Chapter 1: Critical Thinking Questions: 1, 2, 3, 5, 6, 7, 10, 13, 14

1. Capital budgeting (deciding whether to expand a manufacturing plant), capital structure

(deciding whether to issue new equity and use the proceeds to retire outstanding debt),
and working capital management (modifying the firms credit collection policy with its
customers).
2. Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard
to raise capital funds. Some advantages: simpler, less regulation, the owners are also the
managers, sometimes personal tax rates are better than corporate tax rates.
3. The primary disadvantage of the corporate form is the double taxation to shareholders of
distributed earnings and dividends. Some advantages include: limited liability, ease of
transferability, ability to raise capital, and unlimited life.
5. To maximize the current market value (share price) of the equity of the firm (whether its
publicly-traded or not).
6. In the corporate form of ownership, the shareholders are the owners of the firm. The
shareholders elect the directors of the corporation, who in turn appoint the firms
management. This separation of ownership from control in the corporate form of
organization is what causes agency problems to exist. Management may act in its own or
someone elses best interests, rather than those of the shareholders. If such events occur,
they may contradict the goal of maximizing the share price of the equity of the firm.
7. A primary market transaction.
10. Presumably, the current stock value reflects the risk, timing, and magnitude of all future
cash flows, both short-term and long-term. If this is correct, then the statement is false.
13. The goal of management should be to maximize the share price for the current
shareholders. If management believes that it can improve the profitability of the firm so
that the share price will exceed $35, then they should fight the offer from the outside
company. If management believes that this bidder or other unidentified bidders will
actually pay more than $35 per share to acquire the company, then they should still fight
the offer. However, if the current management cannot increase the value of the firm
beyond the bid price, and no other higher bids come in, then management is not acting in
the interests of the shareholders by fighting the offer. Since current managers often lose
their jobs when the corporation is acquired, poorly monitored managers have an
incentive to fight corporate takeovers in situations such as this.
14. We would expect agency problems to be less severe in countries with a relatively small
percentage of individual ownership. Fewer individual owners should reduce the number
of diverse opinions concerning corporate goals. The high percentage of institutional
ownership might lead to a higher degree of agreement between owners and managers on
decisions concerning risky projects. In addition, institutions may be better able to
implement effective monitoring mechanisms on managers than can individual owners,
based on the institutions deeper resources and experiences with their own management.
The increase in institutional ownership of stock in the United States and the growing
activism of these large shareholder groups may lead to a reduction in agency problems

for U.S. corporations and a more efficient market for corporate control.

Chapter 2: Critical Thinking Questions: 1, 2, 3, 5

1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss
in value. Its desirable for firms to have high liquidity so that they have a large factor of safety in
meeting short-term creditor demands. However, since liquidity also has an opportunity cost
associated with itnamely that higher returns can generally be found by investing the cash into
productive assetslow liquidity levels are also desirable to the firm. Its up to the firms financial
management staff to find a reasonable compromise between these opposing needs.
2. The recognition and matching principles in financial accounting call for revenues, and the costs
associated with producing those revenues, to be booked when the revenue process is essentially
complete, not necessarily when the cash is collected or bills are paid. Note that this way is not
necessarily correct; its the way accountants have chosen to do it.
3. Historical costs can be objectively and precisely measured whereas market values can be difficult to
estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff
between relevance (market values) and objectivity (book values).
5. Market values can never be negative. Imagine a share of stock selling for $20. This would mean
that if you placed an order for 100 shares, you would get the stock along with a check for $2,000.
How many shares do you want to buy? More generally, because of corporate and individual
bankruptcy laws, net worth for a person or a corporation cannot be negative, implying that liabilities
cannot exceed assets in market value.

Chapter 2: Questions and Problems 1-7, 15, 16

1.
To find owners equity, we must construct a balance sheet as follows:
CA
NFA
TA

Balance Sheet
CL
LTD
OE
$28,900
TL & OE
$5,100
23,800

$4,300
7,400
??
$28,900

We know that total liabilities and owners equity (TL & OE) must equal total assets of $28,900.
We also know that TL & OE is equal to current liabilities plus long-term debt plus owners equity,
so owners equity is:
OE = $28,900 7,400 4,300 = $17,200
NWC = CA CL = $5,100 4,300 = $800
2.
The income statement for the company is:

Income Statement
Sales
$586,000
Costs
247,000
Depreciation
43,000
EBIT
$296,000
Interest
32,000
EBT
$264,000
Taxes(35%)
92,400
Net income
$171,600
3.
One equation for net income is:
Net income = Dividends + Addition to retained earnings
Rearranging, we get:
Addition to retained earnings = Net income Dividends = $171,600 73,000 = $98,600
4.
EPS = Net income / Shares = $171,600 / 85,000 = $2.02 per share
DPS = Dividends / Shares

= $73,000 / 85,000

= $0.86 per share

5
To find the book value of current assets, we use: NWC = CA CL. Rearranging to solve for
current assets, we get:
CA = NWC + CL = $380,000 + 1,100,000 = $1,480,000
The market value of current assets and fixed assets is given, so:
Book value CA
= $1,480,000
Book value NFA = $3,700,000
Book value assets = $5,180,000

Market value CA
= $1,600,000
Market value NFA = $4,900,000
Market value assets = $6,500,000

6.
Taxes = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($236K 100K) = $75,290
7.
The average tax rate is the total tax paid divided by net income, so:
Average tax rate = $75,290 / $236,000 = 31.90%
The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39%.

15.

The solution to this question works the income statement backwards. Starting at the bottom:
Net income = Dividends + Addition to ret. earnings = $1,500 + 5,100 = $6,600
Now, looking at the income statement:
EBT EBT Tax rate = Net income
Recognize that EBT Tax rate is simply the calculation for taxes. Solving this for EBT yields:
EBT = NI / (1 tax rate) = $6,600 / (1 0.35) = $10,154
Now you can calculate:
EBIT = EBT + Interest = $10,154 + 4,500 = $14,654
The last step is to use:
EBIT = Sales Costs Depreciation
$14,654 = $41,000 19,500 Depreciation
Solving for depreciation, we find that depreciation = $6,846

16.

The balance sheet for the company looks like this:

Cash
Accounts receivable
Inventory
Current assets
Tangible net fixed assets
Intangible net fixed assets
Total assets

Balance Sheet
$195,000
Accounts payable
137,000
Notes payable
264,000
Current liabilities
$596,000
Long-term debt
Total liabilities
2,800,000
780,000
Common stock
Accumulated ret. earnings
$4,176,000
Total liab. & owners equity

$405,000
160,000
$565,000
1,195,300
$1,760,300
??
1,934,000
$4,176,000

Total liabilities and owners equity is:

TL & OE = CL + LTD + Common stock + Retained earnings
Solving for this equation for equity gives us:
Common stock = $4,176,000 1,934,000 1,760,300 = $481,700

Chapter 3: Critical Thinking Questions: 2-7, 12

2. The firm has increased inventory relative to other current assets; therefore, assuming current liability
levels remain unchanged, liquidity has potentially decreased.

3. A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in
current assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and
suppliers for immediate payment, the firm might have a difficult time meeting its obligations. A
current ratio of 1.50 means the firm has 50% more current assets than it does current liabilities. This
probably represents an improvement in liquidity; short-term obligations can generally be met completely
with a safety factor built in. A current ratio of 15.0, however, might be excessive. Any excess
funds sitting in current assets generally earn little or no return. These excess funds might be put to
better use by investing in productive long-term assets or distributing the funds to shareholders.
4. a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects
of inventory, generally the least liquid of the firms current assets.
b. Cash ratio represents the ability of the firm to completely pay off its current liabilities with its
most liquid asset (cash).
c. Total asset turnover measures how much in sales is generated by each dollar of firm assets.
d. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures
the dollar worth of firm assets each equity dollar has a claim to.
e. Long-term debt ratio measures the percentage of total firm capitalization funded by long-term
debt.
f. Times interest earned ratio provides a relative measure of how well the firms operating earnings
can cover current interest obligations.
g. Profit margin is the accounting measure of bottom-line profit per dollar of sales.
h. Return on assets is a measure of bottom-line profit per dollar of total assets.
i. Return on equity is a measure of bottom-line profit per dollar of equity.
j. Price-earnings ratio reflects how much value per share the market places on a dollar of
accounting earnings for a firm.
5. Common size financial statements express all balance sheet accounts as a percentage of total assets
and all income statement accounts as a percentage of total sales. Using these percentage values rather
than nominal dollar values facilitates comparisons between firms of different size or business type.
Common-base year financial statements express each account as a ratio between their current year
nominal dollar value and some reference year nominal dollar value. Using these ratios allows the
total growth trend in the accounts to be measured.
6. Peer group analysis involves comparing the financial ratios and operating performance of a
particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm
to its peers allows the financial manager to evaluate whether some aspects of the firms operations,
finances, or investment activities are out of line with the norm, thereby providing some guidance on
appropriate actions to take to adjust these ratios if appropriate. An aspirant group would be a set of
firms whose performance the company in question would like to emulate. The financial manager
often uses the financial ratios of aspirant groups as the target ratios for his or her firm; some
managers are evaluated by how well they match the performance of an identified aspirant group.
7. Return on equity is probably the most important accounting ratio that measures the bottom-line
performance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes the
role of a firms profitability, asset utilization efficiency, and financial leverage in achieving an ROE
figure. For example, a firm with ROE of 20% would seem to be doing well, but this figure may be
misleading if it were marginally profitable (low profit margin) and highly levered (high equity
multiplier). If the firms margins were to erode slightly, the ROE would be heavily impacted.
12. Increasing the payables period increases the cash flow from operations. This could be beneficial for
the company as it may be a cheap form of financing, but it is basically a one time change. The
payables period cannot be increased indefinitely as it will negatively affect the companys credit
rating if the payables period becomes too long.

Chapter 3: Questions and Problems 1, 2, 5, 6, 18, 27-29

1.
Using the formula for NWC, we get:
NWC = CA CL
CA = CL + NWC = $3,720 + 1,370 = $5,090
So, the current ratio is:
Current ratio = CA / CL = $5,090/$3,720 = 1.37 times
And the quick ratio is:
Quick ratio = (CA Inventory) / CL = ($5,090 1,950) / $3,720 = 0.84 times
2.
We need to find net income first. So:
Profit margin = Net income / Sales
Net income = Sales(Profit margin)
Net income = ($29,000,000)(0.08) = $2,320,000
ROA = Net income / TA = $2,320,000 / $17,500,000 = .1326 or 13.26%
To find ROE, we need to find total equity.
TL & OE = TD + TE
TE = TL & OE TD
TE = $17,500,000 6,300,000 = $11,200,000
ROE = Net income / TE = 2,320,000 / $11,200,000 = .2071 or 20.71%
5.
Total debt ratio = 0.63 = TD / TA
Substituting total debt plus total equity for total assets, we get:
0.63 = TD / (TD + TE)
Solving this equation yields:
0.63(TE) = 0.37(TD)
Debt/equity ratio = TD / TE = 0.63 / 0.37 = 1.70
Equity multiplier = 1 + D/E = 2.70

6.
Net income

= Addition to RE + Dividends

= $430,000 + 175,000 = $605,000

Earnings per share

= NI / Shares

= $605,000 / 210,000 = $2.88 per share

Dividends per share

= Dividends / Shares

= $175,000 / 210,000 = $0.83 per share

Book value per share = TE / Shares

= $5,300,000 / 210,000 = $25.24 per share

Market-to-book ratio

= Share price / BVPS

= $63 / $25.24 = 2.50 times

P/E ratio

= Share price / EPS

= $63 / $2.88 = 21.87 times

Sales per share

= Sales / Shares

= $4,500,000 / 210,000 = $21.43

P/S ratio

= Share price / Sales per share = $63 / $21.43 = 2.94 times

18.
Profit margin = net income / sales
Total Asset Turnover = sales / total assets
Equity Multiplier = 1 + Debt / Equity
ROE = PM x TAT x EM
ROE = 0.15 = (PM)(TAT)(EM) = (PM)(S / TA)(1 + D/E)
Solving the DuPont Identity for profit margin, we get:
PM = [(ROE)(TA)] / [(1 + D/E)(S)]
PM = [(0.15)($3,105)] / [(1 + 1.4)( $5,276)] = .0368
Now that we have the profit margin, we can use this number and the given sales figure to solve for net
income:
PM = .0368 = NI / S
NI = .0368($5,276) = $194.16
27. Return on equity
Return on equity
Profit margin
Profit margin
Equity multiplier
Equity multiplier
Total asset turnover
Total asset turnover

= Net income / Total equity

= $36,475 / $192,840 = 0.1891 or 18.91%
= Net income / Sales
= $36,475 / $305,830 = 0.1193 or 11.93%
= 1 + D/E
= 1 + ($43,235 + 85,000) / $192,840 = 1+0.66= 1.66
= Sales / Total assets
= $305,830 / $321,075 = 0.95 times

The DuPont identity is:

ROE = (PM)(TAT)(EM)
ROE = (0.1193)(0.95)(1.66) = 0.1891 or 18.91%
28.

SMOLIRA GOLF CORP.

Statement of Cash Flows
For 2009
Cash, beginning of the year

$ 21,860

Operating activities
Net income
Plus:
Depreciation
Increase in accounts payable
Increase in other current liabilities
Less:
Increase in accounts receivable
Increase in inventory

$ 36,475
$ 26,850
3,530
1,742
$ (2,534)
(1,566)

Net cash from operating activities

$ 64,497

Investment activities
Fixed asset acquisition
Net cash from investment activities

$(53,307)
$(53,307)

Financing activities
Increase in notes payable
Dividends paid
Increase in long-term debt
Net cash from financing activities

$ (1,000)
(20,000)
10,000
$(11,000)

Net increase in cash

Cash, end of year

$ 22,050

29. Earnings per share

Earnings per share

= Net income / Shares

= $36,475 / 25,000 = $1.46 per share

P/E ratio
P/E ratio

= Shares price / Earnings per share

= $43 / $1.46 = 29.47 times

Dividends per share

= Dividends / Shares

190

Dividends per share

Book value per share
Book value per share

= $20,000 / 25,000 = $0.80 per share

= Total equity / Shares
= $192,840 / 25,000 shares = $7.71 per share

Market-to-book ratio
Market-to-book ratio

= Share price / Book value per share

= $43 / $7.71 = 5.57 times

PEG ratio
PEG ratio

= P/E ratio / Growth rate

= 29.47 / 9 = 3.27 times