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Chapter 3 Problems 3.1 through 3.8 are based on the following information: The Ruffy Stuffed Toy Company’s balance sheet at the end of 19x7 was as follows: Assets Cash Accounts Receivable Inventory Total Current Assets 119,300 Property, Plant, and Equipment Equipment Less Accumulated Depreciation



Net Equipment 22,500 Furniture Less Accumulated Depreciation



Net Furniture Total Prop, Plant, Equip Total Assets 155,800 Liabilities and Shareholders’ Equity Payables Accounts Payable Salary Payable 3,000 Utilities Payable 1,500 Loans (Long-term debt) 25,000 Total Liabilities Common Stock 45,000 Retained Earnings Total Shareholders’ Equity 61,300 Total Liabilities & Shareholders’ Equity 155,800



27,300 35,000 57,000 25,000 16,000 14,000 36,500



65,000



94,500 16,300



During 19x8, the Ruffy Stuffed Toy Company recorded the following transactions: a. Early in the year, purchased a new toy stuffing machine for $9,000 cash and signed a 3-year note for the balance of $12,000. b. Had cash sales of $115,000 and sales on credit of $316,000. c. Purchased raw materials from suppliers for $207,000. d. Made payments of $225,000 to its raw materials suppliers. e. Paid rent expenses totaling $43,000. f. Paid insurance expenses totaling $23,000. g. Paid utility bills totaling $7,500; $1,500 of this amount reversed the existing payable from 19x7. h. Paid wages and salaries totaling $79,000; $3,000 of this amount reversed the payable from 19x7. i. Paid other miscellaneous operating expenses totaling $4,000. j. Collected $270,000 from its customers who made purchases on credit. k. The interest rate on the Loan Payable is 10% per year. Interest was paid on 12/31/19x8. Other information: 1. The equipment has been estimated to have a useful life of 20 years, with no salvage value. Two years have been depreciated through 19x7. 2. The existing furniture has been estimated to have a useful life of 8 years (no salvage value), of which one year has been depreciated through 19x7. 3. The new stuffing machine has been estimated to have a useful life of 7 years, and will probably have no salvage value. 4. The tax rate is 35%, and assume that taxes are paid on 12/31/19x8.



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5. 6. 7.



Dividend payout, if possible, will be 10% of net income. Cost of Goods Sold for the year’s sales were $250,000. Ending Balance in accounts receivable = Beginning Balance  cash received from credit customers + sales on credit 8. Ending Balance in accounts payable = Beginning Balance + purchases – cash payments to suppliers 9. Ending Balance in Inventory = Beginning Balance + purchases of raw material – cost of goods sold 10. The company’s stock price at market close on 12/31/19x8 was 4 5/8. It has 20,000 shares outstanding. 3.1 3.2 3.3 3.4



Construct the balance sheet for the Ruffy Stuffed Toy Company as of 12/31/19x8. Construct the income statement for operations during the year 19x8. Construct a cash flow statement for the year 19x8. Calculate the following Profitability Ratios: Return on Sales, Return on Assets, Return on Equity 3.5 Calculate the following Asset Turnover Ratios: Receivables turnover, Inventory turnover, Asset turnover 3.6 Calculate the following Financial Leverage and Liquidity Ratios: debt, times interest earned, current ratio, quick (acid) test 3.7 What is the Ruffy’s book value per share at the end of 19x8? 3.8 Calculate the firm’s price-to-earnings ratio and the ratio of its market share price to its book value per share. SOLUTION: BALANCE SHEETS Assets Cash Accounts Receivable Inventory Total Current Assets Property, Plant, and Equipment Equipment Less Accumulated Depreciation Net Equipment Furniture Less Accumulated Depreciation Net Furniture Machine Less Accumulated Depreciation Net Machine Total Prop, Plant, Equip Total Assets



19x7



19x8



27,300 35,000 57,000 119,300



10,896.25 81,000 14,000 105,896.25



25,000 (2500) 22,500 16,000 (2000) 14000



25,000 (3,750) 21,250 16,000 (4,000) 12,000 21,000 (3,000) 18,000



36,500



51,250



155,800



Liabilities and Shareholders’ Equity Payables Accounts Payable Salary Payable Utilities Payable Note payable Loans (Long-term Debt) Total Liabilities Common Stock Retained Earnings Total Shareholders’ Equity Total Liabilities and Shareholders’ Equity



157,146.25



65,000 3,000 1,500 0 25,000 94,500 45,000 16,300 61,300



47,000 0 0 12000 25,000 84,000 45,000 28,146.25 73,146.25



155,800



157,146.25



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INCOME STATEMENT 431,000 250,000 181,000



Sales Revenue COGS Gross Margin Expenses Wages and Salaries Expense Rent Expense Insurance Expense Utility Expense Miscellaneous Operating Expense Depreciation Expense



181,000 Income Before Interest and Tax Interest Expense Taxable Income Taxes (0.35)



22,750 2,500 20,250 7,087.50



Net Income Dividends (0.1) Income after Dividends



13,162.50 1,316.25 11,846.25 CASH FLOW STATEMENT



Net Income +Dep - A/R increase + Inventory decrease - A/P decrease Total Cash Flow from Operations - Investment in PPE Total cash from investing activities - Dividends + Increase in Notes Payable Total cash from financing activities Change in Cash Flow



35000 57000 69500



81000 14000 47000



13162.5 6,250 (46,000) 43,000 (22,500) 6087.5 21000 21000 1316.25 +12000 +10683.75 16403.75



RATIOS: ROS ROA ROE Receivables Turnover Inventory Turnover Asset Turnover Debt Times Interest Earned Current Quick P/E Mkt to Book



76,000 43,000 23,000 6,000 4,000 6,250 158,250



22750 22750 13162.5 431000



431000 156473.13 67223.13 58000



0.0528 0.1454 0.1958 7.4310



250000 431000 84000 22750 105896.25 91,896.25 4.625 4.625



35500 156473.13 157146.25 2500 47000 47000 0.6581 3.6573



7.0423 2.7545 0.5345 9.1000 2.2531 1.9552 7.0278 1.2646



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3.9 You have the following information taken from the 1996 financial statements of Computronics Corporation and Digitek Corporation: (All figures are in $ millions except per share amounts.)



Net income Dividend payout ratio EBIT Interest expense Average assets Sales Average shareholders’ equity Market price of the common stock: at beginning of year at end of year Shares of common stock outstanding



Computronix 153.7 40% 317.6 54.7 2,457.9 3,379.3 1,113.3



Digitek 239.0 20% 403.1 4.8 3,459.7 4,537.0 2,347.3



$15 $12 200 million



$38 $40 100 million



Compare and contrast the financial performance of the two companies using the financial ratios discussed in this chapter. SOLUTION: To compute total shareholder returns we need to first compute dividends per share and then follow the definition— change in share price plus dividend divided by beginning share price: For Computronix the dividend per share is (.4 x $153.7 million) /200 million shares = $.3074, and total shareholder return is: ($12  $15 + .3074) /$15 = 17.95% For Digitek the dividend per share is (.2 x $239 million) /100 million shares = $.478,and total shareholder return is: ($40  $38 + .478) /$38 = 6.52% Ratios: Total Times Shareholder Interest Firm Return ROE ROA ROS ATO Earned Debt/Equity Computronix Digitek · · · ·



-17.95% 6.52%



13.8% 12.9% 9.4% 1.37 10.2% 11.7% 8.9% 1.31



5.806 83.979



1.21 0.47



Digitek offered a higher return to its shareholders than did Computronix: 6.52% vs. 17.95%, despite the fact that Computronix had a higher ROE, a higher ROA, a higher ROS, and a higher ATO. Average liabilities for Computronix were $1,344.6 million and for Digitek $1,112.4 million. Times interest earned was 5.806 for Computronix and 83.979 for Digitek. 



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3.10 Refer to the following financial statements: INCOME STATEMENT



20x6



20x7



Sales



$1,200,000



$1,500,000



COGS



750,000



937,500



Gross Margin



450,000



562,500



Advertising Expense



50,000



62,500



Rent Expense



72,000



90,000



Salesperson Commission Expense



48,000



60,000



Utilities Expense



15,000



18,750



EBIT



265,000



331,250



Interest Expense



106,000



113,000



Taxable Income



159,000



218,250



20x8e



Operating Expenses



Taxes (35%)



55,650



76,388



Net Income



103,350



141,863



Dividends (40% payout)



41,340



56,745



Change in Retained Earnings



62,010



85,118



BALANCE SHEET Assets Cash



$300,000



$375,000



Receivables



200,000



250,000



Inventory



700,000



875,000



1,800,000



2,250,000



$3,000,000



$3,750,000



$300,000



$375,000



Short-term debt (10% interest)



500,000



989,882



Long-term debt (7% interest)



800,000



900,000



1,100,000



1,100,000



Property, Plant, Equipment Total Assets Liabilities and Shareholders’ Equity Liabilities Payables



Shareholders’ Equity Common Stock Retained Earnings Total Liabilities and Equity



a. b. c. d. e.



300,000



385,118



$3,000,000



$3,750,000



Determine which items varied in constant proportion to sales between 20x6 and 20x7. Determine the rate of growth in sales that was achieved from 20x6 to 20x7. What was the firm’s return on equity for 20x7? Can you calculate it for 20x6? What was the firm’s external (additional) funding requirement determined to be for 20x7? How was the funding obtained? Prepare pro forma statements for 20x8 with the following assumptions: · Rate of growth in sales = 15% · The firm intends to pay down $100,000 of its short-term debt on Jan. 1, 20x8. · Interest rates on debt are as stated in the balance sheet, and are applied to the · the start-of-year (20x8) balances for short-term and long-term debt. Remember that the firm intends to pay down part of the short-term loan on 1/1/20x8.



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The firm’s dividend payout in 20x8 will be reduced to 30%.



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1. 2.



f.



How much additional funding will the firm need for 20x8? The firm will close 40% of any additional funding gap by issuing new stock. It will then use up to $100,000 of long-term debt, with the remainder coming from 9% short-term borrowing. Complete the pro forma balance sheet for 20x8. 3. What would be the firm’s forecasted return on equity for 20x8? Suppose the firm anticipates an increase in the corporate tax rate to 38%. Determine the amount of additional funding that would be required if this change comes to pass.



SOLUTION: a. INCOME STATEMENT Sales



20x6



20x7



20x6



20x7



$1,200,000



$1,500,000



100.0%



100.0%



COGS



750,000



937,500



62.5%



62.5%



Gross Margin



450,000



562,500



37.5%



37.5%



Advertising Expense



50,000



62,500



4.2%



4.2%



Rent Expense



72,000



90,000



6.0%



6.0%



Salesperson Commission Expense



48,000



60,000



4.0%



4.0%



Utilities Expense



15,000



18,750



1.3%



1.3%



EBIT



265,000



331,250



22.1%



22.1%



Interest Expense



106,000



113,000



8.8%



7.5%



Taxable Income



159,000



218,250



13.3%



14.6%



Taxes (35%)



55,650



76,388



4.6%



5.1%



Net Income



103,350



141,863



8.6%



9.5%



Dividends (40% payout)



41,340



56,745



3.4%



3.8%



Change in Retained Earnings



62,010



85,118



5.2%



5.7%



Operating Expenses



BALANCE SHEET



20x6



20x7



20x6



20x7



$300,000



$375,000



25.0%



25.0%



200,000



250,000



16.7%



16.7%



Assets Cash Receivables Inventory



700,000



875,000



58.3%



58.3%



1,800,000



2,250,000



150.0%



150.0%



$3,000,000



$3,750,000



250.0%



250.0%



$300,000



$375,000



25.0%



25.0%



Short-term debt (10% interest)



500,000



989,882



41.7%



66.0%



Long-term debt (7% interest)



800,000



900,000



66.7%



60.0%



1,100,000



1,100,000



91.7%



73.3%



300,000



385,118



25.0%



25.7%



$3,000,000



$3,750,000



250.0%



250.0%



Property, Plant, Equipment Total Assets Liabilities and Shareholders’ Equity Liabilities Payables



Shareholders’ Equity Common Stock Retained Earnings Total Liabilities and Equity



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(1,500,000 – 1,200,000)/1,200,000 = .25 or 25% 9.83% = (141,863/((1,400,000 + 1,485,118)/2)). Since the denominator is the average of the period beginning and ending shareholders’ equity, 20x5 ending shareholders’ equity would be needed to calculate ROE for 20x6. The retained earnings in 20x5 can be calculated: RE19x5= 300,000  62,010 = 237,990. Assuming no additional stock was issued in 20x6, hence, Common Stock19x5 = 1,100,000. ROE = (103,350/((1,337,990 + 1,400,000)/2)) = 7.55% $589,882. $489,882 was acquired from short-term debt and the remaining $100,000 from long-term debt. INCOME STATEMENT



Sales COGS Gross Margin Operating Expenses Advertising Expense Rent Expense Salesperson Commission Expense Utilities Expense EBIT Interest Expense Taxable Income Taxes (35%) Net Income Dividends (30% payout) Change in Retained Earnings BALANCE SHEET Assets Cash Receivables Inventory Property, Plant, Equipment Total Assets Liabilities and Shareholders’ Equity Liabilities Payables Short-term debt (10% interest) Long-term debt (7% interest) Shareholders’ Equity Common Stock Retained Earnings Total Liabilities and Equity 1



20x8e $1,725,000 1,078,125 646,875 $



72,450 103,500 69,000 22,425 379,500 151,9881 227,512 79,629 147,883 44,365 103,518



$ 431,250 288,075 1,005,675 2,587,500 $4,312,500



431,250 889,882



489,290 $4,312,500



Interest Expense calculated as .10*($889,882) + .07*(900,000)



1) Additional Funding = Change in Assets - Increase in RE  Increase in Payables + Decrease in Short term debt (10% interest) on 1/1/19x8 $502,078 = 562,500  104,172  56,250 + 100,000 Note that this equation takes into account the financing needed to pay down the $100,000 of the short-term debt on Jan 1, 20x8.



Instructor’s Manual 2) 20x8 balance for: Short-term debt (10%): Short-term debt (9%): Long-term debt: Common Stock:



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$889,882 $201,247 = ((502,078 x .6)  100,000) $1,000,000 = $900,000 + $100,000 $1,300,831 = (40% x 502,078 + 1,100,000)



Liabilities and Shareholders’ Equity Liabilities Payables Short-term debt (10% interest) Short-term debt (9% interest) Long-term debt (7% interest) Shareholders’ Equity Common Stock Retained Earnings Total Liabilities and Equity



20x8e 431,250 889,882 201,247 1,000,000 1,300,831 489,290 $4,312,500



Note that when using the pro forma statements to determine the required amount of additional (external) funding needed, one important assumption is made: that the debt used to satisfy the funding is acquired in total at the end of the year 20x8, though this may not be the case in real life. This assumption removes the circular reference problem between debt and the associated interest expense, because it essentially holds the interest constant. Pb 3.14 below deals with that issue. 3) Forecasted ROE for 20x8e = (148,883/((1,485,118 + 1,790,121)/2)) = 9.0% f.



Additional funding required = 562,500 – 98,740 – 56,250 + 100,000 = $507,510 The external funding requirement is larger by $5,432, which is the reduction in the increase of retained earnings brought about by the higher tax rate.



3.11 Take the pro forma statements (with tax rate = .35) developed in problem 3.10, and: a. Revise them assuming a growth rate in sales from 19x7 to 19x8 of 10%. What is the additional funding required for 19x8 under this scenario? b. Now, develop pro forma statements for 19x9 assuming a growth rate in sales of 20% from 19x8 to 19x9. What is the additional funding needed for 19x9? The firm plans to use 9 % short-term debt to cover this entire amount. SOLUTION: a. Additional Funding = Change in Assets - Increase in R/E - Increase in Payables + Decrease in Short term Debt (at 10% interest) $341,489 = 375,000  96,011  37,500 + 100,000 Note that this equation takes into account the financing needed to pay down the $100,000 of the short-term debt on Jan. 1, 19x8.



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INCOME STATEMENT Sales (assuming 10% growth over 19x7) COGS Gross Margin Operating Expenses Advertising Expense Rent Expense Salesperson Commission Expense Utilities Expense EBIT Interest Expense Taxable Income Taxes (35%) Net Income Dividends (30% payout) Change in Retained Earnings



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19x8e 1,650,000 1,031,250 618,750 69,300 99,000 66,000 21,450 363,000 151,9881 211,012 73,854 137,158 41,147 96,011



BALANCE SHEET Assets Cash Receivables Inventory Property, Plant, Equipment Total Assets Liabilities and Shareholders’ Equity Liabilities Payables Short-term debt (10% interest) Short-term debt (9% interest) Long-term debt (7% interest) Shareholders’ Equity Common Stock Retained Earnings Total Liabilities and Equity 1



Interest Expense calculated on 19x8 beginning debt balances: .10*($889,882) + .07*(900,000) 2 Calculated as: .40 x (341,489) + 1,100,000



$412,500 275,550 961,950 2,475,000 $4,125,000



$412,500 889,882 104,893 1,000,000 1,236,5962 481,129 $4,125,000



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b. INCOME STATEMENT Sales COGS Gross Margin Operating Expenses Advertising Expense Rent Expense Salesperson Commission Expense Utilities Expense EBIT Interest Expense Taxable Income Taxes (35%) Net Income Dividends (30% payout) Change in Retained Earnings



19x9e $1,980,000 1,237,500 742,500 83,160 118,800 79,200 25,740 435,600 168,4291 267,171 93,510 173,661 52,098 121,563



BALANCE SHEET Assets Cash Receivables Inventory Property, Plant, Equipment Total Assets Liabilities and Shareholders’ Equity Liabilities Payables Short-term debt (10% interest) Short-term debt (9% interest) Long-term debt (7% interest) Shareholders’ Equity Common Stock Retained Earnings Total Liabilities and Equity 1



$495,000 330,660 1,154,340 2,970,000 $4,950,000



$495,000 889,882 725,8302 1,000,000 1,236,596 602,692 $4,950,000



Interest Expense calculated on 19x9 beginning debt balances: .10*($889,882) + .07*($1,000,000) + .09*($104, 893) 2 Calculated as $104,893 balance from 19x8e + the 19x9e requirement ($620,937). The additional funding requirement for 19x9 will be: 825,000 – 122,329 – 82,500 = $620,171



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3.12 Suppose that after analyzing the results of 19x8 and preparing pro forma statements for 19x9, the Give Me Debt Company anticipates an increase in total assets of $50, an increase in retained earnings of $25, and an increase in payables of $40. Assume that other than the payables, the firm’s liabilities include short-term and long-term debt, and that its equity includes common stock and retained earnings. a. The Chief Financial Officer of the company asks you to determine the required amount of external funding in19x9. What do you tell the CFO? b. What actions can Give Me Debt Co. undertake to address the situation you have found? SOLUTION: a. You tell the CFO that the company is “over-funded” by $15. That is, the difference between the increase in assets ($50) and the increase in retained earnings plus the increase in payables is $15. (50  25  40 = 15) b. The company can take some of the retained earnings and pay them out as dividends, or it could use it to reduce any of the debt classes (payables, short-term debt, long-term debt). 3.13 Place the following planning events in their likely order of occurrence within the planning cycle: ___ Funding needs for implementation of tactical plans are estimated ___ The final firm-wide plan and budgets are completed ___ CEO and top management team establish strategic objectives for the firm (ex: increase market share from 10% to 12%) ___ Line managers devise action plans to support strategic objectives ___ Revisions are made to the strategic plan and divisional budgets based on feedback from divisional managers with regards to resource (money, people) requirements ___ Decisions are made as to which sources of external financing to tap ___ Integration of divisional budgets into a preliminary firm-wide budget by CEO and top management team ___ The firm determines the amount of required external financing ___ Tactical plans and budgets are reviewed with division management; priorities are assigned to planned activities ___ Division managers review the strategic objectives with their line (or tactical) management. SOLUTION: Place the following planning events in their likely order of occurrence within the planning cycle: _4_ Funding needs for implementation of tactical plans are estimated _8_ The final firm-wide plan and budgets are completed _1_ CEO and top management team establish strategic objectives for the firm (ex: increase market share from 10% to 12%) _3_ Line managers devise action plans to support strategic objectives _7_ Revisions are made to the strategic plan and divisional budgets based on feedback from divisional managers with regards to resource (money, people) requirements 10_ Decisions are made as to which sources of external financing to tap _6_ Integration of divisional budgets into a preliminary firm-wide budget by CEO and top management team _9_ The firm determines the amount of required external financing _5_ Tactical plans and budgets are reviewed with division management; priorities are assigned to planned activities _2_ Division managers review the strategic objectives with their line (or tactical) management.



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3.14 Suppose that the sharply abbreviated actual 19x8 and pro forma 19x9 income statement and balance sheet for Cones ‘R’ Us, an ice-cream retailer, appear as follows: INCOME STATEMENT EBIT Interest Expense Taxable Income Net Income (after taxes of .33) Dividends Change in Retained Earnings BALANCE SHEET Assets Liabilities Payables Debt Shareholders’ Equity



19x8



19x9e $100 25 75 50 20 30



$800



$1000



80 300 420



100 450 450



The $25 interest expense projected for 19x9 is based on a rate of 8.33% applied to the outstanding debt balance of $300 at the end of 19x8. Debt increases from $300 to $450 because of external financing that is obtained to close the gap exhibited in the relationship: Additional Financing = Change in Assets - increase in retained earnings - increase in payables Needed a.



What problems are created in using the pro forma statements to determine the required amount of additional (external) financing if the debt that will be used to satisfy the funding need is acquired in total at the beginning of 19x9, rather than at the end of 19x9 as is implied in these statements? b. Is this problem likely to be significant? Why? SOLUTION: a. The problem is the circular relationship between a means used to meet funding needs (debt) and a factor used to determine the amount of that need (interest). Interest expense is a factor in determining net income and, ultimately, the size of the change to retained earnings. The change in retained earnings is further used to determine the amount of required additional financing. Some portion of the additional funding will be met by increased debt, which creates additional interest expense. If this debt is assumed to be acquired at the start of 19x9, then the additional interest expense will be incurred in 19x9, which will change the addition to retained earnings for that year, which will change the determination of the amount of additional funding required, hence again changing the debt and the associated interest expense. Assuming the debt at the end of a year removes the circular reference problem, because it essentially holds interest constant. b.



The problem is not likely to be significant. As an illustration, with debt at 10% and taxes at 40%: $200 Debt acquired $200 Debt not acquired at start of year until end of year ($1200 balance) ($1000 balance) EBIT 500 500 Interest 120 100 Taxable Income 380 400 Net Income 228 240 Dividends (10%) 22.80 24.00 Change in R/E 205.20 216.00



In this one iteration scenario, a $200 difference in debt produces a $20 difference in interest, with an eventual $10.80 reduction in the change in retained earnings. On the second iteration, this lower retained earnings would result in a larger additional funding need (by $10.80). If this is met exclusively by debt (acquired at the start of a



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period), total debt would be $1210.80, with associated interest of $121.08, or $1.08 larger than the first iteration. The effect becomes negligible. In the context of preparation of pro forma statements, which use estimates (hence containing varying amounts of error), the difference in approach is even less material. 3.15 Assume a firm has net income in 19x9 of $20 and its end-of-year 19x8 total assets were $450. Further assume that the firm has a standing requirement to maintain a debt/equity ratio of 0.8, and that its managers are prohibited from further borrowing or stock issuance. a. What is this firm’s maximum sustainable growth rate? b. If the firm pays $6 of the $20 net income as a dividend, and plans to maintain this payout ratio into the future, now what is its maximum sustainable growth rate? c. If the firm uses $12 of the $20 net income to repurchase some of its outstanding shares, and plans to maintain the use of this ratio of net income for future repurchases, now what is its maximum sustainable growth rate? d. If the firm takes action as described in parts b) and c), what would its maximum sustainable growth rate be? SOLUTION: a. Debt/Equity = .8; Assets = $450; Debt = $200; Equity = $250; growth rate = 20/250 =8% b. growth rate = 8% x (1-6/20) = 5.6% c. growth rate = 8% x (1-12/20) = 3.2% d. growth rate = 8% x (1- 6/20 – 12/20) =0 .8% 3.16 Working capital management questions: a. Suppose you own a firm that manufactures pool tables. Thirty days ago, you hired a consultant to examine your business and suggest improvements. The consultant’s proposal, if implemented, would allow your firm to shorten the time between each sale and the subsequent cash collection by 20 days, slightly lengthen the time between inventory purchase and sale by only 5 days, but shorten the time between inventory purchase and your firm’s payment of the bill by 15 days. Would you implement the consultant’s proposal? Why? b. In general, the principles of cash cycle time management call for a firm to shorten (minimize) the time it takes to collect receivables, and lengthen (maximize) the time it takes to pay amounts it owes to suppliers. Explain what trade-offs need to be managed if the firm offers discounts to customers who pay early, and the firm also foregoes discounts offered by its suppliers by extending the time until it pays invoices. c. Suppose it is 3/13/x2, and you just received your monthly credit card statement with a new balance of $2000. The payment is due on 4/5/x2, but your spouse panics at the sight (and size) of the balance and wants to pay it immediately. If you practice the principles of cash cycle time management in your personal finances, when would you make the payment? Why? What danger exists in adopting this strategy? d. Some furniture companies conduct highly-advertised annual sale events in which customers can either take an upfront discount for a cash (or credit card) purchase, or defer finance charges for up to one year on their purchases by charging it to the company’s credit account. Assume that the two options do not present a time value of money advantage for the company. In terms of cash cycle management: (1) Why does the company offer the discount? (2) Why might the company be willing to forego cash collection for one year if a customer chooses to defer? What risk does the company assume in the deferment case that it does not assume in the discount case? e. Compare the frequency with which you think a firm may monitor its working capital situation, and move to correct a problem, with the frequency of the firm’s planning exercise in forecasting future sales and determining the need for additional financing. f. If a firm were to monitor its working capital situation closely, what problem might it be looking to avoid?



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SOLUTION: a. Cash cycle time = Inventory period + receivables period - payables period +5 -20 -15 The consultant’s proposal results in no net change to cash cycle time, so there’s no reason to implement it. b. By offering discounts to customers for early payment, the firm is shortening its receivables period, but also “giving away” some money in the form of the discount. By waiting to pay its suppliers, the firm is extending its payables period, but the net effect is to spend more money than is necessary to resolve open invoices. A question to be asked: Is the firm earning more by holding its money over the period between when the discount is forgone and the total invoice from a supplier comes due, than it is “incurring” in the form of the implicit interest charge by paying later? Or, is there some circumstance which at the present time calls for the retention of cash for as long as possible? c. You would make the payment as close to the 4/5/x2 due date as you can without being late and incurring the finance charges. You’d be lengthening your personal “payables period” by waiting for the due date rather than paying immediately. d. The company offers the discount to collect its cash as soon as possible, or to shorten its receivables period. The company is willing to defer cash collection for one year because it will be moving inventory out of its stores, or shortening its inventory period. This is a larger consideration if the inventory represents a model year that is coming to a close and new inventory is soon to be delivered. The risk that a company assumes in the deferment case is the risk of default. Since the customer will not pay for one year and has charged the purchase to a company credit account, the company is exposed to the possibility that the customer will not pay when one year passes. It does not have this exposure when the customer pays cash or uses another (external) credit account. e.



f.



Working capital management is an operational activity that may be performed daily, weekly, or monthly. Firms in trouble that are concerned about meeting their short-term obligations will monitor it more on a daily or weekly basis, while stable firms may monitor it less frequently, perhaps monthly. The planning exercise and the determination of required additional funding is normally done in earnest once a year, but the plan is revisited throughout the year, perhaps quarterly, to compare actual results against estimated results and to decide upon adjustments to the plan. Illiquidity.



3.17 How would the following assets and liabilities be recorded on the balance sheets of their owners? a. a lottery ticket b. a successful song c. an unsuccessful movie SOLUTION: a. It will not be recorded. The existence of a future economic benefit is very uncertain. b. Though an economically significant asset, it will not be recorded on the accounting balance sheet. c. Not recorded on balance sheet.



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3.18 Personal accounting Show how the following events and transactions should appear on your personal income statement, balance sheet, and cash flow statement. a. On July 1, 200X, you receive $20,000 in gifts upon graduation from school and pay off a $10,000 student loan. b. On August 1, 200X, you get a job as a finance intern at General Financial Services Inc. You are promised a salary of $4,000 per month, payable on the last day of each month. c. On August 31, you receive your first statement of GFS salary and benefits showing the following items: Gross salary $4,000 Income tax withholding 1,400 Social Security and Medicare tax 500 Health care premium 150 Contribution to pension plan 200 Employer Social Security tax 300 Employer contribution to pension plan 200 Employer contribution to health care 150 Amount credited to employee checking account at GFS Bank 1,750 Total employer benefit 650 d. On September 1, you purchase a new car for $20,000. You make a down payment of $5,000 and borrow the remaining $15,000 from GFS bank at a monthly interest rate of 1%. Your monthly payment is $498.21 for 36 months. e. As an individual or a household, why might you want to maintain a balance sheet? How often would you update it? Should you mark-to-market or leave your assets and liabilities at their historical values? SOLUTION: a. The $20,000 in gifts increases your assets as well as your net worth by the same amount. It will not affect your cash flow statement if it’s not in cash. It will not affect your personal income statement either. The $10,000 paid to close your loan decreases your liabilities (debt), and your cash by the same amount. It will not affect your net worth, nor your personal income statement. b. No effect. Though the job might be an economically significant asset, in the sense that you expect it will bring you some economic benefit in the future, you have not yet earned your future revenue since you haven’t started yet. c. Increase in cash of $1,750, increase in income of $1,750, increase in pension plan benefits asset of $400. Pension plan benefits are part of your savings, hence they increase your net worth. The Social Security and Medicare taxes, though might bring you some benefit in the future, this benefit is not related with the tax you’re paying now, hence most people will consider them simply as expenses, and never mention them in their personal balance sheet. The health insurance premium and contribution from employer will appear as a “Prepaid insurance” on the balance sheet before end of year, but will be expensed by the end of year. d. Balance sheet effect: “Car” asset increases by $20,000. Cash decreases by $5,000. Debt increases by $15,000. Every month, your cash drops by $498.21 and you incur an interest expense of 0.01 * (remaining principal of debt), your remaining debt decreases by the difference between the $498.21 installment and the interest expense paid. For example, in the first month of payment, you incur an interest expense of $150 on your income statement, your cash decreases by $498.21 and your debt by $348.21. e. You might want to keep a personal balance sheet for planning purposes, and to keep track of your assets, liabilities and net worth (e.g. if you apply for a loan, you might need to present your kept records). You would need to update it once a year, or as needed, depending on your purposes for keeping it. Obviously, you will need to keep your records at market value. Historical values of assets and liabilities are not useful for personal accounting.



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3.19 Uses of accounting information You are thinking of taking a trip to Florida for your spring vacation, which begins two months from now. You use Excite’s free preview Travel service on the www to find the cheapest round trip fare from Boston to Fort Lauderdale. It tells you that the cheapest airline is AirTran. You have never heard of this airline before and are concerned that it may have gone out of business before you can use your ticket two months from now. How can you use financial data available on the www (e.g. at www.quicken.com) to investigate the risk to you of buying an AirTran ticket? Which firms are in the relevant “benchmark” group for your purposes? SOLUTION: You can use relevant financial ratios available from the financial information disclosed, such as profitability, turnover, financial leverage, liquidity and market value ratios. These ratios can then be compared with the ratios of a comparable set of companies, namely other airline companies that are “pure plays.”