Type:
Solution Manual
Resource:
Financial Management Principles and Applications
Edition:
13th Edition
Author(s):
Sheridan Titman Arthur J. Keown John D. Martin
Part One Instructor’s Manual
.
Chapter 1 Getting Started—Principles of Finance ◼ Chapter Orientation Finance is the study of how people and businesses evaluate investments and raise capital to fund these investments. Key principles guide the process of evaluating investment decisions. This chapter lays the foundation for understanding the principles that underpin financial decision making. Financial decisions permeate every aspect of the business world and of our personal lives. Understanding basic financial concepts is critical to making informed decisions concerning the use of financial resources. This chapter describes the three types of business organizations--sole proprietorships, partnerships, and corporations—and compares and contrasts the similarities and differences among these types of business organization. Further, the role of finance is discussed relative to the overall structure of the organization. The overriding goal of finance is to maximize shareholder wealth. Ethical errors in judgment tend to destroy trust in management thereby preventing management from working toward that goal. Finance encompasses five basic principles: Money has a time value; there is a risk-return tradeoff; cash flows are the source of value; market prices reflect information; and individuals respond to incentives.
◼ Chapter Outline 1.1 Overview of Finance A. Finance is the study of how people and businesses evaluate investments and raise capital for these investments. B. Finance concerns the study of the management of money, as well as the interpretation of information. 1.2 Three Types of Business Organization A. A sole proprietorship is a business owned by a single individual. B. A general partnership is an association of two or more persons who come together as owners for the purpose of operating a business for profit. C. A corporation is a business organization that legally functions separately and apart from its owners (shareholders).
3 .
4
• Financial Management, Thirteenth Edition
Titman/Keown/Martin
1.3 The Goal of the Financial Manager: Maximize Shareholder Wealth A. Because shareholders are the owners of the firm, the goal of the financial manager is the maximize shareholder wealth. B. Maximizing shareholders wealth is achieved by maximizing stock price. C. The Sarbanes-Oxley Act attempts to safeguard the interests of shareholders by providing protection against agency problems related to accounting fraud and financial misconduct. 1.4 Financial concepts can be classified into four general principles. A. Principle 1: Money has a time value B. Principle 2: There is a Risk-Return tradeoff C. Principle 3: Cash flows are the source of value D. Principle 4: Market prices reflect information E. Principle 5: Individuals respond to incentives
◼ Learning Objectives 1.1. Understand the importance of finance in your personal and professional lives and identify the three primary business decisions that financial managers make. 1.2. Identify the key differences between three major legal forms of business. 1.3. Understand the role of the financial manager within the firm and the goal for making financial choices. 1.4. Explain the five principles of finance that form the basis of financial management for both businesses and individuals.
◼ End-of-Chapter Problem Complexity Rating and Spreadsheet Solutions The end-of-chapter problems are sorted below, according to their level of complexity. Simple
Average
Complex
There are no problems in this chapter.
◼ Lecture Tips 1. Identify various investments that individuals make that require knowledge of finance: a) going to college b) purchasing a car c) buying a home d) rent versus owning a home
.
Chapter 1
Getting Started—Principles of Finance
2. Use real-world, non-financial situations to describe the relationship between risk and return; for example, choice of career, travels, etc.
◼ Further Questions for Class Discussion 1. When managers act in an unethical manner, it can have a long-term impact on the value of the firm. Use the example of Enron’s board of directors temporarily suspending its own “code of ethics” to describe how that impact may be negative and permanent. 2. Explain the difference between cash flow and profit.
◼ Internet Resources None
.
5
Chapter 2 Firms and the Financial Market ◼ Chapter Overview This chapter provides an overview of U.S. financial markets. Financial markets consist of the institutions that facilitate the transfer of money from investors to companies and individuals. The three principal players in the financial markets are borrowers, savers (i.e., investors), and financial institutions (i.e., intermediaries). There is a wide variety of financial institutions that make up our financial markets including: commercial banks, financial services corporations, insurance companies, investment banks, investment companies, mutual funds and exchange traded funds, hedge funds, and private equity firms. The purpose of each of these institutions is to bring borrowers and investors together. Borrowers and investors are linked together through the buying and selling of a variety of securities that are traded on financial markets. While there are innumerable types of financial instruments traded on financial markets, most are some form of debt or equity security.
◼ Chapter Outline 2.1. The Basic Structure of U.S. Financial Markets A. A financial market is any place where money and credit is exchanged. B. The three principal sets of players in financial markets are borrowers, savers (investors), and financial institutions (intermediaries). 2.2. The Financial Marketplace—Financial Institutions A. The financial institutions that make up the financial marketplace facilitate the movement of money from savers to borrowers. 1. The money market refers to transactions in short-term debt instruments. 2. Capital markets are markets for long-term financial instruments. B. Non-Bank financial intermediaries provide financial services to businesses. There are a variety of non-bank financial intermediaries. 1. Financial services corporations are in the lending or financing business, but they are not commercial banks. 2. Insurance companies are in the business of selling insurance to individuals businesses to protect their investments. 3. Investment banks are specialized financial intermediaries that help companies and governments raise money and provide advisory services to client firms. 4. Investment companies are financial institutions that pool the savings of individual savers and invest the money in the securities issued by other companies purely for investment purposes. 6 .
Chapter 2 Firms and the Financial Market
5.
6. 7.
Mutual funds and exchange traded funds (ETFs) are special types of intermediaries through which individuals can invest in virtually all of the securities offered in the financial markets. Hedge funds are like mutual funds, but are less regulated and tend to take on greater risk. Private equity firms include venture capital firms and leveraged buyout funds.
2.3. The Financial Marketplace—Securities Markets A. A security is a negotiable instrument that represents a financial claim and can take the form of ownership (stocks) or a debt agreement. B. A primary market is a market in which new securities are bought and sold for the first time. C. A secondary market is where all subsequent trading of previously issued securities takes place. D. Firms borrow money by issuing debt securities. These can be either short-term (i.e., notes) or long-term securities (i.e., bonds). E. Equity securities represent ownership of the corporation. 1. Common stock is a security that represents equity ownership, provides voting rights, and entitles the holder to a share of the company’s earnings in the form of dividends or capital appreciation. 2. Preferred stock is an equity security without voting rights but with a defined dividend payment. Preferred stock dividends must be paid before common stock dividends can be distributed. F.
7
Stock markets consist of both physical trading areas (i.e., organized security exchanges) and electronic trading areas (i.e., over-the-counter markets).
G. While many factors contributed to the financial crisis of 2008, one large factor was the collapse of the real estate market and the resulting defaults on subprime mortgages.
◼ Learning Objectives 1. Describe the structure and functions of financial markets 2. Distinguish between commercial banks and other financial institutions in the financial marketplace. 3. Describe the different securities markets for bonds and stock.
◼ End-of-Chapter Problem Complexity Rating and Spreadsheet Solutions Simple
Average
There are no problems in this chapter.
.
Complex
8
Titman/Keown/Martin
• Financial Management, Thirteenth Edition
◼ Lecture Tips 1. Bring in a copy of the Wall Street Journal and have the students look at the various tables relevant to the security markets. Discuss the meaning of the information and how the numbers and terms relate to the chapter. 2. Simulate the start-up of a corporation with various class members playing the role of creditors and shareholders of the firm.
◼ Further Questions for Class Discussion 1. Why is it important to distinguish between depository and non-depository financial institutions? 2. Why are secondary markets important?
◼ Internet Resources http://www.sec.gov/answers/mutfund.htm www.sec.gov/investor/tools/mfcc/mfcc-int.htm http://www.mckensey.com/mgi/reports/pdfs/Mapping_Global/MGI_Global_full_Report.pdf
.
Chapter 3 Understanding Financial Statements, Taxes, and Cash Flows ◼ Chapter Overview This chapter focuses on accounting and financial statements. Understanding the financial health of a business by reviewing its financial statements is an important function of financial management. The accounting and regulatory authorities mandate the following four types of financial statements: income statement, balance sheet, cash flow statement, and statement of shareholders’ equity. Financial statement analysis is important for a number of reasons. First, the study of these accounting statements aids in assessing the financial condition of a business. Second, financial statements are a tool for managers to use in monitoring and controlling the firm’s operations. Third, financial planning and forecasting often is done through the medium of financial statements.
◼ Chapter Outline 3.1
An Overview of the Firm’s Financial Statements A. The four basic financial statements are: income statement, balance sheet, cash flow statement, and statement of shareholders’ equity. B. Accountants use three fundamental principles when preparing a firm’s financial statements: 1. The revenue recognition principle 2. The matching principle 3. The historical cost principle
3.2
The Income Statement A. The income statement can be expressed as: Revenue − Expenses = Profits. B. The income statement recognizes both cash and noncash expenses. C. Firms must adhere to GAAP in constructing the income statement. D. Corporate executives have an incentive to manage the firm’s earnings through earnings management.
3.3
Corporate Taxes A. Taxable income is referred to in the income statement as earnings before taxes which is equal to a firm’s net operating income less interests expenses. B. When firms analyze the tax consequences of a new business venture, it is important to use the marginal tax rate rather than the average tax rate. 9 .
10
Titman/Keown/Martin
3.4
The Balance Sheet
• Financial Management, Thirteenth Edition
A. The balance sheet is defined as: Total Assets = Total Liabilities + Total Shareholders’ Equity. B. Total liabilities represent the total amount of money the firm owes to creditors. C. Total shareholders’ equity refers to the difference in the value of the firm’s total assets and the firm’s total liabilities. D. The balance sheet reflects the book value of the firm’s assets. This is usually not equal to the market value of the firm’s assets. E. Assets: The lefthand side of the balance sheet shows what the firm owns. a. Total assets = current assets + fixed assets F.
Sources of Financing: The righthand side of the balance sheet shows where the funds came from to purchase assets. a. Liabilities = accounts payable + notes payable + long-term debt b. Stockholders’ equity = par value + paid-in capital + retained earnings
G. Net working capital is a simple measure of the firm’s liquidity. a. Working capital = current assets − current liabilities 3.5
The Cash Flow Statement A. Change in Cash Balance = Ending Cash Balance − Beginning Cash Balance. B. A source of cash is any activity that brings cash into the firm. C. A use of cash in any activity that causes cash to leave the firm. D. Sources and uses of cash are classified into three broad categories: operating activities, investment activities, and financing activities. E. A popular indication of earnings quality is the quality of earnings ratio. a. Quality of earnings ratio = cash flow from operations / net income.
◼ Learning Objectives 3-1. Describe the content of the four basic financial statements and discuss the importance of financial statement analysis to the financial manager. 3-2. Evaluate firm profitability using the income statement. 3-3. Estimate a firm’s tax liability using the corporate tax schedule and distinguish between the average and marginal tax rate. 3-4. Use the balance sheet to describe a firm’s investments in assets and the way it has financed them. 3-5. Identify the sources and uses of cash flow for a firm using the firm’s cash flow statement.
.
Chapter 3
Understanding Financial Statements, Taxes, and Cash Flows
11
◼ Lecture Tips 1.
Have the students complete the Business of Life: Your Personal Balance Sheet and Income Statement. Use this as an introduction to the discussion of financial statements.
2.
Describe some of the alternatives to GAAP.
◼
Questions for Further Class Discussion
1.
What is the significance of a positive net working capital? Of a negative net working capital? Of a zero net working capital?
2.
Discuss the ways in which managers can “manage the firm’s earnings.” Should earnings management always be viewed negatively?
3.
Discuss some of the ways that a firm’s quality of earnings might be low.
◼
End-of-Chapter Problem Complexity Rating
The end-of-chapter problems are sorted below, according to their level of complexity.
◼
Simple
Average
Complex
1, 2, 3, 9, 10
4, 5, 7, 8, 11, 12, 16
6, 13, 14, 15, 17
Spreadsheet Solutions in Excel
The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative. Problems: 3-1—3-16
◼ Internet Resources http://finance.yahoo.com http://money.cnn.com http://www.smartmoney.com www.fool.com www.google.com/finance
.
Chapter 4 Financial Analysis—Sizing Up Firm Performance ◼ Chapter Overview Financial statements analysis involves the process of extracting information from a firm’s financial statements in order to evaluate the firm’s financial performance. Analyzing past performance of a firm is a valuable tool in predicting future performance and cash flows. Financial analysis is important to a variety of constituencies, including managers, lenders, suppliers, credit-rating agencies, and investors. This chapter will develop a number of key types of statements and measures that are valuable in performing a financial analysis. Common-size statements standardize financial statements to allow for comparison. Financial ratios are developed to assess a firm’s liquidity, leverage, asset management efficiency, profitability, and market performance. The DuPont Method provides a way of analyzing the relationship among a number of key ratios and identifying key factors that affect firm performance. Two main types of benchmarks are used in analyzing a firm’s financial performance: trend analysis and peer group comparisons.
◼ Chapter Overview 4.1
Why Do We Analyze Financial Statements? A. Financial analysis provides an internal tool to assess employee performance and to make interdivisional comparisons. B. Financial analysis is performed by external parties to assess a firm’s credit standing and to provide input for investment decisions.
4.2
Common Size Statements: Standardizing Financial Information A. A common-size income statement expresses all entries in an income statement as a percent of sales. B. A common-size balance sheet expresses all entries on a balance sheet as a percent of total assets.
4.3
Using Financial Ratios A. Financial ratios provide another method for standardizing the financial information in the income statement and balance sheet. B. Liquidity ratios assess a firm’s ability to pay its bills as they come due. 1. The Current Ratio and Quick Ratio are measures of the firm’s overall liquidity. 2. Several ratios assess the liquidity of specific asset categories. These include: a. Average Collection Period b. Accounts Receivable Turnover Ratio c. Inventory Turnover Ratio d. Days’ Sales in Inventory 12 .
Chapter 4 Financial Analysis—Sizing Up Firm Performance
13
C. Capital Structure Ratios indicate how the firm has financed the purchase of its assets using debt and equity funds. 1. The Debt Ratio measures the percentage of the firm’s assets that were financed using current plus long-term liabilities. 2. The Times Interest Earned Ratio measures a firm’s ability to service its debt. D. Asset Management Efficiency Ratios analyze how efficient the firm’s management has been in utilizing its assets to generate sales. 1. Total Asset Turnover Ratio represents the amount of sales generated per dollar invested in the firm’s assets. 2. Fixed Asset Turnover Ratios measures the amount of sales generated per dollar invested in the firm’s fixed assets. E. Profitability Ratios determine if the firm has earned adequate returns on its investments. 1. Gross Profit Margin assesses the cost of goods sold and markups of the firm. 2. Operating Profit Margin tells managers how much profit they generated from each dollar of sales after accounting for both costs of goods sold and operating expenses. 3. Net Profit Margin identifies how much of each dollar of sales the firm has after paying all of its expenses. 4. Operating Return on Assets Ratio considers management’s success in controlling expenses and its efficient use of assets to generate firm sales. 5. Return on Equity determines the earnings available for distribution to the firm’s shareholders. 6. The DuPont Method is a way to decompose Return on Assets and Return on Equity into component parts. F.
4.4
Market Value Ratios examine how a firm’s shares are valued in the stock market. 1. Price-Earnings Ratio indicates how much investors have been willing to pay for $1 of reported earnings. 2. Market-to-Book Ratio compares the market’s valuation of the firm to the accumulated investment made by the shareholders in the firm.
Selecting a Performance Benchmark A. Trend analysis compares a firm’s recent financial ratios with its past financial ratios and provides insight into whether the firm is improving or deteriorating in its financial performance over time. B. Peer firm comparisons compare a firm’s performance to that of a relevant peer group of firms. This is often done using industry average financial ratios.
4.5
Limitations of Ratio Analysis A. Financial analysts must be aware of a number of limitations in performing financial analysis for a firm.
◼ Learning Objectives 4-1. Explain what we can learn by analyzing a firm’s financial statements. 4-2. Use common size financial statements as a tool of financial analysis. 4-3. Calculate and use a comprehensive set of financial ratios to evaluate a company’s performance.
.
14
Titman/Keown/Martin
• Financial Management, Thirteenth Edition
4-4. Select an appropriate benchmark for use in performing a financial ratio analysis. 4-5. Describe the limitations of financial ratio analysis.
◼ Lecture Tips 1.
Use a flowchart to show how the DuPont Method incorporates all ratios.
2.
Rather an using the example in the book, select a real-world firm and give students a copy of the income statement and balance sheet for this firm. As a class, calculate the ratios from these statements. An example is the Mini Case at the very end of the chapter.
◼
Questions for Further Class Discussion
1.
Discuss which ratios would be particularly useful to creditors, managers, shareholders, and bondholders.
2.
How would one use industry ratios and peer comparisons when the firm you are analyzing is the industry leader? When the firm you are analyzing is an average-size firm in this market?
3.
Discuss the difficulty in using published industry average when analyzing a firm that competes in multiple industries.
◼
End-of-Chapter Problem Complexity Rating
The end-of-chapter problems are sorted below, according to their level of complexity.
◼
Simple
Average
Complex
6, 13, 14, 15, 16, 18
1, 2, 3, 4, 5, 7, 8, 9, 10, 11, 12, 17, 19, 20, 21, 22, 23, 25, 29
24, 26, 27, 28, 30, 31, 32, 33, 34, 35, 36
Spreadsheet Solutions in Excel
The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative. Problems: 4-1—4-36
◼ Internet Resources www.google.com/finance www.finance.yahoo.com
.
Chapter 5 Time Value of Money—The Basics ◼ Chapter Overview Time value of money is one of the most important concepts in finance. The basic premise of time value of money problems is that time impacts the value of a dollar. That is, a dollar received today is worth more than one received in the future. The principles of time value of money are used in a variety of applications in finance, including capital budgeting, capital structure, cost of capital, and working capital management decisions. This chapter explores time value of money concepts as they apply to a lump sum or single cash flow. Future value is the value of a sum of money compounded at a given interest rate for a specific period of time. Present value is the current value of a sum of money to be received at a specified time in the future, given a stated rate of interest.
◼ Chapter Outline 5.1
Using Timelines to Visualize Cash Flows A. A timeline identifies the timing and amount of a stream of payments, along with the interest rate it earns. B. Timelines are the first step in visualizing and solving time value of money problems.
5.2
Compounding and Future Value A. Simple versus Compound Interest 1. Simple interest is the interest earned on the principal amount. 2. Compound interest is the interest earned on both the initial principal amount and on reinvested interest from previous periods. B. Future Value is the value of a current sum of money at a time in the future, given a specified compound interest rate. 1. The future value of an investment grows with the number of periods it is compounded; the longer the time, the larger the future value. 2. The future value increases with the level of the rate of interest; the higher the interest rate, the larger the future value. C. Compounding principles can be applied to things other than money. 1. Compounding applies to anything that grows. 2. Examples include sales, population, inflation rates, etc.
15 .
• Financial Management, Thirteenth Edition
16
Titman/Keown/Martin
5.3
Discounting and Present Value A. Present value is the value today of a future cash flow. 1. The process of discounting involves determining the present value of an expected future cash flow, given a specified rate of interest. 2. Present value decreases as the number of periods until the payment is received is increased. 3. Present value decreases as the interest rate increases. B. Present value techniques can be used to solve problems for either the number of periods or interest rate to reach a future value.
5.4
Making Interest Rates Comparable A. Annual Percentage Rate (APR) is the amount of interest rate paid or earned without compounding. APR = Interest Rate per Period Compounding Periods B
Effective Annual Rate (EAR) is the annual compounded rate that produces the same return as the nominal, or stated, rate. EAR = (1 + Quoted Annual Rate/Compounding Periods per year)m − 1
C. Continuous Compounding occurs when the time intervals between when interest is paid is infinitely small.
◼ Learning Objectives 5-1. Construct cash flow timelines to organize your analysis of problems involving the time value of money 5-2. Understand compounding and calculate the future value of cash flows using mathematical formulas, a financial calculator, and an Excel spreadsheet. 5-3. Understand discounting and calculate the present value of cash flows using mathematical formulas, a financial calculator, and an Excel spreadsheet. 5-4. Understand how interest rates are quoted and know how to make them comparable.
◼ Lecture Tips 1.
Introduce Future Value by looking at a variety of examples: a. Population growth b. Weight change c. Salary over a lifetime d. Prices given a constant inflation rate
2.
Use the Rule of 72 to explore how the growth rate significantly affects the time for a quantity to double. Vary the growth rate to see how doubling is affected for such examples as population, sales, prices, etc.
3.
Use ads from various financial institutions showing interest rates on CDs to illustrate the concepts of APR and EAR.
.
Chapter 5
Time Value of Money—The Basics
◼
Questions for Further Class Discussion
1.
What is the relationship between present value and future value?
2.
Explain what is meant by continuous compounding? How can compounding occur continuously?
3.
When you graduate from college, you are offered the choice between a job with a starting salary of $30,000 per year which grows annually at 6% or a job with a starting salary of $40,000 per year which grows annually at 4%. How would you determine which is the best job to take if you assume you will stay in this position for 5 years? At what growth rate would you be indifferent between the two positions?
◼
End-of-Chapter Problem Complexity Rating
17
The end-of-chapter problems are sorted below, according to their level of complexity.
◼
Simple
Average
Complex
1,2, 4, 5,10, 17, 19-22, 29-30
3,6-9, 11, 13-16, 18, 23-24, 26, 27, 29-38
12, 25, 28,39,40
Spreadsheet Solutions in Excel
The following end-of-chapter problem solutions are available with Excel spreadsheets. These spreadsheets are available on the Instructor’s Resource Center at www.pearsonhighered.com. If you do not have a login and password for this Web site, contact your Pearson sales representative. Problems: 5-1—5-40
◼ Internet Resources http://antwrp.gsfc.nasa.gov/htmltest/gifcity/e.5mil http://tr.im/fabcam www.kiplinger.com/tools/index.html www.dinkytown.net www.bankrate.com/calculators.aspx www.interest.com www.predatorylendingassociation.com www.responsiblelending.org/payday-lending
.