Ross - Corporate Finance: Core Principles and Applications - 4e, solutions manual and test bank 0077861655
End of Chapter Solutions
Corporate Finance: Core Principles and Applications
4th edition
Ross, Westerfield, Jaffe, and Jordan
06-08-2013
Prepared by
Brad Jordan
University of Kentucky
Joe Smolira
Belmont University
CHAPTER 1
INTRODUCTION TO CORPORATE FINANCE
Answers to Concept Questions
1. The three basic forms are sole proprietorships, partnerships, and corporations. Some disadvantages of sole proprietorships and partnerships are: unlimited liability, limited life, difficulty in transferring ownership, and hard to raise capital funds. Some advantages are: simpler, less regulation, the owners are also the managers, and sometimes personal tax rates are better than corporate tax rates. The primary disadvantage of the corporate form is the double taxation to shareholders on distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life. When a business is started, most take the form of a sole proprietorship or partnership because of the relative simplicity of starting these forms of businesses.
2. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly traded or not).
3. 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 firm’s 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 else’s 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.
4. Such organizations frequently pursue social or political missions, so many different goals are conceivable. One goal that is often cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society. A better approach might be to observe that even a not-for-profit business has equity. Thus, one answer is that the appropriate goal is to maximize the value of the equity.
5. 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.
6. An argument can be made either way. At the one extreme, we could argue that in a market economy, all of these things are priced. There is thus an optimal level of, for example, unethical and/or illegal behavior, and the framework of stock valuation explicitly includes these. At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process. A classic (and highly relevant) thought question that illustrates this debate goes something like this: “A firm has estimated that the cost of improving the safety of one of its products is $30 million. However, the firm believes that improving the safety of the product will only save $20 million in product liability claims. What should the firm do?”
7. The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions.
8. 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.
9. We would expect agency problems to be less severe in other countries, primarily due to the 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.
10. How much is too much? Who is worth more, Larry Ellison or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor. Executive compensation is the price that clears the market. The same is true for athletes and performers. Having said that, one aspect of executive compensation deserves comment. A primary reason that executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation. Such movement is obviously consistent with the attempt to better align stockholder and management interests. When stock prices soar, management cleans up. It is sometimes argued that much of this reward is simply due to rising stock prices in general, not managerial performance. Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases.
CHAPTER 2
FINANCIAL STATEMENTS AND CASH FLOW
Answers to Concept Questions
1. Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value. It’s 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 it - namely that higher returns can generally be found by investing the cash into productive assets - low liquidity levels are also desirable to the firm. It’s up to the firm’s 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; it’s the way accountants have chosen to do it.
3. The bottom line number shows the change in the cash balance on the balance sheet. As such, it is not a useful number for analyzing a company.
4. The major difference is the treatment of interest expense. The accounting statement of cash flows treats interest as an operating cash flow, while the financial statement of cash flows treats interest as a financing cash flow. The logic of the accounting statement of cash flows is that since interest appears on the income statement, which shows the operations for the period, it is an operating cash flow. In reality, interest is a financing expense, which results from the company’s choice of debt/equity. We will have more to say about this in a later chapter. When comparing the two cash flow statements, the financial statement of cash flows is a more appropriate measure of the company’s operating performance because of its treatment of interest.
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.
6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly leading to negative cash flow from assets. In general, what matters is whether the money is spent productively, not whether cash flow from assets is positive or negative.
7. It’s probably not a good sign for an established company, but it would be fairly ordinary for a start-up, so it depends.
8. For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline. The same might be true if it becomes better at collecting its receivables. In general, anything that leads to a decline in ending NWC relative to beginning would have this effect. Negative net capital spending would mean more long-lived assets were liquidated than purchased.
9. If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative. If a company borrows more than it pays in interest and principal, its cash flow to creditors will be negative.
10. The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences.
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.
Basic
1. To find owner’s equity, we must construct a balance sheet as follows:
Balance Sheet
CA $7,300 CL $5,700
NFA 26,200 LTD 12,900
OE ??
TA $33,500 TL & OE $33,500
We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $33,500. We also know that TL & OE is equal to current liabilities plus long-term debt plus owners’ equity, so owners’ equity is:
OE = $33,500 –12,900 – 5,700 = $14,900
NWC = CA – CL = $7,300 – 5,700 = $1,600
2. The income statement for the company is:
Income Statement
Sales $675,300
Costs 297,800
Depreciation 45,100
test bank
test bank
ch2 Key
1. | Assume both current and deferred taxes are positive values. Given this, deferred taxes will:
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Difficulty Level: 2 Medium |
2. | Which one of these is handled differently in calculating cash flows for accounting versus financial purposes?
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Difficulty Level: 1 Easy |
3. | Which one of these will increase earnings per share?
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Difficulty Level: 2 Medium |
4. | A current asset is best defined as:
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Difficulty Level: 1 Easy |
5. | The long-term debts of a firm are liabilities:
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Difficulty Level: 1 Easy |
6. | A(n) ____ asset is one which can be quickly converted into cash without significant loss in value.
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Difficulty Level: 1 Easy |
7. | Noncash items refer to:
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Difficulty Level: 1 Easy |
8. | Your _____ tax rate is the percentage of the next taxable dollar of income you earn that is payable as a tax.
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Difficulty Level: 1 Easy |
9. | Your _____ tax rate measures the total taxes you pay divided by your total taxable income.
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Difficulty Level: 1 Easy |
10. | _____ refers to the cash flow resulting from a firm's ongoing, normal business activities.
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Difficulty Level: 2 Medium |
11. | _____ refers to the changes in net capital assets.
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Difficulty Level: 2 Medium |
12. | _____ refers to the difference between a firm's current assets and its current liabilities.
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Difficulty Level: 1 Easy |
13. | _____ is calculated by adding back noncash expenses to earnings before interest and taxes, subtracting taxes, and adjusting for any changes in total assets or current liabilities that affect cash flows.
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Difficulty Level: 2 Medium |
14. | _____ refers to a firm's interest payments minus any net new borrowing.
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Difficulty Level: 1 Easy |
15. | _____ refers to a firm's dividend payments minus any net new equity raised.
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Difficulty Level: 1 Easy |
16. | Which of the following are included in current assets?
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Difficulty Level: 1 Easy |
17. | Which of the following are included in current liabilities?
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Difficulty Level: 2 Medium |
18. | Which one of the following accounts is generally the most liquid?
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Difficulty Level: 1 Easy |
19. | Which one of the following statements concerning liquidity is correct?
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