SM_Ch3-6.docx

Fundamentals of Corporate Finance Second European Edition

Solutions Manual Chapter 3 BASIC 12. Building a Statement of Financial Position [LO1] Cable & Wireless plc has current assets of £1.541 billion, non-current assets of £3.650 billion, current liabilities of £1.856 billion, and non-current liabilities of £1.291 billion. What is the value of the shareholders’ equity account for this firm? How much is net working capital? Answer: To find owner’s equity, we must construct a statement of financial position as follows:

Cable & Wireless Statement of Financial Position 31-Dec-201X Assets

Liabilities & Owners' Equity £ in billion 1.541

Current assets Non-current assets

3.65

£ in billion Current liabilities Non-current liabilities Owners' equity

5.19 1 Owners' equity

Current assets Current liabilities Net working capital

x

2.044 £ in billion 1.541 1.856 -0.315

13. Building an Income Statement [LO1] Johnson Matthey plc has revenues of £7.848 billion, costs of £7.324 billion, depreciation expense of £108.9 million, interest expense of £42.7 million, and a tax rate of 28 per cent. What is the net income for this firm? Answer: © McGraw-Hill Education 2014

1.856 1.291 x 5.191

Fundamentals of Corporate Finance Second European Edition

Johnson Matthey plc Income Statement £ in billion 7.848 7.324

Revenues Costs

0.524 0.0427 0.1089

Gross Profit Interest Expense Depreciation Taxable Income Tax (28%)

0.3724 0.104272 0.268128

Net Income

14. Calculating Liquidity Ratios [LO2] Essilor International SA has current assets of €2,826 million, current liabilities of €1,875 million, and inventory of €833 million. What is the current ratio? What is the quick ratio? Answer: The relevant formulae are:

Current ratio =

Quick ratio =

Current assets Current liabilities

Current assets  Inventory Current liabilities

Current Ratio =

Quick Ratio =

2,826  1.51 1,875

2,826  833  1.06 1,875

15. Calculating Profitability Ratios [LO2] Volkswagen AG had sales of €113,808 million, total assets of €167,919 million, and total debt of €69,380 million. If the profit margin is 4.173 per cent, what was net income? What was ROA? What was ROE? Answer: We need to find net income first. So: Profit margin = Net income / Sales Net income = Sales(Profit margin) Net income = (€113,808)(0.04173) = €4,749.2 ROA = Net income / TA = €4749.2 / €167,919 = .0282 or 2.82% To find ROE, we need to find total equity. Since TL & TE equals TA: © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

TA = TD + TE TE = TA – TD TE = €167,919 – 69,380 = €98,539 ROE = Net income / TE = €4,749.2 / €98,539 = .0482 or 4.82% 16. Calculating Leverage Ratios [LO2] GNR plc has a total debt ratio of 0.43. What is its debt–equity ratio? What is its equity multiplier? Answer: Total debt ratio = 0.43 = TD / TA Substituting total debt plus total equity for total assets, we get: 0.43 = TD / (TD + TE) Solving this equation yields: 0.43(TE) = 0.57(TD) Debt/equity ratio = TD / TE = 0.43 / 0.57 = 0.75 Equity multiplier = 1 + D/E = 1 + 0.75 = 1.75 17. Calculating Market Value Ratios [LO2] Axel plc had additions to retained earnings for the year just ended of £430,000. The firm paid out £175,000 in cash dividends, and it has ending total equity of £5.3 million. If the company currently has 210,000 shares of equity outstanding, what are earnings per share? Dividends per share? Book value per share? If the equity currently sells for £63 per share, what is the market-to-book ratio? The price– earnings ratio? If the company had sales of £4.5 million, what is the price–sales ratio? Answer: Net income = £430,000 + 175,000 = £605,000

= Addition to RE + Dividends

Earnings per share= NI / Shares per share

= £605,000 / 210,000 = £2.88

Dividends per share £175,000 / 210,000 = £0.83 per share

= Dividends / Shares =

Book value per share 210,000 = £25.24 per share Market-to-book ratio £25.24 = 2.50 times P/E ratio

= Share price / EPS

= TE / Shares

= £5,300,000 /

= Share price / BVPS

= £63 /

= £63 / £2.88 = 21.87 times © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

Sales per share £21.43

= Sales / Shares

=

£4,500,000

P/S ratio times

= Share price / Sales per share

/

210,000

=

= £63 / £21.43 = 2.94

INTERMEDIATE 18. Book Values versus Market Values [LO1] In preparing a balance sheet, why do you think International Accounting Standards allow both historical cost and fair value approaches? Answer: Historical costs can be objectively and precisely measured whereas market values can be difficult to estimate, and different analysts would come up with different numbers. Thus, there is a tradeoff between relevance (market values) and objectivity (book values). 19. Residual Claims [LO1] Moneyback Limited is obligated to pay its creditors £7,300 during the year. (a) What is the market value of the shareholders’ equity if assets have a market value of £8,400? (b) What if assets equal £6,700? Answer: The market value of shareholders’ equity cannot be negative. A negative market value in this case would imply that the company would pay you to own the equity. The market value of shareholders’ equity can be stated as: Shareholders’ equity = Max [(TA – TL), 0]. So, if TA is £8,400, equity is equal to £1,100, and if TA is £6,700, equity is equal to £0. We should note here that the book value of shareholders’ equity can be negative. 20. Net Income and OCF [LO1] This year, Southern Coat Company had sales of £730,000. Cost of goods sold, administrative and selling expenses, and depreciation expenses were £580,000, £105,000 and £135,000 respectively. In addition, the company had an interest expense of £75,000 and a tax rate of 28 per cent. (Ignore any tax loss carry-back or carry-forward provisions.) (a) What is Southern Coat Company’s net income? (b) What is its operating cash flow? (c) Explain your results in (a) and (b). Answer: Income Statement Sales £730,000 COGS 580,000 © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

a.

A&S expenses 105,000 Depreciation 135,000 Operating Profit–£90,000 Interest 75,000 Profit before Tax–£165,000 Tax (28%) 0 Net income –£165,000

b. OCF = Operating Profit + Depreciation – Taxes = –£90,000 + 135,000 – 0 = £45,000 c. Net income was negative because of the tax deductibility of depreciation and interest expense. However, the actual cash flow from operations was positive because depreciation is a non-cash expense and interest is a financing expense, not an operating expense. 21. Accounting Values versus Cash Flows [LO1] In Problem 20, suppose Southern Coat Company paid out £25,000 in cash dividends. Is this possible? If spending on non-current assets and net working capital was zero, and if no new shares were issued during the year, what do you know about the firm’s long-term debt? Answer: A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficient cash flow to make the dividend payments. Cash Flow from Operating Activities = Operating Profit + Depreciation – Taxes = £45,000 Cash Flow from Financing Activities = Net New Long Term Debt – Interest -Dividends = = New LT Debt - £75,000 -£25,000 = LTD £100,000 Cash Flow from Investing Activities = £0

The Net cash flow = CF from OA + CF from FA + CF from IA = £45,000 + LTD - £100,000 = £0 = LTD - £55,000 LTD = £55,000 To avoid having negative cash balance, at least £55,000 of new LTD must be raised. 22. Calculating Cash Flows [LO1] Consider the following abbreviated financial statements for Parrothead Enterprises: Parrothead Enterprises 2012 and 2013 Partial balance sheets © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

Assets

Liabilities and owners’ equity

2012 2013

2012 £

2013 £

£

£

Current assets

 653

 707

Current liabilities

 261

 293

Non-current assets

2,69 1

3,240

Non-current liabilities

1,422

1,512

Parrothead Enterprises 2013 Income statement £ Sales

8,280

Costs

3,861

Depreciation Interest paid

738 211

(a) What is owners’ equity for 2012 and 2013? (b) What is the change in net working capital for 2013? (c) In 2013, Parrothead Enterprises had capital expenditure of £1,350. How much in non-current assets did Parrothead Enterprises sell? What is the cash flow from investing activities for the year? (The tax rate is 28 per cent.) (d) During 2013, Parrothead Enterprises raised £270 in new long-term debt. How much long-term debt must Parrothead Enterprises have paid off during the year? What is the cash flow from financing activities? Answer: a. Total assets 2012 Total liabilities 2012 Owners’ equity 2012

= £653 + 2,691 = £3,344 = £261 + 1,422 = £1,683 = £3,344 – 1,683 = £1,661

Total assets 2013 Total liabilities 2013 Owners’ equity 2013

= £707 + 3,240 = £3,947 = £293 + 1,512 = £1,805 = £3,947 – 1,805 = £2,142

b. NWC 2012 = CA12 – CL12 = £653 – 261 = £392 NWC 2013 = CA13 – CL13 = £707 – 293 = £414 Change in NWC = NWC12 – NWC13 = £414 – 392 = £22 c. We can calculate cash flow from investing activities as: Cash flow from investing activities = Non-Current Assets 2013 – Non Current Assets 2012 + Depreciation Cash flow from investing activities = £3,240 – 2,691 + 738 = £1,287 © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

So, the company had a cash flow from investing activities of £1,287. We also know that cash flow from investing activities is: Cash flow from investing activities = Non-current assets bought – Noncurrent assets sold £1,287 = £1,350 – Non-current assets sold Non-current assets sold = £1,350 – 1,287 = £63 d. Net new borrowing = NCL13 – NCL12 = £1,512 – 1,422 = £90 Cash flow from financing activities = New borrowing - Interest = £90 £211 = -£121 Net new borrowing = £90 = Debt issued – Debt retired Debt retired = £270 – 90 = £180

23. Profit Margin [LO2] In response to complaints about high prices, a grocery chain runs the following advertising campaign: ‘If you pay your child £3 to go and buy £50 worth of groceries, then your child makes twice as much on the trip as we do.’ You’ve collected the following information from the grocery chain’s financial statements: (millions) Sales

£750

Net income

22.5

Total assets

420

Total debt

280

Evaluate the grocery chain’s claim. What is the basis for the statement? Is this claim misleading? Why or why not? Answer: Child: Profit margin = NI / S = £3.00 / £50 Store: Profit margin £750,000,000

= 0.06 or 6%

= NI / S = 0.03 or 3%

=

£22,500,000

/

The advertisement is referring to the store’s profit margin, but a more appropriate earnings measure for the firm’s owners is the return on equity. ROE = NI / TE = NI / (TA – TD) ROE = £22,500,000 / (£420,000,000 – £280,000,000) = 0.1607 or 16.07%

CHALLENGE Some recent financial statements for the luxury goods company LVMH © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

Moet Hennessy Louis Vuitton SA follow. Use this information to attempt Problems 24–27. Income statements for LVMH Moet Hennessy Louis Vuitton

Revenue Cost of revenue Gross profit Selling/general/admin. expenses Amortization Unusual expense (income) Other operating expenses, total Operating profit Interest expense Interest/invest income

Y/E 2013

Y/E 2012

€m

€m

17,193

16,481

6,012

5,786

11,181

10,695

7,553

7,140

0

6

126

116

17

4

3,485

3,429

255

241

15

30

  41

Other, net Profit before taxes Provision for income taxes Profit after taxes Minority interest Equity in affiliates

  41

3,204

3,177

893

853

2,311

2,324

292

306

7

Profit attributable to shareholders

7

2,026

2,025

Statements of financial position LVMH Moet Hennessy Louis Vuitton Dec 13 €m Current assets

Dec 12 €m

Dec 13 €m

Dec 12 €m

Current liabilities

Cash and shortterm investments

1,013

1,559 Trade payables

2,292

2,095

Trade receivables

1,650

1,595 Accrued expenses

1,866

1,552

229

151 Notes payable/ short-term debt

1,571

2,212

Receivables – other

© McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

Total inventory

5,767

4,812 Current port. of LT debt/capital leases

Other current assets

  1,695

  Other current 2,001 liabilities

Total current assets

10,3 54

Non-current assets

10,1 Total current 18 liabilities

276

926

  610

  628

6,615

7,413

Non-current liabilities

Property/plant/ equipment

6,081

5,419 Total long-term debt

3,738

2,477

Goodwill, net

4,423

4,818 Deferred income tax

3,113

2,843

Intangibles, net

8,523

7,999 Minority interest

989

938

Long-term investments

591

952 Other liabilities

Other long-term assets

1,51 1

1,07 Total non-current 8 liabilities

12,06 11,38 4 1

Total noncurrent assets

21,1 29

20,2 Total liabilities 66

18,67 18,79 9 4

 4,224

  5,123

Shareholders’ equity Ordinary shares

147

147

Additional paid-in capital

1,737

1,736

Retained earnings (accumulated deficit)

12,274

11,19 2

983

877

Treasury stock – common _____

Total assets

31,4 83

_____ Other equity, total

371

608

Total equity

12,80 11,59 4 0

30,3 Total liabilities 84 and shareholders’ equity

31,48 30,38 3 4

24. Calculating Financial Ratios [LO2] Find the following financial ratios for LVMH Moet Hennessy Louis Vuitton SA (use yearend figures rather than average values where appropriate): Short-term solvency ratios: © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

(a) Current ratio (b) Quick ratio (c) Cash ratio Asset utilization ratios: (d) Total asset turnover (e) Inventory turnover (f) Receivables turnover Long-term solvency ratios: (g) Total debt ratio (h) Debt–equity ratio (i) Equity multiplier (j) Times interest earned ratio Profitability ratios: (k) Profit margin (l) Return on assets (m)

________________________ ________________________ ________________________ ________________________ ________________________ ________________________ ________________________ ________________________ ________________________ ________________________ ________________________ ________________________ Return on equity ________________________

Answer: Short-term solvency ratios: Current ratio = Current assets / Current liabilities Current ratio 2013 = €10,354m / €6,615m = 1.57 times Current ratio 2012 = €10,118m / €7,413m = 1.36 times Quick ratio Quick ratio 2013 times Quick ratio 2012 times

= (Current assets – Inventory) / Current liabilities = (€10,354m – €5,767m) / €6,615m = 0.69

Cash ratio Cash ratio 2013 Cash ratio 2012

= (€10,118m – €4,812m) / €7,413m = 0.72 = Cash / Current liabilities = €1,013m / €6,615m = 0.15 times = €1,559m / €7,413m = 0.21 times

Asset utilization ratios: Total asset turnover = Sales / Total assets Total asset turnover 2013 = €17,193m / €31,483m = 0.55 times Total asset turnover 2012 = €16,481m /€30,384m = 0.54 times Inventory turnover Inventory turnover 2013 Inventory turnover 2012

= Cost of goods sold / Inventory = €6,012m / €5,767m = 1.04 times = €5,786m /€4,812m =1.2 times

Receivables turnover = Sales / Trade receivables Receivables turnover 2013 = €17,193m / €1,650m = 10.42 times Receivables turnover 2012 = €16,481m /€1,595m = 10.33 times Long-term solvency ratios: © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

Total debt ratio = (Total assets – Total equity) / Total assets Total debt ratio 2013 = (€31,483m– €12,804m) / €31,483m = 0.59 Total debt ratio 2012 = (€30,384m – €11,590m) / €30,384m = 0.62 Debt-equity ratio Debt-equity ratio 2013 Debt-equity ratio 2012

= Total debt / Total equity = (€31,483m – €12,804m) / €12,804m = 1.46 = (€30,384m – €11,590m) / €11,590m = 1.62

Equity multiplier Equity multiplier 2013 Equity multiplier 2012

= 1 + D/E = 1 + 1.46 = 2.46 = 1 + 1.62 = 2.62

Times interest earned = Operating Profit / Interest Times interest earned 2013 = €3,485m / €255m = 13.67 times Times interest earned 2012 = €3,429m /€241m =14.23 times Profitability ratios: Profit margin Profit margin 2013 Profit margin 2012

= Net income / Sales = €2,026m / €17,193m = 0.1178 or 11.78% = €2,025m /€16,481m = 0.1229 or 12.29%

Return on assets Return on assets 2013 Return on assets 2012

= Net income / Total assets = €2,026m / €31,483m = 0.0644 or 6.44% = €2,025m /€30,384m = 0.0666 or 6.66%

Return on equity Return on equity 2013 Return on equity 2012

= Net income / Total equity = €2,026m / €12,804m = 0.1582 or 15.82% = €2,025m /€11,590m = 0.1747or 17.47%

25. Du Pont Identity [LO2] Construct the Du Pont identity for LVMH Moet Hennessy Louis Vuitton SA. Answer: The DuPont identity is: ROE = (PM)(TAT)(EM) ROE = (0.1178)(0.55)(2.46) = 0.1582 or 15.82%

26. Market Value Ratios [LO2] LVMH Moet Hennessy Louis Vuitton SA has 473.06 million ordinary shares outstanding, and the market price for a share of equity at the end of 2012 was €46.79. What is the price–earnings ratio? What is the market-to-book ratio at the end of 2012? If the company’s growth rate is 9 per cent, what is the PEG ratio? Answer: Earnings per share Earnings per share P/E ratio P/E ratio Book value per share Book value per share

= Net income / Shares = €2,026 / 473.06 = €4.28 per share = Share price / Earnings per share = €46.79 / €4.28 = 10.93 times = Total equity / Shares = €12,804 / 473.06 shares = €27.06 per share

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Fundamentals of Corporate Finance Second European Edition

Market-to-book ratio = Share price / Book value per share Market-to-book ratio = €46.79 / €27.06 = 1.73 times PEG ratio PEG ratio

= P/E ratio / Growth rate = 10.93 / 9 = 1.21 times

27. Tobin’s Q [LO2] What is Tobin’s Q for LVMH Moet Hennessy Louis Vuitton SA? What assumptions are you making about the book value of debt and the market value of debt? What about the book value of assets and the market value of assets? Are these assumptions realistic? Why or why not? Assume that the book value of debt is equal to the market value of debt and the assets can be replaced at the current value on the statement of financial position (balance sheet). Answer: First, we will find the market value of the company’s equity, which is: Market value of equity = Shares × Share price Market value of equity = €473.06m (€46.79) = €22,134.48m The total book value of the company’s debt is: Total debt = Current liabilities + Non-Current Liabilities Total debt = €18,679m Now we can calculate Tobin’s Q, which is: Tobin’s Q = (Market value of equity + Book value of debt) / Book value of assets Tobin’s Q = (€22,134.48m + €18,679m) / €31,483m Tobin’s Q = 1.30 Using the book value of debt implicitly assumes that the book value of debt is equal to the market value of debt. This will be discussed in more detail in later chapters, but this assumption is generally true. Using the book value of assets assumes that the assets can be replaced at the current value on the statement of financial position (balance sheet). There are several reasons this assumption could be flawed. First, inflation during the life of the assets can cause the book value of the assets to understate the market value of the assets. Since assets are recorded at cost when purchased, inflation means that it is more expensive to replace the assets. Second, improvements in technology could mean that the assets could be replaced with more productive, and possibly cheaper, assets. If this is true, the book value can overstate the market value of the assets. Finally, the book value of assets may not accurately represent the market value of the assets because of depreciation. Depreciation is done according to some schedule, generally reducing balance or straight-line. Thus, the book value and market value can often diverge. © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

28. Earnings Management [LO1] Companies often try to keep accounting earnings growing at a relatively steady pace, thereby avoiding large swings in earnings from period to period. They also try to meet earnings targets. To do so, they use a variety of tactics. The simplest way is to control the timing of accounting revenues and costs, which all firms can do to at least some extent. For example, if earnings are looking too low this year, then some accounting costs can be deferred until next year. This practice is called earnings management. It is common, and it raises a lot of questions. Why do firms do it? Why are firms even allowed to do it under International Accounting Standards? Is it ethical? What are the implications for cash flow and shareholder wealth? Answer: In general, it appears that investors prefer companies that have a steady earnings stream. If true, this encourages companies to manage earnings. Under International Accounting Standards, there are numerous choices for the way a company reports its financial statements. Although not the reason for the choices under IAS, one outcome is the ability of a company to manage earnings, which is not an ethical decision. Even though earnings and cash flow are often related, earnings management should have little effect on cash flow (except for tax implications). If the market is “fooled” and prefers steady earnings, shareholder wealth can be increased, at least temporarily. However, given the questionable ethics of this practice, the company (and shareholders) will lose value if the practice is discovered. 29. Cash Flow [LO1] What are some of the actions that a small company like The Grandmother Calendar Company (see Questions 6 to 10) can take if it finds itself in a situation in which growth in sales outstrips production capacity and available financial resources? What other options (besides expansion of capacity) are available to a company when orders exceed capacity? Answer: Demanding cash up front, increasing prices, subcontracting production, and improving financial resources via new owners or new sources of credit are some of the options. When orders exceed capacity, price increases may be especially beneficial. 30. Non-Current Assets and Depreciation [LO1] On the simplified statement of financial position, the non-current assets (NCA) account is equal to the gross property, plant and equipment (PPE) account (which records the acquisition cost of property, plant and equipment) minus the accumulated depreciation (AD) account (which records the total depreciation taken by the firm against its property, plant and equipment). Using the fact that NCA = PPE  AD, show that the expression for net capital spending, NCA end  NCAbeg + D (where D is the depreciation expense during the year), © McGraw-Hill Education 2014

Fundamentals of Corporate Finance Second European Edition

is equivalent to PPEend  PPEbeg. Answer: Net capital spending = NCAend – NCAbeg + Depreciation = (NCAend – NCAbeg) + (Depreciation + ADbeg) – ADbeg = (NCAend – NCAbeg)+ ADend – ADbeg = (NCAend + ADend) – (NCAbeg + ADbeg) = PPEend – PPEbeg

© McGraw-Hill Education 2014