Corporate Finance

Seminar 1

Problem #1

Problem 2.1 from Ross, Westerfield and Jaffe (in the reader)

Problem #2

Use the following information for Shoe Soul Corporation to answer the questions below. Assume that
deferred taxes are zero and current liabilities contain neither short-term debt nor current maturities
of long term debt. The corporate tax rate is 34%.

Shoe Soul Corporation

1994 1995

Sales 2230 2890

Costs 1050 1437
Depreciation 418 418
Interest 225 276
Dividends 350 400
Current Assets 1140 1335
Fixed Assets 5670 5877
Current Liabilities 884 1006
Long-Term Debt 2349 2666

1. What is the 1995 EBIT?

2. What are 1995 taxes?
3. What is 1995 net income?
4. What are the 1995 additions to net working capital?
5. What is the 1995 net capital spending?
6. What is the 1995 cash flow from assets (to investors)?
7. What is the 1995 net new borrowing of long-term debt?
8. What is the 1995 cash flow to creditors?
9. What is the 1995 cash flow to stockholders?
10. What is the 1995 net new equity issued?

Problem #2 Answers

1. Sales 2890
- Costs 1437
1453
- Depr. 418
EBIT 1035

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2. EBIT 1035
- Interest 276
EBT 759
Tax Rate .34
Taxes 258

3. EBIT 1035
- Interest 276
759
- Taxes 258
Net Income501

4. 1994 NWC 1995 NWC Additions NWC

C.A. 1140 C.A. 1335
- C.L. 884 - C.L. 1006
94 NWC 256 95 NWC 329 73

5. 1995 Fixed Assets 5877

- 1994 Fixed Assets 5670
207
+ Depreciation 418
Net Capital Spending 625

6. Net Income 501

Under our assumptions, this is
+ Depreciation 418
OCF change in cash
+ Interest 276
- Additions to NWC 73
- Net capital spending 625
Cash Flow from Assets 497

7. 1995 L-T Debt 2666

- 1994 L-T Debt 2349
Net New Debt 317

8. Interest 276
- Net New Debt 317
Cash Flow to Creditors -41

9. Cash Flow from Assets 497

- Cash Flow to Creditors 41
Note that subtracting a negative number means add
Cash Flow to Stockholders 538

10. Dividends 400

- Cash Flow to Stockholders -538
Net New Equity Issued -138

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 Problem #3

Using the 1995 Income Statement and Balance Sheet, what is the:

1. Current Ratio 15. Days Sales in Receivables

2. Quick Ratio 16. NWC Turnover
3. Cash Ratio 17. Fixed Asset Turnover
4. Net Working Capital to Total Assets 18. Total Asset Turnover
6. Total Debt Ratio 19. Profit Margin
7. Debt Equity Ratio 20. Return on Assets
8. Equity Multiplier 21. Return on Equity
9. Long-term Debt Ratio 22. Earnings Per Share
11. Cash Coverage Ratio 23. Price/Earnings Ratio
12. Inventory Turnover 24. Market-to-Book Ratio
13. Days Sales in Inventory 25. Book Value Per Share
14. Receivables Turnover

Balance Sheet as of December 31, 1994 and 1995

1994 1995
Assets
Current Assets
Cash $4,000 $3,000
Accounts Receivable $9,000 $11,000
Inventory $5,000 $4,500
Total $18,000 $18,500

Fixed Assets
Net Plant and Equipment $30,000 $31,500

Total Assets $48,000 $50,000

Liabilities and Owners' Equity

Current Liabilities
Accounts Payable $3,000 $2,500
Notes Payable $6,000 $6,416
Total $9,000 $8,916

Long-term Debt $15,000 $13,000

Owners' Equity
Common Stock and
Paid-In Surplus $14,000 $16,500
Retained Earnings $10,000 $11,584

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 Total $24,000 $28,084

Total Liabilities and Equity $48,000 $50,000

Coogan Development Company, Inc.

1995 Income Statement

Sales $25,000
Cost of Goods Sold $16,000
Depreciation $3,000

Earnings Before Interest and Taxes $6,000

Interest Paid $2,000

Taxable Income $4,000

Taxes (@34%) $1,360

Net Income $2,640

Retained Earnings $1,584

Dividends $1,056

There are 1,000 shares of common stock outstanding.

The market price per share is $40.00.

Problem #3 Answers

1. Current ratio = CurrentAssets / CurrentLiabilities = $18,500/$8916 = 2.07

2. Quick ratio = (CurrentAssets-Inventory)/CurrentLiabilities = ($18,500 - $4,500)/$8,916 = 1.57
3. Cash ratio = Cash/CurrentLiabilities = $3,000/$8,916 = .34
4. Net working capital to total assets = (CurrentAssets CurrentLiabilities)/TotalAssets=($18,500 -
$8,916)/$50,000 = .19
6. Total debt ratio = (TotalAssets OwnersEquity)/ TotalAssets = ($50,000 - $28,084)/$50,000 = .44
7. Debt/Equity ratio = (TotalAssets OwnersEquity)/OwnersEquity = $21,916/$28,084 = .78
8. Equity multiplier = TotalAssets/ OwnersEquity = $50,000/$28,084 = 1.78
9. Long-term debt ratio = LongTermDebt / (LongTermDebt+OwnersEquity) = $13,000/($13,000 +
$28,084) = .316
11. Cash coverage ratio = (EBIT+Depreciation)/TotalInterest = ($6,000 + $3,000)/$2,000 = 4.5 times
12. Inventory turnover = CostofGoods/Inventory = $16,000/$4,500 = 3.56 times
13. Days sales in inventory = 365days/InventoryTurnover = 365 days/3.56 = 103 days
14. Receivables turnover = Sales/AccountsReceivable= $25,000/$11,000 = 2.27 times
15. Days sales in receivables = 365 days/ReceivablesTurnover = 365 days/2.27 = 161 days
16. NWC turnover =Sales/ (CurrentAssets CurrentLiabilities) = $25,000/($18,500 - $8,916) = 2.61
times
17. Fixed asset turnover = Sales/FixedAssets = $25,000/$31,500 = .79 times
18. Total asset turnover = Sales/TotalAssets = $25,000/$50,000 = .50 times
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19. Profit margin = NetIncome/Sales= $2,640/$25,000 = 10.56%
20. Return on assets = NetIncome/TotalAssets = $2,640/$50,000 = 5.28%
21. Return on equity = NetIncome/OwnersEquity = $2,640/$28,084 = 9.4%
22. Earnings Per Share = NetIncome/NumberOfShares = $2,640/1,000 = $2.64
23. P/E ratio = SharePrice/EPS = $40/$2.64 = 15.2
24. Market-to-book ratio = Price/ (OwnersEquity/NumberOfShares) = $40/$28.08 = 1.42 times
25. The book value per share equals (OwnersEquity/NumberOfShares) = ($28.084/1,000) = $28.08

Problem 4

Quisco Systems has 6.5 billion shares outstanding and a share price of $18. Quisco is considering
developing a new networking product in house at a cost of $500 million.Alternatively, Quisco can
acquire a firm that already has the technology for $900 worth (at the current price) of Quisco stock.
Suppose that absent the expense of the new technology, Quisco will have EPS of $0.80.
a) Suppose Quisco develops the product in house. What impact would the development cost have
on Quiscos EPS? Assume all costs are incurred this year and are treated as an R&D expense,
Quiscos tax rate is 35%, and the number of shares outstanding is unchanged.
b) Suppose Quisco does not develop the product in house but instead acquires the technology.
What effect would the acquisition have on Quiscos EPS this year? (Note that acquisition
expenses do not appear directly on the income statement. Assume the acquired firm has no
revenues or expenses of its own, so that the only effect on EPS is due to the change in the
number of shares outstanding.)
c) Which method of acquiring the technology has a smaller impact on earnings? Is this method
cheaper? Explain.

Problem 4. Answers

a. If Quisco develops the product in house, its earnings would fall by $500 (1 35%) = $325
million. With no change to the number of shares outstanding, its EPS would decrease by
$325
$0.05 = to $0.75. (Assume the new product would not change this years revenues.)
6500

b. If Quisco acquires the technology for $900 million worth of its stock, it will issue $900 / 18 =
50 million new shares. Since earnings without this transaction are $0.80 6.5 billion = $5.2
5.2
billion, its EPS with the purchase is = $0.794 .
6.55

c. Acquiring the technology would have a smaller impact on earnings. But this method is not
cheaper. Developing it in house is less costly and provides an immediate tax benefit. The
earnings impact is not a good measure of the expense. In addition, note that because the
acquisition permanently increases the number of shares outstanding, it will reduce Quiscos
earnings per share in future years as well.