s wealth is a duty that needs to be fulfill by corporations.

A money market is a financial market for debt securities with maturities of less than 1 year (shortterm). The New York money market is the example of money market. Capital markets are the financial markets for long-term debt and corporate stocks. The New York Stock Exchange is an example of a capital market. Primary markets are the markets in which newly issued securities are sold for the first time. Secondary markets are where securities are resold after initial issue in the primary market. The New York Stock Exchange is a secondary market.

In private markets, transactions are worked out directly between two parties and structured in any manners that appeal to them. Bank loans and private placements of debt with insurance companies are examples of private market transactions. In public markets, standardized contracts are traded on organized exchanges. Securities that are issued in public markets, such as common stock and corporate bonds, are ultimately held by a large number of individuals. Private market securities are more tailor-made but less liquid, whereas public market securities are more liquid but subject to greater standardization. Derivatives are those underlying asset that derives their value from other traded assets. Futures, options, forwards are the examples of derivative market. Therefore, the value of a derivative security is derived from the value of an underlying real asset.

An investment banker is a facilitator between businesses and savers. Investment banking houses assist in the design of corporate securities and then sell them to savers (investors) in the primary markets. Financial service corporations offer a wide range of financial services such as brokerage operations, insurance, and commercial banking. A financial intermediary buys security with funds that is obtained by issuing its own securities. An example is a common stock mutual fund that buys common stocks with funds obtained by issuing shares in the mutual fund.

A mutual fund is an organization that pools the money deposited by savers to buy financial instruments. These instruments receive dividends and interest on it. The resulting dividends, interest, and capital gains are distributed to the fund’s shareholders after the deduction of operating expenses. Different funds are designed to meet different objectives. Money market funds are mutual funds which invest in short-term securities carry low-risk and also offer their shareholders interest-bearing checking accounts.

An open outcry auction is a method where traders meet face to face at particular location at an agreed price and quantity. These traders communicate with each other through hand signals and shouts. In a dealer market, a dealer holds an inventory of the security and makes a market by offering to buy or sell. Others who wish to buy or sell can see the offers made by the dealers, and can contact the dealer of their choice to arrange a transaction. An automated trading platform is a computer system in which buyers and sellers post orders and in which trades are automatically executed for matching orders.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

be demanded now. Consumption time preferences refer to the preferred pattern of consumption. Consumers’ time preferences for consumption establish how much consumption they are willing to save or consume at different levels of interest. It majorly impacts required rate of return.

1-2

A foreign trade deficit occurs when businesses and individuals in the United States import more goods from foreign countries compared to exports. This cause an increase in an interest rate. Trade deficits must be financed, and the main source of financing is debt. Foreign trade surplus occurs when exports are more than imports. As the trade deficit increases, the debt financing increases, driving up interest rates. U.S. interest rates must be competitive with foreign interest rates; if the Federal Reserve attempts to set interest rates lower than foreign rates, foreigners will sell U.S. bonds, decreasing bond prices, resulting in higher U.S. rates.

Algorithmic trading occurs when computers are programed to buy or sell stocks on behalf of stockholders if a particular event or sequence of events happens. High frequency trading (HFT) is a type of algorithmic trading in which HFT traders, which are computers, buy and sell hundreds or thousands of times a day. Most HFT is done by firms that are created for this purpose because HFT requires expensive computer systems and highly paid programmers.

What are the three principal forms of business organization? What are the advantages and disadvantages of each? Answer: Sole proprietorship, partnership, and corporation are the three principal forms of business organization. The advantages of the Sole proprietorship and partnership includes ease and low cost of formation. The advantages of the corporation include limited liability, indefinite life, ease of ownership transfer, and access to capital markets. The disadvantages of a sole proprietorship are (1) difficulty in obtaining large sums of capital, (2) unlimited personal liability for business debts, and (3) limited life. The disadvantages of a partnership are (1) unlimited liability, (2) limited life, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The disadvantages of a corporation are (1) double taxation of earnings and (2) requirements to file state and federal reports for registration, which are expensive, complex, and time-consuming.

1-3

What is a firm’s fundamental value (which is also called its intrinsic value)? What might cause a firm’s intrinsic value to be different from its actual market value? Answer: A firm’s fundamental, or intrinsic, value is the present value of its free cash flows when discounted at the weighted average cost of capital. If the market price reflects all relevant information, then the observed price is also the intrinsic price. Intrinsic value depends on all of its expected future cash flows.

1-4

Edmund Corporation recently made a large investment to upgrade its technology. Although these improvements won’t have much of an impact on performance in the short run, they are expected to reduce future costs significantly. What impact will this investment have on Edmund’s earnings per share this year? What impact might this investment have on the company’s intrinsic value and stock price? Answer: Earnings per share in the current year will decline due to cost of the investment made in the current year and no significant performance impact in the short run. However, the company’s stock price should increase due to the significant cost savings expected in the future.

1-5

Describe the ways in which capital can be transferred from suppliers of capital to those who are demanding capital. Answer:

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

In a well-functioning economy, capital will flow efficiently from those who supply capital to those who demand it. This transfer of capital can take place in three different ways:

1-6

Direct transfers of money and securities occur when a business sells its stocks or bonds directly to savers, without going through any type of financial institution. The business delivers its securities to savers, who in turn give the money to the firm it needs.

Capital can also be transferred indirectly through an investment bank that underwrites the issue. An underwriter serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to the investment bank, which in turn sells these same securities to savers. The businesses’ securities and the savers’ money merely ―pass through‖ the investment banking house.

Transfers can also be made through a financial intermediary. Here, the intermediary obtains funds from savers in exchange for its own securities. The intermediary uses this money to buy and hold businesses’ securities. Intermediaries literally create new forms of capital. The existence of intermediaries greatly increases the efficiency of money and capital markets.

What are financial intermediaries, and what economic functions do they perform? Answer: Financial intermediaries are business organizations that receive funds in one form and repackage them for the use of those who need funds. Through financial intermediation, resources are allocated more effectively, and the real output of the economy is thereby increased.

1-7

Is an initial public offering an example of a primary or a secondary market transaction? Answer: A primary market is the market in which corporations raise capital by issuing new securities. An initial public offering is a stock issue where privately held firms go to public. Therefore, an IPO would be an example of a primary market transaction. A secondary offering of stock by a publicly traded company is also a primary market transaction. Other examples include bond issuances by companies or governments. A secondary market is for buying and selling securities that have already been issued. For example, a stock exchange is a secondary market.

1-8

Contrast and compare trading in face-to-face auctions, dealer markets, and automated trading platforms. Answer: Traders meet face to face in an open outcry auction at a particular location at an agreed rate. In a dealer market, there are ―market makers‖ who keep an inventory of the stock. These dealers list the prices at which they are willing to buy or sell. In a traditional dealer market, computerized quotation systems keep track of all bid and ask quotes, but they don’t actually match buyers and sellers. Instead, traders must contact a specific dealer to complete the transaction. An automated trading platform is a computer system in which buyers and sellers post their orders and then let the computer automatically determine whether a match exists. If a match exists, the computer automatically executes and reports the trade.

1-9

Describe some similarities and differences among broker-dealer networks, alternative trading systems (ATSs), and registered stock exchanges. Answer: Broker-dealer networks are registered with the SEC but are much less regulated than alternative trading systems (ATS) and registered stock exchanges. In a typical broker-dealer network, the broker-dealer purchases the stock being offered for sale by a client and then immediately sells it to another client who wished to buy the stock. The broker-dealer is the counterparty to each of the clients. The broker-dealer must report the transactions, but not any information prior to the trade. An alternative trading system is a broker-dealer that registers with the SEC as an ATS. An ATS usually has an automated trading platform to match orders from clients, so the owner of the ATS is not always the counterparty, in contrast to a

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

broker-dealer network. The ATS must report trades, but not any pre-trade information. Therefore, an ATS is often called a dark pool. Stocks can only be listed at a registered stock exchange, although they may be traded elsewhere. A stock exchange must comply with more regulations than an ATS. In addition to reporting trades, a stock exchange must also report pre-trade information regarding bids and quotes. 1-10 What are some similarities and differences between the NYSE and the NASDAQ Stock Market? Answer: The NYSE and NASDAQ are the two largest registered stock exchange around the globe. These stock exchange provides trading platform for securities situated in New York. The NYSE is a market that uses designated markets makers. NASDAQ is a dealer market where every makers is in competition with each other. The NASDAQ Stock Market has the most listings because it is willing to list smaller corporations than the NYSE. However, the NYSE’s listings have a much bigger market value than NASDAQ’s listed stocks.

MINI CASE Assume that you recently graduated and have just reported to work as an investment advisor at the brokerage firm of Balik and Kiefer, Inc. One of the firm’s clients is Michelle DellaTorre, a highly ranked professional tennis player who has just come to the United States from Chile. DellaTorre would like to start a company to produce and market apparel she designs. She also expects to invest substantial amounts of money through Balik and Kiefer. DellaTorre is very bright, and she would like to understand in general terms what will happen to her money. Your boss has developed the following set of questions you must answer to explain the U.S. financial system to DellaTorre. a.

Why is corporate finance important to all managers? Answer: Corporate finance provides the skills that is required by managers. Such as:(1) identify and select the corporate strategies and individual projects that add value to their firm; and (2) forecast the funding requirements of their company, and devise strategies for acquiring those funds.

Describe the organizational forms a company might have as it evolves from a start-up to a major corporation. List the advantages and disadvantages of each form. Answer: The three main forms of business organization are (1) sole proprietorships, (2) partnerships, and (3) corporations. In addition, several hybrid forms are gaining popularity. These hybrid forms are the limited partnership, the limited liability partnership, the professional corporation, and the s corporation. The proprietorship has three important advantages: (1) it is easily and inexpensively formed, (2) it is subject to few government regulations, and (3) the business pays no corporate income taxes. The proprietorship also has three important limitations: (1) it is difficult for a proprietorship to obtain large sums of capital, (2) the proprietor has unlimited personal liability for the business’s debts, and (3) the life of a proprietorship is limited to the life of the individual who created it. The major advantage of a partnership is its low cost and ease of formation. The disadvantages are similar to those associated with proprietorships: (1) unlimited liability, (2) limited life of the organization, (3) difficulty of transferring ownership, and (4) difficulty of raising large amounts of capital. The tax treatment of a partnership is similar to that for proprietorships, which is often an advantage. The corporate form of business has three major advantages: (1) unlimited life, (2) easy transferability of ownership interest, and (3) limited liability. While the corporate form offers significant advantages over proprietorships and partnerships, it does have two primary disadvantages: (1) corporate earnings may be

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

subject to double taxation and (2) setting up a corporation and filing the many required state and federal reports is more complex and time-consuming than for a proprietorship or a partnership. In a limited partnership, the limited partners are liable only for the amount of their investment in the partnership; however, the limited partners typically have no control. The limited liability partnership form of organization combines the limited liability advantage of a corporation with the tax advantages of a partnership. Professional corporations provide most of the benefits of incorporation but do not relieve the participants of professional liability. S-corporations are similar in many ways to limited liability partnerships, but LLPS frequently offer more flexibility and benefits to their owners. c.

How do corporations go public and continue to grow? What are agency problems? What is corporate governance? Answer: A company goes public when it sells stock to the public as the firm grows, it might issue additional stock or debt. An agency problem occurs when the managers of the firm act in their own self-interests and not in the interests of the shareholders. Corporate governance is the set of rules that control a company’s behavior towards its directors, managers, employees, shareholders, creditors, customers, competitors, and community.

What should be the primary objective of managers? Answer: The corporation’s primary goal is stockholder’s wealth maximization, which translates to maximizing the price of the firm’s common stock. 1.

Do firms have any responsibilities to society at large? Answer: Firms have an ethical responsibility to provide a safe working environment, to avoid polluting the air or water, and to produce safe products. However, the most significant cost-increasing actions will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all businesses.

Is stock price maximization good or bad for society? Answer: The same actions that maximize stock prices also benefit society. Stock price maximization requires efficient, low-cost operations that produce high-quality goods and services at the lowest possible cost. Stock price maximization requires the development of products and services that consumers want and need, so the profit motive leads to new technology, to new products, and to new jobs. Also, stock price maximization necessitates efficient and courteous service, adequate stocks of merchandise, and welllocated business establishments. All these factors are necessary to generate sales revenues, which are necessary to generate profits.

Should firms behave ethically? Answer: Yes, results of a recent study indicate that the executives of most major firms in the United States believe that firms do try to maintain high ethical standards in all of their business dealings. Furthermore, most executives believe that there is a positive correlation between ethics and long-run profitability. Conflicts often arise between profits and ethics. Companies must deal with these conflicts on a regular basis, and a failure to handle the situation properly can lead to huge product liability suits and even can lead to bankruptcy. There is no room for unethical behavior in the business world.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

What three aspects of cash flows affect the value of any investment? Answer: (1) amount of expected cash flows, (2) timing of the cash flow stream, and (3) riskiness of the cash flows

What are free cash flows? Answer: Free cash flows are the cash flows available for distribution to all investors (stockholders and creditors) after paying expenses (including taxes) and making the necessary investments to support growth. FCF = Sales revenues – Operating costs - Operating taxes − Required investments in Operating Capital

What is the weighted average cost of capital? Answer: The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors). It is affected by the firm’s capital structure, interest rates, the firm’s risk, and the market’s overall attitude toward risk.

How do free cash flows and the weighted average cost of capital interact to determine a firm’s intrinsic value? Answer: A firm’s intrinsic value is the sum of all future expected free cash flows, converted into today’s dollars. Value 

FCF1 (1  WACC)1



FCF2 (1  WACC) 2

 ....

FCF

(1  WACC) 

Who are the providers (savers) and users (borrowers) of capital? How is capital transferred between savers and borrowers? Answer: Households are net savers. Most governments are net borrowers. The United States, Italy, and France have been net borrowers each year from 2001–2020. A relatively small number of countries during this period were not net borrowers but instead were net lenders. These countries include Norway (borrowed 1 year), South Korea (borrowed 4 years), New Zealand (borrowed in 6 years), and Luxemburg (borrowed 5 years). Non-financial corporations are net borrowers. Financial corporations (i.e., financial intermediaries including banks) are slightly net borrowers, but they are almost breakeven. Capital is transferred through: (1) direct transfer (e.g., corporation issues commercial paper to insurance company), (2) an investment banking house (e.g., IPO, seasoned equity offering, or debt placement), and (3) a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company).

What is a required rate of return? What components make up the required rates of return on debt and stocks? What is the cost of debt and what is the cost of equity? Answer: A required rate of return is the rate that an investor expects from an investment in order to compensate the risk involved in investment. An investor’s expected rate of return is comprised of expected payments to the investor and expected changes in the investment’s value. For debt, the lender’s expected rate of return consists of expected interest payments and expected changes in the debt’s value.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

For stock, the shareholder’s expected rate of return consists of expected dividend payments and expected changes in the stock’s price. Providing expected required returns to lenders and shareholders is usually difficult and costly. Therefore, the required expected rate of return on debt is also called the cost of debt and the required expected rate of return on equity is also called the cost of equity. In other words, the required rate of return on a source of capital is equal to the cost of using the capital. k.

What are some economic conditions that affect interest rates, which subsequently affect required rates of return? Answer: Interest rates are influenced by (1) Federal Reserve policy, (2) the federal budget deficit or surplus, (3) the level of business activity, and (4) foreign trade balances. (1) Federal Reserve Policy: The Federal Reserve sets a target interest rate and often acts to keep interest rates close to the target. If the Federal Reserve wishes to keep interest rates low, then it usually implements open market operations. The Fed will purchase Treasury securities held by banks, which increases the demand for Treasury securities, which in turn increases the prices of Treasury securities. When the price of any bond goes up and the payments remain unchanged, the bond’s rate of return goes down. If the Fed wishes to increase interest rates, it reverses this policy and sells Treasury securities. This increases supply which causes the prices of Treasury securities to fall. When the price goes down and the payments remain unchanged, the subsequent rate of return goes up. (2) Federal Budget Deficits or Surpluses: A budget deficit occurs when the federal government spends more than it collects from tax revenues. To fund excess spending, the government either must borrow or increase the money supply. The government borrows by issuing new Treasury securities (or by selling ones that it had previously repurchased). This creates a greater supply of Treasury securities than currently is demanded, which causes a decrease in prices of Treasury securities until there is no more excess supply. When the price of a bond goes down and the payments remain unchanged, the rate of return (i.e., the interest rate) goes up. If a miracle were to occur and the government had a surplus, then the government could repurchase some of its debt. This demand for Treasury securities would cause their prices to go up, which would reduce their rate of return. (3) Level of Business Activity: An increase in the level of business activity means that the demand for borrowing also increases. This creates a temporary imbalance in which the supply of loans is less than the demand for loans. When supply exceeds demand, the ―price‖ must change until supply and demand are equal. In this situation, the interest rate will increase until the demand decreases and the supply increases to the point that both are equal. The reverse is true if a decrease in the level of business activity reduces the demand for loans. If the interest rate doesn’t fall, the supply of loans will exceed the demand for loans. Therefore, the interest rate must fall until the supply and demand for loans are equal. (4) Foreign Trade Deficits or Surpluses: A foreign trade deficit occurs when a country imports more than it exports. If people and companies in the United States import more goods and services than they export, then they must spend more money on the imports than they make on the exports. The U.S. companies and individuals usually borrow to finance this additional net spending. Higher demand for borrowing will cause interest rates to go up, all else held equal. The reverse is true for a country with foreign trade surpluses.

What four fundamental factors affect required rates of return? Answer: The required rate of return depends on these four fundamental factors: (1) production opportunities, (2) time preferences for consumption, (3) risk, and (4) inflation.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Production opportunities are the cash generating activity that require cash in the present but have the ability to generate more cash in future. The higher the production opportunities, the more cash will be demanded now. Time preference for consumption refers to consumers’ preferences for current consumption versus savings for future consumption: consumers with low preferences for current consumption will be willing to lend at a lower rate than consumers with a high preference for current consumption. Inflation refers to the tendency of prices to rise, and the higher the expected rate of inflation, the larger the required rate of return. Risk, in a money and capital market context, refers to the chance that the future cash flows will not be as high as expected—the higher the perceived default risk, the higher will be the required rate of return. Risk is also linked to the maturity and liquidity of a security. The longer the maturity and the less liquid (marketable) the security, the higher the required rate of return, other things constant. m. What are financial instruments? Describe the major types of financial instruments with respect to risk, original maturity, and rates of return. Answer: Financial instruments are documents (either on paper or on computers) with contractual obligations. Some are short-term (i.e., they mature within a year) and have low default risk, such as U.S. Treasury bills, commercial paper, and CDs. Short-term financial instruments usually have low risk and low rates of return. Commercial loans (which have maturities up to 7 years) have rates that are usually tied to the prime rate (i.e., the rate that U.S. banks charge to their best customers) or SOFR (Secured Overnight Financing Rate, which is based on actual overnight loans that use Treasury securities as collateral). U.S. Treasury notes and bonds have maturities from 2 to 30 years; they have no default risk. Mortgages have maturities up to 30 years. Municipal bonds have maturities of up to thirty years; their interest is exempt from most taxes. Corporate bonds have maturities up to 40 years. Municipal and corporate bonds are subject to default risk. Some preferred stocks have no maturity date; some do have a specific maturity date. Common stock has no maturity date, and is riskier than preferred stock. n.

What is a financial institution? List some financial institutions. Answer: A financial institution acts as an intermediary between providers of funds and users of funds and provides; in other words, a financial institution facilitates transfers of capital. There are many types of financial institutions, including commercial banks, savings and loan associations (S&Ls), mutual savings banks, credit unions, life insurance companies, mutual fund companies, pension funds, hedge funds, and private equity funds. Following are definitions of these institutions: 1.

Commercial banks: Financial intermediaries whose primary purpose is to take deposits and make loans to businesses and individuals.

Savings and loan associations (S&Ls): Financial institutions that accept deposits from small savers and lend this money to homeowners and consumers.

Mutual savings banks: Similar to S&Ls, but they operate primarily in the northeastern states.

Credit unions: Cooperative associations that take deposits from members and then make loans only to other members, generally for auto purchases, home-improvement loans, and home mortgages.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Life insurance companies: Take premiums from customers, invest these funds in stocks, bonds, real estate, and mortgages, and then make payments to beneficiaries.

Mutual fund companies: Corporations that sell shares in the fund and use the proceeds to buy stocks, long-term bonds, or short-term debt instruments. The resulting dividends, interest, and capital gains are distributed to the fund’s shareholders after the deduction of operating expenses. Some funds specialize in certain types of securities, such as growth stocks, international stocks, or municipal bonds.

Pension funds: Retirement plans funded completely or partially by a corporation or government agency.

Hedge funds: Raise money from institutional investors and a relatively small number of high-net-worth individuals, and then engage in a variety of investment activities.

Private equity funds: Raise money from institutional investors and a relatively small number of highnet-worth individuals. Private equity funds primarily invest in stock of private companies.

What is a financial market? What are some types of financial markets? Answer: A market is a method of exchanging one asset (usually cash) for another asset. Some types of markets are: physical assets vs. financial assets; spot versus future markets; money versus capital markets; and primary versus secondary markets. Physical asset markets include markets for such products as wheat, autos, real estate, computers, and machinery. Financial asset markets included stock markets, bond markets, and other means of trading financial instruments. Spot markets require payment when the transaction takes place, such as purchases of groceries, stocks, and bonds. Future markets are for futures contracts in which no money changes hands until the price of the underlying asset changes. There are futures markets for many commodities, including agricultural products like wheat or oil. Financial assets with an original maturity of less than a year are traded in money markets; those with an original maturity of more than a year trade in capital markets. Primary markets are where new securities are created and first sold. Secondary markets are for trading securities that have already been created.

What are some differences between primary markets and secondary markets? Why are secondary markets important? Answer: Primary markets are where new securities are created and sold, providing cash to the issuer of the security. For example, new shares of stock are created when a company has an IPO. New shares can also be created if a company sells additional shares to the public (this is called a secondary offering). Another example of primary markets is a company issuing (i.e., selling) bonds. After a new security has been created, it can be sold in a secondary market. For example, previously issued shares of stock are traded on stock exchanges. Notice that the original issuer of the security is not involved in a secondary market transaction. One reason that secondary markets are important is that they allow entrepreneurs to reap rewards for their efforts in creating a company. They can do this by selling some shares of their own stock in the secondary market. Then they can use the cash they receive from the secondary market transaction for other purposes. For example, they might buy a new car, buy a better house, or go on a scuba diving trip. Secondary markets also allow investors to buy or sell stock if they need a change. For example, many investors have a target for the percent of their wealth that is invested in stock or bonds. If stock prices increase, investors can use secondary markets to rebalance their portfolios to get back to the target.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Secondary markets allow investors to determine the value of their investments by looking at current prices of stocks.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

What are the three major U.S. stock exchanges? Compare and contrast them with respect to the number of listed stocks and the market values of the listed stocks. Answer: The three major exchanges are the New York Stock Exchange (NYSE), NASDAQ, and the NYSE American Exchange. Their listing and market value of listings are shown below.

Exchange

Market Value of Listings (Trillions)

Percent of Total Market Value

NYSE

2,199

$36.0

57.0%

NASDAQ

2,027

27.1

42.8%

0.1

0.2%

4,288

$63.2

100%

NYSE American Total r.

Number of Listings

What is a full-service brokerage account? What are two other types of brokerage accounts? Answer: A client at a full-service broker usually can call a person at the firm to discuss their portfolio and get advice. A client with a full-service broker usually must pay fees to open the account, pay annual fees maintain the account, and pay additional commissions for each stock purchase of sale. The minimum balance required for a full-service brokerage account is usually between $50,000 to $100,000. Two other types of accounts are online-only accounts and robo-advisor accounts. An online-only account is much less expensive than a full-service account and requires a much lower minimum balance, but it offers significantly fewer services. A customer doesn’t have access to a personal broker, but an online account has lots of educational material available for its account holders. Another type of online-only account provides a robo-advisor, which is a fully automated computer system that automatically makes trades on a client’s behalf based on the answers to a detailed questionnaire that the client filled out that has questions about the client’s financial situation, goals, and degrees of risk tolerance.

What are the differences between market orders and limit orders? Explain how orders from buyers and sellers are matched and executed at open outcry auctions, in dealer markets, and by automated trading platforms. Answer: Market orders instruct the broker to transact as quickly as possible at the current price. Limit orders instruct brokers to transact only if a specific situation occurs. For example, buy 100 shares if the price drops to $50 or below during the next two hours. Open outcry auctions have a physical location at which human traders meet face to face and execute trades. For example, there is still some stock trading on the floor of the NYSE. Derivatives and options also trade at physical exchanges. Dealers (i.e., market makers) buy from and sell to clients from an inventory of stocks. Orders are usually, but not always, automatically matched by computers. Automated trading platforms match orders and execute trades automatically.

What is a broker-dealer network? What is an Alternative Trading System (ATS)? What is a Trade Reporting Facility (TRF)? Answer:

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Broker-dealer networks are registered with the SEC but are much less regulated than registered stock exchanges. In a typical broker-dealer network, the broker-dealer purchases the stock being offered for sale by a client and then immediately sells it to another client who wished to buy the stock. Because the brokerdealer is the counterparty to each of the clients, this is called internalization. The broker-dealer must report the transactions, but not any information prior to the trade. Trades in broker-dealer networks are called ―off exchange‖ or over-the-counter (OTC). Trades can be with individuals (called retail trades) or with institutions. Large trades (10,000 shares or more) are called block trades and are sometimes called ―upstairs‖ trades. An alternative trading system (ATS) is a broker-dealer that registers with the SEC as an ATS. An ATS usually has an automated trading platform to match orders from clients, so the owner of the ATS is not always the counterparty, in contrast to a broker-dealer network. The ATS must report trades, but not any pre-trade information. Therefore, an ATS is often called a dark pool. Off-exchange trades are reported to the trade reporting facility (TRF) for the exchange, The situation is very different today. Both exchanges have about the same number of listed stocks: 2,199 for the NYSE and 2,027 for NASDAQ. The total market values of stocks listed on each exchange are also similar: $36 trillion for the NYSE and $27 trillion for NASDAQ. u.

What are the dollar volumes of trading at major stock trading venues, including Trade Reporting Facilities? Answer: Trade reporting facilities have the most dollar volume of trading, as shown in the table below.

Trading Venues

Dollar Volume (Trillions)

Percentage of Dollar Volume

Off-Exchange Trade Reporting Facilities (TRF)

$53

38%

NASDAQ

21%

Intercontinental Exchange

21%

Cboe Global Markets

15%

Other Exchanges

$142

100%

Total

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Solution and Answer Guide CHAPTER 2: FINANCIAL S TATEMENTS , CASH F LOWS, AND TAXES

TABLE OF CONTENTS ANSWERS TO END-OF-CHAPTER QUESTIONS............................................................................. 14 SOLUTIONS TO END-OF-CHAPTER PROBLEMS .......................................................................... 17 Easy Problems 1-9 .................................................................................................................................. 17 Intermediate Problems 10-17 .................................................................................................................. 20 Challenging Problems 18-19................................................................................................................... 25 SOLUTION TO SPREADSHEET PROBLEM ..................................................................................... 29 MINI CASE ............................................................................................................................................... 32

ANSWERS TO END-OF-CHAPTER QUESTIONS 2-1

Define each of the following terms: a. Annual report; balance sheet; income statement b. Common stockholders’ equity, or net worth; retained earnings c. Statement of stockholders’ equity; statement of cash flows d. Depreciation; amortization; EBITDA e. Operating current assets; operating current liabilities; net operating working capital; total net operating capital f. Accounting profit; net cash flow; NOPAT; free cash flow; return on invested capital g. Market Value Added; Economic Value Added h. Progressive tax; taxable income; marginal and average tax rates i. Capital gain or loss; tax loss carryforward j. Improper accumulation; S corporation Answer: a. The annual report is a report issued annually by a corporation to its stockholders. It contains basic financial statements, as well as management’s opinion of the past year’s operations and the firm’s future prospects. A firm’s balance sheet is a statement of the firm’s financial position at a specific point in time. It specifically lists the firm’s assets on the left-hand side of the balance sheet, while the right-hand side shows its liabilities and equity, or the claims against these assets. An income statement is a statement summarizing the firm’s revenues and expenses over an accounting period. Net sales are shown at the top of each statement, after which various costs, including income taxes, are subtracted to obtain the net income available to common stockholders. The bottom of the statement reports earnings and dividends per share. b.

Common stockholders’ equity (net worth) is the capital supplied by common stockholders–capital stock, paid-in capital, retained earnings, and, occasionally, certain reserves. Paid-in capital is the difference between the stock’s par value and what stockholders paid when they bought newly issued

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

shares. Retained earnings is the portion of the firm’s earnings that have been saved instead of paying out as dividends. c.

The statement of stockholders’ equity shows how much of the firm’s earnings were retained in the business rather than paid out in dividends. It also shows the resulting balance of the retained earnings account and the stockholders’ equity account. Note that retained earnings represents a claim against assets, not assets per se. Firms retain earnings primarily to expand the business, not to accumulate cash in a bank account. The statement of cash flows reports the impact of a firm’s operating, investing, and financing activities on cash flows over an accounting period. It shows the inflow and outflow of the cash occurred in an accounting year.

Depreciation is a non-cash expense against tangible assets, such as buildings or machines. It is taken for the purpose of showing an asset’s estimated dollar cost of the capital equipment used up in the production process. Amortization is a non-cash expense against intangible assets, such as goodwill. EBITDA is earnings before interest, taxes, depreciation, and amortization.

Operating current assets are the current assets used to support operating activities, such as cash, accounts receivable, and inventory. It does not include short-term investments. Operating current liabilities are the current liabilities that are a natural consequence of the firm’s operations, such as accounts payable and accruals. It does not include notes payable or any other short-term debt that charges interest. Net operating working capital is operating current assets minus operating current liabilities. Total net operating capital is sum of net operating working capital and operating longterm assets, such as net plant and equipment. Operating capital also is equal to the net amount of capital raised from investors. This is the amount of interest-bearing debt plus preferred stock plus common equity minus short-term investments.

Accounting profit is a firm’s net income as reported on its income statement. Net cash flow, as opposed to accounting net income, is the sum of net income plus non-cash adjustments. NOPAT (net operating profit after taxes), is the amount of profit a company would generate if it had no debt and no financial assets. Free cash flow is the cash flow actually available for distribution to investors after the company has made all investments in fixed assets and working capital necessary to sustain ongoing operations. Return on invested capital is equal to NOPAT divided by total net operating capital. It shows the rate of return that is generated by assets.

Market value added is the difference between the market value of the firm (i.e., the sum of the market value of common equity, the market value of debt, and the market value of preferred stock) and the book value of the firm’s common equity, debt, and preferred stock. If the book values of debt and preferred stock are equal to their market values, then MVA is also equal to the difference between the market value of equity and the amount of equity capital that investors supplied. Economic value added represents the residual income that remains after the cost of all capital, including equity capital, has been deducted.

A progressive tax means the higher one’s income, the larger the percentage paid in taxes. Taxable income is defined as gross income less a set of exemptions and deductions which are spelled out in the instructions to the tax forms individuals must file. Marginal tax rate is defined as the tax rate on the last unit of income. Average tax rate is calculated by taking the total amount of tax paid divided by taxable income.

Capital gain (loss) is the profit (loss) from the sale of a capital asset for more (less) than its purchase price. Ordinary corporate operating losses can be carried backward for 2 years forward for indefinitely and used to offset future taxable income.

Improper accumulation is the retention of earnings by a business for the purpose of enabling stockholders to avoid personal income taxes on dividends. An S corporation is a small corporation

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

which, under Subchapter S of the Internal Revenue Code, elects to be taxed as a proprietorship or a partnership yet retains limited liability and other benefits of the corporate form of organization. 2-2

What four statements are contained in most annual reports? Answer: The four financial statements contained in most annual reports are the balance sheet, income statement, statement of stockholders’ equity, and statement of cash flows.

2-3

If a ―typical‖ firm reports $20 million of retained earnings on its balance sheet, can the firm definitely pay a $20 million cash dividend? Answer: No, because the $20 million of retained earnings doesn’t mean the company has $20 million in cash. The retained earnings figure represents cumulative amount of net income that the firm has not paid out as dividends during its entire history. Thus, most of the reinvested earnings were probably spent on the firm’s operating assets, such as buildings and equipment.

2-4

Explain the following statement: ―Whereas the balance sheet can be thought of as a snapshot of the firm’s financial position at a point in time, the income statement reports on operations over a period of time.‖ Answer: The income statement shows the amount sales, costs, taxes, net income, and other items that have occurred during a specific time interval, such as a year, quarter, or month. For example, it would show the interest expense that a company paid in a year. In contrast, the balance sheet reports the actual amount of cash, inventory, fixed assets, and other assets that a company owns on a specific date. It also shows the amounts of current liabilities, debt, and other liabilities as of a specific date. For example, it might show the balance of accounts payable on the date the balance sheet was constructed.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

2-5

What is operating capital, and why is it important? Answer: Operating capital is the amount of interest-bearing debt, preferred stock, and common equity used to acquire the company’s net operating assets. Without this capital, a firm cannot exist, as there is no source of funds with which to finance operations.

2-6

Explain the difference between NOPAT and net income. Which is a better measure of the performance of a company’s operations? Answer: NOPAT is the amount of net income a company would generate if it had no debt and held no financial assets. NOPAT is a better measure of the performance of a company’s operations because debt lowers income. In order to get a true reflection of a company’s operating performance, one would want to take out debt to get a clearer picture of the situation.

2-7

What is free cash flow (FCF)? Why is it the most important measure of cash flow? Answer: Free cash flow is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations. It is the most important measure of cash flows because it shows the exact amount available to all investors.

2-8

Explain the differences between net cash flow, cash flow from operations (also called operating cash flow), and free cash flow. Answer: Net cash flow is net income plus non-cash expenses less non-cash income. Usually, this amounts to net income plus depreciation. It is an adjustment to net income that reflect non-cash items. Cash flow from operations is the cash flow given in the operating section of the statement of cash flows. It also adjusts net income for depreciation and other non-cash expenses but also adjusts for the required investment in current assets less cash provided by operating current liabilities. So, it extends the definition of cash flow to include some, but not all investments. Free cash flow is NOPAT minus investment in operating assets. FCC is different from net cash flow and operating cash flow as it starts with EBIT (not net income) and adjusts it for investment in all net operating assets (not just the short-term assets like in operating cash flow).

2-9

If you were starting a business, what tax considerations might cause you to prefer to set it up as a proprietorship or a partnership rather than as a corporation? Answer: If the business were organized as a partnership or a proprietorship, its income could be passed to the owners without being subject to taxation at the business level. Also, if you expected to have losses for a few years while the company was getting started, if you were not incorporated, and if you had outside income, the business losses can be used to offset your other income and reduce your total tax bill. These factors would lead you to not incorporate the business. An alternative would be to organize it as an S Corporation, if requirements are met.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS EASY PROBLEMS 1-9 2-1

Personal After-Tax Yield. An investor recently purchased a corporate bond that yields 7.68%. The investor is in the 25% federal-plus-state tax bracket. What is the bond’s after-tax yield to the investor?

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Solution: Corporate yield = 7.68%; Tax = 25% After Tax yield = (Pre-tax yield) (1 – Tax) = 7.68%(0.75) = 5.76% 2-2

Personal After-Tax Yield. Corporate bonds issued by Johnson Corporation currently yield 8.0%. Municipal bonds of equal risk currently yield 5.5%. At what personal tax rate would an investor be indifferent between these two bonds? Solution: Corporate bond yields 8%. Municipal bond yields 6%.

Equivalent pretax yield  Yield on municipal bond on taxable bond (1  Tax) 8% 

5.5% (1  T )

0.08  0.08T  0.055 0.08T  0.025 T  .3125  31.25%. 2-3

Income Statement. Holly's Art Galleries recently reported $7.9 million of net income. Its EBIT was $13 million, and its federal tax rate was 21% (ignore any possible state corporate taxes). What was its interest expense? (Hint: Write out the headings for an income statement and then fill in the known values. Then divide $7.9 million net income by 1 – T = 0.79 to find the pre-tax income. The difference between EBIT and taxable income must be the interest expense. Use this procedure to work some of the other problems.) Solution: NI = $7,900,000; EBIT = $13,000,000; T = 21%; Interest = ? Set up an income statement, plug in the given values, and work in the order of the steps shown below. (As with most problems, there are alternative ways of solving the problem.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

EBIT = $13,000,000 (3)

(Given)

−Interest= 3,000,000 EBT =$10,000,000

(1) (2)

EBT = $10,000,000

NI = EBT(1 − T)  EBT =

NI (1  T)

$7,900,000

 $10,000,000

0.79

−Taxes (21%)= 2,100,000 = EBT(T)= $10,000,000) (0.21) = $2,100,000. NI = $7,900,000

(Given)

More directly, use algebra to determine: Interest = EBIT – [NI/ (1 – T)] = $13,000,000 − $7,900,000/ (1 − 0.21) = $3,000,000. 2-4

Income Statement. Nicholas Health Care Systems recently reported an EBITDA of $25.0 million and net income of $15.8 million. It had $2.0 million of interest expense, and its federal tax rate was 21% (ignore any possible state corporate taxes). What was its charge for depreciation and amortization? Solution: EBITDA = $25,000,000; NI = $15,800,000; Int = $2,000,000; T = 21% ; D&A = ? Set up an income statement, plug in the given values, and work in the order of the steps shown below. (As with most problems, there are alternative ways of solving the problem. EBITDA = $25,000,000

(Given)

(4)

−D&A = 3,000,000

EBITDA – D&A = EBIT  D&A = EBITDA – EBIT

(3)

EBIT

= $22,000,000

EBIT = EBT + Int = $20,000,000 + $2,000,000

−Int

= 2,000,000

(Given)

EBT

= $20,000,000

NI = EBT(1 − T)  EBT =

(1)

(2) −Taxes (21%) NI

NI (1  T)

$15, 800, 000

= $20, 000, 000

0.79

= 4,200,000 = $15,800,000

(Given)

More directly, D&A = EBITDA – Int – (NI/ (1 – T)) = $25,000,000 – $2,000,000 – ($15,800,000/ (1 – 0.21)) = $3,000,000. 2-5

Net Cash Flow. Kendall Corners Inc. recently reported net income of $3.1 million and depreciation of $500,000. What was its net cash flow? Assume it had no amortization expense. Solution: NI = $3,100,000; DEP = $500,000; AMORT = 0 ; NCF = ? NCF = NI + DEP and AMORT = $3,100,000 + $500,000 = $3,600,000.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

2-6

Statement of Retained Earnings. In its most recent financial statements, Del-Castillo Inc. reported $70 million of net income and $900 million of retained earnings. The previous retained earnings were $855 million. How much in dividends did the firm pay to shareholders during the year? Solution: NI = $70,000,000; R/EY/E = $900,000,000; R/EB/Y = $855,000,000; Dividends =? R/EB/Y + NI – Div = R/EY/E $855,000,000 + $70,000,000 – Div = $900,000,000 $925,000,000 – Div = $900,000,000 $25,000,000 = Div

2-7

Net Operating Profit after Taxes (NOPAT). Zucker Inc. recently reported $4 million in earnings before interest and taxes (EBIT). Its federal-plus-state tax rate is 25%. What is its net operating profit after taxes (NOPAT)? Solution: NOPAT = EBIT (1 – T) = $4,000,000(1 – 0.25) = $3,000,000.

2-8

Total Net Operating Capital. Jenn Translation (JT) Inc. reported $10 million in operating current assets, $15 million in net fixed assets, and $3 million in operating current liabilities. How much total net operating capital does JT have? Solution: Total net operating capital = Net fixed assets + Net operating working capital = Net fixed assets + (Operating CA – Operating CL) = $15,000,000 + ($10,000,000 – $3,000,000) = $22,000,000.

2-9

Free Cash Flow (FCF). Carter Swimming Pools has $16 million in net operating profit after taxes (NOPAT) in the current year. Carter has $12 million in total net operating assets in the current year and had $10 million in the previous year. What is its free cash flow? Solution: Free cash flow = NOPAT – Net investment in total operating capital = NOPAT – (Total net operating capital in current year – Total net operating capital in previous year) = $16,000,000 – ($12,000,000 − $10,000,000) = $14,000,000.

INTERMEDIATE PROBLEMS 10-17 2-10 Corporate Tax Liability. The Talley Corporation had taxable operating income of $365,000 (i.e., earnings from operating revenues minus all operating costs). Talley also had (1) interest charges of $50,000, (2) dividends received of $15,000, and (3) dividends paid of $25,000. Its federal tax rate was 21% (ignore any possible state corporate taxes). Recall that 50% of dividends received are tax exempt. What is the taxable income? What is the tax expense? What is the after-tax income?

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Solution: Pre-tax operating earnings

$365,000

Less: Interest deduction

50,000

Plus: Taxable dividends received

Taxable income

7,500 $322,500

For a corporation, 50% of dividends received are excluded from taxes; therefore, taxable dividends are calculated as $15,000(1 – 0.5) = $7,500. Tax expense = 21%($322,500) = $67,725.00. After-tax income: Taxable income

$322,500.00

Minus taxes

67,725.00

Net income before non-taxable dividends Plus taxable dividends received

Net income

$254,775.00 7,500.00 $262,275.00

Non-taxable dividends are calculated as $15,000 − $7,500 = $7,500.

2-11 Corporate Tax Liability. The Wendt Corporation reported $50 million of taxable income. Its federal tax rate was 21% (ignore any possible state corporate taxes). a. What is the company’s federal income tax bill for the year? b. Assume the firm receives an additional $1 million of interest income from some bonds it owns. What is the additional tax on this interest income? c. Now assume that Wendt does not receive the interest income but does receive an additional $1 million as dividends on some stock it owns. Recall that 50% of dividends received are tax exempt. What is the additional tax on this dividend income? Solution: a. Tax = $50,000,000)(0.21) = $10,500,000. b.

Tax = $1,000,000(0.21) = $210,000.

Tax = ($1,000,000)(1 − 0.50)(0.21) = $105,000.

2-12 Corporate After-Tax Yield. The Shrieves Corporation has $10,000 that it plans to invest in marketable securities. It is choosing among AT&T bonds (which yield 6.6%), AT&T preferred stock (with a dividend yield of 6.0%), and State of Florida municipal bonds (which yield 5% but are not taxable). The federal tax rate is 21% (ignore any possible state corporate taxes). Recall that 50% of dividends received are tax exempt. Find the after-tax rates of return on all three securities after paying federal corporate taxes. Solution: A-T yield on AT&T bond = 6.6% − Taxes = 6.6% − 6.6%(0.21) = 5.214%. Check: Invest $10,000 @ 6.6% = $660 interest. Pay 21% tax, so A-T income = $660(1 − T) = $660(0.79) = $521.4. A-T rate of return = $521.40/$10,000 = 5.214%. A-T yield on AT&T preferred stock:

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

A-T yield = 6% − Taxes = 6% − (50%)(6%)(0.21) = 6% − 0.630% = 5.370%. A-T yield on FLA bond = 5.000%. Therefore, invest in AT&T preferred stock. 2-13 Net Cash Flows. The Moore Corporation has operating income (EBIT) of $750,000. Its depreciation expense is $200,000. Moore is 100% equity financed. The federal tax rate is 21% (ignore any possible state corporate taxes). What is the company’s net income? What is its net cash flow? Solution: EBIT = $750,000; DEP = $200,000; 100% Equity; T = 21% Set up an income statement, plug in the given values, and work in the order of the steps shown below. (As with most problems, there are alternative ways of solving the problem.) EBIT Interest

$750,000 0

EBT

$750,000

Taxes (21%)

157,500

$592,500

Given No debt with 100% equity

NCF = NI + DEP = $592,500 + $200,000 = $792,500. 2-14 Income and Cash Flow Analysis. The Berndt Corporation expects to have sales of $12 million. Costs other than depreciation are expected to be 75% of sales, and depreciation is expected to be $1.5 million. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. The federal tax rate is 21% (ignore any possible state corporate taxes). Berndt has no debt. a. Set up an income statement. What is Berndt’s expected net income? Its expected net cash flow? b. Suppose Congress changed the tax laws so that Berndt’s depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow? c. d.

Now suppose that Congress changed the tax laws such that, instead of doubling Berndt’s depreciation, it was reduced by 50%. How would profit and net cash flow be affected? If this were your company, would you prefer Congress to cause your depreciation expense to be doubled or halved? Why?

Solution: a.

Sales revenues

Income Statement

$12,000,000 Given

Costs except depreciation

9,000,000 = 75%($12,000,000)

EBITDA

3,000,000

Interest

Depreciation EBT Taxes (21%)

1,500,000 Given $ 1,500,000 = Sales – (cost except depr) – depr 315,000

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Sales revenues

$12,000,000 Given

Net income

$ 1,185,000

Add back depreciation

1,500,000

Net cash flow b.

$ 2,685,000

If depreciation doubled, depreciation would increase to 2($1,500,000) = $3,000,000. Taxable income (EBT) would fall EBITDA – Depr = $3,000,000 – $3,000,000 = 0; taxes would be zero. Thus, net income would decrease to zero, but net cash flow would rise to NI + Depr = $0 + $3,000,000. The company would save $315,000 in taxes, thus increasing its cash flow. Alternatively: ∆CF = T(∆Depreciation) = 0.21($1,500,000) = $315,000. Net cash flow = Previous net cash flow + ∆CF = $2,685,000 + $315,000 = $3,000,000.

If depreciation were halved, depreciation would fall to 0.5($1,500,000) = $750,000. Taxable income (EBT) would increase to EBITDA – Depr = $3,000,000 – $750,000 = $2,250,000; taxes would increase to T(EBT) = 0.21($2,250,000) = $472,500 Therefore, net income would rise to EBT – Tax = $2,250,000 – $472,500 = $1,177,500. However, net cash flow would fall to NI + Depr = $1,177,500 + $750,000 = $2,527,500.

You should prefer to have higher depreciation charges and higher cash flows. Net cash flows are the funds that are available to the owners to withdraw from the firm and, therefore, cash flows should be more important to them than net income.

2-15 Net Operating Profit after Tax (NOPAT). Use the following income statement of Elliott Game Theory Consulting to determine its net operating profit after taxes (NOPAT). Use 25% as the tax rate.

Elliot Game Theory Consulting: Income Statement for Year Ending December 31 2023 Sales

$800,000

Operating costs excluding depreciation

700,000

Depreciation and amortization

20,000

Earnings before interest and taxes Less interest Pre-tax income Taxes (25%) Net income available to common stockholders

$ 80,000 2,000 $ 78,000 19,500 $ 58,500

Solution: NOPAT = EBIT(1 – T) = $80,000(1 – 0.25) = $60,000. 2-16 Net Operating Working Capital (NOWC). Using the following balance sheets of Mimi’s Gymnastics Inc., what is the net operating working capital (NOWC) for 2023?

Mimi’s Gymnastics Inc.: Balance Sheets as of December 31 (Millions of Dollars)

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

2023 Assets Cash

Short-term investments

110

Accounts receivable

1,200

Inventories

900

Total current assets

$2,300

Net plant and equipment

2,200

Total assets

$4,500

Liabilities and Equity Accounts payable

600

Accruals

200

Notes payable

180

Total current liabilities Long-term debt Total liabilities

980 800

$ 1,780

Common stock

2,200

Retained earnings

520

Total common equity

$ 2,720

Total liabilities and equity

$4,500

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Solution: NOWC = Operating CA – Operating CL = (Cash + AR + INV) – (AP + Accruals) = ($90 + $1,200 + $900) – ($600 + $200) = $1,390 million. 2-17 Investment in Total Net Operating Capital. Athenian Venues Inc. just reported the following selected portion of its financial statements for the end of 2023. Your assistant has already calculated the 2023 end-of-year net operating working capital (NOWC) from the full set of financial statements (not shown here), which is $13 million. The total net operating capital for 2022 was $50 million. What was the 2023 net investment in operating capital?

Athenian Venues Inc.: Selected Balance Sheet Information as of December 31 (Millions of Dollars) Assets

2023

Cash

$ 1

Short-term investments

Accounts receivable

Inventories Total current assets

11 $24

Net plant and equipment

Total assets

$75

Solution: Net investment in operating capital = (NOWC + Op LT assets) – (Total net Op Cap. in previous year) = ($13 + $51) – ($50) = $14 million.

CHALLENGING PROBLEMS 18-19 2-18 Free Cash Flows. Rhodes Corporation’s financial statements are shown after part f. Suppose the federalplus-state tax corporate tax is 25%. Answer the following questions: a. What is the net operating profit after taxes (NOPAT) for 2023? b. What are the amounts of net operating working capital for both years? c. What are the amounts of total net operating capital for both years? d. What is the free cash flow for 2023? e. What is the ROIC for 2023? f. How much of the FCF did Rhodes use for each of the following purposes: after-tax interest, net debt repayments, dividends, net stock repurchases, and net purchases of short-term investments? (Hint: Remember that a net use can be negative.)

Rhodes Corporation: Income Statements for Year Ending December 31 (Millions of Dollars)

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

Sales

2023

2022

$11,000

$10,000

9,612

8,728

380

360

Operating costs excluding depreciation Depreciation and amortization Earnings before interest and taxes

$ 1,008

Less interest Pre-tax income

Taxes (25%)

912

120

100

888

$812

222

203

Net income available to common stockholders

666

609

Common dividends

202

200

Rhodes Corporation: Balance Sheets as of December 31 (Millions of Dollars) 2023

2022

Assets

Cash

550

500

Short-term investments

110

100

Accounts receivable

2,750

2,500

Inventories

1,650

1,500

Total current assets

$5,060

$4,600

Net plant and equipment

3,850

3,500

$ 8,910

$ 8,100

$ 1,100

$ 1,000

Accruals

550

500

Notes payable

384

200

$2,034

$ 1,700

1,100

1,000

$ 3,134

$ 2,700

Common stock

4,312

4,400

Retained earnings

1,464

1,000

Total common equity

$ 5,776

$5,400

Total liabilities and equity

$ 8,910

$ 8,100

Total assets Liabilities and Equity

Accounts payable

Total current liabilities Long-term debt Total liabilities

Solution: a.

Brigham/Ehrhardt Financial Management: Theory & Practice--Ehrhardt/Brigham Corporate Finance: A Focused Approach

2023 EBIT

$1,008

x (1 − Tax rate)

75.0%

Net operating profit after taxes (NOPAT)

$ 756

2023

2022

$ 550

$ 500

+ Accounts receivable

2,750

2,500

+ Inventories

1,650

1,500

Operating current assets

$4,950

$4,500

Accounts payable

$ 1,100

$ 1,000

550

500

Operating current liabilities

$ 1,650

$ 1,500

Operating current assets

$4,950

$4,500

− Operating current liabilities

1,650

1,500

$3,300

$3,000

2023

2022

$3,300

$3,000

3,850

3,500

$ 7,150

$6,500

Cash

+ Accruals

Net operating working capital (NOWC) c.

Net operating working capital (NOWC) + Net plant and equipment Total net operating capital d.

2023 NOPAT − Investment in total net operating capital Free cash flow

$756 650 $ 106