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Financial Management cabrera answer key

Secondary Education (Trece Martires City College)

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FINANCIAL
MANAGEMENT
Complementary Volume

2019 – 2020
Edition

MA. ELENITA BALATBAT CABRERA

BBA MBA CPA CMA

GILBERT ANTHONY B. CABRERA

BBA MBA CPA

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Table of Contents
Unit I Overview of Financial Management

Chapter 1 NATURE, PURPOSE AND SCOPE OF FINANCIAL

MANAGEMENT 1-1 to 1-3

2 RELATIONSHIP OF FINANCIAL OBJECTIVES TO

ORGANIZATIONAL STRATEGY AND OTHER

ORGANIZATIONAL OBJECTIVES 2-1 to 2-3

3 FUNCTIONS OF FINANCIAL MANAGEMENT 3-1 to 3-2

4 BUSINESS ORGANIZATION AND TRENDS 4-1 to 4-4

Unit II Evaluating Operating and Financial

Performance of a Business Entity

Chapter 5 UNDERSTANDING FINANCIAL STATEMENTS 5-1 to 5-15

6 ASSESSMENT OF THE FIRM’S OPERATING EFFICIENCY AND

FINANCIAL POSITION THROUGH FINANCIAL
STATEMENTS ANALYSIS 6-1 to 6-19

7 CASH FLOW ANALYSIS 7-1 to 7-7

8 OPERATING AND FINANCIAL LEVERAGE 8-1 to 8-14

Unit III Financial Forecasting, Planning and Control

Chapter 9 FINANCIAL FORECASTING FOR STRATEGIC GROWTH 9-1 to 9-9

10 FORECASTING SHORT-TERM OPERATING FINANCIAL

REQUIREMENTS 10-1 to 10-7

Unit IV Working Capital Management

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Chapter 11 ADDRESSING THE WORKING CAPITAL POLICIES AND

MANAGEMENT OF SHORT-TERM ASSETS AND
LIABILITIES 11-1 to 11-5

12 CASH AND MARKETABLE SECURITIES MANAGEMENT 12-1 to 12-7

13 ACCOUNTS RECEIVABLE AND INVENTORY MANAGEMENT 13-1 to 13-9

14 SHORT-TERM SOURCES FOR FINANCING CURRENT ASSETS 14-1 to 14-10

Unit V Long-Term Investment Decisions

Chapter 15 CALCULATING THE COST OF CAPITAL 15-1 to 15-4

16 THE BASICS OF CAPITAL BUDGETING 16-1 to 16-5

17 SCREENING AND SELECTING CAPITAL INVESTMENT

PROPOSALS 17-1 to 17-7

Unit VI Capital Structure Issues

Chapter 18 ASSESSING LONG-TERM DEBT, EQUITY AND CAPITAL

STRUCTURE 18-1 to 18-9

19 SOURCES OF LONG-TERM FINANCING 19-1 to 19-9

20 SHARING FIRM WEALTH: DIVIDENDS, SHARE

REPURCHASE AND OTHER PAYOUTS 20-1 to 20-18

21 MERGERS AND ACQUISITIONS; DIVESTITURES 21-1 to 21-3

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CHAPTER 1

NATURE, PURPOSE, AND

SCOPE OF FINANCIAL MANAGEMENT

Answer to Questions

1. The goal of financial management is to make money and add value for the owner. The kinds of activities
that financial management deals with relate the three financial decisions that finance managers must
make namely, investing, financing and dividend decisions.

2. Refer to page 8 – Relationship between Financial Management and Accounting.

3. The owners’ perspective holds that the only appropriate goal is “to maximize shareholder wealth”. The
competing viewpoint is from the stakeholders’ perspective, which emphasizes social responsibility over
profitability. This view maintains that managers must maximize the total satisfaction of all stakeholders in
a business. While strong arguments speak in favor of both perspectives, financial practitioners and
academics now tend to believe that the manager’s primary responsibility should be to maximize
shareholder wealth and give only secondary consideration to other stakeholders’ welfare. The invisible
hand of the market, acting through compensation and the free price system, would ensure that only those
activities most efficient and beneficial to society as a whole would survive in the long run. Thus, those
same activities would also profit the individual most. When companies try to implement a goal other than
profit maximization, their efforts tend to backfire. Consider the firm that tries to maximize employment,
the high number of employees raises costs. Soon the firm will find that its costs are too high to allow it to
compete against more efficient firms, especially in a global business environment. When the firm fails, all
employees are let go and employment ends up being minimized, not maximized.

4. Financially stable firms are good for stakeholders, such as employees, managers, customers and local
communities.

5. Theoretically, managers work for shareholders. In reality, because shareholders aren’t involved in day-to-
day firm activities, managers control the firm. Managers might be tempted to operate the firm in such a
way as to benefit themselves more than the shareholders. Corporate governance is the system of
incentives and monitors that tries to overcome this agency problem. Shareholders can align managers’
interest with stockholder interests by making managers part owners of the firm. Then, various monitors
follow the firm and report on its activities.

6. 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 firm’s credit collection policy with its customers).

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7. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly-traded
or not).

8. The primary objective of financial managers is to maximize the wealth of the firm of the price of the firm’s
stock. A secondary objective is to maximize earnings per share.

9. In striving for optimum profits, a firm may overlook risk. In other words, investment decisions based on
high profits can cause profits to disappear or fluctuate excessively; this could lead to insolvency, a great
deal of uncertainty, and a decline in the price of the firm’s stock.

10. Investors are looking for the highest returns at the lowest risk. Creditors want to be assured that the firm
maintains a sound financial structure and that’s its policies ensure payment of interest and repayment of
principal. Creditors don’t want the firm to take unnecessary chances, which could lead to insolvency.

11. Firms must try to minimize such environmental hazards as air and water pollution. By buying pollution
equipment, a firm allocates funds to unproductive and unprofitable equipment. In doing so, it cannot
achieve the highest financial return but it will enhance its image.

12. Firm-related micro factors are mainly supply, demand, and prices. Macro factors are external in nature and
include the business cycle, the rate of inflation, trends in the financial field, and changes in foreign
exchange rates. Correct timing and forecasting of these macro factors are essential.

13. The income statement, the balance sheet, and the statement of cash flows. The balance sheet tells the firm
how it is allocating its funds to various assets and how the firm generates funds from internal and external
sources. The income statement is concerned with sales, costs, and profits. The statement of cash flows
traces cash inflows and out flows for operating, investing and financing purposes.

14. Financial managers must be ethical and seek to interact with the community. They must conform to
environmental, legal, health, and safety standards. In this connection, they should avoid investments in
ventures that transgress democratic principles and should seek to hire minorities. In other words, a balance
should be struck between attempts to maximize wealth and the attainment of social betterment. A firm
should also establish rules to prevent sexual harassment and to eliminate salary differentials based on
gender or race.
15. Besides having the responsibility of maximizing the price of a company's shares at the least risk possible, a
manager must adopt flexible financing methods in order to control costs. Furthermore, when implementing
a plan, constant monitoring is required, and when the plan fails to achieve the desired goal, a new strategy
should be adopted.

Answer to Multiple Choice Questions

1. C

2. B

3. B

4. C

5. D

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CHAPTER 2

RELATIONSHIP OF FINANCIAL OBJECTIVES

TO ORGANIZATIONAL STRATEGY ANDOTHER ORGANIZATIONAL OBJECTIVES

Answer to Questions

1. 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.

2. By acting as agents, managers may adopt conservative approaches to avoid making big mistakes they may
be forced to reconcile the different aims of stockholders and creditors, agents may not be able to devote
enough time and effort to achieve maximization of the firm’s wealth. Agents may not be willing to assume
the added risks of certain projects even though such investments may more than adequately compensate the
firm for the risks incurred.
The best managers can be attracted to the firm in two ways: first, by offering them attractive compensation
and second, by giving them options to buy stock in the firm as an incentive to make decisions that will raise
the market value of shares.

3. Financial theory is a starting point. It merely provides some tools which cannot substitute for experience
and judgment. However, despite its limitations, theory helps to explain the financial process and shows
how to avoid pitfalls in making investment decisions.

4. 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.

5. The board of directors should set CEO compensation dependent on how well the firm performs. The
compensation package should be sufficient to attract and retain the CEO but not go beyond what is
needed. Compensation should be structured so that the CEO is rewarded on the basis of the stock’s
performance over the long run, not the stock’s price on an option exercise date. This means that options
(or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to
keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable
manner, then performance pay could be based on changes in intrinsic value. However, it is easier to
measure the growth rate in reported profits than the intrinsic value, although reported profits can be
manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since
intrinsic value is not observable, compensation must be based on the stock’s market price—but the price
used should be an average over time rather than on a specific date.

6. Stockholder wealth maximization is a long-term goal. Companies, and consequently the stockholders,
prosper by management making decisions that will produce long-term earnings increases. Actions that
are continually shortsighted often “catch up” with a firm and, as a result, it may find itself unable to

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compete effectively against its competitors. There has been much criticism in recent years that firms are
too short-run profit-oriented. A prime example is the auto industry, which has been accused of
continuing to build large “gas guzzler” automobiles because they had higher profit margins rather than
retooling for smaller, more fuel-efficient models.

7. Useful motivational tools that will aid in aligning stockholders’ and management’s interests include: (1)
reasonable compensation packages, (2) direct intervention by shareholders, including firing managers
who don’t perform well, and (3) the threat of takeover.

The compensation package should be sufficient to attract and retain able managers but not go beyond
what is needed. Also, compensation packages should be structured so that managers are rewarded on
the basis of the stock’s performance over the long run, not the stock’s price on an option exercise date.
This means that options (or direct stock awards) should be phased in over a number of years so managers
will have an incentive to keep the stock price high over time. Since intrinsic value is not observable,
compensation must be based on the stock’s market price—but the price used should be an average over
time rather than on a specific date.

Stockholders can intervene directly with managers. Today, the majority of stock is owned by institutional
investors and these institutional money managers have the clout to exercise considerable influence over
firms’ operations. First, they can talk with managers and make suggestions about how the business
should be run. In effect, these institutional investors act as lobbyists for the body of stockholders.
Second, any shareholder who has owned ₱2,000 of a company’s stock for one year can sponsor a
proposal that must be voted on at the annual stockholders’ meeting, even if management opposes the
proposal. Although shareholder-sponsored proposals are non-binding, the results of such votes are
clearly heard by top management.

If a firm’s stock is undervalued, then corporate raiders will see it to be a bargain and will attempt to
capture the firm in a hostile takeover. If the raid is successful, the target’s executives will almost certainly
be fired. This situation gives managers a strong incentive to take actions to maximize their stock’s price.

8. a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to create a
more attractive community that will make it easier to hire a productive work force. This corporate
philanthropy could be received by stockholders negatively, especially those stockholders not living in
its headquarters city. Stockholders are interested in actions that maximize share price, and if
competing firms are not making similar contributions, the “cost” of this philanthropy has to be borne
by someone - the stockholders. Thus, stock price could decrease.

b. Companies must make investments in the current period in order to generate future cash flows.
Stockholders should be aware of this, and assuming a correct analysis has been performed, they should
react positively to the decision. Assuming that the correct capital budgeting analysis has been made, the
stock price should increase in the future.

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c. Government treasury bonds are considered safe investments, while common stocks are far more risky.
If the company were to switch the emergency funds from treasury bonds to stocks, stockholders
should see this as increasing the firm’s risk because stock returns are not guaranteed - sometimes
they increase and sometimes they decline. The firm might need the funds when the prices of their
investments were low and not have the needed emergency funds. Consequently, the firm’s stock
price would probably fall.

9. Earnings per share in the current year will decline due to the 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.

Answer to Multiple Choice Questions

6. D

7. C

8. D

9. A

10. D

CHAPTER 3

FUNCTIONS OF FINANCIAL MANAGEMENT

Questions

1. The treasurer’s office and the controller’s office are the two primary organizational groups that report
directly to the chief financial officer. The controller’s office handles cost and financial accounting, tax
management, and management information systems, while the treasurer’s office is responsible for cash
and credit management, capital budgeting, and financial planning. Therefore, the study of corporate
finance is concentrated within the treasury group’s functions.

2. 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, ethical 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

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believes that improving the safety of the product will only save ₱20 million in product liability claims.
What should the firm do?”

3. 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.

4. How much is too much? Who is worth more, Ray Irani or Roger Federer? 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 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. In recent years, stock
prices have soared, so management has cleaned 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.

5. Refer to page 31.

6. External auditor’s role is to review and examine the presentation of the Financial Statements (FS) of an
entity. He expresses a professional opinion as to whether the FS present fairly the financial position,
results of operations and cash flows of the company.

Internal auditor on the other hand reviews financial as well as nonfinancial practice for efficiency and
effectiveness.

7. Refer to page 29 and 30.

Answer to Multiple Choice Questions

11. C

12. A

13. C

14. D

15. B

16. D

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CHAPTER 4

FORMS OF BUSINESS ORGANIZATION AND TRENDS

Questions

1. Refer to pages 35 through 40.

2. Of the three basic forms of business ownership, corporations have better access to capital. The ability to
raise capital in a sole proprietorship and partnership is limited to the personal capacity of the owner(s) to
attract potential creditors and other investors.

3. The founder can eventually lose control of the firm if the business continually incurs losses and
uncontrolled indebtedness. The founder can avoid losing control by ensuring that the business is
operating profitably and earnings are reinvested profitably.

4. 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.

5. Statistics provide the tools for comparing the financial status of the firm with that of other companies and
of its own industry. Statistical techniques are invaluable for projecting the returns and relative risks of
different investments. They can be used to simulate the outcome of investments, given different
assumptions. Statistics can help managers to monitor operations and to time borrowings, purchases of
goods, and capacity expansion.

6. Firms seek global exposure because they wish to increase growth, diversity risk, gain from new technology
exchanges, lower labor, and benefit from cheap imports. However, they must be aware of certain risks such
as exchange rate devaluations, expropriations, and the potential losses in the value of assets.

7. Managers have to be aware of the different tax laws and legal aspects in foreign countries. They should
take advantage of lower interest rates when borrowing abroad. It is also important to consider differences in
discount rates between domestic and foreign projects involving similar projects. Strategies should be
adopted to protect against losses in current assets and liabilities. The interpretation of the D/E ratio can
differ significantly in various countries calling for a different attitude toward debt risk and insolvency.
Managers must learn to employ financial derivatives as hedges against currency rate changes. Among the
most popular derivatives are futures and swaps. Also, because managers face an exchange rate risk, they
have to adjust the projected cash flows of a foreign project for expected changes in currency values and
they must adopt strategies to protect the values of working capital assets.

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Repatriation of earnings is not simple because of losses that a firm can incur in currency translations.
Furthermore, managers cannot employ the same standards of accounting. They should be cognizant of the
differences in capital structure interpretations because abroad, high D/E ratios are more acceptable than in
the domestic market. Although there are many benefits in globalizing, a prudent policy is advised to avoid
overexposure in weak currency countries.

8. By outsourcing a firm can avoid technological obsolescence. The firm does not have to incur the costs of
pollution control and worker safety. If the existing capacity mix fails to match changing demand,
outsourcing can fill the deficiency gap. Above all, the firm benefits from low labor and other costs. In
contrast, the firm is faced with new risks such as adverse changes in exchange rates. Loss of depreciation
cash flows is a real possibility. Foreign investments may be subject to expropriation.

9. Compensation packages should be sufficient to attract and retain able managers, but they should not go
beyond what is needed. Also, compensation should be structured so that managers are rewarded on the
basis of the stock’s performance over the long run, not the stock’s price on an option exercise date. This
means that options (or direct stock awards) should be phased in over a number of years so that managers
have an incentive to keep the stock price high over time. When the intrinsic value can be measured in an
objective and verifiable manner, performance pay can be based on changes in intrinsic value. However,
because intrinsic value is not observable, compensation must be based on the stock’s market price – but the
price used should be an average over time rather than on a specific date.

10. Until recently, the profitability of a large firm’s management being ousted by its stockholders was so
remote that it posed little threat. Most firm’s shares were so widely distributed and the CEO had so much
control over the voting mechanism that it was virtually impossible for dissident stockholders to get the
votes needed to overthrow a management team.

Stockholders can intervene directly with managers. Years ago, most stock was owned by individuals.
Today, however, the majority of stock is owned by institutional investors such as insurance companies,
pension funds, hedge funds, and mutual funds; and private equity groups are ready and able to step in and
take over underperforming firms. These institutional money managers have the clout to exercise
considerable influence over firms’ operations. First, they can speak with managers and make suggestions
about how the business should be run.

It has long been recognized that managers’ personal goals may compete with shareholder wealth
maximization. In particular, managers might be more interested in maximizing their own wealth than their
stockholders’ wealth; therefore, managers might pay themselves excessive salaries.

Case

1. The advantages to a limited partnership are:

a) Reduction of personal liability. A sole proprietor has unlimited liability, which can include the
potential loss of all personal assets except for at least one partner who assumes unlimited
liability.

b) Taxes. Forming a limited partnership may mean that more expenses can be considered business
expenses and be deducted from the company’s income.

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c) Improved credibility. The business may have increased credibility in the business world compared
to a sole proprietorship.

d) Ability to attract investment. Limited partnerships can raise capital through the sale of equity or
interest in the firm.

e) Continuous life. Sole proprietorships have a limited life, as compared with limited partnerships
which have potentially longer life.

f) Transfer of ownership. It is easier to transfer ownership in a sole proprietorship than in a

partnership.

The biggest disadvantage is the potential cost, although the cost of forming a limited partnership can be
relatively small. There are also other potential costs, including more expansive record-keeping.

2. Forming a corporation has the same advantages as forming a limited partnership, except that costs are
likely to be higher and in a corporation, ownership is easier to transfer.

3. As a small company, changing to a limited partnership is probably the most advantageous decision at the
current time. If the company grows, and Dee and Lyn are willing to sell more equity ownership, the
company can reorganize as a corporation at a later date. Additionally, forming a limited partnership is
likely to be less expensive than forming a corporation.

Multiple Choice Questions

17. A

18. A

19. D

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CHAPTER 5

UNDERSTANDING FINANCIAL STATEMENTS

Questions

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

2. Bankers and investors use financial statements to make intelligent decisions about what firms to extend
credit or in which to invest, managers need financial statements to operate their businesses efficiently,
and taxing authorities need them to assess taxes in a reasonable way.

3. No, because the ₱20 million of retained earnings would probably not be held as cash. The retained
earnings figure represents the reinvestment of earnings by the firm over its life. Consequently, the ₱20
million would be an investment in all of the firm’s assets.

4. The balance sheet shows the firm’s financial position on a specific date, for example, December 31, 20X4.
It shows each account balance at that particular point in time. For example, the cash account shown on
the balance sheet would represent the cash the firm has on hand and in the bank on December 31, 20X4.
The income statement, on the other hand, reports on the firm’s operations over a period of time, for
example, over the last 12 months. It reports revenues and expenses that the firm has incurred over that
particular time period. For example, the sales figures reported on the income statement for the period
ending December 31, 20X4, would represent the firm’s sales over the period from January 1, 20X4,
through December 31, 20X4, not just sales for December 31, 20X4.

5. Investors need to be cautious when they review financial statements. While companies are required to
follow the financial reporting standard, managers still have quite a lot of discretion in deciding how and
when to report certain transactions. Consequently, two firms in exactly the same operating situation may
report financial statements that convey different impressions about their financial strength. Some
variations may stem from legitimate differences of opinion about the correct way to record transactions.
In other cases, managers may choose to report numbers in a way that helps them present either higher
earnings or more stable earnings over time. As long as they follow the financial reporting standard, such
actions are not illegal, but these differences make it harder for investors to compare companies and
gauge their true performances.

Unfortunately, there have also been cases where managers overstepped the bounds and reported
fraudulent statements. Indeed, a number of high-profile executives have faced criminal charges because
of their misleading accounting practices.

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6. The earnings (less dividends) reported in the income statement is transferred to the ownership section of
the balance sheet as retained earnings. Thus, what we earn in the income statement becomes part of the
ownership interest in the balance sheet.

7. The balance sheet is based on historical costs. When prices are rising rapidly, historical cost data may lose
much of their meaning particularly for plant, equipment and inventory.

8. The income statement and balance sheet are based on the accrual method of accounting, which attempts
to match revenues and expenses in the period in which they occur. However, accrual accounting does not
attempt to properly assess the cash flow position of the firm. The statement of cash flows fulfills this
need.

9. The three primary sections of the statement of cash flows are:

a) Cash flows from operating activities

b) Cash flows from investing activities

c) Cash flows from financing activities

The payment of cash dividends falls into the financing activities category.

10. Free cash flow is equal to cash flow from operating activities:

Minus: Capital expenditures required to maintain the productive capacity of the firm

Minus: Dividends (required to maintain the payout on common stock and to cover any
preferred stock obligation)

The analyst or banker normally looks at free cash flow to determine whether there are sufficient excess
funds to pay back the loan associated with the leveraged buy-out.

11. Interest expense is a tax deductible item to the corporation, while dividend payments are not. The net
cost to the corporation of interest expense is the amount paid multiplied by the difference of one minus
the applicable tax rate.

12. CURRENT (C) ; NONCURRENT – (NC)

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Retained earnings NC Bonds payable NC

Accounts payable C Accrued wages payable C
Prepaid expenses C Accounts receivable C
Plant and equipment NC Capital in excess of par NC
Inventory C Preferred stock NC
Common stock NC Marketable securities C

13. Sales
Cost of Goods Sold

Gross profit

Selling and administrative expense

Depreciation expense

Operating profit

Interest expense

Earnings before taxes

Taxes

Earnings after taxes

Preferred stock dividends

Earnings Available to Common Stockholders

Shares Outstanding

Earnings per share

14.
Increase in accounts receivable Decreases cash flow (use)
Increase in notes payable Increases cash flow (source)
Depreciation expense Increases cash flow (source)
Increase in investments Decreases cash flow (use)
Decrease in accounts payable Decreases cash flow (use)
Decrease in prepaid expenses Increases cash flow (source)
Increase in inventory Decreases cash flow (use)
Dividend payment Decreases cash flow (use)
Increase in accrued expenses Increases cash flow (source)

15.
1. Balance Sheet (BS) 5. Current Liabilities (CL)
2. Income Statement (IS) 6. Long-term Liabilities (LL)
3. Current Assets (CA) 7. Stockholders’ Equity (SE)
4. Fixed Assets (FA)

Indicate whether If on Balance Item

Items is on Balance Sheet,

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Sheet (BS) or Designate

Income Statement which
(IS) Category
BS SE Retained earnings
IS Income tax expense
BS CA Accounts receivable
BS SE Common stock
BS SE Capital in excess of par value
BS LL Bonds payable
BS CL Notes payable
IS Net income
IS Selling and administrative expenses
BS CA Inventories
BS CL Accrued expenses
BS CA Cash
BS FA Plant and equipment
IS Sales
IS Operating expenses
BS CA Marketable securities
BS CL Accounts payable
IS Interest expense
BS CL Income tax payable

Problems

Problem 1 (Balance Sheet)

From the data given in the problem, we know the following:

Current assets ₱ 500,000 Accounts payable and

accruals ₱ 100,000
Net plant and Notes payable 150,000
equipment 2,000,000 Current liabilities ₱ 250,000
Long-term debt 750,000
Total common equity 1,500,000
Total liabilities and
Total assets ₱2,500,000 equity ₱2,500,000

a. We are given that the firm’s total assets equal ₱2,500,000. Since both sides of the balance sheet must
equal, total liabilities and equity must equal total assets = ₱2,500,000.

b. Total assets = Current assets + Net plant and equipment

₱2,500,000 = Current assets + ₱2,000,000 Current assets =
₱2,500,000 – ₱2,000,000
Current assets = ₱500,000

c. Total liabilities and equity = Current liabilities + Long-term debt + Total common equity
₱2,500,000 = Current liabilities + ₱750,000 + ₱1,500,000
₱2,500,000 = Current liabilities + ₱2,250,000
Current liabilities = ₱2,500,000 – ₱2,250,000
Current liabilities = ₱250,000

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d. Current liabilities = Accounts payable and accruals + Notes payable

₱250,000 = Accounts payable and accruals + ₱150,000
Accounts payable and accruals = ₱250,000 – ₱150,000
Accounts payable and accruals = ₱100,000

e. Net working capital = Current assets – Current liabilities

Net working capital = ₱500,000 – ₱250,000
Net working capital = ₱250,000

f. Net operating working capital = Current assets – (Current liabilities – Notes payable)
Net operating working capital = ₱500,000 – (250,000 – ₱150,000)
Net operating working capital = ₱400,000

Problem 2 (Statement of Stockholders’ Equity)

NI = ₱50,000,000; R/EY/E = ₱810,000,000; R/EB/Y = ₱780,000,000; Dividends = ?

R/EB/Y + NI – Div = R/EY/E

₱780,000,000 + ₱50,000,000 – Div = ₱810,000,000

₱830,000,000 – Div = ₱810,000,000

₱20,000,000 = Div.

Problem 3 (Book Value and P/E ratio)

Jennifer’s Apparel

a. Total assets ₱800,000

Current liabilities 150,000
Long-term liabilities 120,000
Stockholders’ equity ₱530,000
Preferred stock 65,000
Net worth assigned to common ₱465,000

Common shares outstanding 30,000

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Book value (net worth) per share ₱15.50

b. Earnings available to common ₱48,000

Shares outstanding 30,000
Earnings per share ₱1.60

P/E ratio x Earnings per share = Price

15 x ₱1.60 = ₱2400

c. Market value per share (price) to Book value per share

₱24.00 ÷ ₱15.50 = 1.55

d. 2 x Book value per share = Price

2 x ₱15.50 = ₱31.00

Price
= P/E
Earnings per share

₱31.00
= 19.375 P/E ratio round to 19
₱1.60

Problem 4 (Determination of Profitability)

Red Book Inc.

Statement of Comprehensive Income

Sales (1,300 books at ₱650 each) ₱845,000

Cost of goods sold (1,300 books at ₱450 each) 585,000
Gross Profit 260,000
Selling expense 20,000
Depreciation expense 60,000
Operating profit 180,000
Interest expense 35,000
Earnings before taxes 145,000
Taxes @ 20% 29,000
Earnings after taxes ₱116,000

Problem 5 (Determination of Profitability)

Toyota Auto Shop

Statement of Comprehensive Income

a. Sales ₱700,000
Cost of goods sold (70% of sales) 490,000
Gross profit 210,000
Selling and administrative expense (12% of
sales) 84,000
Depreciation 10,000
Operating profit 116,000
Interest expense 8,000

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Earnings before taxes 108,000

Taxes @ 30% 32,400
Earnings after taxes ₱ 75,600
b. Sales ₱750,000
Cost of goods sold (66% of sales) 495,000
Gross profit 255,000
Selling and administrative expense
(14% of sales) 105,000
Depreciation 10,000
Operating profit 140,000
Interest expense 15,000
Earnings before taxes 125,000
Taxes @ 30% 37,500
Earnings after taxes ₱87,500

Analysis: Ms. Lim’s idea will increase profitability.

Problem 6 (Determination of Earnings and Earnings per Share)

Angelique Corporation

a. Retained earnings, Dec. 31, 20X5 ₱450,000

Less: Retained earnings, Dec. 31, 20X4 400,000
Change in retained earnings 50,000
Add: Common stock dividends 25,000
Earnings available to common stockholders ₱ 75,000

₱75,000
b. Earnings per share = = ₱3.75 per share
20,000 shares

Problem 7 (Construction of Income Statement and Balance Sheet)

Shadow Corporation
20X5 Income Statement

a. Sales ₱220,000
Cost of goods sold (60%) 132,000
Gross profit 88,000
Selling and administrative expense 22,000
Depreciation expense (8%) 20,0001
Operating profit (EBIT) 46,000
Interest expense 8,0002
Earnings before taxes 38,000
Taxes (20%) 7,600
Earnings after taxes (EAT) 30,400

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Preferred stock dividends 2,000

Earnings available to common stockholder ₱24,800

Shares outstanding 10,000

Earnings per share ₱2.84

1
8% x ₱250,000 = ₱20,000

Shadow Corporation
20X5 Statement of Retained Earnings

b. Retained earnings balance, Jan. 1, 20X4 ₱ 80,000

Add: Earnings available to common
stockholders, 20X4 28,400
Deduct: Cash dividend declared in 20X4 8,400
Retained earnings balance, Dec. 31, 20X5 ₱100,000

Shadow Corporation
20X5 Balance Sheet

c. Assets
Current assets
Cash ₱10,000
Accounts receivable 16,500
Inventory 27,500
Prepaid expenses 12,000
Total current assets ₱66,000
Fixed assets
Gross plant 285,000
Accumulated depreciation (70,000)3
Net plant 215,000
Total assets ₱281,000

Liabilities and Owners’ equity

Liabilities:
Accounts payable ₱15,000
Notes payable 26,000
Bonds payable 40,000
Total liabilities ₱81,000
Owners’ equity:
Common stock ₱ 75,000
Paid in capital in excess of par 25,000
Retained earnings 100,000

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Total equity ₱200,000

Total liabilities and equity ₱281,000

3
₱50,000 + ₱20,000 = ₱70,000

Problem 8 (Statement of Cash Flows)

Maris Corporation
Statement of Cash Flows
For the Year Ended December 31, 20X5

Cash flows from operating activities:

Net income (earnings after taxes) ₱250,000
Adjustments to determine cash flow
from operating activities:
Add back depreciation 230,000
Increase in accounts receivable (10,000)
Increase in inventory (30,000)
Decrease in prepaid expenses 30,000
Increase in accounts payable 250,000
Decrease in accrued expenses (20,000)
Total adjustments 450,000
Net cash flows from operating activities ₱700,000

Cash flows from investing activities:

Decrease in investments 10,000
Increase in plant and equipment (600,000)
Net cash flows from investing activities (590,000)

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Cash flows from financing activities:

Increase in bonds payable 60,000
Preferred stock dividends paid (10,000)
Common stock dividends paid (140,000)
Net cash flows from financing activities (90,000)

Net increase (decrease) in cash flows ₱20,000

Analysis: It should be observe that the increase in cash flows of ₱20,000 equals the ₱20,000 change in the
cash account on the balance sheet. This indicates the statement is correct.

a. Cash flows from operating activities far exceeds net income. This occurs primarily because we
add back depreciation of ₱230,000 and accounts payable increase by ₱250,000. Thus, the
reader of the cash flow statement gets important insights as to how much cash flow was
developed from daily operations.

b. The buildup in plant and equipment of ₱600,000 (gross) and ₱370,000 (net) has been financed,
in part, by the large increase in accounts payable (₱250,000). This is not a very satisfactory
situation. Short-term sources of funds can always dry up while fixed asset needs are
permanent in nature. The firm may wish to consider more long-term financing such as a
mortgage, to go along with profits, the increase in bonds payable and the add back of
depreciation.

c. The book value per common share for both 20X4 and 20X5 are:

Book value Stockholders’ equity − Preferred stock

=
per share Common shares outstanding

Book value per (₱1,390,000 − ₱90,000)

=
share (20X4) 150,000

₱1,300,000
=
150,000

(20X4) = ₱8.67

Book value per (₱1,490,000 − ₱90,000)

=
share (20X5) 150,000

₱1,400,000
=
150,000

(20X5) = ₱9.33

d. The firm’s P/E ratio for 20X5 is:

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Market value = 2.8 x ₱9.33 = ₱26.12

P/E ratio = ₱26.12 ÷ ₱1.60 = 16.325 round to 16

Problem 9 (Preparing a Balance Sheet)

SM Farms
Balance Sheet
September 30, 20X5

a. Assets
Cash ₱16,710
Accounts receivable 22,365
Land 550,000
Barns and sheds 78,300
Citrus trees 76,650
Livestock 120,780
Irrigation system 20,125
Farm machinery 42,970
Fences and gates 33,570
Total assets ₱961,470
Liabilities and Owners’ equity
Liabilities:
Notes payable ₱530,000
Accounts payable 77,095
Property taxes payable 9,135
Wages payable 1,820
Total liabilities ₱618,050
Owners’ equity:
Share capital ₱250,000
Retained earnings* 93,420
Total liabilities and equity ₱961,470

b. The loss of an asset, barns and Sheds, from a typhoon would cause a
decrease in total assets. When total assets are decreased, the balance
sheet total of liabilities and equity must also decrease. Since there is no
change in liabilities as a result of the destruction of an asset, the
decrease on the right hand side of the balance sheet must be in the
retained earnings account. The amount of the decrease in Barns and
Sheds, in the equity, and in both balance sheet totals is ₱23,800.

*
Total assets, ₱961,470, minus total liabilities, ₱618,050, less share capital, ₱250,000.

Problem 10 (Preparing a Balance Sheet and Cash Flow Statement; Effects of Business Transactions)

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The Tasty Bakery

Balance Sheet
August 1, 20X5

a. Assets Liabilities and Owners’ equity

Cash ₱6,940 Liabilities:
Accounts Notes payable ₱ 74,900
receivable 11,260 Accounts
Supplies 7,000 payable 16,200
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities 100,000
Equipment Equity:
and fixtures 44,500 Share capital 80,000
Retained earnings 40,700
Total liabilities
Total assets ₱220,700 and owners’ equity ₱220,700

The Tasty Bakery

Balance Sheet
August 3, 20X5

b. Assets Liabilities and Owners’ equity

Cash ₱14,490 Liabilities:
Accounts Notes payable ₱ 74,900
receivable 11,260 Accounts
Supplies 8,250 payable 7,200
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities 91,000
Equipment Equity:
and fixtures 51,700 Share capital 105,000
Retained earnings 40,700
Total liabilities
Total assets ₱236,700 and owners’ equity ₱236,700
The Tasty Bakery
Statement of Cash Flows
For the Period August 1 – 3, 20X5

Cash flows from operating activities:

Cash payment of accounts payable ₱(16,200)
Cash purchase of supplies (1,250)
Cash used in operating activities ₱(17,450)

Cash flows from investing activities:

None

Cash flows from financing activities:

Sale of share capital 25,000

Increase in cash 7,550

Cash balance, August 1, 20X5 6,940
Cash balance, August 3, 20X5 ₱ 14,490

c. The Tasty Bakery is in a stronger financial position on August 3 than it was on August 1.

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On August 1, the highly liquid assets (cash and accounts receivable) total only ₱18,200 but the
company has ₱25,100 in debts due in the near future (accounts payable plus salaries payable).

On August 3, after additional infusion of cash from the sale of stock, the liquid assets total ₱25,750,
and debts due in the near future amount to ₱16,100.

Note to Instructor: The analysis of financial position strength in requirement (c) is based solely upon
the balance sheets at August 1 and August 3. Hopefully, students will raise many legitimate issues
regarding necessity of information about operations, rate at which cash flows into the business, etc.
In this problem, the improvement in financial position results solely from the sale of share capital.

Problem 11 (Preparing Financial Statements; Effects of Business Transactions)

The First Malt Shop

Balance Sheet
September 30, 20X5

a. Assets Liabilities and Owners’ equity

Cash ₱ 7,400 Liabilities:
Accounts Notes payable* ₱ 70,000
receivable 1,250 Accounts
Supplies 3,440 payable 8,500
Land 55,000 Total liabilities 78,500
Building 45,500 Equity:
Furniture Share capital 50,000
and fixtures 20,000 Retained earnings 4,090
Total liabilities
Total assets ₱132,590 and owners’ equity ₱132,590

*Total assets, ₱132,590, less equity, ₱54,090, less accounts payable, ₱8,500, equals notes payable.

The First Malt Shop

Balance Sheet
October 6, 20X5

b. Assets Liabilities and Owners’ equity

Cash ₱ 29,400 Liabilities:
Accounts Notes payable ₱ 70,000
receivable 1,250 Accounts
Supplies 4,440 payable 18,000
Land 55,000 Total liabilities 88,000
Building 45,500 Equity:
Furniture Share capital 80,000
and fixtures 38,000 Retained earnings 5,590

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Total liabilities
Total assets ₱173,590 and owners’ equity ₱173,590

The First Malt Shop

Income Statement
For the Period October 1 – 6, 20X5

Revenues ₱ 5,500
Expenses (4,000)
Net income ₱ 1,500

The First Malt Shop

Statement of Cash Flows
For the Period October 1 – 6, 20X5

Cash flows from operating activities:

Cash received from revenues ₱5,500
Cash paid for expenses (4,000)
Cash paid for accounts payable (8,500)
Cash for paid supplies (1,000)
Cash used in operating activities ₱(8,000)

Cash flows from investing activities:

None

Cash flows from financing activities:

Cash received from sale of share capital ₱30,000

Increase in cash ₱22,000

Cash balance, October 1, 20X5 7,400
Cash balance, October 6, 20X5 ₱29,400

c. The First Malt Shop is in a stronger financial position on October 6 than on September 30. On
September 30, the company had highly liquid assets (cash and accounts receivable) of ₱8,650, which
barely exceeded the ₱8,500 in liabilities (accounts payable) due in the near future. On October 6,
after the additional investment of cash by shareholders, the company’s cash alone exceeded its short-
term obligations.

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CHAPTER 6

ASSESSMENT OF THE FIRM’S OPERATING

EFFICIENCY AND FINANCIAL POSITION
THROUGH FINANCIAL STATEMENTS ANALYSIS

Questions

1. The emphasis of the various types of analysts is by no means uniform nor should it be. Management is
interested in all types of ratios for two reasons. First, the ratios point out weaknesses that should be
strengthened; second, management recognizes that the other parties are interested in all the ratios and
that financial appearances must be kept up if the firm is to be regarded highly by creditors and equity
investors. Equity investors (stockholders) are interested primarily in profitability, but they examine the
other ratios to get information on the riskiness of equity commitments. Credit analysts are more
interested in the debt, TIE, and EBITDA coverage ratios, as well as the profitability ratios. Short-term
creditors emphasize liquidity and look most carefully at the current ratio.

2. The inventory turnover ratio is important to a grocery store because of the much larger inventory
required and because some of that inventory is perishable. An insurance company would have no
inventory to speak of since its line of business is selling insurance policies or other similar financial
products—contracts written on paper and entered into between the company and the insured. This
question demonstrates that the student should not take a routine approach to financial analysis but
rather should examine the business that he or she is analyzing.

3. Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to
vary among industries. For example, a steel company needs a greater number of dollars in assets to
produce a dollar in sales than does a grocery store chain. Also, profit margins and turnover ratios may
vary due to differences in the amount of expenses incurred to produce sales. For example, one would
expect a grocery store chain to spend more per dollar of sales than does a steel company. Often, a large
turnover will be associated with a low profit margin, and vice versa.

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4. ROE is calculated as the return on assets multiplied by the equity multiplier. The equity multiplier,
defined as total assets divided by common equity, is a measure of debt utilization; the more debt a firm
uses, the lower its equity, and the higher the equity multiplier. Thus, using more debt will increase the
equity multiplier, resulting in a higher ROE.

5. Return on investment relates to income earned on the capital invested in the business firm. Unsatisfactory
ROI could possibly lead to withdrawal of capital provided by investors which could result to the demise of
the business.

6. Refer to pages 171 through 174.

7. Example: If a company defers or postpones a regular maintenance and repair activity with a view of
reducing current year’s expenses. Such act may in the long-run bring about unfavorable outcomes such as
delays in production, poor product quality, etc.

8. Liquidity is the firm’s ability to meet cash needs as they arise such as payment of accounts payable, bank
loans and operating expenses. Liquidity is crucial to the firm’s survival because if the company is unable to
fulfill its obligations, operations could be disrupted that could result to its closure.

9. Short-term lenders – liquidity because their concern is with the firm’s ability to pay short-term obligations
as they come due.

Long-term lenders – leverage because they are concerned with the relationship of debt to total assets.
They also will examine profitability to insure that interest payments can be made.

Stockholders – profitability because they are concerned with the secondary consideration given to debt
utilization, liquidity and other ratios. Since stockholders are the ultimate owners of the firm, they are
primarily concerned with profits or the return on their investment.

10. If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a
longer period of time. This means the average collection period will be increasing.

11. The fixed charge coverage ratio measures the firm’s ability to meet all fixed obligations rather that
interest payments alone, on the assumption that failure to meet any financial obligation will endanger the
position of the firm.

12. No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between
industries or time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do offer
some initial insight into the operations of the firm, and when used with caution by the analyst can provide
information.

13. a. Return on investment = Net income/Total assets

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Inflation may cause net income to be overstated and total assets to be understated. Too high a
ratio could be reported.

b. Inventory turnover = Sales/Inventory

Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also
reflect “inflation-influenced” pesos and the net effect will be nil. If the firm uses LIFO accounting,
inventory will be stated in old pesos and too high a ratio could be reported.

c. Fixed asset turnover = Sales/Fixed assets

Fixed assets will be understated relative to sales and too high a ratio could be reported.

d. Debt to total assets = Total debt/Total assets

Since both are based on historical costs, no major inflationary impact will take place in the ratio.

14. Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm’s
income statement. This is particularly true for firms in highly cyclical industries where prices tend to rise
and fall quickly.

15. Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power
of the peso. Lessening inflation also means that the required return that investors demand on financial
assets will be going down, and with this lower demanded return, future earnings or interest should
receive a higher current evaluation.

Problems

Problem 1 (Day Sales Outstanding)

DSO = 40 days; S = ₱7,300,000; AR = ?

AR AR
DSO = S 40 = ₱7,300,000
365 365

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40 = AR/₱20,000 AR = (₱20,000) (40) = ₱800,000

Problem 2 (Debt Ratio)

A/E = 2.4; D/A = ?

D
A
= 1−( 1
A/E )
D
A
= 1−( 1
2.4 )
D
= 0 . 5833 = 58.33%.
A

Problem 3 (Market/Book Ratio)

TA = ₱10,000,000,000; LT debt = ₱3,000,000,000

CL = ₱1,000,000,000; CE = ₱6,000,000,000

Share outstanding = 800,000,000; Stock price = ₱32; M/B = ?

₱6,000,000,000
Book Value = = ₱7.50
800,000,000

₱32.00
MB = = 4.2667
₱7.50

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Problem 4 (Price/Earnings Ratio)

EPS = ₱2.00; BVPS = ₱20; M/B = 1.2; P/E = ?

M/B = 1.2×

P/₱20 = 1.2×

P = (₱20) ( 1.2×)

P = ₱24.00

P/E = ₱24.00/₱2.00 = 12.0

Problem 5 (DuPont and ROE)

PM = 2%; EM = 2.0; Sales = ₱100,000,000; Assets = ₱50,000,000;

ROE = ?

ROE = PM x TATO x EM

= NI/S x S/TA x A/E

= 2% x ₱100,000,000/₱50,000,000 x 2

ROE = 8%

Problem 6 (DuPont and Net Income)

Step 1: Calculate total assets from information given.

Sales = ₱6,000,000

3.2 × = Sales/TA

3.2 × = ₱6,000,000/Assets

Assets = ₱6,000,000/3.2 ×

Assets = ₱1,875,000

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Step 2: Calculate net income. There is 50% debt and 50% equity, so, Equity = ₱1,875,000 x 0.5 = ₱937,500.

ROE = NI/S x S/TA x TA/E

0.12 = NI/₱6,000,000 x 3.2 x ₱1,875,000/₱937,500

0.12 = 6.4NI/₱6,000,000

6.4NI = (₱60,000) (0.12)

NI = ₱720,000/6.4

NI = ₱112,500

Problem 7 (Basic Earning Power)

ROA = 8%; NI = ₱600,000; TA = ?

ROA = NI/TA

8% = ₱600,000/TA

TA = ₱600,000/8%

TA = ₱7,500,000

To calculate BEP, we still need EBIT. To calculate EBIT, construct a partial income statement.

EBIT ₱1,148,077 (₱225,000 + ₱923,077)

Interest 225,000 Given

EBT 923,077 (₱600,000/0.65)

Taxes (35%) 323,077

NI ₱ 600,000

BEP = EBIT/TA

= ₱1,148,077/₱7,500,000

= (0.1531)

BEP= 15.31%

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Problem 8 (Ratio Calculations)

We are given ROA = 3% and Sales/Total assets = 1.5

From the DuPont equation:

ROA = Profit margin x Total assets turnover

3% = Profit margin (1.5)

Profit margin = 3%/1.5

Profit margin = 2%

We can also calculate the company’s debt-to-assets ratio in a similar manner, given the facts of the
problem. We are given ROA (NI/A) and ROE (NI/E); if we use the reciprocal of ROE we have the following
equation:

E NI E D E
= × and = 1 − , so
A A NI A A
E 1
= 3% ×
A 0 .05
E
= 60% .
A
D
= 1 − 0. 60 = 0 .40 = 40% .
A

Alternatively, using the DuPont equation:

ROE = ROA x EM

5% = 3% x EM

EM = 5%/3% = 5/3 = TA/E

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Take reciprocal: E/TA = 3/5 = 60%, therefore, D/A = 1 – 0.60 = 0.40 or 40%. Thus, the firm’s profit
margin = 2% and its debt-to-assets ratio = 40%.

Problem 9 (Ratio Calculations)

TA = ₱12,000,000,000; T = 40%; EBIT/TA = 15%; ROA = 5%; TIE = ?

EBIT
₱12,000,000,00 = 0.15EBIT = ₱1,800,000,000
0

NI
₱12,000,000,00 = 0.05 NI = ₱600,000,000
0

Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.
INT = EBIT – EBT
EBIT ₱1,800,000,000 See above.
= ₱1,800,000,000 –
INT 800,000,000

EBT ₱1,000,000,000 EBT = ₱600,000,000/0.6

Taxes (40%) 400,000,000

NI ₱ 600,000,000 See above.

TIE = EBIT/INT

= ₱1,800,000,000/₱800,000,000

TIE = 2.25×

Problem 10 (Return on Equity)

ROE = Profit margin x TA turnover x Equity multiplier

= NI/Sales x Sales/TA x TA/Equity

Now we need to determine the inputs for the DuPont equation from the data that were given. On the left we set up an
income statement, and we put numbers in it on the right:

Sales (given) ₱10,000,000

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– Cost N/A

EBIT (given) ₱ 1,000,000

– INT (given) 300,000

EBT ₱ 700,000

– Taxes (34%) 238,000

NI ₱ 462,000

Now we can use some ratios to get some more data:

Total assets turnover = 2 = S/TA; TA = S/2 = ₱10,000,000/2

Total asset turnover = ₱5,000,000

D/A = 60%; so E/A = 40%; and, therefore,

Equity multiplier = TA/E = 1/ (E/A) = 1/0.4 = 2.5

Now we can complete the DuPont equation to determine ROE:

ROE = ₱462,000/₱10,000,000 x ₱10,000,000/₱5,000,000 x 2.5

ROE = 0.231 = 23.1%

Problem 11 (Current Ratio)

₱1,312,500

Present current ratio = ₱525,000 = 2.5

₱1,312,500 + NP

Minimum current ratio = ₱525,000 + NP= 2.0

₱1,312,500 + NP = ₱1,050,000 + 2NP

NP = ₱262,500

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Short-term debt can increase by a maximum of ₱262,500 without violating a 2 to 1 current ratio, assuming that the
entire increase in notes payable is used to increase current assets. Since we assumed that the additional funds
would be used to increase inventory, the inventory account will increase to ₱637,500 and current assets will
total ₱1,575,000, and current liabilities will total ₱787,500.

Problem 12 (DSO and Accounts Receivable)

Step 1: Solve for current annual sales using the DSO equation:
55 = ₱750,000/ (Sales/365)
55Sales = ₱273,750,000
Sales = ₱273,750,000/55
Sales = ₱4,977,272.73

Step 2: If sales fall by 15%, the new sales level will be ₱4,977,272.73 (0.85) = ₱4,230,681.82. Again, using
the DSO equation, solve for the new accounts receivable figure as follows:

35 = AR/ (₱4,230,681.82/365)
35 = AR/₱11,590.91
AR= (₱11,590.91) (35)
AR= ₱405,681.82  ₱405,682

Problem 13 (Balance Sheet Analysis)

1. Total debt = (0.50) (Total assets) = (0.50) (₱300,000) = ₱150,000

2. Accounts payable = Total debt – Long-term debt

= ₱150,000 – ₱60,000

Accounts payable = ₱90,000

3. Common stock = Total liabilities and equity – Debt – Retained earnings

Common stock = ₱300,000 – ₱150,000 – ₱97,500 = ₱52,500

4. Sales = (1.5) (Total assets) = (1.5) (₱300,000) = ₱450,000

5. Inventories = Sales/5 = ₱450,000/5 = ₱90,000

6. Accounts receivable = (Sales/365) (DSO)

= (₱450,000/365) (36.5)

Accounts receivable = ₱45,000

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7. Cash + Accounts receivable + Inventories = (1.8) (Accounts payable)

Cash + ₱45,000 + ₱90,000 = (1.8) (₱90,000)

Cash + ₱135,000 = ₱162,000

Cash = ₱27,000

8. Fixed assets = Total assets – (Cash + Accounts receivable + Inventories)

Fixed assets = ₱300,000 – (₱27,000 + ₱45,000 + ₱90,000) = ₱138,000

9. Cost of goods sold = (Sales) (1 – 0.25) = (₱450,000) (0.75) = ₱337,500

Problem 14 (Ratio Analysis)

a. Amounts in thousands
Firm Industry
average
Current Current assets ₱655,000
= = = 1.98 2.0
ratio Current liabilities ₱330,000

Current assets − ₱655,000 −

Quick ratio = Inventories = ₱241,500 = 1.25 1.3
Current liabilities ₱330,000

Accounts receivable ₱336,000 76.3

DSO = = = 35 days
Sales/365 ₱4,404.11 days

Inventory Sales ₱1,607,500

= = = 6.66 6.7
turnover Inventories ₱241,500

T.A. Sales ₱1,607,500

= = = 1.70 3.0
turnover Total assets ₱947,500

Profit Net income ₱27,300

= = = 1.7% 1.2%
margin Sales ₱1,607,500

Net income ₱27,300

ROA = = = 2.9% 3.6%
Total assets ₱947,500

Net income ₱27,300

ROE = = = 7.6% 9.0%
Common equity ₱361,000

Total debt ₱586,500

Debt ratio = = = 61.9% 60.0%
Total assets ₱947,500

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b. For the firm;

₱947,500
₱361,000 = 7.6%
ROE = PM x TA turnover x EM = 1.7% x 1.7 x

For the industry, ROE = 1.2% x 3 x 2.5 = 9%

Note: To find the industry ratio of assets to common equity, recognize that 1 – (Total debt/Total assets) =
Common equity/Total assets. So, Common equity/Total assets = 40%, and 1/0.40 = 2.5 = Total
assets/Common equity.

c. The firm’s days sales outstanding ratio is more than twice as long as the industry average,
indicating that the firm should tighten credit or enforce a more stringent collection policy. The
total assets turnover ratio is well below the industry average so sales should be increased, assets
decreased or both. While the company’s profit margin is higher than the industry average, its other
profitability ratios are low compared to the industry – net income should be higher given the amount of
equity and assets. However, the company seems to be in average liquidity position and financial leverage
is similar to others in the industry.

d. If 20X4 represents a period of supernormal growth for the firm, ratios based on this year will be distorted
and a comparison between them and industry averages will have little meaning. Potential investors who
look only at 20X4 ratios will be misled, and a return to normal conditions in 20X5 could hurt the firm’s
stock price.

Problem 15 (Ratio Analysis)

Ratio Analysis 20X4 20X3 Industry Average

Liquidity

Current ratio 2.33 2.11 2.7

Asset Management

Inventory turnover 4.74 4.47 7.0

Days sales outstanding 37.79 32.94 32

Fixed assets turnover 9.84 7.89 13.0

Total assets turnover 2.31 2.18 2.6

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Profitability

Return on assets 1.00% 5.76% 9.1%

Return on equity 2.22% 11.47% 18.2%

Profit margin 0.43% 2.64% 3.5%

Debt Management

Debt-to-assets ratio 54.81% 49.81% 50.0%

Market Value

P/E ratio 15.43 5.65 6.0

Price/cash flow ratio 1.60 2.16 3.5

a. Mango’s liquidity position has improved from 20X3 to 20X4; however, its current ratio is still below the
industry average of 2.7.

b. Mango’s inventory turnover, fixed assets turnover, and total assets turnover have improved from 20X3 to
20X4; however, they are still below industry averages. The firm's days sales outstanding ratio has
increased from 20X3 to 20X4—which is bad. In 20X3, its DSO was close to the industry average. In 20X4,
its DSO is somewhat higher. If the firm's credit policy has not changed, it needs to look at its receivables
and determine whether it has any uncollectibles. If it does have uncollectible receivables, this will make
its current ratio look worse than what was calculated above.

c. Mango’s debt ratio has increased from 20X3 to 20X4, which is bad. In 20X3, its debt ratio was right at the
industry average, but in 20X4 it is higher than the industry average. Given its weak current and asset
management ratios, the firm should strengthen its balance sheet by paying down liabilities.

d. Mango’s profitability ratios have declined substantially from 20X3 to 20X4, and they are substantially
below the industry averages. Mango needs to reduce its costs, increase sales, or both.

e. Mango’s P/E ratio has increased from 20X3 to 20X4, but only because its net income has declined
significantly from the prior year. Its P/CF ratio has declined from the prior year and is well below the
industry average. These ratios reflect the same information as Corrigan's profitability ratios. Corrigan
needs to reduce costs to increase profit, lower its debt ratio, increase sales, and improve its asset
management.

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f. ROE = PM × TA Turnover × Equity Multiplier

20X4 2.22% 0.43% 2.31 2.21

20X3 11.47% 2.64% 2.18 1.99

Industry Avg. 18.20% 3.50% 2.60 2.00

Looking at the DuPont equation, Mango's profit margin is significantly lower than the industry average
and it has declined substantially from 20X3 to 20X4. The firm's total assets turnover has improved slightly
from 20X3 to 20X4, but it's still below the industry average. The firm's equity multiplier has increased
from 20X3 to 20X4 and is higher than the industry average. This indicates that the firm's debt ratio is
increasing and it is higher than the industry average.

Mango should increase its net income by reducing costs, lower its debt ratio, and improve its asset
management by either using less assets for the same amount of sales or increase sales.

g. If Mango initiated cost-cutting measures, this would increase its net income. This would improve its
profitability ratios and market value ratios. If Mango also reduced its levels of inventory, this would
improve its current ratio—as this would reduce liabilities as well. This would also improve its inventory
turnover and total assets turnover ratio. Reducing costs and lowering inventory would also improve its
debt ratio.

Problem 16 (Profitability Ratios)

Esther Company

Sales ₱960,000
Assets = = = ₱400,000
Total asset turnover 2.4

Sales ₱960,000
Net income = = = ₱67,200
Profit margin 0.07

ROA(invest- Net income ₱ 67,200

= = = 16.80%
ment) Total assets ₱400,000

Problem 17 (Overall Ratio Analysis)

Bryan Corporation

Current assets ₱570,000

a. Current ratio = = = 1.90
Current liabilities ₱300,000

b. Quick ratio = (Current assets − = = 1.10

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Inventory) ₱330,000
Profit margin ₱300,000

c. Debt to total Total debt ₱ 418,000

= = = 44%
assets Total assets ₱950,000

Sales ₱ 3,040,000
d. Asset turnover = = = 3.20
Total assets ₱ 950,000

e. Average Accounts receivable ₱ 280,000

collection = Average daily credit = (₱3,040,000 x 0.75)
period sales 360 days

₱ 280,000
= = 44.21 days
₱6,333 per day

Problem 18 (Profitability Ratios)

Alpha Industries

a. Total asset turnover x Profit margin = Return on total assets

1.4 x ? = 8.4%
Profit margin = 8.4%/1.4 = 6.0%
b. 12 x 7% = 8.4%

It did not change at all because the increase in profit margin made up for the decrease in the
asset turnover.

Problem 19 (DuPont System of Analysis)

King Company

Return on assets
a. Return on (investment) 12%
= =
equity (1 – Debt /Assets) (1 – 0.40)

12%
= = 20%
0.60
b. The same as return on assets (12%).

Problem 20 (Average Collection Period)

Average Accounts receivable ₱ 180,000

collection = Average daily credit = (₱1,200,000 x 0.90)
period sales 360 days

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₱ 180,000
= = 60 days
₱3,000 per day

Problem 21 (Average Daily Sales)

Charlie Corporation

Average daily Credit sales

=
credit sales 360

To determine credit sales, multiply accounts receivable by accounts receivable

turnover.
₱90,000 x 12 = ₱1,080,000

Average daily ₱1,080,000

= = ₱3,000
credit sales 360

Problem 22 (DuPont System of Analysis)

Jerry Company

a. Net income = Sales x Profit margin

= ₱4,000,000 x 3.5%
= ₱140,000

Stockholders’ equity = Total assets − Total liabilities

Total assets = Sales /Total asset turnover

= ₱4,000,000/2.5
Total assets = ₱1,600,000

Total liabilities = Current liabilities + Long-term liabilities

= ₱100,000 + ₱300,000
Total liabilities = ₱400,000

Stockholders’ equity = ₱1,600,000 − ₱400,000

= ₱1,200,000

Return on = Net income = ₱ 140,000 = 11.67%

stockholders’ Stockholders’ equity ₱1,200,000

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equity

b. The value for sales will be:

Sales = Total assets x Total asset turnover

= ₱1,600,000 x 3
Sales = ₱4,800,000

Net income = Sales x Profit margin

= ₱4,800,000 x 3.5%
Net income = ₱168,000

Return on Net income ₱ 168,000

stockholders’ = Stockholders’ equity = ₱1,200,000 = 14%
equity

Problem 23 (Analysis by Divisions)

Global Corporation

a. Medical supplies Heavy machinery Electronics

Net income/
sales 6.0% 3.8% 8.0%

The heavy machinery division has the lowest return on sales.

b. Medical supplies Heavy machinery Electronics

Net income/
Total assets 15.0% 2.375% 10.67%

The medical supplies division has the highest return on assets.

c. Corporate net income ₱1,200,000 + ₱190,000 + ₱320,000
=
Corporate total assets ₱8,000,000 + ₱8,000,000 + ₱3,000,000

₱ 1,710,000
=
₱19,000,000

Return on assets = 9.0%

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d. Return on redeployed assets in heavy machinery.

15% x ₱8,000,000 = ₱1,200,000

Corporate net income ₱1,200,000 + ₱1,200,000 + ₱320,000

=
Corporate total assets ₱19,000,000

₱ 2,720,000
=
₱19,000,000

Return on assets = 14.32%

Problem 24 (Using Ratios to Construct Financial Statements)

Inventory = ₱420,000/7
= ₱60,000

Current assets = ₱2 x ₱80,000

= ₱160,000

Accounts receivable = (₱420,000/360) x 36

= ₱42,000

Cash = ₱160,000 − ₱60,000 − ₱42,000

= ₱58,000

Current assets
Cash ₱ 58,000
Accounts receivable ₱ 42,000
Inventory ₱ 60,000
Total current assets ₱160,000

Problem 25 (Using Ratios to Construct Financial Statements)

Shannon Corporation

Sales/Total assets = 2.5 times

Total assets = ₱750,000/2.5 = ₱300,000

Cash = 2% of total assets

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Cash = 2% x ₱300,000 = ₱6,000

Sales/Accounts receivable = 10 times

Accounts receivable = ₱750,000/10 = ₱75,000

Sales/Inventory = 15 times
Inventory = ₱750,000/15 = ₱50,000

Fixed assets = Total assets − Current assets

Total current asset = ₱6,000 + ₱75,000 + ₱50,000 = ₱131,000
Fixed assets = ₱300,000 − ₱131,000 = ₱169,000

Current assets/current debt = 2

Current debt = Current assets/2 = ₱131,000/2 = ₱65,500

Total debt/total assets = 45%

Total debt = .45 x ₱300,000 = ₱135,000

Long-term debt = Total debt − Current debt

Long-term debt = ₱135,000 − ₱65,500 = ₱69,500

Net worth = Total assets − Total debt

Net worth = ₱300,000 − ₱135,000 = ₱165,000

Shannon Corporation
Balance Sheet as of December 31, 20X4

Cash ₱ 6,000 Current debt ₱65,500

Accounts receivable 75,000 Long-term debt 69,500
Inventory 50,000 Total debt 135,000
Total current assets 131,000 Net worth 165,000
Fixed assets 169,000 Total debt and
Total assets ₱300,000 Stockholders’ equity ₱300,000

Problem 26 (Using Ratios to Determine Account Balances)

Cathy Corporation

a. Accounts receivable = Sales/Receivables turnover

= ₱3,000,000/6x = ₱500,000

b. Marketable securities = Current assets − (Cash + Accounts receivable

+ Inventory)

Current assets = Current ratio x Current liabilities

= 2.5 x ₱700,000 = ₱1,750,000

Marketable securities = ₱1,750,000 − (₱150,000 + ₱500,000 +

₱850,000)
Marketable securities = ₱1,750,000 − ₱1,500,000 = ₱250,000

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c. Fixed assets = Total assets − Current assets

Total assets = Sales/Asset turnover

= ₱3,000,000/1.2x = ₱2,500,000

Fixed assets = ₱2,500,000 − ₱1,750,000 = ₱750,000

d. Long-term debt = Total debt − Current liabilities

Total debt = Debt to assets x Total assets

= 40% x ₱2,500,000 = ₱1,000,00

Long-term debt = ₱1,000,000 − ₱700,000 = ₱300,000

Problem 27 (Using Ratios to Construct Financial Statements)

a. Yes. This is reflected in the increasing current ratios from year 20X7 to year 20X9.

b. No. Credit card turnover ratio is decreasing and this means collection period is increasing (Note: divide 365
days by Turnover).
c. Yes. Accounts receivable turnover is increasing and therefore average collection period is decreasing.

d. More money tied up in inventory. The food inventory turnover ratio is decreasing and that means
increase in average food inventory.

e. Not improving. The return on stockholders’ equity has been decreasing over the 3-year period.

f. Yes. Total liabilities to total equity or assets ratio has been declining.

g. No. The decline in liabilities accompanied by the decrease in the return on stockholders’ equity means that
the company has not been using leverage to the advantage of the stockholders.

Problem 28

Current assets P23,500

Current ratio = Current liabilities = P10,200 = 2.30 times

Quick assets P16,000

Quick ratio = Current liabilities = P10,200 = 1.60 times

Net sales P80,000

Accounts receivable turnover = Accounts receivable =
P13,000 = 6.2 times

365 days P80,000

Average collection period = Accounts receivable turnover = P13,000 = 6.2 days

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Cost of goods sold P57,000

Inventory turnover = Inventory = P6,500 = 8.8 times

Net sales P80,000

Fixed asset turnover = Net fixed assets = P31,000 = 2.6 times

Net sales P80,000

Total asset turnover = Total assets = P54,500 = 1.5 times

Total liabilities P26,200

Debt ratio = Total assets = P54,500 = 48.1 percent

Total liabilities P26,200

Debt-equity ratio = Stockholders’ equity = P28,300 = 92.6 percent

EBIT P9,500
Time-interest-earned ratio = Interest expense = P2,000 = 4.8 times

CHAPTER 7

CASH FLOW ANALYSIS

Answer to Questions

1. The only way depreciation generates cash flows for the company is by serving as a tax shield against
reported income. This non-cash deduction may provide cash flow equal to the tax rate times the
depreciation charged. This much in taxes will be saved, while no cash payments occur.

2. Refer to pages 136 through 138.

3. Refer to page 135.

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Answer to Problems

Problem 1 (Statement of Cash Flows)

Cash flow from

Operating activities ₱(817,000) Outflow
Investing activities (2,567,000) Outflow
Financing activities 3,459,000 Inflow
Increase in Cash ₱ 75,000

Cash balance, beginning ₱ 950,000

Cash balance, end 1,025,000
Increase in Cash ₱ 75,000

Note: The problem did not indicate whether the cash flows from investing and financing activities represented
net inflow or outflow. It is assumed that following normal course of operations, investments will represent
usage or outflow of cash and financing will represent sourcing or inflow of cash. Hence since the cash account
posted a net increase of ₱75,000, operating activities must have used up a net cash flow of ₱817,000.

Problem 2 (Free Cash Flow)

EBIT ₱62,000,000
Less: Taxes 17,000,000
EAT ₱45,000,000
Add: Depreciation 5,000,000
Operating Cash Flow ₱50,000,000
Free Cash Flow = Operating cash flow – Investment in operating capital
= ₱50,000,000 – [₱32,000,000 + (₱20,000,000 −₱12,000,000)]
Free Cash Flow = ₱50,000,000 − ₱40,000,000 = ₱10,000,000

Problem 3 (Free Cash Flow)

Free Cash Flow = Operating cash flow – Investment in operating capital

₱23,000,000 = OCF − ₱13,000,000
OCF = ₱36,000,000

EBIT ₱45,000,000
Less: Taxes 17,000,000
EAT ₱28,000,000
Add: Depreciation 8,000,000
Operating Cash Flow ₱36,000,000

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Problem 4 (Statement of Cash Flows)

Notes payable, beginning ₱208,000,000

Payment 23,000,000
Notes payable, end ₱185,000,000

Problem 5 (Free Cash Flow)

GABRIELLE CORPORATION
Income Statement for the Year Ending December 31, 20X4
(In millions of pesos)
20X4

Net sales ₱ 107.1

Less: Cost of goods sold 75.6

Gross profit 31.5

Less: Depreciation 6.0

Earnings before interest and taxes (EBIT) 25.5

Less: Interest --*

Earnings before taxes (EBT) 37.33

Less: Taxes (25%) 9.33

Net income ₱ 28
* No information given relative to Interest.

Problem 6 (Free Cash Flow)

Mitch’s Petals Galore, Inc.

Statement of Financial Position as of December 31, 20X3 and 20X4
(in millions of pesos)

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20X3 20X4
Assets
Current assets:
Cash and marketable securities ₱ 25 ₱ 28
Accounts receivable 65 75
Inventory 100 118
Total 190 221
Fixed assets:
Gross plant and equipment 300 333
Less: Depreciation 40 54
Net plant and equipment 260 279
Other long-term assets 50 50
Total 310 329
Total assets ₱500 ₱550

Liabilities and Equity

Current liabilities:
Accrued wages and taxes ₱ 15 ₱ 17

Accounts payable 50 56

Notes payable 45 45
Total 110 118
Long-term debt: 190 195
Stockholders’ equity:
Preferred stock (5 million shares) 5 5
Common stock and paid-in
surplus (20 million shares) 40 40
Retained earnings 155 192
Total 200 237
Total liabilities and equity ₱500 ₱550

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Problem 7 (Working with Financial Statements)

Garcia’s Health Care, Inc.

Statement of Financial Position as of December 31, 20X4 and 20X5
(in millions of pesos)

20X4 20X5
Assets
Current assets:

Cash and marketable securities ₱ 395 ₱ 421

Accounts receivable 1,020 1,109

Inventory 1,581 1,760

Total 2,996 3,290

Fixed assets:

Gross plant and equipment 4,743 5,812

Less: Depreciation 640 840

Net plant and equipment 4,103 4,972

Other long-term assets 790 892

Total 4,893 5,864

Total assets ₱ 7,889 ₱9,154

Liabilities and Equity

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Current liabilities:
Accrued wages and taxes ₱ 242 ₱ 316
Accounts payable 791 867

Notes payable 714 872

Total 1,747 2,055

Long-term debt: 3,005 3,090

Stockholders’ equity:
Preferred stock (25 million shares) 60 60
Common stock and paid-in

surplus (200 million shares) 637 637

Retained earnings 2,440 3,312

Total 3,137 4,009
Total liabilities and equity ₱ 7,889 ₱ 9,154

Garcia’s Health Care, Inc.

Income Statement for Years Ending December 31, 20X4 and 20X5

(in millions of pesos)

20X4 20X5

Net sales ₱ 4,348 ₱ 4,980

Less: Cost of goods sold 2,135 2,37

1

Gross profits 2,213 2,609

Less: Depreciation 191 200

Earnings before interest and taxes (EBIT) 2,022 2,409

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Less: Interest 285 315

Earnings before taxes (EBT) 1,737 2,094

Less: Taxes 632 ₱ 767

Net income ₱ 1,105 ₱ 1,327

Less: Preferred stock dividends ₱ 60 ₱ 60

Net income available to common

stockholders 1,045 1,267

Less: Common stock dividends 395 395

Addition to retained earnings ₱ 650 ₱ 872

Per (common) share data:

(1)
Earnings per share (EPS) ₱ 5.225 ₱ 6.33

Dividends per share (DPS) ₱ 1.975 ₱ 1.97 (2)

5

Book value per share (BVPS) ₱ 15.385 ₱ 19.8 (3)

2

Market value (price) per share (MVPS) ₱22.500 ₱26.850

2004 2005

(1) 1,045M = 5.225 1,267M = 6.335

200M 200M

(2) 395M = 1.975 395M = 1.975

200M 200M

(3) 3,137 – 60 = 15.385 4,009 – 60 = 19.82

200M 200M

Garcia’s Health Care, Inc.

Statement of Cash Flows for Year Ending December 31, 20X5

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(in millions of pesos)

20X5
A. Cash flows from operating activities

Net income ₱ 1,327

Additions (sources of cash):

Depreciation 200

Increase accrued wages and taxes (316 – 242) 74

Increase in accounts payable (867 – 791) 76

Subtractions (uses of cash):

Increase in accounts receivable (1,109 – 1,020) 89

Increase in inventory (1,760 – 1,581) 179

Net cash flow from operating activities ₱ 1,904

B. Cash flows from investing activities

Subtractions:

Increase fixed assets (5,812 – 4,743) 1,069

Increase in other long-term assets (892 – 790) 102

Net cash flow from investing activities ₱ (1,171)

C. Cash flows from financing activities

Additions:

Increase in notes payable (872 – 714) ₱ 158

Increase in long-term debt (3,090 – 3,005) 85

Increase in common and preferred stock --

Subtractions:

Pay dividends (60 + 395) 455

Net cash flow from financing activities ₱ (212)

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D. Net change in cash and marketable securities + ₱26

Garcia’s Health Care, Inc.

Statement of Retained Earnings as of December 31, 20X5
(in millions of pesos)

Balance of retained earnings, December 31, 20X4 ₱ 2,440

Plus: Net income for 20X5 1,327

Less: Cash dividends paid

Preferred stock 60

Common stock 395

Total cash dividends paid 455

Balance of retained earnings, December 31, 20X5 ₱ 3,312

Answer to Multiple Choice Questions

1. D 5. A 9. C 13. A

2. C 6. B 10. A 14. B

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3. D 7. A 11. B 15. A

4. D 8. D 12. D 16. D

CHAPTER 8

OPERATING AND FINANCIAL LEVERAGE

Answer to Questions

1. The contribution margin (CM) ratio is the ratio of the total contribution margin to total sales revenue. It can
be used in a variety of ways. For example, the change in total contribution margin from a given change in
total sales revenue can be estimated by multiplying the change in total sales revenue by the CM ratio. If
fixed costs do not change, then a dollar increase in contribution margin results in a dollar increase in net
operating income. The CM ratio can also be used in target profit and break-even analysis.

2. Incremental analysis focuses on the changes in revenues and costs that will result from a particular action.

3. Operating leverage measures the impact on net operating income of a given percentage change in sales. The
degree of operating leverage at a given level of sales is computed by dividing the contribution margin at
that level of sales by the net operating income at that level of sales.

4. The break-even point is the level of sales at which profits are zero.

5. (a) If the selling price decreased, then the total revenue line would rise less steeply, and the break-even
point would occur at a higher unit volume. (b) If the fixed cost increased, then both the fixed cost line and
the total cost line would shift upward and the break-even point would occur at a higher unit volume. (c) If
the variable cost increased, then the total cost line would rise more steeply and the break-even point would
occur at a higher unit volume.

6. The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It
states the amount by which sales can drop before losses begin to be incurred.

7. The sales mix is the relative proportions in which a company’s products are sold. The usual assumption in
cost-volume-profit analysis is that the sales mix will not change.

8. A higher break-even point and a lower net operating income could result if the sales mix shifted from high
contribution margin products to low contribution margin products. Such a shift would cause the average
contribution margin ratio in the company to decline, resulting in less total contribution margin for a given
amount of sales. Thus, net operating income would decline. With a lower contribution margin ratio, the
break-even point would be higher because more sales would be required to cover the same amount of fixed
costs.

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9. A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an
automobile company, which is generally subject to the influences of the business cycle. An automobile
manufacturer may not be able to service a large amount of debt when there is a downturn in the
economy.

10. A labor-intensive company will have low-fixed costs and a correspondingly low break-even point.
However, the impact of operating leverage on the firm is small and there will be little magnification of
profits as volume increases. A capital-intensive firm, on the other hand, will have a higher break-even
point and enjoy the positive influences of operating leverage as volume increases.

11. For break-even analysis based on accounting flows, depreciation is considered part of fixed costs. For cash
flow purposes, it is eliminated from fixed costs. The accounting flows perspective is longer-term in nature
because we must consider the problems of equipment replacement.

12. Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost
resources. This is inherently risky because the obligation to make payments remains regardless of the
condition of the company or the economy.

13. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of
financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of
using financial leverage tend to be the greatest in industries that are highly cyclical in nature.

14. The higher the interest rate on new debt, the less attractive financial leverage is to the firm.

15. Operating leverage primarily affects thee operating income of the firm. At this point, financial leverage
takes over and determines the overall impact on earnings per share.

16. At progressively higher levels of operation than the break-even point, the percentage change in operating
income as a result of a percentage change in unit volume diminishes. The reason is primarily
mathematical - as we move to increasingly higher levels of operating income, the percentage change from
the higher base is likely to be less.
17. The point of equality only measures indifference based on earnings per share. Since, our ultimate goal is
market value maximization; we must also be concerned with how these earnings are valued. Two plans
that have the same earnings per share may call for different price-earnings ratios, particularly when there
is a differential risk component involved because of debt.

Answer to Problems

Problem 1 (Computing and Using the CM Ratio)

1. The company’s contribution margin (CM) ratio is:

Total sales......................................................... ₱200,000

Total variable expenses..................................... 120,000
= Total contribution margin.............................. 80,000
÷ Total sales...................................................... ₱200,000
= CM ratio......................................................... 40%

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2. The change in net operating income from an increase in total sales of ₱1,000 can be estimated by using the
CM ratio as follows:
Change in total sales.....................................................................................
₱1,000
× CM ratio....................................................................................................
40 %
= Estimated change in net operating income............................................... ₱ 400

This computation can be verified as follows:

Total sales............................................... ₱200,000
÷ Total units sold.................................... 50,000 units
= Selling price per unit........................... ₱4.00 per unit

Increase in total sales.............................. ₱1,000

÷ Selling price per unit........................... ₱4.00 per unit
= Increase in unit sales........................... 250 units
Original total unit sales.......................... 50,000 units
New total unit sales................................ 50,250 units

Original New
Total unit sales....................................... 50,000 50,250
Sales ₱200,000 ₱201,000
Variable expenses................................... 120,000 120,600
Contribution margin............................... 80,000 80,400
Fixed expenses....................................... 65,000 65,000
Net operating income............................. ₱ 15,000 ₱ 15,400
Problem 2 (Compute the Break-even Point)

1. The equation method yields the break-even point in unit sales, Q, as follows:

Profit = Unit CM × Q − Fixed expenses

₱0 = (₱15 − ₱12) × Q − ₱4,200
₱0 = (₱3) × Q − ₱4,200
₱3Q = ₱4,200
Q = ₱4,200 ÷ ₱3
Q = 1,400 baskets

2. The equation method can be used to compute the break-even point in sales pesos as follows:

Unit contribution margin

CM =
Unit selling price

CM = ₱3/₱15 = 0.20

Profit = CM ratio × Sales − Fixed expenses

₱0 = 0.20 × Sales − ₱4,200
0.20 × Sales = ₱4,200
Sales = ₱4,200 ÷ 0.20
Sales = ₱21,000

3. The formula method gives an answer that is identical to the equation method for the break-even point in
unit sales:

Unit sales to break even = Fixed expenses

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Unit CM

Unit sales to break even = ₱4,200/₱3 = 1,400 baskets

4. The formula method also gives an answer that is identical to the equation method for the break-even point
in peso sales:

Fixed expenses
Peso sales to break even =
CM ratio

Peso sales to break even = ₱4,200/0.20 = ₱21,000

Problem 3 (Compute the Margin of Safety)

1. To compute the margin of safety, we must first compute the break-even unit sales.

Profit = Unit CM × Q − Fixed expenses

₱0 = (₱30 − ₱20) × Q − ₱7,500
₱0 = (₱10) × Q − ₱7,500
₱10Q = ₱7,500
Q = ₱7,500 ÷ ₱10
Q = 750 units

Sales (at the budgeted volume of 1,000 units).................... ₱30,000

Less break-even sales (at 750 units).................................... 22,500
Margin of safety (in pesos).................................................. ₱ 7,500

2. The margin of safety as a percentage of sales is as follows:

Margin of safety (in pesos)................................................. ₱ 7,500

÷ Sales................................................................................. ₱30,000
Margin of safety percentage................................................ 25%

Problem 4 (Compute and Use the Degree of Operating Leverage)

1. The company’s degree of operating leverage would be computed as follows:

Contribution margin............................................................ ₱48,000

÷ Net operating income....................................................... ₱10,000
Degree of operating leverage.............................................. 4.8

2. A 5% increase in sales should result in a 24% increase in net operating income, computed as follows:
Degree of operating leverage.............................................. 4.8
× Percent increase in sales................................................... 5%
Estimated percent increase in net operating income........... 24%

3. The new income statement reflecting the change in sales is:

Amount Percent of Sales
Sales ₱84,000 100%
Variable expenses............................... 33,600 40%

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Contribution margin........................... 50,400 60%

Fixed expenses.................................... 38,000
Net operating income.......................... ₱12,400
Net operating income reflecting change in sales................. ₱12,400
Original net operating income............................................. ₱10,000
Percent change in net operating income.............................. 24%

Problem 5 (Target Profit and Break-Even Analysis; Margin of Safety; CM Ratio)

1. Profit = Unit CM × Q − Fixed expenses

₱0 = (₱30 − ₱12) × Q − $216,000
₱0 = (₱18) × Q − ₱216,000
₱18Q = ₱216,000
Q = ₱216,000 ÷ ₱18
Q = 12,000 units, or at ₱30 per unit, ₱360,000

Alternative solution:

Fixed expenses
Unit sales to break even =
Unit CM

Unit sales to break even = ₱216,000/₱18 = 12,000 units

or at ₱30 per unit, ₱360,000

2. The contribution margin is ₱216,000 because the contribution margin is equal to the fixed expenses at the
break-even point.

Target profit + Fixed expenses

Unit sold to attain target profit =
Unit CM

₱90,000 + ₱216,000
Unit sold to attain target profit =
₱18

Unit sold to attain target profit = 17,000 units

3. Total Unit
Sales (17,000 units × ₱30 per unit)................... ₱510,000 ₱30
Variable expenses
(17,000 units × ₱12 per unit)........................ 204,000 12
Contribution margin.......................................... 306,000 ₱18
Fixed expenses.................................................. 216,000
₱
Net operating income........................................ 90,000

4. Margin of safety in peso terms:

Margin of safety in pesos = Total sales − Break even sales

Margin of safety in pesos = ₱450,000 − ₱360,000 = ₱90,000

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Margin of safety in percentage terms:

Margin of safety in pesos

Margin of safety percentage =
Total sales

Margin of safety percentage = ₱90,000/₱450,000 = 20%

5. The CM ratio is 60%.

Expected total contribution margin: (₱500,000 × 60%)............. ₱300,000

Present total contribution margin: (₱450,000 × 60%)................ 270,000
Increased contribution margin.................................................... ₱ 30,000

Alternative solution:

₱50,000 incremental sales × 60% CM ratio = ₱30,000

Given that the company’s fixed expenses will not change, monthly net operating income will also increase
by ₱30,000.

Problem 6 (Operating Leverage)

1. Total Per Unit

Sales (15,000 games)....................... ₱3,000,000 ₱200
Variable expenses............................ 900,000 60
Contribution margin..................................... 2,100,000 ₱140
Fixed expenses............................................. 1,820,000
Net operating income................................... ₱ 280,000

0 The degree of operating leverage is:

Contribution margin
Degree of operating leverage =
Net operating income

Degree of operating leverage = ₱2,100,000/₱280,000 = 7.5

2. a. Sales of 18,000 games represent a 20% increase over last year’s sales. Because the degree of
operating leverage is 7.5, net operating income should increase by 7.5 times as much, or by 150%
(7.5 × 20%)
b. The expected total amount of net operating income for next year would be:

Last year’s net operating income..................................... ₱280,000

Expected increase in net operating income
next year (150% × ₱280,000)....................................... 420,000
Total expected net operating income............................... ₱700,000

Problem 7 (Multiproduct Break-even Analysis)

1.
Super Fast Dynamic Shot Total Company
Amount % Amount % Amount %
Sales ₱150,000 100 ₱250,000 100 ₱400,000 100.0

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Variable expenses............. 30,000 20 160,000 64 190,000 47.5

Contribution margin......... ₱120,000 80 ₱ 90,000 36 210,000 52.5*
Fixed expenses.................. 183,750
Net operating income....... ₱ 26,250

*₱210,000 ÷ ₱400,000 = 52.5%

2. The break-even point for the company as a whole is:

Fixed expenses
Peso sales to break even =
Overall CM ratio

₱183,750
Peso sales to break even = = ₱350,000
0.525

3. The additional contribution margin from the additional sales is computed as follows:

₱100,000 × 52.5% CM ratio = ₱52,500

Assuming no change in fixed expenses, all of this additional contribution margin of ₱52,500 should drop to
the bottom line as increased net operating income.

This answer assumes no change in selling prices, variable costs per unit, fixed expense, or sales mix.

Problem 8 (Break-even Analysis)

₱2,000,000
a. BE = = 4,000 units
₱1,200 − ₱700

Profit + FC ₱1,500,000 + ₱2,000,000

b. Q = =
(P − VC) ₱1,200 − ₱700

₱3,500,000
Q= = 7,000 units
₱500

Problem 9 (Break-even Analysis)

₱70,000 ₱70,000
BE (before) = = = 50,000 units
₱4.00 − ₱2.60 ₱1.40

₱105,000 ₱105,000
BE (after) = = = 60,000 units
₱4.00 − ₱2.25 ₱1.75

The break-even point will go up.

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Problem 10 (Degree of Leverage)

Q = 20,000, P = ₱60, VC = ₱30, FC = ₱400,000, I = ₱50,000

Q (P − VC) 20,000 (₱60 − ₱30)

a. DOL = =
Q (P − VC) − FC 20,000 (₱60 − ₱30) − ₱400,000

20,000 (₱30) ₱600,000

= =
20,000 (₱30) − ₱400,000 ₱600,000 − ₱400,000

₱600,000
DOL = = 3x
₱200,000

EBIT ₱200,000
b. DFL = =
EBIT − I ₱200,000 − ₱50,000

₱200,000
DFL = = 1.33x
₱150,000

Q (P − VC)
c. DCL =
Q (P − VC) − FC − I

20,000 (₱60 − ₱30)

=
20,000 (₱60 − ₱30) − ₱400,000 − ₱50,000
₱600,000
=
₱600,000 − ₱400,000 − ₱50,000

₱600,000
DCL = = 4x
₱150,000

₱400,000 ₱400,000
d. BE = = = 13,333 units
₱60 − ₱30 ₱30

Problem 11 (Break-even Point and Degree of Leverage)

₱80,000 ₱80,000
a. BE = = = 16,000 pieces
₱15 − ₱10 ₱5

b. 15,000 pieces 30,000 pieces

Sales @ ₱15 per piece ₱225,000 ₱450,000
Less: Variable costs (₱10) (150,000) (300,000)
Fixed costs (80,000) (80,000)
Profit or Loss (₱5,000) (₱70,000)

Q (P − VC)
c. DOL =
Q (P − VC) − FC

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20,000 (₱15 – ₱10)

DOL at 20,000 =
20,000 (₱15 − ₱10) − ₱80,000

₱100,000
DOL at 20,000 = = 5x
₱20,000

30,000 (₱15 – ₱10)

DOL at 30,000 =
30,000 (₱15 − ₱10) − ₱80,000

₱150,000
DOL at 30,000 = = 2.14x
₱70,000

Leverage goes down because we are further away from the break-even point, thus the firm is operating
on a larger profit base and leverage is reduced.

EBIT
d. DFL =
EBIT − I

First, determine the profit or loss (EBIT) at 20,000 pieces. As indicated in part (b), the profit (EBIT) at
30,000 pieces is ₱70,000.

20,000 pieces
Sales @ ₱15 per piece ₱300,000
Less: Variable costs (₱10) (200,000)
Fixed costs (80,000)
Profit or Loss (₱20,000)

₱20,000
DFL at 20,000 =
₱20,000 − ₱10,000

₱20,000
DFL at 20,000 = = 2x
₱10,000
₱70,000
DFL at 30,000 =
₱70,000 − ₱10,000

₱70,000
DFL at 30,000 = = 1.17x
₱60,000

Q (P − VC)
e. DCL =
Q (P − VC) − FC − I

20,000 (₱15 − ₱10)

DCL at 20,000 =
20,000 (₱15 − ₱10) − ₱80,000 − ₱10,000

₱100,000
DCL at 20,000 = = 10x
₱10,000

30,000 (₱15 − ₱10)

DCL at 30,000 =
30,000 (₱15 − ₱10) − ₱80,000 − ₱10,000

DCL at 30,000 = ₱150,000 = 2.50x

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₱60,000

Problem 12 (Japanese Firm and Combined Leverage)

Q (P − VC)
DCL =
Q (P − VC) − FC − I

125,000 (₱25 − ₱5)

=
125,000 (₱25 − ₱5) − ₱1,800,000 − ₱400,000

125,000 (₱20)
=
125,000 (₱20) − ₱2,200,000

₱2,500,000
DCL = = 8.33x
₱2,500,000 − ₱2,200,000

Problem 13 (Leverage and Sensitivity Analysis)

Income Statements

a. Return on assets = 10% EBIT = ₱1,200,000

Current Plan D Plan E

EBIT ₱1,200,000 ₱1,200,000 ₱1,200,000
Less: Interest 600,0001 960,0002 300,0003
EBT 600,000 240,000 900,000
Less: Taxes (45%) 270,000 108,000 405,000
EAT 330,000 132,000 495,000
Common shares 750,0004 375,000 1,125,000
EPS ₱.44 ₱.35 ₱.44

(1) ₱6,000,000 debt @ 10%

(2) ₱600,000 interest + (₱3,000,000 debt @ 12%)

(3) (₱6,000,000 − ₱3,000,000 debt retired) x 10%

(4) (₱6,000,000 common equity) ÷ (₱8 par value) = 750,000 shares

Plan E and the original plan provide the same earnings per share because the cost of debt at 10 percent is
equal to the operating return on assets of 10 percent. With Plan D, the cost of increased debt rises to 12
percent, and the firm incurs negative leverage reducing EPS and also increasing the financial risk to Dream
Company.

b. Return on assets = 5% EBIT = ₱600,000

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Current Plan D Plan E

EBIT ₱600,000 ₱600,000 ₱600,000
Less: Interest 600,000 960,000 300,000
EBT 0 (360,000) 300,000
Less: Taxes (45%) 0 (162,000) 135,000
EAT 0 (198,000) 165,000
Common shares 750,000 375,000 1,125,000
EPS 0 (₱.53) ₱.15

Return on assets = 15% EBIT = ₱1,800,000

Current Plan D Plan E

EBIT ₱1,800,000 ₱1,800,000 ₱1,800,000
Less: Interest 600,000 960,000 300,000
EBT 1,200,000 840,000 1,500,000
Less: Taxes (45%) 540,000 378,000 675,000
EAT 660,000 462,000 825,000
Common shares 750,000 375,000 1,125,000
EPS ₱.88 ₱1.23 ₱.73

If the return on assets decreases to 5%, Plan E provides the best EPS, and at 15% return, Plan D provides
the best EPS. Plan D is still risky, having an interest coverage ratio of less than 2.0.

c. Return on assets = 10% EBIT = ₱1,200,000

Current Plan D Plan E

EBIT ₱1,200,000 ₱1,200,000 ₱1,200,000
EAT 330,000 132,000 495,000
Common shares 750,000 500,0001 1,000,0002
EPS ₱.44 ₱.26 ₱.50

(1) 750,000 – (₱3,000,000/₱12 per share)

= 750,000 – 250,000 = 500,000

(2) 750,000 + (₱3,000,000/₱12 per share)

= 750,000 + 250,000 = 1,000,000

As the price of the common stock increases, Plan E becomes more attractive because fewer shares can be
retired under Plan D and, by the same logic, fewer shares need to be sold under Plan E.

Problem 14 (Leverage and Sensitivity Analysis)

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a. Return on assets = 12%

Current Plan A Plan B

EBIT ₱1,500,000 ₱2,250,000 ₱2,250,000
Less: Interest 1,200,0001 1,920,0003 1,200,0005
EBT 300,000 330,000 1,050,000
Less: Taxes (40%) 120,000 132,000 420,000
EAT 180,000 198,000 630,000
Common shares 200,0002 300,0004 700,0006
EPS ₱.90 ₱.66 ₱.90

(1) (80% x ₱10,000,000) x 15% = ₱8,000,000 x 15% = ₱1,200,000

(2) (20% x ₱10,000,000)/ ₱10 = ₱2,000,000/₱10 = 200,000 shares

(3) ₱1,200,000 (current) + (80% x ₱5,000,000) x 18%

= ₱1,200,000 + ₱720,000 = ₱1,920,000

(4) 200,000 shares (current) + (20% x ₱5,000,000)/ ₱10

= 200,000 + 100,000 = 300,000 shares

(5) Unchanged

(6) 200,000 shares (current) + ₱5,000,000/₱10

= 200,000 + 500,000 = 700,000 shares

EBIT
b. DFL =
EBIT − I

₱1,500,000
DFL (Current) = = 5x
₱1,500,000 − ₱1,200,000
₱2,250,000
DFL (Plan A) = = 6.82x
₱2,250,000 − ₱1,920,000

₱2,250,000
DFL (Plan B) = = 2.14x
₱2,250,000 − ₱1,200,000

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c. Plan A Plan B
EAT ₱198,000 ₱630,000
Common shares 250,0001 450,0002
EPS ₱.79 ₱1.40

(1) 200,000 shares (current) + (20% x ₱5,000,000)/ ₱20

= 200,000 + 50,000 = 250,000 shares

(2) 2000,000 shares (current) + ₱5,000,000/₱20

= 200,000 + 250,000 = 450,000 shares

Plan B would continue to provide the higher earnings per shares. The difference between Plans A and B is
even greater than that indicated in part (a).

d. Not only does the price of the common stock create wealth to the shareholder, which is the major
objective of the financial manager, but it greatly influences the ability to finance projects at a high or low
cost of capital.

Answer to Multiple Choice Questions

1. A 11. C 21. B 31. A

2. A 12. B 22. D 32. B

3. B 13. B 23. B 33. A

4. D 14. D 24. B 34. D

5. B 15. A 25. B 35. B

6. C 16. B 26. D 36. B

7. D 17. D 27. A 37. A

8. C 18. B 28. A 38. D

9. D 19. A 29. A 39. D

10. B 20. C 30. D

CHAPTER 9

FINANCIAL FORECASTING FOR STRATEGIC GROWTH

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Answer to Questions

1. The main purposes of financial planning and control are estimating future financing needs, deciding how to
finance, identifying sources and uses of funds, and taking corrective actions as to how funds are allocated.

2. The Chrysler Corporation in the 1970s.

3. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees,
and, in fact, just about every aspect of its operations and financing exist to directly or indirectly support
sales. Put differently, a firm’s future need for things like capital assets, employees, inventory, and financing
are determined by its future sales level.

4. The equation is

A L
Eternal required financing = ( ΔS ) − ( ΔS )−rS
S S
where A = assets that change with sales
ΔS = expected change in sales forecast for the year
L = liabilities that change with sales
r = ratio of net profits after dividends to sales

5. Accounts payable, accrued wages and accrued taxes increase spontaneously and proportionately with
sales. Retained earnings increase, but not proportionately.

6. False. At low growth rates, internal financing will take care of the firm’s needs.

7. The internal growth rate is greater than 15%, because at a 15% growth rate the negative EFN indicates
that there is excess internal financing. If the internal growth rate is greater than 15%, then the sustainable
growth rate is certainly greater than 15%, because there is additional debt financing used in that case
(assuming the firm is not 100% equity-financed). As the retention ratio is increased, the firm has more
internal sources of funding, so the EFN will decline. Conversely, as the retention ratio is decreased, the
EFN will rise. If the firm pays out all its earnings in the form of dividends, then the firm has no internal
sources of funding (ignoring the effects of accounts payable); the internal growth rate is zero in this case
and the EFN will rise to the change in total assets.

Answer to Problems

Problem 1 (Pro Forma Statements)

It is important to remember that equity will not increase by the same percentage as the other assets. If every
other item on the income statement and balance sheet increases by 15 percent, the pro forma income
statement and balance sheet will look like this:

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Pro forma Pro forma

Income Statement Balance Sheet

Sales ₱26,450 Assets ₱18,170 Debt ₱ 5,980

Costs 19,205 _______ Equity 12,190
Net income ₱ 7,245 Total ₱18,170 Total ₱18,170

In order for the balance sheet to balance, equity must be:

Equity = Total liabilities and equity – Debt

Equity = ₱18,170 – 5,980 = ₱12,190

Equity increased by:

Equity increase = ₱12,190 – 10,600 = ₱1,590

Net income is ₱7,245 but equity only increased by ₱1,590; therefore, a dividend of ₱5,655 must have been
paid. Dividends paid is the additional financing needed.

Dividend = ₱7,245 – 1,590 = ₱5,655

Problem 2 (Calculating EFN)

An increase of sales to ₱7,424 is an increase of:

Sales increase = (₱7,424 – 6,300) / ₱6,300 = .18 or 18%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:

Pro forma Pro forma

Income Statement Balance Sheet

Sales ₱7,434 Assets ₱21,594 Debt ₱12,400

Costs 4,590 _______ Equity 8,744
Net income ₱2,844 Total ₱21,594 Total ₱21,144

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If no dividends are paid, the equity account will increase by the net income, so:

Equity = ₱5,900 + 2,844 = ₱8,744

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = ₱21,594 – 21,144 = ₱450

Problem 3 (Calculating EFN)

An increase of sales to ₱21,840 is an increase of:

Sales increase = (₱21,840 – 19,500) / ₱19,500 = .12 or 12%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:

Pro forma Pro forma

Income Statement Balance Sheet

Sales ₱21,840 Assets ₱109,760 Debt ₱52,500

Costs 16,800 ______ _ Equity 79,208
EBIT 5,040 Total ₱109,760 Total ₱99,456
Taxes (40%) 2,016
Net income ₱ 3,024

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net
income, or:

Dividends = (₱1,400 / ₱2,700) (₱3,024) = ₱1,568

The addition to retained earnings is:

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Addition to retained earnings = ₱3,024 – 1,568 = ₱1,456

And the new equity balance is:

Equity = ₱45,500 + 1,456 = ₱46,956

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = ₱109,760 – 99,456 = ₱10,304

Problem 4 (Sales and Growth)

The maximum percentage sales increase is the sustainable growth rate. To calculate the sustainable growth
rate, first we need to calculate the ROE, which is:

ROE = NI / TE

ROE = ₱8,910 / ₱56,000 = .1591 or 15.91%

The plowback ratio, b, is one minus the payout ratio, so:

b = 1 – .30 = .70

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.1591(.70)] / [1 – .1591(.70)] = .1253 or 12.53%

So, the maximum peso increase in sales is:

Maximum increase in sales = ₱42,000 (.1253) = ₱5,264.03

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Problem 5 (Calculating Retained Earnings from Pro Forma Income)

Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income statement will look
like this:

Jordan Corporation

Pro Forma Income Statement

Sales ₱45,600.00

Costs 22,080.00

Taxable income ₱23,520.00

Taxes (34%) 7,996.80

Net income ₱ 15,523.20

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net
income, or:

Dividends = (₱5,200/₱12,936) (₱15,523.20) = ₱6,240.00

And the addition to retained earnings will be:

Addition to retained earnings = ₱15,523.20 – 6,240 = ₱9,283.20

Problem 6 (Applying Percentage of Sales)

Below is the balance sheet with the percentage of sales for each account on the balance sheet. Notes payable,
total current liabilities, long-term debt, and all equity accounts do not vary directly with sales.

Jordan Corporation
Balance Sheet

Assets (₱) (%)

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Current assets
Cash ₱ 3,050 8.03
Accounts receivable 6,900 18.16
Inventory 7,600 20.00
Total ₱17,550 46.18
Fixed assets
Net plant and equipment ₱34,500 90.79
Total assets ₱52,050 136.97
Liabilities and Owners’ equity
Current liabilities
Accounts payable ₱ 1,300 3.42
Notes payable 6,800 n/a
Total ₱ 8,100 n/a
Long-term debt ₱25,000 n/a
Owners’ equity
Common stock and paid-in surplus ₱15,000 n/a
Retained earnings 3,950 n/a
Total ₱18,950 n/a
Total liabilities and Owners’ equity ₱52,050 n/a

Problem 7 (External Financing Requirements)

a., b., & c.

Lewis Company
Pro Forma Income Statement
December 31, 2015
(Millions of Pesos)

1st Pass AFN 2nd Pass

2014 (1 + g) 2015 Effects 2015
Sales ₱8,000 (1.2) ₱9,600 ₱9,600
Operating costs 7,450 (1.2) 8,940 8,940
EBIT ₱ 550 ₱ 660 ₱ 660
Interest 150 150 +30* 180
EBT ₱ 400 ₱ 510 ₱ 480
Taxes (40%) 160 204 192
Net income ₱ 240 ₱ 306 ₱ 288

Dividends: ₱1.04 x 150 = ₱ 156 ₱1.10 x 150 ₱ 165 +24** ₱ 189

Addition to RE: ₱ 84 ₱ 141 ₱ 99

*∆ in interest expense = (₱51 + ₱248) x 0.10 = ₱30.

**∆ in 2015 Dividends = ₱368/₱16.96 x ₱1.10 = ₱24.

∆ in addition to retained earnings = ₱99 − ₱141 = −₱42.

Lewis Company
Pro Forma Balance Sheet
December 31, 2015
(Millions of Pesos)

1st Pass 2nd

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AFN Pass
2014 (1 + g) Additions 2015 Effects 2015
Cash ₱ 80 (1.2) ₱ 96 ₱ 96
Accounts
receivable 240 (1.2) 288 288
Inventory 720 (1.2) 864 864
Total current
assets ₱1,040 ₱1,248 ₱1,248
Fixed assets 3,200 (1.2) 3,840 3,840
Total assets ₱4,240 ₱5,088 ₱5,088
Accounts payable
₱ 160 (1.2) ₱ 192 ₱ 192
Accruals 40 (1.2) 48 48
Notes payable 252 252 +51** 303
Total current
liabilities ₱ 452 ₱ 492 ₱543
Long-term debt 1,244 1,244 +248** 1,492
Total debt ₱1,696 ₱1,736 ₱2,035
Common stock 1,605 1,605 +368** 1,973
Retained earnings
939 141* 1,080 −42*** 1,038
Total liabilities and
equity ₱4,240 ₱4,421 ₱5,046

AFN = ₱ 667 ₱ 42

*See Income Statement, 1st pass.

** CA/CL = 2.3; D/A = 40%.

Maximum total debt = 0.4 x ₱5,088 = ₱2,035.

Maximum increase in debt = ₱2,035 − ₱1,736 = ₱299.

Maximum current liabilities = ₱1,248/2.3 = ₱543.

Increase in notes payable = ₱543 − ₱492 = ₱51.

Increase in long-term debt = ₱299 − ₱51 = ₱248.

Increase in common stock = ₱667 − ₱299 = ₱368.

***∆ in RE = ₱99 − ₱141 = −₱42.

Problem 8 (Long-term financing needed)

a. Total liabilities and equity = Accounts payable + Long-term debt +

Common stock + Retained earnings

₱1,200,000 = ₱375,000 + LTD + ₱425,000 + ₱295,000

Long-term debt (LTD) = ₱105,000

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Total debt = Accounts payable + Long-term debt

Total debt = ₱375,000 + ₱105,000 = ₱480,000

Alternatively;

Total debt = Total liabilities and equity − Common stock − Retained earnings

Total debt = ₱1,200,000 − ₱425,000 − ₱295,000 = ₱480,000

b. Assets/Sales (A*/S) = ₱1,200,000/₱2,500,000 = 48%

Liabilities/Sales (L*/S) = ₱375,000/₱2,500,000 = 15%

2015 Sales = (1.25) (₱2,500,000) = ₱3,125,000

AFN = (A*/S) (∆S) − (L*/S) (∆S) − PS2 (1 − D)

= (0.48) (₱625,000) – (0.15) (₱625,000) – (0.06) (₱3,125,000) (0.6)

− ₱75,000

AFN = ₱300,000 − ₱93,750 − ₱112,500 − ₱75,000 = ₱18,750

Problem 9 (Additional Funds Needed)

Cash ₱ 100 x 2 = ₱ 200

Accounts receivable 200 x 2 = 400
Inventory 200 x 2 = 400
Net fixed assets 500 + 0.0 = 500
Total assets ₱1,000 ₱1,500

Accounts payable ₱ 50 x 2 = ₱ 100

Notes payable 150 150*
Accruals 50 x 2 = 100
Long-term debt 400 400
Common stock 100 100
Retained earnings 250 + 40 = 290
Total liabilities and equity ₱1,000 ₱1,140

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AFN = ₱360

*₱150 + ₱360 = ₱510

Capacity sales = Current sales/0.5 = ₱1,000/0.5 = ₱2,000

Target FA/S ratio = ₱500/₱2,000 = 0.25

Target FA = 0.25 (₱2,000) = ₱500 = Required FA. Since the firm currently has ₱500 of FA, no new FA will be required.

Addition to RE = P (S2) (1 – Payout ratio) = 0.05 (₱2,000) (0.4) = ₱40

Problem 10 (Additional Funds Needed)

Percent of Sales Table

Cash 5% Accounts payable 30.0%

Accounts receivable 30 Accrued expenses 2.5
Inventory 20
Current assets 55% Current liabilities 32.5%
(spontaneous) (spontaneous)

Sales = 20% (₱3,000,000) = ₱600,000

New Sales level = ₱3,000,000 + ₱600,000 = ₱3,600,000

New Funds Required (NFR) = A (∆S) – L (∆S) – PS 2 (1 – D)

NFR = 55% (₱600,000) – 32.5% (₱600,000) – 8% (₱3,600,000) (1 – 7)

NFR = ₱330,000 – ₱195,000 – ₱86,400 = ₱48,600

Problem 11 (Percent-of-sales method)

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Sales = (10%) (₱100,000,000) = ₱10,000,000

New Sales level = ₱100,000,000 + ₱10,000,000 = ₱110,000,000

New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS 2 (1 – D)

= (₱85,000,000/100) (₱10,000,000) – (₱25,000,000/100) (₱10,000,000) − .07 (₱110,000,000) (.60)

NFR = ₱8,500,000 − ₱2,500,000 − ₱4,620,000 = ₱1,380,000

Problem 12 (Percent-of-sales method)

a. Sales = (15%) (₱300,000,000) = ₱45,000,000

New Sales level = ₱300,000,000 + ₱45,000,000 = ₱345,000,000

New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS 2 (1 – D)

= (₱240,000,000/₱300,000,000) (₱45,000,000) – (₱120,000,000/₱300,000,000) (₱45,000,000) − .08

(₱345,000,000) (1 − .25)

NFR = ₱36,000,000 − ₱18,000,000 − ₱20,700,000 = (₱2,700,000)

A negative figure for new funds required indicated that an excess of funds (₱2,700,000) is available for
new investment. No external funds are needed.

b. New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS 2 (1 – D)

= ₱36,000,000 − ₱18,000,000 − .095 (₱345,000,000) (1 − .5)

= ₱36,000,000 − ₱18,000,000 − ₱16,387,500

NFR = ₱1,612,500 external funds required

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The net profit margin increased slightly, from 8% to 9.5%, which decreases the need for external funding.
The dividend payout ratio increased tremendously, however, from 25% to 50%, necessitating more
external financing. The effect of the dividend policy change overpowered the effect of the net profit
margin change.

Problem 13 (External Funds Requirement)

a. Sales = (15%) (₱100,000,000) = ₱15,000,000

Spontaneous Assets = 5% + 15% + 20% + 40% = 80%

Spontaneous Liabilities = 15% + 10% = 25%

New Sales level = ₱100,000,000 + ₱15,000,000 = ₱115,000,000

New Funds Required (NFR) = A (∆S) – L (∆S) – PS 2 (1 – D)

NFR = 80% (₱600,000) – 25% (₱600,000) – 10% (₱115,000,000) (1 – .5)

NFR = ₱12,000,000 – ₱3,750,000 – ₱5,750,000 = ₱2,500,000

b. If Mercury reduces the payout ratio, the company will retain more earnings and need less external funds.
A slower growth rate means that less assets will have to be financed and in this case, less external funds
would be needed. A declining profit margin will lower retained earnings and forced Mercury to seek more
external funds.

CHAPTER 10

FORECASTING SHORT-TERM
OPERATING FINANCIAL REQUIREMENTS

Answer to Questions

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1. The pro forma financial statements and cash budget enable the firm to determine its future level of asset
needs and the associated financing that will be required. Furthermore, one can track actual events against
the projections. Bankers and other lenders also use these financial statements as a guide in credit
decisions.

2. The collections and purchase schedules measure the speed at which receivables are collected and
purchases are paid. To the extent collections do not cover purchasing costs and other financial
requirements, the firm must look to borrowing to cover the deficit.

3. The more rapid the turnover inventory, the greater the need for purchase and replacement. Rapidly
turning inventory makes for somewhat greater ease in foreseeing future requirements and reduces the
cost of carrying inventory.

4. Rapid growth in sales and profits is often associated with rapid growth in asset commitment. A ₱100,000
increase in sales may occasion a ₱50,000 increase in assets, with perhaps only ₱10,000 of the new
financing coming from profits. It is very seldom that incremental profits from sales expansion can meet
new financing needs.

5. Level production in a cyclical industry has the advantage of allowing for the maintenance of a stable work
force and reducing inefficiencies caused by shutting down production during slow periods and
accelerating work during crash production periods. A major disadvantage is that a large stock of inventory
may be accumulated during the slow sales period. This inventory may be expensive to finance, with an
associated danger of obsolescence.

6. The percent-of-sales forecast is only as good as the functional relationship of assets and liabilities to sales.
To the extent that past relationships accurately depict the future, the percent-of-sales method will give
values that reasonably represent the values derived through the pro forma statements and the cash
budget.

7.
a. Sales forecast – a forecast of a firm’s unit and peso sales for some future period; generally based on
recent sales trends plus forecasts of the economic prospects for the nation, region, industry and so
forth.

b. Projected financial statement method – a method of forecasting financial requirements based on

forecasted financial statements.

c. Spontaneously generated funds – funds that are obtained automatically from routine business
transactions.

d. Dividend payout ratio – the percentage of earnings paid out in dividends.

e. Pro forma financial statement – same as letter (b)

f. Additional funds needed (AFN) – funds that a firm must raise externally through borrowing or by
selling new common or preferred stock.

AFN formula = Required increase in assets – Spontaneous increase in liabilities – Increase in retained
earnings

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g. Capital intensity ratio – the amount of assets required per peso of sales (A/S).

h. Lumpy assets – assets that cannot be acquired in small increments but must be obtained in large,
discrete units.

i. Financing feedback – the effects on the income statement and balance sheet of actions taken to
finance increases in assets.

8. A budget is a detailed quantitative plan for the acquisition and use of financial and other resources over a
given time period. Budgetary control involves using budgets to increase the likelihood that all parts of an
organization are working together to achieve the goals set down in the planning stage.

9. a. Budgets communicate management’s plans throughout the organization.

b. Budgets force managers to think about and plan for the future. In the absence of the necessity to
prepare a budget, many managers would spend all of their time dealing with day-to-day emergencies.
c. The budgeting process provides a means of allocating resources to those parts of the organization
where they can be used most effectively.
d. The budgeting process can uncover potential bottlenecks before they occur.
e. Budgets coordinate the activities of the entire organization by integrating the plans of its various parts.
Budgeting helps to ensure that everyone in the organization is pulling in the same direction.
f. Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent
performance.

10. A master budget represents a summary of all of management’s plans and goals for the future, and outlines
the way in which these plans are to be accomplished. The master budget is composed of a number of
smaller, specific budgets encompassing sales, production, raw materials, direct labor, manufacturing
overhead, selling and administrative expenses, and inventories. The master budget usually also contains a
budgeted income statement, budgeted balance sheet, and cash budget.

11. The level of sales impacts virtually every other aspect of the firm’s activities. It determines the production
budget, cash collections, cash disbursements, and selling and administrative budget that in turn determine
the cash budget and budgeted income statement and balance sheet.

12. No. Planning and control are different, although related concepts. Planning involves developing goals and
developing budgets to achieve those goals. Control, by contrast, involves the means by which management
attempts to ensure that the goals set down at the planning stage are attained.

13. The flow of budgeting information moves in two directions—upward and downward. The initial flow
should be from the bottom of the organization upward. Each person having responsibility over revenues or
costs should prepare the budget data against which his or her subsequent performance will be measured. As
the budget data are communicated upward, higher-level managers should review the budgets for
consistency with the overall goals of the organization and the plans of other units in the organization. Any
issues should be resolved in discussions between the individuals who prepared the budgets and their
managers. All levels of an organization should participate in the budgeting process—not just top
management or the accounting department. Generally, the lower levels will be more familiar with detailed,
day-to-day operating data, and for this reason will have primary responsibility for developing the specifics
in the budget. Top levels of management should have a better perspective concerning the company’s
strategy.

14. The direct labor budget and other budgets can be used to forecast workforce staffing needs. Careful
planning can help a company avoid erratic hiring and laying off of employees.

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15. The principal purpose of the cash budget is NOT to see how much cash the company will have in the bank
at the end of the year. Although this is one of the purposes of the cash budget, the principal purpose is to
provide information on probable cash needs during the budget period, so that bank loans and other sources
of financing can be anticipated and arranged well in advance.

Answer to Problems

Problem 1

a. February March April May June

Sales ₱60,000 ₱70,000 ₱75,000 ₱95,000 ₱110,000
Credit sales 54,000 63,000 67,500 85,500 99,000
Collections:
Cash
(10% of Sales) 6,000 7,000 7,500 9,500 11,000
60% first month
after sale 37,800 40,500 51,300
40% second
month after sale 21,600 25,200 27,000
Total Receipts ₱66,900 ₱75,200 ₱89,300

b. Receivables at End of June:

90% of June Sales ₱ 99,000
40% of May Credit Sales 34,200
₱133,200

Problem 2

January February March April May

Cash ₱4,200 ₱6,000 ₱7,800 ₱6,600 ₱5,400

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Credit 9,800 11,400 18,200 15,400 12,600

Collections:
Cash 7,800 6,600 5,400
40% on the following month 5,600 7,280 6,160
60% on the second month 5,880 8,400 10,920
Total Collections ₱19,280 ₱22,280 ₱22,480

Cash Budget
Collections ₱19,280 ₱22,280 ₱22,480
− Payments 21,300 19,100 22,400
Cash Flow (2,020) 3,180 80
+ Beginning Cash Balance 2,000 2,000 2,000
Cumulative Cash Balance (20) 5,180 2,080
Loan (Repayment) 2,020 (3,180) (80)
Cumulative Loan Balance 4,020 840 760
Ending Cash Balance ₱2,000 ₱2,000 ₱2,000

Problem 3

a. February March April May June

Sales ₱60,000 ₱80,000 ₱100,000 ₱120,000 ₱110,000
Credit sales 54,000 72,000 90,000 108,000 99,000
Collections:
Cash
(10% of Sales) 10,000 12,000 11,000
70% 1 month
following sale 50,400 63,000 75,600
30% 2 months
following sale 16,200 21,600 27,000
Monthly Cash
Receipts ₱76,600 ₱96,600 ₱113,600

b. Accounts receivables at the End of June:

90% of June Credit Sales ₱ 99,000
30% of May Credit Sales 32,400
Total Receivables Balance ₱131,400

Problem 4

a. April May June Total

February sales: ₱ 23,000 ₱ 23,000

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₱230,000 × 10%
March sales:
₱260,000 × 70%, 10% 182,000 ₱ 26,000 208,000
April sales: ₱300,000 ×
20%, 70%, 10% 60,000 210,000 ₱ 30,000 300,000
May sales:
₱500,000 × 20%, 70% 100,000 350,000 450,000
June sales:
₱200,000 × 20% 40,000 40,000
Total cash collections ₱265,000 ₱336,000 ₱420,000 ₱1,021,000

Observe that even though sales peak in May, cash collections peak in June. This occurs because the bulk of the
company’s customers pay in the month following sale. The lag in collections that this creates is even more
pronounced in some companies. Indeed, it is not unusual for a company to have the least cash available in the
months when sales are greatest.

b. Accounts receivable at June 30:

From May sales: ₱500,000 × 10% ₱ 50,000

From June sales: ₱200,000 × (70% + 10%) 160,000
Total accounts receivable at June 30 ₱210,000

Problem 5

Unit volume (3,000 x 1.20) 3,600

Price (₱200 x 1.10) ₱ 220
Total sales ₱792,000
Returns (5%) 39,600
Net sales ₱752,400

Problem 6

Projected sales 40,000 units

Desired ending inventory 6,000 (15% x 40,000)
Beginning inventory 8,500
Units to be produced 37,500

Problem 7

Projected sales 12,000 units (8,000 x 1.50)

Desired ending inventory 600 (5% x 12,000)
Beginning inventory 400

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Units to be produced 12,200

Problem 8

Projected sales 50,000 units

Desired ending inventory 5,600 (40% x 14,000)
Beginning inventory 14,000
Units to be produced 41,600

Problem 9

September October November December

Credit sales ₱50,000 ₱40,000 ₱35,000 ₱60,000
20% Collected in
month of sales 8,000 7,000 12,000
70% Collected in
month after sales 35,000 28,000 24,500
Total cash receipts ₱43,000 ₱35,000 ₱36,500

Problem 10

April May June Quarter

Budgeted sales in units 50,000 75,000 90,000 215,000
Add: Desired ending inventory* 7,500 9,000 8,000 8,000
Total needs 57,500 84,000 98,000 223,000
Less: Beginning inventory 5,000 7,500 9,000 5,000
Required production 52,500 76,500 89,000 218,000

*10% of the following month’s sales in units.

Answer to Multiple Choice Questions

1. B 6. D 11. A 16. C 21. C

2. B 7. C 12. C 17. B 22. A

3. E 8. C 13. C 18. C 23. B

4. C 9. C 14. C 19. B 24. C

5. C 10. D 15. D 20. C 25. A

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CHAPTER 11

ADDRESSING WORKING CAPITAL

POLICIES AND MANAGEMENT OF
SHORT-TERM ASSETS AND LIABILITIES

Answer to Questions

1. These are firms with relatively long inventory periods and/or relatively long receivables periods. Thus,
such firms tend to keep inventory on hand, and they allow customers to purchase on credit and take a
relatively long time to pay.

2. These are firms that have a relatively long time between the time purchased inventory is paid for and the
time that inventory is sold and payment received. Thus, these are firms that have relatively short payables
periods and/or relatively long receivable cycles.

3. Carrying costs will decrease because they are not holding goods in inventory. Shortage costs will probably
increase depending on how close the suppliers are and how well they can estimate need. The operating
cycle will decrease because the inventory period is decreased.

4. Since the cash cycle equals the operating cycle minus the accounts payable period, it is not possible for the
cash cycle to be longer than the operating cycle if the accounts payable period is positive. Moreover, it is
unlikely that the accounts payable period would ever be negative since that implies the firm pays its bills
before they are incurred.

Problems

Problem 1 (Cash Equation)

The total liabilities and equity of the company are the net book worth, or market value of equity, plus current
liabilities and long-term debt, so:

Total liabilities and equity = ₱10,380 + 1,450 + 7,500 = ₱19,330

This is also equal to the total assets of the company. Since total assets are the sum of all assets, and cash is an
asset, the cash account must be equal to total assets minus all other assets, so:

Cash = ₱19,330 – 15,190 – 2,105 = ₱2,035

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We have NWC other than cash, so the total NWC is:

NWC = ₱2,105 + 2,035 = ₱4,140

We can find total current assets by using the NWC equation. NWC is equal to:

NWC = CA – CL

₱4,140 = CA – ₱1,450

CA = ₱5,590

Problem 2 (Changes in the Operating Cycle)

a. Increase. If receivables go up, the time to collect the receivables would increase, which increases the
operating cycle.

b. Increase. If credit repayment times are increased, customers will take longer to pay their bills, which will
lead to an increase in the operating cycle.

c. Decrease. If the inventory turnover increases, the inventory period decreases.

d. No change. The accounts payable period is part of the cash cycle, not the operating cycle.

e. Decrease. If the receivables turnover increases, the receivables period decreases.

f. No change. Payments to suppliers affects the accounts payable period, which is part of the cash cycle,
not the operating cycle.

Problem 3 (Changes in Cycles)

a. Increase; Increase. If the terms of the cash discount are made less favorable to customers, the accounts
receivable period will lengthen. This will increase both the cash cycle and the operating cycle.

b. Increase; No change. This will shorten the accounts payable period, which will increase the cash cycle. It
will have no effect on the operating cycle since the accounts payable period is not part of the operating
cycle.

c. Decrease; Decrease. If more customers pay in cash, the accounts receivable period will decrease. This
will decrease both the cash cycle and the operating cycle.

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d. Decrease; Decrease. Assume the accounts payable period does not change. Fewer raw materials
purchased will reduce the inventory period, which will decrease both the cash cycle and the operating
cycle.

e. Decrease; No change. If more raw materials are purchased on credit, the accounts payable period will
tend to increase, which would decrease the cash cycle. We should say that this may not be the case. The
accounts payable period is a decision made by the company’s management. The company could increase
the accounts payable account and still make the payments in the same number of days. This would leave
the accounts payable period unchanged, which would leave the cash cycle unchanged. The change in
credit purchases made on credit will not affect the inventory period or the accounts payable period, so the
operating cycle will not change.

f. Increase; Increase. If more goods are produced for inventory, the inventory period will increase. This
will increase both the cash cycle and operating cycle.

Problem 4 (The Operating and Cash Cycles)

We first need the turnover ratios. Note that we use the average values for all balance sheet items and that we
base the inventory and payables turnover measures on cost of goods sold:

Inventory turnover = ₱11,375/ [(₱1,273 + ₱1,401)/2] = 8.51 times

Receivables turnover = ₱14,750/ [(₱3,782 + ₱3,368)/2] = 4.13 times

Payables turnover = ₱11,375/ [(₱1,795 + ₱2,025)/2] = 5.96 times

We can now calculate the various periods:

Inventory period = 365 days/8.51 times = 42.89 days

Receivables period = 365 days/4.13 times = 88.38 days

Payables period = 365 days/5.96 times = 61.24 days

So the time it takes to acquire inventory and sell it is about 43 days. Collection takes another 88 days, and the
operating cycle is thus 43 + 88 = 131 days. The cash cycle is thus 131 days less the payables period: 131 – 61 =
70 days.

Problem 5 (Working Capital)

a. Working Capital = ₱400,000

Net Working Capital = ₱400,000 − ₱200,000 = ₱200,000

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Current Ratio = ₱400,000/₱200,000 = 2 times

b. Five Star’s return on equity is 12.5 percent (₱62,700/₱500,000).

Five Star Manufacturing Company

Income Statement
For the Year Ended December 31, 2014

Net sales ₱800,000

EBIT (20% of sales) 160,000
Less: Interest expense
Short-term debt (10%) 20,000
Long-term debt (15%) 45,000
Earnings before taxes 95,000
Less: Income taxes (34%) 32,300
Net income ₱62,700

c. The net working capital and current ratios for each strategy are shown below:

Strategies
Current Assets as a Percent of Sales
30% 50% 70%
Current assets (CA) ₱300,000 ₱ 500,000 ₱ 700,000
Fixed assets 600,000 600,000 600,000
Total assets ₱900,000 ₱1,100,000 ₱1,300,000

Current liabilities (CL)* ₱180,000 ₱ 200,000 ₱ 260,000

Long-term liabilities 270,000 330,000 390,000
Total liabilities ₱450,000 ₱ 550,000 ₱ 650,000
Stockholders’ equity (SE) 450,000 550,000 650,000
Total liabilities and equity ₱900,000 ₱1,100,000 ₱1,300,000

Net working capital (CA – CL) ₱120,000 ₱ 300,000 ₱ 440,000

Current ratio (CA/CL) 1.7 times 2.5 times 2.7 times

*Assume that all current liabilities are in the form of short-term debt.

d. The firm’s liquidity position, as measured by the amount of net working capital and current ratio,
improves when current assets are a higher percentage of sales.

e. The rate of return on equity for each strategy is shown below:

Strategies
Current Assets as a Percent of Sales
30% 50% 70%
Net sales ₱1,000,000 ₱1,000,000 ₱1,000,000
EBIT (18% of sales) 180,000 180,000 180,000
Interest expense

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Short-term debt (10%) 18,000 20,000 26,000

Long-term debt (15%) 40,500 49,500 58,500
Earnings before taxes (EBT) 121,500 110,500 95,500
Income taxes (34%) 41,310 37,570 32,470
Net income ₱ 80,190 ₱ 72,930 ₱ 63,030

Return on equity (NI/SE) 17.8% 13.0% 9.7%

f. Five Star’s profitability decreases as liquidity increases. For example, the firm’s liquidity (current ratio =
2.7 times) is the highest but profitability (ROE = 9.7 percent) is the lowest when current assets are 70
percent of sales.

g. The return on equity, net working capital and current ratio for each strategy are shown below:

Financing- Mix Strategies

Restricted Compromise Flexible
EBIT ₱180,000 ₱180,000 ₱180,000
Interest expenses
Short-term (10%) 10,000 30,000 45,000
Long-term (15%) 52,500 22,500 0
Earnings before taxes (EBT) 117,500 127,500 135,000
Income taxes (34%) 39,950 43,350 45,900
Net income ₱77,550 ₱84,150 ₱89,100

Return on equity (NI/SE) 17.2% 18.7% 19.8%

Net working capital (CA – CL) ₱200,000 0 (₱150,000)
Current ratio (CA/CL) 3.0 times 1.0 times 0.7 times

Answer to Multiple Choice Questions

1. C 6. A 11. C

2. C 7. B 12. B

3. B 8. D 13. D

4. C 9. C 14. B

5. D 10. B

CHAPTER 12

CASH AND MARKETABLE

SECURITIES MANAGEMENT

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Answer to Questions

1. Cash and marketable securities are generally used to meet the transaction needs of the firm and for
contingency purposes. Because the funds must be available when needed, the primary concern should be
with safety and liquidity rather than the maximum profits.

2. Float exists because of the delay time in check processing. Electronic funds transfer, or the electronic
movement of funds between computer terminals, would eliminate the need for checks and thus eliminate
float.

3. A firm could operate with a negative balance on the corporate books knowing float will carry them
through at the bank. Checks written on the corporate books may not clear until many days later at the
bank. For this reason, a negative account balance on the corporate books of ₱100,000 may still represent
a positive balance at the bank.

4. By slowing down disbursements or the processing of checks against the corporate account, the firm is
able to increase float and also to provide a source of short-term financing.

5. Float represents the difference between a corporation’s recorded cash balances and the amount credited
to the corporation by the bank. It is the latter item that is of particular interest to us. To the extent a
corporation can accelerate check collections to the bank account and slow down check payments from its
bank account, the cash balance at the bank may exceed the recorded amount on the company books. The
differential or float may be thought of as a short-term source of funds to the corporation.

6. Cash and marketable securities are generally used to meet the transaction needs of the firm and for
contingency purposes. Because the funds must be available when needed, the primary concern should be
with safety and liquidity rather than the maximum profits.

7. A firm could operate with a negative balance on the corporate books knowing float will carry them
through at the bank. Checks written on the corporate books may not clear until many days later at the
bank. For this reason, a negative account balance on the corporate books of ₱100,000 may still represent
a positive balance at the bank.
8. The primary criteria a firm should use in selecting short-term marketable securities in its portfolio should
consider the following principles: (1) Default risk, (2) Marketability and, (3) Maturity dates.

9. Several techniques are now used both to speed collections and to get funds where they are needed.
Included are lockbox plans established close to customers and requiring large customers to pay by wire.

A lockbox plan is one of the oldest cash management tools. In a lockbox system, incoming checks are sent
to post office boxes rather than to corporate headquarters.

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Several times a day, a local bank will collect the contents of the lockbox and deposit the checks into the
company’s local account. The bank would then provide the firm with daily record of the receipts collected,
usually via an electronic data transmission system in a format that permits on-line updating of the firm’s
receivable accounts.

A lockbox system reduces the time required for a firm to receive incoming checks, to deposit them, and to
get them cleared through the banking system so that the funds are available to use.

The time reduction occurs because mail time and check collection time are both reduced if the lockbox is
located in the geographic area where the customer is located. Lockbox services can often increase the
availability of funds by two to five days over the “regular” system.

Firms are increasingly demanding payments of larger bills by wire, or even by automatic electronic debits.
This is, of course, the ultimate in a speeded-up collection process, and computer technology is making
such a process increasingly feasible and efficient.

No single action controls cash outflows more effectively than the centralized processing of payables. This
permits the financial manager to evaluate the payments coming due for the entire firm and to schedule
the availability of funds to meet these needs on a company-wide basis. Centralizing disbursements also
permits more efficient monitoring of payables and float balances. Of course, there are also disadvantages
to a centralized disbursement system – regional offices may not be able to make prompt payment for
services rendered, which can create ill will and raise the company’s operating costs. More than one firm
has saved a few pennies by using a cheaper check-disbursing system but lost far more as a result of higher
operating costs caused by ill will.

10. Free cash flows are the cash flows available to pay the firm’s stockholders and debt holders after the firm
has made the necessary working capital investments, fixed asset investments, and developed the
necessary new products to sustain the firm’s ongoing operations.

To calculate free cash flow, we start with operating cash flow. Firms generate operating cash flow (OCF)
after they have paid necessary taxes. Depreciation, a noncash charge, is added back to operating cash
flow to determine total OCF. We add other relevant noncash charges, such as amortization and depletion,
back as well. Firms either buy physical assets or earmark funds for eventual equipment replacement to
sustain firm operations; this is called investment in operating capital (IOC). In accounting term, IOC
includes the firm’s net investments or changes in fixed assets, current assets, and spontaneous current
liabilities such as accounts payable and accrued wages.

11. Firms hold cash for the following reasons:

1. Transaction balance – a cash balance associated with payments and collections; the balance necessary
for day–to–day operations.

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2. Compensating balance – a checking account balance that a firm must maintain with a bank to
compensate the bank for services rendered or for granting a loan.

3. Precautionary balance – a cash balance held in reserve for random, unforeseen fluctuations in cash
inflows and outflows.

12. 1. Transaction facilitation – firms need cash to pay employee’s wages, taxes, supplier’s bills, interest on
debts, and stock dividends. Though the firm will have cash coming in from day-to-day operations and
any financing activities, the inflows and outflows are not usually perfect synchronized, so the firm will
need to keep enough cash on hand to meet reasonable transaction demands.

2. Compensating balances – firms must often keep a certain percentage of borrowed funds in their
checking accounts with their lending institution. Since lenders are exempt from paying interest on
corporate checking accounts, compensating balances become a cheap source of funds for the lender
and represent opportunity costs for borrowing funds.

13. Yes. Denying credit to customers who are poor credit risk can minimize bad debts. Minimizing bad debts
could improve profitability of the firm.

14. Yes. Projected increases in sales may require the firm to raise cash by borrowing from its bank or by
selling new stock. For examples, if a firm anticipates an increase in sales, it will (1) expend cash to buy or
build fixed assets through the capital budgeting process; (2) step up purchases of raw materials, thereby
increasing both raw materials inventories and accounts payable; (3) increase production, which will lead
to an increase in both accrued wages and work-in-process and; (4) eventually build up its finished goods
inventory.

15. Carrying cost associated with compensating balance requirement. Since funds will be tied up to meet the
compensating balance requirement, the following carrying costs may be incurred. (1) Interest expense – if
money is part of the borrowed funds, and (2) Opportunity costs – income that would have been earned if
money had not been frozen to fulfill the compensating balance requirement.

16. Shortage cost associated with compensating balance requirement. If available funds are just enough to
meet the nominal transaction needs and compensate balance requirement, any unforeseen payments
may have to be met by incurring additional debts which could mean additional interest expense.

17. Increase in trading costs tend to increase likewise the optimal replenishment level in the Baumol Model
because of the higher costs of connecting other assets to cash.

18. The increase in the standard deviation in net daily cash flows will increase the optimal cash return point
under the Miller-Orr model.

19. Yes. A firm can have a negative collection float if the disbursement float period is shorter than the
collection float period.
20. Yes. A firm can have a negative disbursement float if the disbursement float period is longer than the
collection float period.

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Answer to Problems

Problem 1 (Determining Float)

Watermelon Company
Bank Books
Initial amount ₱10,000
Add: Deposits 70,000
Less: Checks 25,000
Balance ₱55,000

Float ₱15,000*

* Based on the balance on the corporate books minus the balance on the bank’s books.

Problem 2 (Determining Float)

a. ₱620 + ₱400 + ₱320 + ₱700 + ₱440 = ₱2,480

b. Amount Probability check has cleared Expected value

₱620 x 75% = ₱ 465
₱400 x 75% = ₱ 300
₱320 x 40% = ₱ 128
₱700 x 40% = ₱ 280
₱440 x 40% = ₱ 176
₱1,349

c. (a – b) = ₱2,480 - ₱1,349 = ₱1,131 float

Problem 3 (Cost-benefit Analysis of Cash Management)

a. ₱4,000,000 daily collections x 2.5 speed up = ₱10,000,000 additional

collections

₱3,000,000 daily disbursements x 1.5 days slow down = ₱4,500,000 delayed

disbursements

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₱10,000,000 + ₱4,500,000 = ₱14,500,000 freed up funds

b. ₱14,500,000 freed up funds

x 6% interest rate
₱ 870,000 interest on freed up cash

Problem 4 (Determination of Optimal Average Cash Balance Using Baumol Model)

a. Calculation of Optimal Transfer Size Using Baumol Model

C= 2FT/I

Where:

C = Optimal transfer size (cash required each time to restore balance to minimum cash)

T = Total cash required during the year (₱30,000,000)

F = Fixed cost per transaction (₱125)

I = Rate of interest on securities (8% per annum)

C= [(2) (₱30,000,000) (₱125)] / 0.08

C = ₱96,825 / 2 = ₱48,413
b. Calculation of Optimal Transfer Size Using Baumol Model if rate of interest is 12% and the transfer cost is
₱75.

C= [(2) (₱30,000,000) (₱75)] / 0.12

C = ₱61,237 / 2 = ₱30,619

Reasons for difference:

1. The opportunity cost of holding cash is high in case part (b), which requires to maintain lesser cash
balance.

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2. The transaction is also lower in case of part (b), which allows the frequent conversion of securities in
cash and therefore less cash balance can be maintained.

Problem 5 (Preparation of Cash Budget)

Collection from Debtors and Commission on Credit Sales

(in thousands of pesos)
20X3 (Actual) 20X4 (Forecast)
Particulars Nov Dec Jan Feb Mar Apr May
Sales ₱80 ₱70 ₱80 ₱100 ₱80 ₱100 ₱90
Cash sales
20% 16 14 16 20 16 20 18
Credit sales
80% 64 56 64 80 64 80 72
Collection of
debtors 0 0 64 56 64 80 64

Commission
on credit sales
(5%) 3.2 2.8 3.2 4 3.2 4 3.6
Payment of
commission 0 0 3.2 2.8 3.2 4 3.2

Calculation of payment to Creditors

(in thousands of pesos)
20X3 (Actual) 20X4 (Forecast)
Particulars Nov Dec Jan Feb Mar Apr May
Purchases (60
% of sales)
₱48 ₱42 ₱48 ₱60 ₱48 ₱60 ₱54
Payment to
creditors (3rd
month of
purchase) 0 0 48 42 48 60 48

Cash Budget of Purple Company for the months of Jan to May 20X3
(in thousands of pesos)
Particulars Jan Feb Mar Apr May Total
Opening balance ₱25 ₱47.05 ₱70.75 ₱42.05 ₱50.55 ₱25
Receipts:
Cash sales 16 20 16 20 18 90
Collection from
debtors 64 56 64 80 64 328
105 123.05 150.75 142.05 132.55 443

Payments:
Payment to creditors 48 42 48 60 48 246
Variable expenses 3.75 4.5 4.5 4.5 4.75 22
Commission 3.2 2.8 3.2 4 3.2 16.4
Rent 3 3 3 3 3 15
Fixed assets 0 0 50 0 0 50
Taxes 0 0 0 20 0 20

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57.95 52.3 108.7 91.50 58.95 369.4

Closing balance ₱47.05 ₱70.75 ₱42.05 ₱50.55 ₱73.6 ₱73.6

Problem 6 (Compensating Balance Interest Rate)

Problem 7 (Optimal Cash Replenishment Level)

Use Miller-Orr Model formula. Refer to page 285.

Problem 8 (Optimal Cash Replenishment Level)

Use Miller-Orr Model formula. Refer to page 285.

Problem 9 (Optimal Cash Return Point) Refer to page 285.

Problem 10 (Optimal Upper Cash Limit) Refer to page 285.

₱70,450.07

Answer to Multiple Choice Questions

1. D 6. D 11. B 16. D

2. D 7. B 12. A 17. D

3. D 8. D 13. A 18. D

4. D 9. C 14. D 19. B

5. C 10. D 15 C

CHAPTER 13

ACCOUNTS RECEIVABLE
AND INVENTORY MANAGEMENT

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Answer to Questions

1. Cash and marketable securities are generally used to meet the transaction needs of the firm and for
contingency purposes. Because the funds must be available when needed, the primary concern should be
with safety and liquidity rather than the maximum profits.

2. Float exists because of the delay time in check processing. Electronic funds transfer, or the electronic
movement of funds between computer terminals, would eliminate the need for checks and thus eliminate
float.

3. A firm could operate with a negative balance on the corporate books knowing float will carry them
through at the bank. Checks written on the corporate books may not clear until many days later at the
bank. For this reason, a negative account balance on the corporate books of ₱100,000 may still represent
a positive balance at the bank.

4. By slowing down disbursements or the processing of checks against the corporate account, the firm is
able to increase float and also to provide a source of short-term financing.

5. The average collection period, the ratio of bad debts to credit sales and the aging of accounts receivable.

6. Trade credit is usually granted on open account. The invoice is the credit instrument.

7. Credit costs: cost of debt, probability of default, and the cash discount. No-credit costs: lost sales. The sum
of these is the carrying costs.

8. 1. Character: determines if a customer is willing to pay his or her debts.

2. Capacity: determines if a customer is able to pay debts out of operating cash flow.

3. Capital: determines the customer’s financial reserves in case problems occur with operating cash
flow.
4. Collateral: assets that can be liquidated to pay off the loan in case of default.
5. Conditions: customer’s ability to weather an economic downturn and whether such a downturn is
likely.
9. 1. Perishability and collateral value
2. Consumer demand
3. Cost, profitability, and standardization

4. Credit risk
5. The size of the account
6. Competition
7. Customer type
If the credit period exceeds a customer’s operating cycle, then the firm is financing the receivables and
other aspects of the customer’s business that go beyond the purchase of the selling firm’s merchandise.

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10. a. B: A is likely to sell for cash only, unless the product really works. If it does,
then they might grant longer credit periods to entice buyers.
b. A: Landlords have significantly greater collateral, and that collateral is not mobile.
c. A: Since A’s customers turn over inventory less frequently, they have a longer inventory period, and
thus, will most likely have a longer credit period as well.
d. B: Since A’s merchandise is perishable and B’s is not, B will probably have a longer credit period.
e. A: Rugs are fairly standardized and they are transportable, while carpets are custom fit and are not
particularly transportable.

11. The three main categories of inventory are: raw material (initial inputs to the firm’s production process),
work-in-progress (partially completed products), and finished goods (products ready for sale). From the
firm’s perspective, the demand for finished goods is independent from the demand for the other types of
inventory. The demand for raw material and work-in-progress is derived from, or dependent on, the firm’s
needs for these inventory types in order to achieve the desired levels of finished goods.

12. JIT systems reduce inventory amounts. Assuming no adverse effects on sales, inventory turnover will
increase. Since assets will decrease, total asset turnover will also increase. Recalling the DuPont equation,
an increase in total asset turnover, all else being equal, has a positive effect on ROE.

13. Carrying costs should be equal to order costs. Since the carrying costs are low relative to the order costs,
the firm should increase the inventory level.

14. Since the price of components can decline quickly, Apple does not have inventory which is purchased and
then declines quickly in value before it is sold. If this happens, the inventory may be sold at a loss. While
this approach is valuable, it is difficult to implement. For example, Apple manufacturing plants will often
have areas set aside that are for the suppliers. When parts are needed, it is a matter of going across the
floor to get new parts. In fact, m0st computer manufacturers are trying to implement similar inventory
systems.

Answer to Problems

Problem 1

The firm’s average daily sales are its annual (credit) sales divided by 365 days.

Average daily sales = ₱912,500/365 days = ₱2,500

The average collection period is the credit period plus the average days past the due date.

Average collection period = 45 + 15 = 60 days

The average investment in accounts receivable is determined by multiplying the average daily sales by the
average collection period.

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Investment in accounts receivable = ₱2,500 x 60 = ₱150,000

Problem 2

a. The accounts receivable turnover is calculated by dividing 365 days by the average collection period of 25
days.

Accounts receivable turnover = 365/25 = 15 times

b. The average investment in accounts receivable is calculated by dividing credit sales by the accounts
receivable turnover.

Average investment in accounts receivable = ₱600,000/15 = ₱40,000

This method uses the total sales value of the accounts receivable. The cost (variable or total) is
sometimes used as the relevant measure of the amount of funds tied up in accounts receivable.
Using only variable cost as the relevant measure, the investment in accounts receivable would
be ₱32,000 (₱40,000 x 0.80).

Problem 3

a. The marginal pretax profits for each risk class are shown below:

Risk Class
A B C
1. Marginal profits on additional sales
= Additional sales x CM
= Additional sales x 0.15 ₱7,500 ₱6,000 ₱3,000
2. Marginal increase in bad debt losses
= Additional sales x Bad debt loss
ratio 2,500 3,200 2,400

3. Marginal investment in A/R

= (Additional sales/365) x 90
A = ₱12,330, B = ₱9,900, C = ₱4,950

Opportunity cost of marginal investment

in AR
= Marginal investment in A/R x

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Opportunity cost 2,466 2,376 6,485

4. Net change in pretax profits

= Marginal profits – Marginal costs ₱2,534 ₱424 (₱885)

* The contribution margin of 0.15 is calculated by subtracting the variable cost percentage from 1.00 or (1.00 –
0.85 = 0.15)

Problem 4

Jazz Auto Supply should not adopt the change in the discount rate because the change results in a net
disadvantage of ₱211.

1. Marginal profits on additional sales

= Additional sales x Contribution margin
= ₱0 x 0.25 ₱ 0

2. Current bad debt losses

= Current sales x Current bad debt loss ratio
= ₱400,000 x 0.03 = ₱12,000

New bad debt losses

= New sales x New bad debt loss ratio
= ₱400,000 x 0.025 = ₱10,000

Reduction in bad debt losses

= Current bad debt losses – New bad debt losses
= ₱12,000 − ₱10,000 2,000

3. Current average A/R balance

= Current average daily sales x Current average collection period
= (₱400,000/365) x 42 = ₱46,032

New average A/R balance

= New average daily sales x New average collection period
= (₱400,000/365) x 38 = ₱41,648
Reduction in A/R investment
= Current average A/R balance – New average A/R balance
= ₱46,032 - ₱41,648 = ₱4,384

Earnings on funds released by reduction in A/R investment

= Reduction in A/R x Required pretax rate of return
= ₱4,384 x 0.18 789

4. Cost of current cash discount

= Current sales x Current percentage taking discount
x Current percentage discount
= ₱400,000 x 0.45 x 0.01 = ₱1,800

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Cost of new discount

= New sales x New percentage taking discount
x New percentage discount
= ₱400,000 x 0.60 x 0.02 = ₱4,800

Cost of increase in cash discount

= Cost of new cash discount – Cost of current cash discount
= ₱4,800 − ₱1,800 3,000

5. Net advantage/disadvantage of changing credit terms

= Marginal returns – Marginal costs
= (₱0 + ₱2,000 + ₱789) − ₱3,000 (₱211)

Problem 5

a. S = 12,000; O = ₱50; C = ₱0.10

Q* = (2) (12,000) (₱50) = 3,464 gallons

₱0.10

b. The average inventory is determined by dividing the economic order quantity,

Q* by 2, as follows:

Average inventory = 3,464/2 = 1,732 gallons

c. C = ₱0.10; Q* = 3,464; S = 12,000 ; O = ₱50

Total inventory costs = CQ/2 + SO/Q

TIC = [(0.10) (3,464) / 2] + [(12,000) (₱50) / 3,464) = ₱346 per month

d. Q* = 3,464; Average daily demand = 12,000/30days

T* = Q*/Average daily demand

T* = 3,464 / (12,000/30 days) = 9 days
e. S = 12,000; Q* = 3,464

N* = S/Q*
N* = 12,000 / 3,464 = 3 orders per month or

Time period = 30; T = 9

N* = Time period/T*
N* = 30 / 9 = 3 orders per month

Problem 6

a. S = 36,000; O = ₱100; C = ₱5

Q* = (2) (36,000) (₱100) = 1,200 fruit cakes

₱5

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b. Q* = 1,200 ; SS = 3,000

Average inventory (Qa) = [(Q*/2) + SS]

Qa = [(1,200 / 2) + 3,000] = 3,600 fruit cakes

c. S = 36,000; Q* = 1,200

N* = S/Q*
N* = 36,000 / 1,200 = 30 orders per year

d. Fruitcake Specialists’ total inventory cost is found by multiplying the average

inventory, 3,600 fruit cakes, by the carrying cost per unit, ₱5, and then adding
the product of the orders per year, 30, multiplied by the ordering costs per
order, ₱100.

Total inventory costs = (3,600) (₱5) + (30) (₱100) = ₱21,000

e. SS = 3,000; S = 36,000; Time period = 365 ; n = 5

Qr = SS + (S/Time period) (n)

Qr = 3,000 + (36,000 / 365) (5) = 3,495 fruitcakes

Problem 7

The costs per period are the same whether or not credit is offered; so we can ignore the production costs. The
firm currently has sales of, and collects ₱110 x 2,000 = ₱220,000 per period. If credit is offered, sales will rise
to ₱120 x 2,000 = ₱240,000.

Defaults will be 4 percent of sales, so the cash inflow under the new policy will be .96 x ₱240,000 = ₱230,400.
This amounts to an extra ₱10,400 every period. At 2 percent per period, the PV is ₱10,400/.02 = ₱520,000. If
the switch is made, Dama de Noche will give up this month’s revenues of ₱220,000; so the NPV of the switch is
₱300,000. If only half of the customers take the credit, then the NPV is half as large: ₱150,000. So, regardless
of what percentage of customers takes the credit, the NPV is positive. Thus, the change is a good idea.

Problem 8

The cash flow from the old policy is the quantity sold times the price, so:

Cash flow from old policy = 40,000(₱510) = ₱20,400,000

The cash flow from the new policy is the quantity sold times the new price, all times one minus the default
rate, so:

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Cash flow from new policy = 40,000(₱537) (1 – .03) = ₱20,835,600

The incremental cash flow is the difference in the two cash flows, so:

Incremental cash flow = ₱20,835,600 – 20,400,000 = ₱435,600

The cash flows from the new policy are a perpetuity. The cost is the old cash flow, so the NPV of the decision
to switch is:

NPV = –₱20,400,000 + ₱435,600/.025 = –₱2,976,000

Problem 9

a. The old price as a percentage of the new price is: ₱90/₱91.84 = .98

So the discount is: Discount = 1 – .98 = .02 or 2%

The credit terms will be: Credit terms: 2/15, net 30

b. We are unable to determine for certain since no information is given concerning the percentage of
customers who will take the discount. However, the maximum receivables would occur if all customers
took the credit, so:

Receivables = 3,300(₱90) = ₱297,000 (at a maximum)

c. Since the quantity sold does not change, variable cost is the same under either plan.

d. No, because: d –  = .02 – .11 = –.09 or –9%

Therefore the NPV will be negative. The NPV is:

NPV = –3,300(₱90) + (3,300) (₱91.84) (.02 – .11)/(.01) = –₱3,023,592

The breakeven credit price is:

P (1 + r) / (1 –) = ₱90 (1.01)/ (.89) = ₱102.13

This implies that the breakeven discount is:

Breakeven discount = 1 – (₱90/₱102.13) = .1188 or 11.88%

The NPV at this discount rate is:

NPV = –3,300(₱90) + (3,300) (₱102.13) (.1188 – .11)/(.01)

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NPV  0

Problem 10

a. The cost of the credit policy switch is the quantity sold times the variable cost. The cash inflow is the
price times the quantity sold, times one minus the default rate. This is a one-time, lump sum, so we need
to discount this value one period. Doing so, we find the NPV is:

NPV = –15(₱760) + (1 – .2) (15) (₱1,140)/1.02 = ₱2,011.76

The order should be taken since the NPV is positive.

b. To find the breakeven default rate, , we just need to set the NPV equal to zero and solve for the
breakeven default rate. Doing so, we get:

NPV = 0 = –15(₱760) + (1 –) (12) (₱1,140)/1.02

 = .3200 or 32.00%

c. Effectively, the cash discount is:

Cash discount = (₱1,140 – 1,090) / ₱1,140 = .0439 or 4.39%

Since the discount rate is less than the default rate, credit should not be granted. The firm would be better
off taking the ₱1,090 up-front than taking an 80% chance of making ₱1,140.

Problem 11

a. The cash discount is:

Cash discount = (₱75 – 71) / ₱75 = .0533 or 5.33%

The default probability is one minus the probability of payment, or:

Default probability = 1 – .90 = .10

Since the default probability is greater than the cash discount, credit should not be granted; the NPV of
doing so is negative.

b. Due to the increase in both quantity sold and credit price when credit is granted, an additional
incremental cost is incurred of:

Additional cost = (6,200) (₱33 – 32) + (6,900 – 6,200) (₱33)

Additional cost = ₱29,300

The breakeven price under these assumptions is:

NPV = 0 = –₱29,300 – (6,200) (₱71) + {6,900 [(1 – .10) P – ₱33] – 6,200(₱71 – 32)} / (1.00753 – 1)

NPV = –₱34,100 – 440,200 + 273,940.31P – 10,044,478.08 – 10,666,468.16

₱21,185,246.24 = ₱273,940.31P
P = ₱77.34

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c. The credit report is an additional cost, so we have to include it in our analysis. The NPV when using the
credit reports is:

NPV = 6,200 (32) – .90 (6,900) 33 – 6,200 (71) – 6,900 (₱1.50) + {6,900 [0.90 (75 – 33) – 1.50] – 6,200
(71 – 32)} / (1.00753 – 1)

NPV = ₱198,400 – 204,930 – 440,200 – 10,350 + 384,457.73

NPV = –₱72,622.27

The reports should not be purchased and credit should not be granted.

Answer to Multiple Choice Questions

1. D 4. A 7. D 10. D 13. D

2. B 5. D 8. C 11. D

3. D 6. C 9. B 12. D

CHAPTER 14

SHORT-TERM SOURCES
FOR FINANCING CURRENT ASSETS

Answer to Questions

1. It is advisable to borrow in order to take a cash discount when the cost of borrowing is less than the cost
of foregoing the discount. If it cost us 36 percent to miss a discount, we would be much better off finding
an alternate source of funds for 8 to 10 percent.

2. The prime rate is the rate that a bank charges its most creditworthy customers. The average customer
can expect to pay one or two percent (or more) above prime.

3. The stated interest rate is the percentage rate unadjusted for time or method of repayment. The
effective interest rate is the true rate and considers all these variables. A 5 percent stated rate for 90 days
provides a 20 percent effective rate. The financial manager should recognize the effective rate as the true
cost of borrowing. The effective rate is also referred to as the APR (Annual Percentage Rate).

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4. Commercial paper can be either purchased or issued by a corporation. To the extent one corporation
purchases another corporation’s commercial paper as a short-term investment, it is a current asset.
Conversely, if a corporation issues its own commercial paper, it is a current liability.

5. Pledging accounts receivable means receivables are used as collateral for a loan; factoring account
receivables means they are sold outright to a finance company.

6. Three types of lender control used in inventory financing are

a. Blanket inventory lien-general claim against inventory or collateral. No specific items are marked or
designated.

b. Trust receipt-borrower holds the inventory in trust for the lender. Each item is marked and has a
serial number. When the inventory is sold, the trust receipt is canceled and the funds go into the
lender’s account.

c. Warehousing the inventory is physically identified, segregated, and stored under the direction of an
independent warehouse company that controls the movement of the goods. If done on the premises
of the warehousing firm, it is termed public warehousing. An alternate arrangement is field
warehousing whereby the same procedures are conducted on the borrower’s property.

7. A secured loan is backed by the collateral that a borrower puts up. This collateral could be accounts
receivable, inventories, or other major tangible assets like property. An unsecured loan has no backing and
relies on the credit standing and the reliability of the borrower. An example of an unsecured loan is a bank
line of credit.

8. Firms establish a relationship with banks because they wish to have a ready source of cash to take care of
their temporary needs for cash and working capital. They could borrow at lower cost by issuing commercial
paper or short-term notes, but it is always helpful to have a line of credit with a bank without having to do
the paperwork and arrange a pubic or private offering. Also, banks provide many services that are
important to a firm.

9. Commercial paper is issued by large corporations with high credit ratings. It is paper having a maturity date
less than 270 days, and the cost of borrowing by this method is lower than borrowing at a bank. The firm
sells this paper at a discount from face value and it usually costs ½% to 1% more than the rate paid on a 3-
month Treasury bill.

10. Accounts payable are a form of trade credit. This is an indirect way of financing the purchase of goods and
services for a specified period of time. If a firm paid cash, it would have to draw on internal or external
sources of funds to finance these purchases. We can consider this credit a loan that must be paid after a
short period of time. Suppliers provide trade credit to attract customers, and they give discounts of 1% to
3% of the value of the goods bought if the customer pays up before the designated payment date.

Answer to Problems

Problem 1

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The discounted interest cost of the commercial paper issue is calculated as follows:

Interest expense = .10 x P200 million x 180 / 360 = P10 million

Loan proceeds
The effective cost of credit can now be calculated as follows:
(for P500,000 loan) P11,667 12

P388,333 2
P10 million + P125,000 1
P200 million  P125,000  P10 million = 180 / 360
RATE =

RATE = 46%

Problem 2

a. Interest for two months = .14 x  x P500,000

= P11,667

= P500,000  (.2 x P500,000 + P11,667)

= P383,333

RATE = x

= .030043 x 6 = .18026, or 18.026%

Note that Jan would actually have to borrow more than the needed P500,000 in order to cover the
compensating balance requirement. However, as we demonstrated earlier, the effective cost of credit
will not be affected by adjusting the loan amount for interest expense changes accordingly.

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b. The estimation of the cost of forgoing trade discounts is generally quite straightforward; however, in this
case the firm actually stretches its trade credit for purchases made during July beyond the due date by an
additional 30 days. If it is able to do this without penalty, then the firm effectively forgoes a 3 percent
discount for not paying within 15 days and does not pay for an additional 45 days (60 days less the
discount period of 15 days). Thus, for the July trade credit, Jan’s cost is calculated as follows:

RATE = (.03 / .97) x (360 / 45) = 24.74%

However, for the August trade credit the firm actually pays at the end of the credit period (the 30th day),
so that the cost of trade credit becomes

RATE = (.03 / .97) x (360 / 15) = 74.22%

c.

= .12 x x P500,000

= P10,000

Pledging fee = .005 x P750,000

= P3,750

2
Interest for two
12
RATE months
= x

P10,000 + P3,750 12
= .0275 x 6 = .165, or 16.5%
P500,000 2

Problem 3
.18 x P200,000 1
P200,000 1
a. RATE = x

.16 x P200,000 1
P200,000 .20 x P200,000 1
= .18, or 18%

.14 x P200,000 1
b. RATE = P200,000 .14 x P200,000 .2x x P200,000 1

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= .20, or 20%

c. RATE = x

= .21212, or 21.212%

Alternative (a) offers the lower-cost service of financing, although it carries the highest stated rate of
interest. The reason for this, of course, its that there is no compensating balance requirement nor is
interest discounted for this alternative.

Problem 4

Cost of not taking a Discount % 360

cash=discount 100%x Disc.% Final due date-
Discount period

2% 360
= 98% x (55 10) = 2.04% x 8 = 16.32%

Effective rate of interest with a 20% compensating balance requirement:

= Interest rate / (1  C)

= 14% / (1  .2)

= 14% / (.8) = 17.5%

The effective cost of the loan, 17.5%, is more than the cost of passing up the discount, 16.32%. Kiwi
Corporation should continue to pay in 55 days and pass up the discount.

Problem 5

P5,500 360
a. Effective rate of interest = P300,000 x 60

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= 1.83% x 6 = 10.98%

2% 360
b. Cost of lost discount = 98% x (70 10)

P6,850 360
P375,000 P75,000 60
= 2.04% x 6 = 12.24%
P6,850

P300,000
c. Yes, because the cost of borrowing is less than the cost of losing the discount.

d. P300,000 P300,000 P300,000 =

(1 C) = (1 .20) .80

= P375,000 amount needed to be borrowed

2 x 4 x P9,000
e. Effective interest rate = x
(P100,000  P20,000  P9,000) x (4 + 1)

= x 6 = 2.28% x 6

= 13.68%

No, do not borrow with a compensating balance of 20 percent since the effective rate is greater than the
savings from taking the cash discount.

Problem 6

a. Trust Bank

Effective interest rate

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= P72,000 / P355,000 = 20.28%

Northeast Bank

Effective interest rate

= P216,000 / P1,170,000 = 18.46%

Choose Northeast Bank since it has the lowest effective interest rate.

b. The numerators stay the same as in part (a) but the denominator increases to reflect the use of more
money because compensating balances are already maintained at both banks.

2 x 12 x P9,000

Trust Bank (P100,000  P10,000) x (12 + 1)

Effective interest rate = P72,000 / (P100,000  P9,000) x 5

= P72,000 / P455,000 = 15.82%

Northeast Bank

Effective interest rate = P216,000 / (P100,000 x 13)

= P216,000 / P1,300,000 = 16.62%

c. Yes. If compensating balances are maintained at both banks in the normal course of business, then Trust
Bank should be chosen over Northeast Bank. The effective cost of its loan will be less.

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Problem 7

a. 11.73%

b. 12.09%

c. 18%

Problem 8

a. Cost of commercial paper =

Cost of commercial paper in the first quarter Costs incurred by using commercial paper

Net funds available from commercial paper

Cost of issuing commercial paper:

Interest (P4,000,000 x .0775 x ¼) P 77,500

Placement fee (P4,000,000 x .00125) 5,000

First quarter cost P 82,500

Funds available for use: =

Funds raised P4,000,000

Less: Compensating balance P400,000

Less: Interest and placement 82,500 482,500

Net funds available in first quarter P3,517,500

Cost of commercial paper in the first quarter P 82,500

P3,517,500

= 2.345%

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Cost of issuing commercial paper per quarter:

Interest (P4,000,000 x .0775 x ¼) P 77,500

Funds available for use:

Funds raised P4,000,000

Less: Compensating balance P400,000 =

77,500 477,500

Net funds available per quarter P3,522,500

Cost of commercial paper per quarter P 77,500

P3,522,500

= 2.20%

Total annual effective cost of commercial paper

Effective cost = 1st quarter cost + 3(cost of 2nd, 3rd, 4th qtrs.)

= .02345 + 3(.02200)

= .02345 + .06600

= .08945

= 8.95%

Familia Inc. should choose commercial paper because the cost of bank financing (10.4 percent) exceeds
the cost of commercial paper (8.95 percent) by greater than 1 percent.

b. The characteristics Familia Inc. should possess in order to deal regularly in the commercial paper market
include:

1. Have a prestigious reputation, be financially strong, and have a high credit rating.
2. Have flexibility to arrange for large amounts of funds through regular banking channels.
3. Have a large and frequently recurring short-term or seasonal needs for funds.
4. Have the ability to deal in large denominations of funds for periods of one to nine months and be
willing to accept the fact that commercial paper cannot be paid prior to maturity.

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Problem 9

a. The expected monthly cost of bank financing is the sum of the interest cost, processing cost, bad debt
expense, and credit department cost. The calculations are as follows:

Interest .15 / 12 x P180,000 = P 2,250

Processing .02 x P180,000 / .75 = 4,800

Credit department = 2,500

Bad debt expense .0175 x .7 x P900,000 = 11,025

Expected monthly cost of bank financing P20,575

b. The expected monthly cost of factoring is the sum of the interest cost and the factor cost. The
calculations are as follows:

Interest .015 x P180,000 = P 2,700

Factor .025 x .7 x P900,000 = 15,750

Expected monthly cost of factoring P18,450

c. The following are possible advantages of factoring:

1. Using a factor eliminates the need to carry a credit department.

2. Factoring is a flexible source of financing because as sales increase, the amount of readily
available financing increases.
3. Factors specialize in evaluating and diversifying credit risks.

d. The following are possible disadvantages of factoring:

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1. The administrative costs may be excessive when invoices are numerous and relatively small in
peso amount.
2. Factoring removes one of the most liquid of the firm’s assets and weakens the position of
creditors. It may mar their credit rating and increase the cost of other borrowing arrangements.
3. Customers could react unfavorably to a firm’s factoring their accounts receivable.

e. Based upon the calculations in Parts a and b, the factoring arrangement should be continued. The
disadvantages of factoring are relatively unimportant in this case, especially since Canada Company has
been using the factor in the past. Before arriving at a final decision, the other services offered by the
factor and bank would have to be evaluated, as well as the margin of error inherent in the estimation of
the source data used in the calculations for Parts a and b. The additional borrowing capacity needed by
Canada Company is irrelevant because the firm only needs P180,000 and the bank will loan P472,500
(P900,000 x .70 x .75) and the factor will lend P567,000 (P900,000 x .70 x .90).

Problem 10

a. The annual percentage cost of each company’s credit terms is calculated as follows:

Discount 360 days

Cost= 1.00 – Discount
x Credit period – Discount period

The cost of each supplier must be weighted by the proportion of the total provided by the supplier.

Annual Weighted
Percentage Cost Average Cost
Weight
(1) (1) x (2)
Supplier (2)

Fort Co. .367 .30 .110

Jester Co. .242 .25 .061

Jam Co. - .35 -

Smitt & Co. .172 .10 .017

Total 1.00 .188

Average effective annual interest rate is 18.8 percent.

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b. No, the average effective annual interest rate does not indicate whether they should borrow funds to take
advantage of the terms on a specific account. The borrowing decision should be based on the effective
annual interest rate of each supplier’s credit terms. Money should be borrowed to pay within the
discount period only when the cost of borrowing is less than the effective annual interest rate of the
credit terms. For instance, Fort Co. has an effective annual interest rate of 36.7% and should be paid on
day 10 only if the cost of borrowing is less than 36.7%.

c. 1. A line of credit is a loan agreement in which the borrower has, with certain specified limitations,
control over the amount borrowed (up to some maximum) and when the funds are repaid.

2. Yes, a line of credit would be appropriate for Billy Madison if the company needs to borrow short-
term money to take advantage of the cash discounts.

Answer to Multiple Choice Questions

1. A 16. B 31. D 46. D

2. B 17. A 32. A 47. A

3. D 18. C 33. A 48. B

4. B 19. D 34. A 49. B

5. D 20. D 35. C 50. C

6. C 21. D 36. D 51. A

7. A 22. C 37. C 52. C

8. D 23. D 38. D 53. C

9. B 24. C 39. B 54. A

10. D 25. D 40. C 55. C

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11. A 26. D 41. D 56. D

12. A 27. A 42. D 57. D

13. B 28. B 43. C

14. C 29. B 44. C

15. B 30. D 45. D

CHAPTER 15

CALCULATING THE COST OF CAPITAL

Problems

Problem 1

The approximate before-tax cost of new debt is:

P120 + (P1,000 – P970) / 15

k’d =
(P1,000 + P970) / 2

=
P122
=
P985

0.1239 or 12.39%

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The approximate after-tax cost of new debt is:

k’dt = (12.39) (1 − 0.34)

= 8.18%

Problem 2

The cost of new preferred share is:

P4.50
=
kp
P47.50
= 0.0947 or 9.47%

Problem 3

(a) The compound annual growth rate (FVIF i,n) at which dividends grew from P1.98 to P2.50 over 4 years is as
follows:

Ending dividend
FVIF i,4 =
Beginning dividend

P2.50
=
P1.98
= 1.263

As shown in the table for Future Value of P1 for 4 periods of 1.263.

(b) The expected dividends to be received during 20x5, D 1, equal P2.65 (1.06 x P2.50). The cost of retained
earnings is:

P2.65

P40.00

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kr = + 0.06

= 0.0663 + 0.06

= 0.1263 or 12.63%

(c) The cost of new ordinary equity share is:

P2.65
ks =
+ 0.06
P40.00 − P3.00
= 0.0716 + 0.06

= 0.1316 or 13.16%

Problem 4

The estimated cost of retained earnings is:

kr = 0.05 + 0.95 (0.13 − 0.05)

= 0.050 + 0.076

= 0.1260 or 12.60%

Problem 5

The cost of retained earnings using the generalized risk premium method is:

kr = 0.100 + 0.025

= 0.1250 or 12.50%

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Problem 6

The cost of retained earnings using the earnings-price ratio is:

= P6.00
kr
P40.00
= 0.1500 or 15.00%

Problem 7

The market value of each source of capital is found as follows:

Number of Market Market

Source of Securities Price Value
Capital (1) (2) (1) (2)
Bonds 3,000 * P965 P 2,895,000
Preferred share 25,000 18 450,000
Ordinary equity share 200,000 40 8,000,000
Total P11,345,000

*3,000,000 book value / P1,000 per bond = 3,000 bonds

Problem 8

(a) The book value weights are:

P2,000,000 P500,000
Long-term debt = Preferred share =
P4,000,000 P4,000,000

= 0.500 = 0.125

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P1,500,000
Ordinary equity share =
P4,000,000
= 0.375

The firm’s weighted average cost of capital is:

WACC = (0.500) (0.0700) + (0.125) (0.1200) + (0.375) (0.1600)

= 0.0350 + 0.0150 + 0.0600

= 0.1100 or 11.00%

(b) The market value weights are:

P1,800,000 P600,000
= Preferred share =
Long-term debt
P6,000,000 P6,000,000
= 0.30 = 0.10

P3,600,000
Ordinary equity share =
P6,000,000
= 0.60

The firm’s weighted average cost of capital is:

WACC = (0.30) (0.0700) + (0.10) (0.1200) + (0.60) (0.1600)

= 0.0210 + 0.0120 + 0.0960

= 0.1290 or 12.90%

Problem 9

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The break-even point of total new investment (financing) is:

P26,000,000
=
BPi
0.65
=

P40,000,000

Answer to Multiple Choice Questions

1. D 4. C 7. C 10. A

2. A 5. D 8. D

3. C 6. A 9. C

CHAPTER 16

BASICS OF CAPITAL BUDGETING

Answer to Questions

11. Only cash can be spent or reinvested, and since accounting profits do not necessarily represent all cash,
they are of less fundamental importance than cash flows for investment analysis.
12. Capital budgeting analysis should only include those cash flows that will be affected by the decision. Sunk
costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting
decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather
than its next best alternative, and externalities are the cash flows (both positive and negative) to other
projects that result from the firm undertaking this project. These cash flows occur only because the firm
took on the capital budgeting project; therefore, they must be included in the analysis.
13. When a firm takes on a new capital budgeting project, it typically must increase its investment in
receivables and inventories, over and above the increase in payables and accruals, thus increasing its net
operating working capital (NOWC). Since this increase must be financed, it is included as an outflow in
Year 0 of the analysis. At the end of the project’s life, inventories are depleted and receivables are

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collected. Thus, there is a decrease (or reduction) in NOWC, which represents an inflow in the final year of
the project’s life.
14. The costs associated with financing are reflected in the weighted average cost of capital. To include
interest expense in the capital budgeting analysis would “double count” the cost of debt financing.
15. Daily cash flows would be theoretically best, but they would be costly to estimate and probably no more
accurate than annual estimates because we simply cannot forecast accurately at a daily level. Therefore,
in most cases we simply assume that all cash flows occur at the end of the year. However, for some
projects it might be useful to assume that cash flows occur at mid-year, or even quarterly or monthly.
There is no clear upward or downward bias on NPV since both revenues and costs are being recognized at
the end of the year. Unless revenues and costs are distributed radically different throughout the year,
there should be no bias.
16. In replacement projects, the benefits are generally cost savings, although the new machinery may also
permit additional output. The data for replacement analysis are generally easier to obtain than for new
products, but the analysis itself is somewhat more complicated because almost all of the cash flows are
incremental, found by subtracting the new cost numbers from the old numbers. Similarly, differences in
depreciation and any other factor that affects cash flows must also be determined.
Answer to Problems

Problem 1

(a) Equipment purchase (P 9,000,000)

NOWC investment (3,000,000)

Initial investment outlay (P12,000,000)

(b) No, last year’s P50,000 expenditure is considered a sunk cost and does not represent an incremental cash
flow. Hence, it should not be included in the analysis.

(c) The potential sale of the building represents an opportunity cost of conducting the project in that building.
Therefore, the possible proceeds after taxes and commissions must be charged against the project as a cost.

Problem 2

(a) The projected cash flow for the first year is:

Project cash flows: t = 1

Sales revenues P10,000,000

Operating costs 7,000,000

Depreciation 2,000,000

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EBITP 1,000,000

Taxes (40%) 400,000

EBIT (1 – T) P 600,000

Add back depreciation 2,000,000

Project cash flow = EBIT (1 – T) + DEP P 2,600,000

Problem 3

Equipment’s original cost P250 M

Depreciation (80%) 200 M

Book value P 50 M

Loss on sale = P5 M – P50 M

= P45 M

Tax savings = P45 M (0.4)

= P18 M

After-tax salvage value = P5 M + P18M

= P23 M

Problem 4

Level of working capital for old machine = P25,000 – P5,000

= P20,000

Level of working capital for new machine = P20,000 – P5,000

= P15,000

Incremental investment in net working capital = P15,000 – P20,000

= – P5,000

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Problem 5

Level of working capital for old machine = P20,000 – P5,000

= P15,000

Level of working capital for new machine = P30,000 – P10,000

= P20,000

Incremental investment in net working capital = P20,000 – P15,000

= P5,000

Problem 6

Investment in net working capital = P1,000,000 + (P750,000 x 0.40) – (P1,000,000 x 0.50)

= P800,000

Problems 7 through 9:

Problem 7

Net investment cash flow = P175,000 + P25,000 + (P50,000 – P22,500)

= P227,500

Problem 8

Operating cash flow = (P120,000 – P50,000) (0.66) + (P50,000) (0.34)

= P63,200

Problem 9

Disposal cash flow = (P50,000) (0.66) + (P50,000 – P22,500)

= P60,500

Problems 10 through 13: Assume that the equipment has 3-year life for tax purposes using straight line
method. Hence no depreciation can be claimed in the 4th and 5th years of the project.

Problem 10

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Net investment in cash flow = P175,000 + (P15,000 x 0.60)

= P184,000

Problem 11

Operating cash flow (1st year) = (P80,000 – P10,000) (0.66) + (175,000 x 0.3333) (0.34)

= P66,033

Problem 12

Operating cash flow (2nd year) = (P80,000 – P10,000) (0.66) + (175,000 x .3333) (0.34)

= P66,033

Problem 13 (Total Cash Flows in the 4th year)

Operating cash flow = (P80,000 – P10,000) (0.66)

= P46,200

Proceeds for sale (no gains for loss asset fully

depreciated) P10,000
Recovery working capital (P15,000 x 0.60) 9,000
Project-disposal cash flow P19,000

Total cash flow = P46,200 + P19,000

= P65,200

Problems 14 through 19: Assume that the equipment has an economic life of 3 years and will be depreciated
over that period using straight line method.

Problem 14

Net investment in cash flow = P2,000,000 + (P250,000 x 0.40)

= P2,100,000

Problem 15

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Operating cash flow (1st year) = (P800,000 – P350,000) (0.66) +

P2,000,000 – P1,000,000 (0.34)

3

= P512,333

Problem 16

Operating cash flow (2nd year) = (P800,000 – P350,000) (0.66) + (P215,333)

= P512,333

Problem 17

Operating cash flow (3rd year) = (P800,000 – P350,000) (0.66) + (P215,333)

= P512,333

Problem 18

Book value = P2,000,000 – P1,900,000

= P100,000. If sold for P100,000, no

gain or loss will occur.

Taxes = (P100,000 – P100,000) (0.34)

= P0

Problem 19

Project-disposal cash flow (end of 3rd year)

Recovery of net working capital (P250,000 x .40) P100,000

Proceeds from sale of equipment 100,000
Total P200,000

CHAPTER 17

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SCREENING AND SELECTING

CAPITAL INVESTMENT PROPOSALS

Answer to Questions

1. Payback period is simply the accounting break-even point of a series of cash flows. To actually compute
the payback period, it is assumed that any cash flow occurring during a given period is realized
continuously throughout the period, and not at a single point in time. The payback is then the point in time
for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined
cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and
reject projects that take longer to payback.

2. Discounted payback is an improvement on regular payback because it takes into account the time value of
money. For conventional cash flows and strictly positive discount rates, the discounted payback will always
be greater than the regular payback period.

3. NPV is superior to the other methods of analysis presented in the text because it has no serious flaws. The
method unambiguously ranks mutually exclusive projects, and can differentiate between projects of
different scale and time horizon. The only drawback to NPV is that it relies on cash flow and discount rate
values that are often estimates and not certain, but this is a problem shared by the other performance criteria
as well. A project with NPV = P2,500 implies that the total shareholder wealth of the firm will increase by
P2,500 if the project is accepted.

4. IRR is frequently used because it is easier for many financial managers and analysts to rate performance in
relative terms, such as “12%”, than in absolute terms, such as “P46,000.” IRR may be a preferred method
to NPV in situations where an appropriate discount rate is unknown are uncertain; in this situation, IRR
would provide more information about the project than would NPV.

5. PI = (NPV + cost)/cost = 1 + (NPV/cost). If a firm has a basket of positive NPV projects and is subject to
capital rationing, PI may provide a good ranking measure of the projects, indicating the “bang for the buck”
of each particular project.

6. For a project with future cash flows that are an annuity:

Payback = I / C

And the IRR is:

0 = – I + C / IRR

Solving the IRR equation for IRR, we get:

IRR = C / I

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Notice this is just the reciprocal of the payback. So:

IRR = 1 / PB

For long-lived projects with relatively constant cash flows, the sooner the project pays back, the greater is
the IRR.

7. The NPV is obtained by discounting future cash flows, and the discounting process actually compounds
the interest rate over time. Thus, an increase in the discount rate has a much greater impact on a cash
flow in Year 5 than on a cash flow in Year 1.

Problems

Problem 1

To calculate the payback period, we need to find the time that the project has recovered its initial investment.
After three years, the project has created:

P1,600 + 1,900 + 2,300 = P5,800

in cash flows. The project still needs to create another:

P6,400 – 5,800 = P600

in cash flows. During the fourth year, the cash flows from the project will be P1,400. So, the payback
period will be 3 years, plus what we still need to make divided by what we will make during the fourth
year. The payback period is:

Payback = 3 + (P600 / P1,400)

= 3.43 years

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Problem 2

When we use discounted payback, we need to find the value of all cash flows today. The value today of the project
cash flows for the first four years is:

Value today of Year 1 cash flow = P42,000/1.14 = P36,842.11

Value today of Year 2 cash flow = P53,000/1.14 2 = P40,781.78

Value today of Year 3 cash flow = P61,000/1.14 3 = P41,173.26

Value today of Year 4 cash flow = P74,000/1.14 4 = P43,813.94

To find the discounted payback, we use these values to find the payback period. The discounted first year cash
flow is P36,842.11, so the discounted payback for a P70,000 initial cost is:

Discounted payback = 1 + (P70,000 – 36,842.11) / P40,781.78

= 1.81 years

For an initial cost of P100,000, the discounted payback is:

Discounted payback = 2 + (P100,000 – 36,842.11 – 40,781.78) / P41,173.26

= 2.54 years

Notice the calculation of discounted payback. We know the payback period is between two and three years, so we
subtract the discounted values of the Year 1 and Year 2 cash flows from the initial cost. This is the numerator,
which is the discounted amount we still need to make to recover our initial investment. We divide this amount by
the discounted amount we will earn in Year 3 to get the fractional portion of the discounted payback.

If the initial cost is P130,000, the discounted payback is:

Discounted payback = 3 + (P130,000 – 36,842.11 – 40,781.78 – 41,173.26) / P43,813.94

= 3.26 years

Problem 3

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Our definition of AAR is the average net income divided by the average book value. The average net income for
this project is:

Average net income = (P1,938,200 + 2,201,600 + 1,876,000 + 1,329,500) /

= P1,836,325

And the average book value is:

Average book value = (P15,000,000 + 0) / 2

= P7,500,000

So, the AAR for this project is:

AAR = Average net income / Average book value

= P1,836,325 / P7,500,000

= .2448 or 24.48%

Problem 4

The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines the IRR for
this project is:

0 = – P34,000 + P16,000 / (1+IRR) + P18,000 / (1+IRR) 2 + P15,000 / (1+IRR)3

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 20.97%

Since the IRR is greater than the required return, we would accept the project.

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Problem 5

The NPV of a project is the PV of the outflows minus the PV of the inflows. Since the cash inflows are an annuity,
the equation for the NPV of this project at an 8 percent required return is:

NPV = –P138,000 + P28,500 (PVIFA8%, 9)

= P40,036.31

At an 8 percent required return, the NPV is positive, so we would accept the project.

The equation for the NPV of the project at a 20 percent required return is:

NPV = –P138,000 + P28,500 (PVIFA20%, 9)

= –P23,117.45

At a 20 percent required return, the NPV is negative, so we would reject the project.

We would be indifferent to the project if the required return was equal to the IRR of the project, since at that
required return the NPV is zero. The IRR of the project is:

0 = –P138,000 + P28,500 (PVIFAIRR, 9)

IRR = 14.59%

Problem 6

The IRR is the interest rate that makes the NPV of the project equal to zero. So, the equation that defines the IRR for
this project is:

0 = –P19,500 + P9,800 / (1+IRR) + P10,300 / (1+IRR) 2 + P8,600 / (1+IRR)3

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Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 22.64%

Problem 7

The NPV of a project is the PV of the outflows minus the PV of the inflows. At a zero discount rate (and only at a
zero discount rate), the cash flows can be added together across time. So, the NPV of the project at a zero percent
required return is:

NPV = –P19,500 + 9,800 + 10,300 + 8,600

= P9,200

The NPV at a 10 percent required return is:

NPV = –P19,500 + P9,800 / 1.1 + P10,300 / 1.1 2 + P8,600 / 1.13

= P4,382.79

The NPV at a 20 percent required return is:

NPV = –P19,500 + P9,800 / 1.2 + P10,300 / 1.2 2 + P8,600 / 1.23

= P796.30

And the NPV at a 30 percent required return is:

NPV = –P19,500 + P9,800 / 1.3 + P10,300 / 1.3 2 + P8,600 / 1.33

= –P1,952.44

Notice that as the required return increases, the NPV of the project decreases. This will always be true for projects
with conventional cash flows. Conventional cash flows are negative at the beginning of the project and positive
throughout the rest of the project.

Problem 8

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The profitability index is defined as the PV of the cash inflows divided by the PV of the cash outflows. The equation
for the profitability index at a required return of 10 percent is:

PI = [P7,300 / 1.1 + P6,900 / 1.1 2 + P5,700 / 1.13] / P14,000

= 1.187

The equation for the profitability index at a required return of 15 percent is:

PI = [P7,300 / 1.15 + P6,900 / 1.152 + P5,700 / 1.153] / P14,000

= 1.094

The equation for the profitability index at a required return of 22 percent is:

PI = [P7,300 / 1.22 + P6,900 / 1.222 + P5,700 / 1.223] / P14,000

= 0.983

We would accept the project if the required return were 10 percent or 15 percent since the PI is greater than one.
We would reject the project if the required return were 22 percent since the PI is less than one.

Problem 9

At a zero discount rate (and only at a zero discount rate), the cash flows can be added together across time. So, the
NPV of the project at a zero percent required return is:

NPV = –P684,680 + P263,279 + P294,060 + P227,604 + P174,356

= P274,619

If the required return is infinite, future cash flows have no value. Even if the cash flow in one year is P1 trillion, at
an infinite rate of interest, the value of this cash flow today is zero. So, if the future cash flows have no value today,
the NPV of the project is simply the cash flow today, so at an infinite interest rate:

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NPV = –P684,680

The interest rate that makes the NPV of a project equal to zero is the IRR. The equation for the IRR of this project
is:

0 = –P684,680 + P263,279 / (1+IRR) + P294,060 / (1+IRR) 2 + P227,604 / (1+IRR)3 + P174,356 / (1+IRR)4

Using a spreadsheet, financial calculator, or trial and error to find the root of the equation, we find that:

IRR = 16.23%

Problem 10

Given the seven year payback, the worst case is that the payback occurs at the end of the seventh year. Thus, the
worst-case:

NPV = –P724,000 + P724,000 / 1.127

= –P396,499.17

The best case has infinite cash flows beyond the payback point. Thus, the best-case NPV is infinite.

Answer to Multiple Choice Questions

1. B 5. C 9. B

2. A 6. D 10. B

3. B 7. D 11. D

4. C 8. B

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CHAPTER 18

ASSESSING LONG-TERM DEBT,

EQUITY AND CAPITAL STRUCTURE

Answer to Questions

17. Capital structure is the composition of a firm’s financing, which consists of its permanent sources of
capital.
18. The financial manager’s objective in making capital structure decisions is to find the financing mix that
maximizes the market value of the firm. This structure is called the optimal capital structure.
19. Under idealized conditions with no income taxes, the traditional approach to capital structure suggests
that there is an optimal capital structure which simultaneously maximizes the firm’s market value and
minimizes its weighted average cost of capital.
Under idealized conditions with no income taxes, the Modigliani and Miller model implies that the total
market value and cost of capital are independent of a firm’s capital structure.

Under idealized conditions with corporate income taxes, the Modigliani and Miller model concludes that
leverage affects value, and that firms should be financed with virtually all debt.

Under relaxed assumptions, the contemporary approach suggests that there is an optimal range for the
capital structure of the firm. If the firm finances outside this range, the value of the firm will decline.

20. Choosing an optimal or target capital structure involves tradeoff among opposing benefits and costs and
requires the use of both analytical techniques and informed judgment.
21. A firm can analyze its capital structure by performing an EBIT – EPS analysis; assessing risk associated with
various capital structures; computing debt management ratios and comparing them with industry
standards; and seeking the opinion of lenders, investment analysts, and investment bankers. EBIT – EPS
analysis is useful for evaluating the sensitivity of EPS to changes in EBIT under various financing plans.
22. The indifference point is the EBIT level at which EPS is equal under alternate financing plans. This point
may be found either graphically or mathematically.
23. EBIT – EPS analysis may be criticized because it does not directly consider the long-run financial
consequences of financing alternatives and concentrates on earnings maximization rather than wealth
maximization.
24. Capital structure decisions are tempered by such considerations as cash flow, market conditions,
profitability and stability, control, management preferences, financial flexibility, and business risk.

Answer to Problems

Problem 1

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For the following problem, assume that:

kd = Cost of debt
I = Interest
ks = Cost of equity
V = Market value of the firm
ka = Weighted average cost of capital
EBI = Earnings before interest and taxes
T
(a) Substituting kd = 0.08 and I = P80,000 and solving for D, the market value of debt is:

0.08 = P80,000

D
= P80,000
D
0.08
=
P1,000,000

Substituting EBIT = P800,000, I = P80,000, and k s = 0.12, the market value of equity is:

P800,000 − P80,000
S =
0.12
P720,000
=
0.12
= P6,000,000

Substituting D = P1,000,000 and S = P6,000,000, the total market value of the firm is:

V = P1,000,000 + P6,000,000

= P7,000,000
(b) Substituting EBIT = P800,000 and V = P7,000,000, the weighted average cost of capital is:

P800,000
ka =
P7,000,000
=
0.1143 or 11.43%

Problem 2

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(a) Substituting kd = 0.08 and I = P200,000 and solving for D, the market value of debt is:
0.08
P200,000
=
D
P200,000
D =
0.08
=

P2,500,000

Substituting EBIT = P800,000, I = P200,000, and k s = 0.125, the market value of equity is:

P800,000 − P200,000
S =
0.125
P600,000
=
0.125
= P4,800,000

Substituting D = P2,500,000 and S = P4,800,000, the total market value of the firm is:

V = P2,500,000 + P4,800,000

= P7,300,000

(b) Substituting EBIT = P800,000 and V = P7,300,000, the weighted average cost of capital is:

P800,000
ka =
P7,300,000
=
0.1096 or 10.96%

(c) The market value of the firm (V) has increased and the weighted average cost of capital (k a) has decreased
with the use of additional debt. Thus, the firm is operating in a world as viewed by the traditionalists.

Problem 3

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(a) According to the MM approach, the market value of the firm remains unchanged at P7,000,000 with
increased leverage.
(b) According to the MM approach, the weighted average cost of capital remains unchanged at 11.43 percent
with increased leverage.
(c) Substituting V = P7,000,000 and D = P2,500,000 and solving for S, the market value of ordinary equity
share outstanding is:
P7,000,000 = P2,500,000 + S

S = P7,000,000 − P2,500,000

= P4,500,000

Substituting EBIT = P800,000, I = P200,000, and S = P4,500,000, the cost of equity is:

= P800,000 − P200,000
ks
P4,500,000

= 0.1333 or 13.33%

Problem 4

(a) Since the firm has no debt, the market value of the firm is found by multiplying the ordinary equity share
selling price per share by the number of shares outstanding:
S = (P25) (400,000)

= P10,000,000

(b) Substituting EBIT = P1,500,000 and S = P10,000,000, the cost of equity is:

P1,500,000
ks =
P10,000,000
=

0.1500 or 15.00%

Problem 5

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(a) Weighted Average Costs of Capital Computation

Source of
Capital A B
Debt (0.30 x 0.08) = 24% (0.60 x 0.10) = 6%
Equity (0.70 x 0.14) = 9.8% (0.40 x 0.18) = 7.2%
Total 12.2% 13.2%

(b) Capital Structure A is less costly.

Problem 6

(a) The value of Rocky Road Corporation with no leverage is:

Value of the firm (P750,000) (1− 0.34)

with no leverage =
0.15

P495,000
=
0.15

= P3,300,000

(b) 1. The value of Rocky Road Corporation with P1,000,000 in debt is:

Value of the firm

with leverage =
P3,300,000 + (0.34) (P1,000,000)

= P3,640,000

2. The total market value with P2,000,000 in debt is:

Value of the firm

with leverage = P3,300,000 + (0.34) (P2,000,000)

= P3,980,000

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Due to the tax shelter, the firm is able to increase its value in a linear manner with more debt.

Problem 7

(a) The market value of the firm under each capital structure is:

Capital
Structure Vu NTD FD V1
A P40,000,000 + P 600,000 − P 0 = P40,600,000
B P40,000,000 + P1,200,000 − P 100,000 = P41,100,000
C P40,000,000 + P2,400,000 − P 250,000 = P42,150,000
D P40,000,000 + P3,600,000 − P 800,000 = P42,800,000
E P40,000,000 + P4,200,000 − P2,000,000 = P42,200,000
F P40,000,000 + P5,400,000 − P5,000,000 = P40,400,000

Capital Structure D is preferred because it provides the greatest market value of the firm.

(b) The major problem in using the contemporary approach is estimating the various inputs. This approach is
relatively easy to apply in theory but difficult to use in practice.

Problem 8

(a) Substituting I = P720,000 (0.09 x P8,000,000), the financial break-even point under Plan A is:

Plan A Fb = P720,000

Under Plan B, the firm does not have any fixed financial costs (interest or preferred share dividends). Thus
the financial breakeven point under Plan B is:

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Plan B Fb = P 0

(b) The EBIT – EPS indifference point is:

EPS (debt) = EPS (ordinary equity share)

(EBIT* – P720) (1 − 0.34) – P 0

(EBIT* – P 0) (1 − 0.34) – P 0
500
750

0.66 EBIT* – P475.20 = 0.66 EBIT*

Cross multiplying: =
500 750
(750) (0.66 EBIT* – P475.20) = (500) (0.66 EBIT*)
495 EBIT* – P356,400 = 330 EBIT*
165 EBIT* = P356,400
EBIT* = P2,160 (in thousands)
or P2,160,000

(c) The EPS are calculated as follows:

Plan B:
Plan A: Ordinary
Debt Equity Share
EBIT P2,750,000 P2,750,000
Less: Interest on new debt 720,000 0
Earnings before taxes 2,030,000 2,750,000
Less: Income taxes (34%) 690,200 935,000
Net income P1,339,800 P1,815,000

Ordinary equity shares 500,000 750,000

Earnings per share P2.68 P2.42

(d) Valdez Sporting Goods should adopt Plan A if it can be reasonably sure that the EBIT will not drop below
the indifference point. Although Plan A results in a higher EPS than Plan B, debt financing involves greater
risk than ordinary equity share financing.

Problem 9

(a) The interest on existing debt is P2,200,000 (0.11 x P20,000,000) and the interest on the new debt is
P1,000,000 (0.10 x P10,000,000). Substituting I 1 = P3,200,000, I 2 = P2,200,000, PD = P525,000 (P5.25 x
100,000), T = 0.34, n1 = 2,000,000, and n2 = 2,500,000 (with thousands of pesos omitted), the EBIT – EPS
indifference point is:

EPS (debt) = EPS (ordinary equity share)

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(EBIT* – P3,200) (1 − 0.34) – P525 (EBIT* – P2,200) (1 − 0.34) – P525

=
2,000 2,500

0.66 EBIT* – P2,112 – P525 0.66 EBIT* – P1,452 – P525

=
2,000 2,500

Cross multiplying:
(2,500) (0.66 EBIT* – P2,637) = (2,000) (0.66 EBIT* – P1,977)
1,650 EBIT* – P6,592,500 = 1,320 EBIT* – 3,954,000
330 EBIT* = P2,638,500
EBIT* = P7,995.455 (in thousands)
or P7,995,455

(b) No. The difference point only identifies the level of EBIT where the EPS of two financing alternatives are
equal. The risk associated with the financing alternatives is not reflected by the indifference point.
(c) Using the maximization of EPS as the criterion, ordinary equity share financing would be favored below
P7,995,455 and debt financing above P7,995,455.
(d) Substituting ri = P7,995,455, ȓ = P9,500,000, and σ = P1,500,000, the z value is:

z P7,995,455 – P9,500,000
=
P1,500,000

– P1,504,545
=
P1,500,000
= – 1.00 (rounded)

The area under the normal curve with a z = – 1.00 is 0.3413. The probability that EBIT will be below the
indifference point of P7,995,455 is 0.1587 (0.5000 – 0.3413), or 15.87 percent.

(e) The EPS are calculated as follows:

Plan 2:
Plan 1: Ordinary
Debt Equity Share
EBIT P9,500,000 P9,500,000
Less: Interest on existing debt 2,200,000 2,200,000
Interest on new debt 1,000,000 0

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Earnings before taxes 6,300,000 7,300,000

Less: Income taxes (34%) 2,142,000 2,482,000
Net income 4,158,000 4,818,000
Less: Preferred share dividends 525,000 525,000
Earnings available to ordinary
equity shareholders P3,633,000 P4,293,000
Ordinary equity shares 2,000,000 2,500,000
Earnings per share P1.82 P1.72

(f) If the expected EBIT is P9,500,000, debt financing should be recommended because it provides a higher
EPS than ordinary equity share financing with an acceptable level of risk. There is a 15.87 percent
probability that the indifference point will not be reached.

Answer to Multiple Choice Questions

1. D 4. B 7. D 10. D

2. D 5. B 8. C

3. A 6. D 9. A

CHAPTER 19

SOURCES OF LONG-TERM FINANCING

Answer to Questions

25. In 1978, the average manufacturing corporation had its interest covered almost eight times. By the mid
1990s, the ratio had been cut in half.
26. The bond agreement specifies basic items such as the par value, the coupon rate, and the maturity date.
27. The priority claims are:

Preferred Senior Secured Debt Senior Debenture Subordinated

Debenture
Share

Subordinated Junior Secured Debt Senior Secured Debt Preferred

Debenture
Share

Ordinary Equity Share Senior Junior Secured Debt Ordinary Equity Share

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Debenture

28. The method of “bond repayment” reduces debt and increases the amount of ordinary equity share
outstanding is called bond conversion.
29. The purpose of serial and sinking fund payments is to provide an orderly procedure for the retirement of a
debt obligation. To the extent bonds are paid off over their life, there is less risk to the security holder.
30. The different bond yield terms may be defined as follows:
Coupon rate is the stated interest rate divided by par value.

Current yield is the stated interest rate divided by the current price of the bond.

Yield to maturity is the interest rate that will equate future interest payments and payment at maturity to
a current market price.

31. The higher the rating on a bond, the lower the interest payment that will be required to satisfy the
bondholder.
32. Refer to pages 503 through 524.
33. Capitalizing lease payments means computing the present value of future lease payments and showing
them as an asset and liability on the statement of financial position.
34. Founders’ share may carry special voting rights that allow the original founders to maintain voting
privileges in excess of their proportionate ownership.
35. The preemptive right provides current shareholders with a first option to buy new shares. In this fashion,
their voting right and claim to earnings cannot be diluted without their consent.
36. The actual owners have the last claim to any and all funds that remain. If the firm is profitable, this could
represent a substantial amount. Thus, the residual claim may represent a privilege as well as a potential
drawback. Generally, other providers of capital may only receive a fixed amount.
37. Preferred share is a “hybrid” or intermediate form of security possessing some of the characteristics of
debt and ordinary equity share. The fixed amount provision is similar to debt, but the noncontractual
obligation is similar to ordinary equity share. Though the preferred shareholder does not have an
ownership interest in the firm, the priority of claim is higher than that of the ordinary shareholder.
38. Most corporations that issue preferred share do so to achieve a balance in their capital structure. It is a
means of expanding the capital base of the firm without diluting the ordinary equity share ownership
position or incurring contractual debt obligations.
39. Preferred share may offer a slightly lower yield than bonds in spite of greater risk because corporate
recipients of preferred share dividends must add only 30 percent of such dividends to its taxable income.
Thus, 70 percent of such dividends are exempt from taxation.
40. With the cumulative feature, if preferred share dividends are not paid in any one year, they accumulate
and must be paid in total before ordinary equity shareholders can receive dividends. Even though
preferred share dividends are not a contractual obligation as is true of interest debt, the cumulative
feature tends to make corporations very aware of obligations to preferred shareholders. Preferred
shareholders may even receive new securities for forgiveness of missed dividend payments.

Answer to Problems

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Problem 1

Coupon P90 interest

(a) =
rate
P1,000 par
=

9%

Current P90 interest

(b) =
rate/yield P820 market price
= 10.98%

Approximate Annual Interest Principal Payment – Price of the Bond

(c) Payment +
Yield = Number of Years to Maturity
to Maturity
.6 (Price of the Bond) + .4 (Principal Payment)

P1,000 − P820
P90 +
5
=
.6 (P820) + .4 (P1,000)

P180
P90 +
=
5

P492 + P400

P90 + P36
=
P892

P126
=
P892

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= 14.13%

Problem 2

Bond A Bond B
(a)

Current P80 interest Current P85 interest

=
rate/yield = rate/yield
P800 market price P900 market price
= 10% = 9.44%

(b) The bond that the investor should select is Bond A because it has a higher current yield.

Approximate Annual Interest Principal Payment – Price of the Bond

(c) = Payment +
Yield Number of Years to Maturity
.6 (Price of the Bond) + .4 (Principal Payment)
to Maturity
P1,000 − P900
P85 +
=
2
.6 (P900) + .4 (P1,000)

P100
P85 +
=
P540 + by
P4002
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(d) Yes. Bond B now has the higher yield to maturity. This is because the P100 discount will be recovered over
only two years. With Bond A, there is a P200 discount, but a 10-year recovery period.

Problem 3

(a) PV of P1,000 for: n = 20, i = 11%, PV IF = .124

P1,000

x .124

(b) PV of P1,000 for: n = 20, i = 9%, PVIF = .178

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P1,000

x .178

(c) PV of P1,000 for: n = 20, i = 13%, PV IF = .087

P1,000

x .087

Problem 4

Note:

Life of the asset is 15 years, not 5 years.

Since one of the five criterias that is the length of the lease contract is 10 years and the economic life of the asset is
15 years, the arrangement constitutes a major part of the asset’s life, for compulsory treatment as a capital lease is
indicated; the transaction must be treated as a capital lease.

Problem 5

(a) Determine 10-year annuity that will yield 12%:

A = PVA/PVIFA (i = 12%, n = 10)

P900,000
=
5.650

= P159,292

(b) The 10% deduction reduces the net cost to P810,000.

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Original cost P900,000

10% 90,000

Annual lease P810,000

=
payment
5.650
=

P143,362.80

Problem 6

Since the dividends grow at 9.8 percent, the next three annual dividends will be:

D1 = P1.68 (1.098) D2 = P1.84 (1.098) D3 = P2.03(1.098)

= P1.84 = P2.03 = P2.22

Discounting these cash flows results in a value of:

P1.84 P2.03 P2.22 + P72

Po = + +
1 + 0.135 (1 + 0.135) 2 (1 + 0.135) 3

= P1.63 + P1.58 + P50.76

= P53.96
At the current P54 per share price, the equity share does not appear undervalued. It appears fairly valued.

Problem 7

It is not initially clear whether this will be good or bad news for the equity share price. A rise in the growth rate
increases the equity share’s value. But a higher required return lowers the value. The two changes somewhat
offset one another. Since the current P70 equity share price is fair, investors require a return of 11.5 percent (1.75
÷ 70 + 0.09) before the announcement. After the announcement, investors will require a 12.7 percent return
(0.115 + 0.012) and expect a 10 percent growth rate. Therefore, the new equity share price should be P64.81 per
share, a decline of P5.19 (− 7.4 percent).

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P1.75
Po = 0.127 − 0.10

= P64.81

This was bad news for the equity share price.

Problem 8

Founder’s family votes = Shared owned x 10

= 51,325 (10)

= 513,250

Class B votes = Total votes – Founder’s family shares

= 1,200,000 – 51,325

= 1,148,675

Founder’s family votes 513,250

=
Class B votes 1,148,675
= 44.68%

Problem 9

(a) Treasury bonds = 9% (1 − .35)

= 9% (.65)

= 5.85%

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(b) Corporate bonds = 12% (1 − .35)

= 12% (.65)

= 7.80%

(c) Preferred share = Dividends reserved by a corporation from another corporation is not taxable in the
Philippines. The yield is therefore 10% also.

The preferred share should be selected because it provides the highest after-tax return.

Problem 10

(a) Preferred share P100,000

Dividend yield 8%

Dividend P8,000

After-tax income P8,000

(b) Loan P100,000

Interest expense 10%

Interest P 10,000

x (1 – T) 66%

After-tax borrowing cost P 6,600

(c) Yes, the after-tax income exceeds the after-tax borrowing cost. Of course, other factors may be considered as
well.

Problem 11

Dividend P8,000

After-tax income P8,000

Interest P 10,000
P10,000 Interest
x (1 – T) (1 – 34%) 66%
or 3,400 Tax shield

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After-tax borrowing cost 8,500

P 6,600

No, the after-tax income is now less than the after-tax borrowing.

Problem 12

The annual interest payment of P140 is computed by multiplying the coupon rate of 14 percent by the P1,000 par
value of the bond.

Problem 13

The bond will sell at a premium because the required rate of return is less than the bond’s coupon rate. Thus,
investors are willing to pay more for this bond because it pays more interest than newly issued bonds with similar
characteristics.

Problem 14

(a) Bond Y should have the greater price sensitivity to a change in the required rate of return because of its longer
maturity. That is, the present value of future cash flows is more affected by changes in discount rates than less
distant cash flows.

(b) The intrinsic value of each bond is as follows:

For Bond X, when I = P80, kd = 9 percent, and n = 5

Po = (P80) (3.890) + (P1,000) (0.650)

= P311.20 + P650

= P961.20

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For Bond Y, when I = P80, kd = 9 percent, and n = 15

Po = (P80) (8.060) + (P1,000) (0.275)

= P644.80 + P275

= P919.80

(c) Each bond sold for its par value of P1,000 before the change in the required rate of return. Bond Y would
decline in value by P80.20 (P1,000 – P919.80) compared to a P38.80 (P1,000 – P961.20) decline for Bond X.

Problem 15

The required rate of return is:

Dp
Po =
kp

Solve for kp:

kp Dp
=
Po

=
P6.75

P75.25

= 8.97%

Problem 16

Substituting Dp = P2.60 and ks = 0.13, the current value is:

P2.60
=
Po 0.13
= P20.00

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Problem 17

Using the Gordon constant growth dividend model, the current value of a share of Zeth Industries is:

(a) For D1 = P1.32 (P1.20 x 1.10), ks = 0.15, and g = 0.10

P1.32
Po =
0.15 – 0.10
= P26.40

(b) For D1 = P1.30 (P1.20 x 1.085), ks = 0.15, and g = 0.085

P1.30
Po =
0.15 – 0.085
= P20.00

(c) For D1 = P1.35 (P1.20 x 1.125), ks = 0.15, and g = 0.125

P1.35
Po =
0.15 – 0.125
= P54.00

Answer to Multiple Choice Questions

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1. A 4. B 7. B 10. D

2. B 5. C 8. A

3. D 6. C 9. B

CHAPTER 20

SHARING FIRM WEALTH:

DIVIDENDS, SHARE REPURCHASES
AND OTHER PAYOUTS

Answer to Questions

41. The marginal principle of retained earnings suggests that the corporation must do an analysis of whether
the corporation or the shareholders can earn the most on funds associated with retained earnings. Thus,
we must consider what the shareholders can earn on other investments.
42. The shareholder would appear to consider dividends as relevant. Dividends do resolve uncertainty in the
minds of investors and provide information content. Some shareholders may say that the dividends are
relevant, but in a different sense. Perhaps they prefer to receive little or no dividends because of the
immediate income tax and higher tax rate imposed on cash dividends.
43. The relationship between a company’s growth possibilities and its dividend policy is that, the greater a
company’s growth possibilities, the more funds that can be justified for profitable internal reinvestment.
44. Management’s desire for control could imply that a closely held firm should avoid dividends to minimize
the need for outside financing. For a larger firm, management may have to pay dividends in order to
maintain their current position through keeping shareholders happy.
45. The asset base remains the same and the shareholders’ proportionate interest is unchanged (everyone
got the same new share). Earnings per share will go down by the exact proportion that the number of
shares increases. If the P/E ratio remains constant, the total value of each shareholder’s portfolio will not
increase.
The only circumstances in which a stock dividend may be of some usefulness and perhaps increase value
is when dividends per share remain constant and total dividends go up, or where substantial information
is provided about a growth company. A stock split may have some functionality in placing the company
into a lower “stock price” trading range.

46. A corporation can make a rational case for purchasing its own equity share as an alternate to a cash
dividend policy. Earnings per share will go up and if the P/E ratio remains the same, the shareholder will
receive the same peso benefit as through a cash dividend. Because the benefits are in the format of
capital gains, the tax rate will be lower and the tax may be deferred until the equity share is sold.

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A corporation also may justify the repurchase of its own equity share because it is at a very low price, or
to maintain constant demand for the shares. Reacquired shares may be used for employee options or as a
part of a tender offer in a merger or acquisition. Firms may also reacquire part of their equity share as
protection against a hostile takeover.

47. Dividend reinvestment plans allow corporations to raise funds continually from present shareholders. This
reduces the need for some external funds. These plans allow shareholders to reinvest dividends at low
costs and to buy fractional shares, neither of which can be easily accomplished in the market by an
individual. The strategy of dividend reinvestment plans allows for the compounding of dividends and the
accumulation of ordinary equity share over time.
48. Dividend policy determines the distribution of a firm’s earnings between retention and dividend payments
to shareholders.
49. The three major arguments favoring the relevance of dividends are: (1) the “bird-in-the-hand” theory, (2)
the informational content effect, and (3) the clientele effect.
50. The residual theory of dividends states that a firm will pay dividends only if acceptable investment
opportunities for these funds are currently unavailable.
51. Numerous factors influence a firm’s choice of dividend policy, including legal, contractual, and internal
constraints; investment opportunities and growth prospects; alternative sources of capital; owner
considerations, including their preferences and desire for control; the cost of selling equity share; the
earnings record; and legal listing.
52. Managers generally prefer a stable peso amount of dividends because they believe that this policy leads
to higher equity share prices and avoids erroneous informational content.
53. Both a stock dividend and a stock split are ways of distributing shares to ordinary equity shareholders. In
theory, they do not increase shareholder wealth. However, they can convey information to investors. The
only real difference between a stock dividend and a stock split is their accounting treatment. Firms may
issue stock dividends or splits to conserve cash, to supplement cash dividends, and to broaden the
ownership base of their equity share.
54. The decision to repurchase shares may be viewed as an alternative to the payment of a cash dividend.
Firms repurchase their own equity share to increase their earnings and market price per share.
Repurchased shares are also used for mergers and acquisitions, stock dividends, and equity share option
plans. Management may repurchase shares because they believe that their shares are currently
undervalued.
55. Corporations may use dividend reinvestment plans to improve shareholder goodwill, to provide market
support for their equity share, to broaden their investor base, and to raise new equity capital. Dividend
reinvestment plans help shareholders reinvest dividends at minimal costs.
56. The goal of dividend policy is to maximize its contribution toward increasing shareholder wealth.
57. Dividend policy deals with the timing of dividend payments, not the amounts ultimately paid. Dividend
policy is irrelevant when the timing of dividend payments doesn’t affect the present value of all future
dividends.
58. A stock repurchase reduces equity while leaving debt unchanged. The debt ratio rises. A firm could, if
desired, use excess cash to reduce debt instead. This is a capital structure decision.
59. Friday, December 29 is the ex-dividend day. Remember not to count January 1 because it is a holiday, and
the exchanges are closed. Anyone who buys the equity share before December 29 is entitled to the
dividend, assuming they do not sell it again before December 29.
60. The change in price is due to the change in dividends, not due to the change in dividend policy. Dividend
policy can still be irrelevant without a contradiction.

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Answer to Problems

Problem 1

The after-tax dividend is the pretax dividend times one minus the tax rate, so:

After-tax dividend = P4.60 (1 – .15)

= P3.91

The equity share price should drop by the after-tax dividend amount, or:

Ex-dividend price = P80.37 – 3.91

= P76.46

Problem 2

(a) The shares outstanding increases by 10 percent, so:

New shares outstanding = 30,000 (1.10)
= 33,000

New shares issued = 3,000

Since the par value of the new shares is P1, the capital surplus per share is P29. The total capital surplus is
therefore:

Capital surplus on new shares = 3,000 (P29)

= P87,000

Ordinary equity share (P1 par value) P 33,000

Capital surplus 372,000
Retained earnings 559,180
P964,180

(b) The shares outstanding increases by 25 percent, so:

New shares outstanding = 30,000 (1.25)

= 37,500

New shares issued = 7,500

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Since the par value of the new shares is P1, the capital surplus per share is P29. The total capital surplus is
therefore:

Capital surplus on new shares = 7,500 (P29)

= P217,500

Ordinary equity share (P1 par value) P 37,500

Capital surplus 502,500
Retained earnings 424,180
P964,180

Problem 3

(a) To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to
old shares, so:

New shares outstanding = 30,000 (4/1)

= 120,000

The equity accounts are unchanged except the par value of the equity share is changed by the ratio of new
shares to old shares, so the new par value is:

New par value = P1 (1/4)

= P0.25 per share

(b) To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new shares to
old shares, so:

New shares outstanding = 30,000 (1/5)

= 6,000
The equity accounts are unchanged except the par value of the equity share is changed by the ratio of new
shares to old shares, so the new par value is:

New par value = P1 (5/1)

= P5.00 per share

Problem 4

To find the new equity share price, we multiply the current equity share price by the ratio of old shares to new
shares, so:

(a) P90 (3/5) = P54.00

(b) P90 (1/1.15) = P78.26
(c) P90 (1/1.425) = P63.16
(d) P90 (7/4) = P157.50

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(e) To find the new shares outstanding, we multiply the current shares outstanding times the ratio of new
shares to old shares, so:

(a) 350,000 (5/3) = 583,333

(b) 350,000 (1.15) = 402,500
(c) 350,000 (1.425) = 498,750
(d) 350,000 (4/7) = 200,000

Problem 5

(a) Let x be the ordinary income tax rate. The individual receives an after-tax dividend of:
After-tax dividend = P1,000 (1 – x)

which she invests in Treasury bonds. The Treasury bond will generate after-tax cash flows to the investor of:

After-tax cash flow from Treasury bonds = P1,000 (1 – x) [1 + .06(1 – x)]

If the firm invests the money, its proceeds are:

Firm proceeds = P1,000 [1 + .06 (1 – .35)]

And the proceeds to the investor when the firm pays a dividend will be:

Proceeds if firm invests first = (1 – x) {P1,000[1 + .06(1 – .35)]}

To be indifferent, the investor’s proceeds must be the same whether she invests the after-tax dividend or
receives the proceeds from the firm’s investment and pays taxes on that amount. To find the rate at which the
investor would be indifferent, we can set the two equations equal, and solve for x. Doing so, we find:

P1,000 (1 – x)[1 + .06(1 – x)] = (1 – x){P1,000[1 + .06(1 – .35)]}

1 + .06(1 – x) = 1 + .06 (1 – .35)

x = .35 or 35%

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Note that this argument does not depend upon the length of time the investment is held.

(b) Yes, this is a reasonable answer. She is only indifferent if the after-tax proceeds from the P1,000 investment in
identical securities are identical. That occurs only when the tax rates are identical.

(c) Since both investors will receive the same pre-tax return, you would expect the same answer as in part (a). Yet,
because Woodrose enjoys a tax benefit from investing in equity share (70 percent of income from equity share
is exempt from corporate taxes), the tax rate on ordinary income which induces indifference, is much lower.
Again, set the two equations equal and solve for x:

P1,000 (1 – x)[1 + .09 (1 – x)] = (1 – x) (P1,000{1 + .09[.70 + (1 – .70) (1 – .35)]})

1 + .09 (1 – x) = 1 + .09 [.70 + (1 – .70) (1 – .35)]
x = .1050 or 10.50%

(d) It is a compelling argument, but there are legal constraints, which deter firms from investing large sums in
equity share of other companies.

Problem 6

Assuming no capital gains tax, the after-tax return for the FYI Company is the capital gains growth rate, plus the
dividend yield times one minus the tax rate. Using the constant growth dividend model, we get:

After-tax return = g + D (1 – t)
= .15
Solving for g, we get:

.15 = g + .05 (1 – .35)

g = .1175

The equivalent pretax return for FYI Company, which pays no dividend, is:

Pretax return = g + D

= .1175 + .05

= .1675 or 16.75%

Problem 7

(a) If the company makes a dividend payment, we can calculate the wealth of a shareholder as:

Dividend per share = P9,000/1,000 shares

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= P9.00

The equity share price after the dividend payment will be:

PX = P64 – 9
= P55 per share

The shareholder will have an equity shares worth P55 and a P9 dividend for a total wealth of P64. If the
company makes a repurchase, the company will repurchase:
Shares repurchased = P9,000/P64
= 140.63 shares

If the shareholder lets their shares be repurchased, they will have P64 in cash. If the shareholder keeps their
shares, they are still worth P64.

(b) If the company pays dividends, the current EPS is P1.30, and the P/E ratio is:
P/E = P55/P1.30
= 42.31
If the company repurchases equity share, the number of shares will decrease. The total net income is the EPS
times the current number of shares outstanding. Dividing net income by the new number of shares outstanding,
we find the EPS under the repurchase is:
EPS = P1.30 (1,000) / (1,000  140.63)
= P1.51

The equity share price will remain at P64 per share, so the P/E ratio is:
P/E = P64/P1.51
= 42.31
A share repurchase would seem to be the preferred course of action. Only those shareholders who wish to sell
will do so, giving the shareholder a tax timing option that he or she does not get with a dividend payment.

Problem 8

Since the P2,000,000 cash is after corporate tax, the full amount will be invested. So, the value of each alternative is:

Alternative 1:

The firm invests in T-bills or in preferred share, and then pays out as special dividend in 3 years.

a. 1. If the firm invests in T-Bills:

If the firm invests in T-bills, the after-tax yield of the T-bills will be:

After-tax corporate yield = .05 (1 – .35)

= .0325 or 3.25%

So, the future value of the corporate investment in T-bills will be:

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FV of investment in T-bills = P2,000,000 (1 + .0325) 3

= P2,201,406.16

Since the future value will be paid to shareholders as a dividend, the after-tax cash flow will be:
After-tax cash flow to shareholders = P2,201,406.16 (1 – .15)
= P1,871,195.23

a. 2. If the firm invests in preferred share (Assumption: 30 percent of dividend taxable):

If the firm invests in preferred share, the assumption would be that the dividends received will be reinvested
in the same preferred share. The preferred share will pay a dividend of:

Preferred dividend = .08 (P2,000,000)

= P160,000

Since 70 percent of the dividends are excluded from tax:

Taxable preferred dividends = (1 – .70) (P160,000)

= P48,000

And the taxes the company must pay on the preferred dividends will be:

Taxes on preferred dividends = .35 (P48,000)

= P16,800

So, the after-tax dividend for the corporation will be:

After-tax corporate dividend = P160,000 – 16,800

= P143,200

This means the after-tax corporate dividend yield is:

After-tax corporate dividend yield = P143,200 / P2,000,000

= .0716 or 7.16%

The future value of the company’s investment in preferred share will be:

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FV of investment in preferred share = P2,000,000 (1 + .0716) 3

= P2,461,093.48

Since the future value will be paid to shareholders as a dividend, the after-tax cash flow will be:

After-tax cash flow to shareholders = P2,461,093.48 (1 – .15)

= P2,091,926.46

Alternative 2:

The firm pays out dividend now, and individuals invest on their own. The after-tax cash received by
shareholders now will be:

After-tax cash received today = P2,000,000 (1 – .15)

= P1,700,000

The individuals invest in Treasury bills:

If the shareholders invest the current after-tax dividends in Treasury bills, the after-tax individual yield will
be:

After-tax individual yield on T-bills = .05 (1 – .31)

= .0345 or 3.45%

So, the future value of the individual investment in Treasury bills will be:

FV of investment in T-bills = P1,700,000 (1 + .0345)3

= P1,882,090.08

The individuals invest in preferred share:

If the individual invests in preferred share, the assumption would be that the dividends received will be
reinvested in the same preferred share. The preferred shares will pay a dividend of:

Preferred dividend = .08 (P1,700,000)

= P136,000

And the taxes on the preferred dividends will be:

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Taxes on preferred dividends = .31 (P136,000)

= P42,160

So, the after-tax preferred dividend will be:

After-tax preferred dividend = P136,000 – 42,160

= P93,840

This means the after-tax individual dividend yield is:

After-tax corporate dividend yield = P93,840 / P1,700,000

= .0552 or 5.52%

The future value of the individual investment in preferred share will be:

FV of investment in preferred share = P1,700,000 (1 + .0552) 3

= P1,997,345.84

The after-tax cash flow for the shareholders is maximized when the firm invests the cash in the preferred
shares and pays a special dividend later.

Problem 9

(a) The earnings per share were:

P3,000,000
=
EPS
1,500,000
= P2.00

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(b) The dividends per share were:

DPS = (0.20) (P2.00)

= P0.40

Problem 10

The dividend payout is computed by dividing the yearly dividends per share by the earnings per share.

Dividend (4) (P0.25)

=
payout
ratio P2.50
=

0.40 or 40%

Problem 11

To maintain the capital structure, the investment must be funded as follows:

Required debt (0.30) (P7,000,000) = P2,100,000

Required equity (0.40) (P7,000,000) = P4,900,000

To provide the P4,900,000 in required equity, Glee Mining Company must retain the entire P4,000,000 in earnings
and issue new equity share for the remaining P900,000. By following the current dividend policy, the company will
pay no cash dividends.

Problem 12

(a) The legal limit depends on the law. If the capital impairment provisions of law are limited to the par value of
ordinary equity share, the maximum amount of dividends is P2,500,000, which is the amount of retained

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earnings (P500,000) plus capital in excess of par (P2,000,000). Otherwise, the maximum amount of dividends
is the retained earnings of P500,000. Neither amount is realistic because the company would not have the
cash available to pay.

(b) In practice, the company’s dividends could not exceed the balance of the retained earnings.

Problem 13

(a) With a stable dividend policy, Elena Company will maintain its current P1.50 cash dividend per share.

(b) With constant dividend payout ratio policy, dividends per share will be P1.75.

Dividends last year = (P1.50) (800,000)

=
P1,200,000

P1,200,000
=
Dividend payout ratio
P3,000,000
=

0.40 or 40%

Dividends this year = (P0.40) (P3,500,000)

= P1,400,000

Dividends per share P1,400,000

=
this year
P800,000
= P1.75

Problem 14

(a) The peso amount transferred from retained earnings is:

Peso amount transferred

from retained earnings

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= (200,000) (0.20) (P30)

= P1,200,000

(b) A total of 40,000 shares (0.20 x 200,000) is added to the ordinary equity share account.

(c) Of the P1,200,000 transferred from retained earnings, P120,000 (P3 par x 40,000) is added to the ordinary
equity share account, and P1,080,000 (P1,200,000 – P120,000) is added to the capital in excess of par account.
The shareholders’ equity accounts are as follows:

Ordinary equity share (240,000 shares outstanding at P3 par) P 720,000

Capital in excess of par 2,480,000
Retained earnings 2,800,000
Total shareholders’ equity P6,000,000

Problem 15

With a 3-for-1 stock split, the par value declines from P3 to P1, and the number of outstanding shares triples to
600,000 shares.

Ordinary equity share (600,000 shares outstanding at P1 par) P 600,000

Capital in excess of par 1,400,000
Retained earnings 4,000,000
Total shareholders’ equity P6,000,000

Problem 16

Dividends = Earnings – Retained funds

= P160 million – P100 million
= P60 million

Dividends
=
Payout ratio Earnings

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P60 million
=
P160 million
= 0.375 or 37.5%

Problem 17

Dividends = (Earnings x Payout ratio)

= (P800 million) (35%)
=

P280 million

Addition to
retained earnings = Earnings – Dividends
= P800 million – P280 million
=

P520 million

Problem 18

Grape Co. is not growing very fast so it does not need cash for growth unless it desires to change its policies.
Assuming it does not, Grape Co. should have a high payout ratio.

Cherry Corp. is growing very fast and needs its cash for reinvestment in assets. For this reason, Cherry should have
a low dividend payout.

Problem 19

(a) Plan A (P1.50 + 1.50 + 1.50 + 1.60 + 1.60) = P7.70

Plan B (P.50 + 2.00 +.20 + 4.00 + 1.70) = P8.40

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(b) Plan A

Dividend Per X PVIF (10%) PV

Share
1 P1.50 .909 P1.36
2 1.50 .826 1.24
3 1.50 .751 1.13
4 1.60 .683 1.09
5 1.60 .621 .99
Present Value of Future Dividends P5.81

Plan B

Dividend Per X PVIF (12%) PV

Share
1 P .50 .893 P .45
2 2.00 .797 1.59
3 .20 .712 .14
4 4.00 .636 2.54
5 1.70 .567 .96
Present Value of Future Dividends P5.68

Plan A will provide the higher present value of future dividends.

Problem 20

Annual dividend = (6.7%) (P40) = P2.68

Quarterly dividend = P2.68 / 4 = P .67

The equity share should go down by P.67 to P39.33.

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Problem 21

Retain

Incremental earnings = (15%) (P400,000)

= P60,000

P750,000 + P60,000
Earnings per share =
300,000

=
P810,000
P2.70
300,000

Price of equity share = (P/E) (EPS)

(16) (P2.70)
=
= P43.20

Payout

New P/E = (1.10) (16)

= 17.6

P750,000
Earnings per share =
300,000

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= P2.50

Price of equity share = (P/E) (EPS)

= (17.6) (P2.50)
= P44.00

The payout option provides the maximum market value.

Problem 22

(a) Eight (8) million shares would be outstanding at a par value of P5 per share. Everything else will be
the same.

(b) Twelve (12) million shares would be outstanding at a par value of P3.33 per share. Everything else
will be the same.

P14,000,000
(c)
EPS Before =
4,000,000

= P3.50 EPS

P14,000,000
EPS After 2-1 Split =
8,000,000

= P1.75 EPS

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P14,000,000
EPS After 3-1 Split =
12,000,000

= P1.17 EPS

(d) Price = (P/E) (EPS)

Price after 2-1 Split = (20) (P1.75)

= P35.00

Price after 3-1 Split = (20) (P1.17)

= P23.40

(e) Probably not. A stock split should not change the price-earnings ratio unless it is combined with a
change in dividends to the shareholders. Generally speaking, nothing of real value has taken place.
Only to the limited extent that new information content from this split increased investor’s
expectations would the stock split possibly have an impact on the P/E ratio.

Problem 23

(a) Price = (P/E) (EPS)

P5,000,000
=
EPS 1,000,000
= P5

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Price = (10) (P5)

P50
=

P4,000,000
Dividends per share =
1,000,000
(b) = P4

P4,000,000
Shares reacquired =
(c)
P54
= 74,074

(d) Shares outstanding

= 1,000,000 – 74,074
after repurchase
= 925,926

P5,000,000
EPS =
925,926
= P5.40

(e) Price = (P/E) (EPS)

= (10) (P5.40)
= P54

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The equity share price has increased by P4.

(f) No. With the cash dividend:

Market value per share P50

Cash dividend per share 4
Total value P54

With the repurchase of equity share:

Total value per share P54

(g) The (potential) appreciation in value associated with an equity share repurchase receives preferential capital
gains tax treatment whereas a cash dividend is taxed at the investor’s normal tax rate. The capital gains tax
may also be deferred until the equity share is sold.

(h) The corporation may think its shares are underpriced in the market. The purchase may stave off further
decline and perhaps even trigger a rally. Reacquired shares may also be used for employee equity share
options or as part of a tender offer in a merger or an acquisition. Firms may also reacquire part of their shares
as a protective device against being taken over as a merger candidate.

Answer to Multiple Choice Questions

1. A 4. B 7. C

2. D 5. D 8. D

3. D 6. A 9. D

CHAPTER 21

MERGERS AND ACQUISITIONS;

DIVESTITURES

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Answer to Questions

61. In a merger, two or more companies are combined, but only the identity of the acquiring firm is
maintained. In a consolidation, an entirely new entity is formed from the combined companies.
62. If two firms benefit from opposite phases of the business cycle, their variability in performance may be
reduced. Risk-averse investors may then discount the future performance of the merged firms at a lower
rate and thus assign a higher valuation than was assigned to the separate firms.
63. Horizontal integration is the acquisition of competitors, and vertical integration is the acquisition of
buyers or sellers of goods and services to the company. Antitrust policy generally precludes the
elimination of competition. For this reason, mergers are often with companies in allied but not directly
related fields.
64. Synergy is said to occur when the whole is greater than the sum of the parts. This “2 + 2 = 5” effect may
be the result of eliminating overlapping functions in production and marketing as well as meshing
together various engineering capabilities. In terms of planning related to mergers, there is often a
tendency to overestimate the possible synergistic benefits that might accrue.
65. The firm can achieve this by acquiring a company at a lower P/E ratio than its own. The firm with lower
P/E ratio may also have a lower growth rate. It is possible that the combined growth rate for the surviving
firm may be reduced and long-term earnings growth diminished.
66. If earnings per share show an immediate appreciation, the acquiring firm may be buying a slower growth
firm as reflected in relative P/E ratios. This immediate appreciation in earnings per share could be
associated with a lower P/E ratio. The opposite effect could take place when there is an immediate
dilution to earning per share. Obviously, a number of other factors will also come into play.
67. Under the “pooling of interests”, the financial statements of the firms are combined subject to some
minor adjustments and no goodwill is created. Under a “purchase of assets”, the difference between
purchase price and adjusted book value is established on the statement of financial position as goodwill
and must be written off over a maximum period of 40 years.

68. An unfriendly takeover may be avoided by:

a. Turning to a second possible acquiring company – a “White Knight”.
b. Moving corporate offices to states with tough pre-notification and protection provisions.
c. Buying back outstanding corporate equity share.
d. Encouraging employees to buy equity share.
e. Staggering the election of directors.
f. Increasing dividends to keep shareholders happy.
g. Buying up other companies to increase size and reduce vulnerability.
h. Reducing the cash position to avoid a leveraged takeover.
69. While management may wish to maintain their autonomy and perhaps keep their jobs, shareholders may
wish to get the highest price possible for their holdings.
70. The advantages of using convertible securities as a method of financing mergers are as follows:

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a. Potential earnings dilution may be partially minimized by issuing a convertible security. If such a
security is designed to sell at a premium over its conversion value, fewer common shares will
ultimately be issued. For example, if the acquirer’s share currently has a market price of P50 per
share, and the price of the acquisition is P10 million, using ordinary equity share would require
issuing 200,000 shares. In comparison, a convertible preferred issue could be designed to sell at
P100 with a 1.7 conversion ratio, which would mean a conversion value of P85. The P10 million
price would be realized by issuing 100,000 preferred shares convertible into 170,000 shares of
ordinary equity share. The purchaser would have decreased the eventual number of shares to be
issued, thereby reducing the dilution in earnings per share that could ultimately result.
b. A convertible issue may allow the acquiring company to comply with the seller’s income
objectives without changing its own dividend policy. If the two firms have different dividend
payout policies and the acquirer does not want to commit its ordinary equity share to a dividend
rate that suits the seller, convertible preferred share may be an appropriate solution.
c. Convertible preferred share also represents a possible way of lowering the voting power of the
acquired company. This reduction of voice in management can be important, especially if the
seller is a closely held corporation.
d. The convertible preferred debenture or equity share may appear more attractive to the firm
being acquired because it combines senior security protection with a portion of the growth
potential of ordinary equity share.
71. The deferred payment plan, which has come to be called an earn-out, represents a relatively recent
approach to merger financing. The acquiring firm agrees to make a specified initial payment of cash or
equity share and, if it can maintain or increase earnings, to pay additional compensation.
72. The amount of the future payments will be determined by three factors:
a. the amount of earnings in the forthcoming years in excess of the base-period profits;
b. the capitalization rate (discount rate) agreed upon by the parties; and
c. the market value of the acquiring organization at the end of each year.
73. Refer to page 605.

Answer to Multiple Choice Questions

1. C 5. B 9. B 13. A

2. D 6. D 10. A 14. C

3. A 7. D 11. D 15. D

4. D 8. C 12. B

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