Analysis for Financial Management, 11e
SUGGESTED ANSWERS TO EVEN-NUMBERED PROBLEMS
Chapter 1
2. Management is either dumb or thinks its board is. Earning $100 million on a $4
billion equity investment is a return of 2.5 percent, a figure well below any reasonable
cost of equity. As a board member, I would vote to cut management’s compensation,
not raise it. I would also criticize them sharply for apparently attempting to deceive
the board.
4. a. Cash rises $500,000; plant and equipment falls $300,000; equity rises $200,000.
b. Net plant and equipment rises $80 million; Cash falls $32 million; Bank debt rises
$48 million.
c. Net plant and equipment rises $60 million; cash falls $60 million.
d. Cash falls $40,000; Accounts payable falls $40,000.
e. Cash falls $240,000; Owners’ equity falls by $240,000 (via an increase in treasury
stock).
f. Cash rises $80,000; Inventory falls; Accrued taxes, Owners’ equity, and possibly
other cost categories rise such that the algebraic sum equals $80,000.
g. Accounts receivable rise $120,000. Other categories change as described in part
f.
h. Cash falls $50,000. Owners’ equity falls by $50,000 (via Retained Earnings).
6. a. R&E Supplies, Inc. Sources and Uses Statement 2011–2014 ($000).
Sources of cash:
Decrease in cash and securities $259
Increase in accounts payable 2,205
Increase in current portion long-term debt 40
Increase in accrued wages 13
Increase in retained earnings 537
Total $3,054
Uses of cash:
Increase in accounts receivable $1,543
Increase in inventories 1,148
Increase in prepaid expenses 4
Increase in net fixed assets 159
Decrease in long-term debt 200
Total $3,054
1
,__________________________________________________________________
b. Insights:
i. R&E is making extensive use of trade credit to finance a buildup in current assets. The
increase in accounts payable equals almost three fourths of total sources of cash.
Increasing accounts receivable and inventories account for almost 90 percent of the
uses of cash.
ii. External long-term debt financing is a use of cash for R&E, meaning that it is repaying
its loans. A restructuring involving less reliance on accounts payable and more bank
debt appears appropriate.
8. Accounting income will be the value of the parcels sold, less their original purchase
price. So if all parcels are sold, the income is 5 × $16 million + 5 × $8 million – $100
million = $20 million. Economic income will be the increase in the market value of
the land, whether sold or not, over the period. At the end of the first year, this will be
$20 million. Answers to each part of the question appear below.
Question Accounting Income Economic Income
a $20 million $20 million
b 0 $20 million
c –$10 million $20 million
d $30 million $20 million
e. Too many companies have tried this. If the market value of a piece of land falls,
the owner loses whether he sells or not. The market price of the land fell because
people thought the future income stream to the owners was worth less.
Continuing to hold the property forces the owner to accept the lower income.
Whether the loss is recognized or not might affect accounting earnings, but has
nothing to do with reality.
10. The accounting profits from Jonathan’s brewery are expected to be $40,000. These
accounting profits do not include the implicit cost of the entrepreneur’s time.
Jonathan’s time is worth at least $62,000, the current income he will have to forego to
manage the brewery. When these implicit opportunity costs are included net income
falls to:
$230,000 – $190,000 – $62,000 = –$22,000
This new venture will reduce Jonathan’s income not increase it.
12. a.
2
, Company A B C
End-of-year cash
Balance $150 million $30 million $120 million
b. It appears that company C retired more debt than it issued, repurchased more
stock than it issued, or some combination of the two.
c. I'd prefer to own company A. A appears to be a growing company as evidenced
by the sizable net cash used in investing activities, and its negative net cash flow
from operations may well be due to increasing accounts receivable and
inventories that naturally accompany sales growth. Company B appears not to be
growing, so its negative net cash flows from operations are probably due to losses
or to increasing receivables and inventories relative to sales, a trend denoting poor
management of current assets.
d. I don't think there is necessarily any cause for concern. It appears company C is a
mature, slow-growth company that is returning its unneeded operating cash flows
to investors in the form of debt repayment, share repurchase, dividends, or some
combination of these. This is a perfectly viable strategy in the absence of
attractive investment opportunities.
14. See Excel solutions at mhhe.com/higgins11e.
Chapter 2
2. a. Price-to-earnings ratios are highly dependent on future growth expectations. I
would thus expect high-growth Google to have the higher ratio than low-growth
Union Pacific.
b. The financial institution should have the higher debt-to-equity ratio because the
liquid, relatively safe nature of its assets enables it to borrow more money at
attractive rates. And in the case of banks, deposit insurance enables the institution
to collect low cost deposits. The principal asset of financial institutions tends to
be relatively safe loans that generate relatively predictable income streams. The
uncertain income stream of the high-tech company makes it less creditworthy.
c. The appliance manufacturer should have the higher profit margin because it adds
more value to its product than a grocer does and hence can charge a higher
markup over cost.
d. The jewelry store should have the higher current ratio. Jewelry stores typically
need to have a lot of expensive display inventory on hand and often offer time
payment plans to customers. Online bookstores, on the other hand, typically carry
little inventory and rely on credit card sales involving little accounts receivable.
3
, 4. a. ROE will most likely fall. The numerator of the ratio, net income, will decline
because the acquired company is losing money. Unless the acquiring firm’s
equity declines due to the acquisition, a highly unlikely event, ROE will decline.
b. This, however, is not important to the decision. This is another example of the
timing problem. If the technology company has great promise, it may make
complete sense to acquire the business even though it is currently losing money.
The proper way to evaluate the acquisition is by estimating the target’s fair
market value and acquiring it at a lower price. This is the topic of Chapter 9.
6. Your colleague's argument has a couple of holes in it. First, he has forgotten the
timing problem. The investment has consequences over many years, and it is
inappropriate to base the decision on only one year's results. As will be discussed
beginning in Chapter 7, the appropriate rate of return for evaluating investment
opportunities is not the division’s accounting ROI but a rate that specifically
incorporates the time value of money.
Second, your company’s performance appraisal system is faulty. Investment return
should be judged against a minimum acceptable return, not the division's historical
return. An irrational implication of the performance system used by your company is
that divisions with very low returns will want to make lots of investments because
many will promise returns higher than the division's ROI. Conversely, high return
divisions, such as yours, will find few opportunities beating the division’s ROI. We
will look at this issue again in Chapter 8 as part of our look at Economic Value
Added.
8. a. R&E Supplies, Inc.
Ratio Analysis
2011 2012 2013 2014
Profitability ratios:
Return on equity (%) 30.9 28.6 24.2 16.8
Return on assets (%) 11.3 10.3 7.7 5.0
Return on invested capital (%) 18.7 18.9 17.4 12.9
Profit margin (%) 3.3 2.9 2.4 1.4
Gross margin (%) 16.0 15.0 15.0 14.0
Turnover-control ratios:
Asset turnover (X) 3.4 3.6 3.2 3.5
Fixed-asset turnover (X) 87.4 111.0 54.6 71.8
4
SUGGESTED ANSWERS TO EVEN-NUMBERED PROBLEMS
Chapter 1
2. Management is either dumb or thinks its board is. Earning $100 million on a $4
billion equity investment is a return of 2.5 percent, a figure well below any reasonable
cost of equity. As a board member, I would vote to cut management’s compensation,
not raise it. I would also criticize them sharply for apparently attempting to deceive
the board.
4. a. Cash rises $500,000; plant and equipment falls $300,000; equity rises $200,000.
b. Net plant and equipment rises $80 million; Cash falls $32 million; Bank debt rises
$48 million.
c. Net plant and equipment rises $60 million; cash falls $60 million.
d. Cash falls $40,000; Accounts payable falls $40,000.
e. Cash falls $240,000; Owners’ equity falls by $240,000 (via an increase in treasury
stock).
f. Cash rises $80,000; Inventory falls; Accrued taxes, Owners’ equity, and possibly
other cost categories rise such that the algebraic sum equals $80,000.
g. Accounts receivable rise $120,000. Other categories change as described in part
f.
h. Cash falls $50,000. Owners’ equity falls by $50,000 (via Retained Earnings).
6. a. R&E Supplies, Inc. Sources and Uses Statement 2011–2014 ($000).
Sources of cash:
Decrease in cash and securities $259
Increase in accounts payable 2,205
Increase in current portion long-term debt 40
Increase in accrued wages 13
Increase in retained earnings 537
Total $3,054
Uses of cash:
Increase in accounts receivable $1,543
Increase in inventories 1,148
Increase in prepaid expenses 4
Increase in net fixed assets 159
Decrease in long-term debt 200
Total $3,054
1
,__________________________________________________________________
b. Insights:
i. R&E is making extensive use of trade credit to finance a buildup in current assets. The
increase in accounts payable equals almost three fourths of total sources of cash.
Increasing accounts receivable and inventories account for almost 90 percent of the
uses of cash.
ii. External long-term debt financing is a use of cash for R&E, meaning that it is repaying
its loans. A restructuring involving less reliance on accounts payable and more bank
debt appears appropriate.
8. Accounting income will be the value of the parcels sold, less their original purchase
price. So if all parcels are sold, the income is 5 × $16 million + 5 × $8 million – $100
million = $20 million. Economic income will be the increase in the market value of
the land, whether sold or not, over the period. At the end of the first year, this will be
$20 million. Answers to each part of the question appear below.
Question Accounting Income Economic Income
a $20 million $20 million
b 0 $20 million
c –$10 million $20 million
d $30 million $20 million
e. Too many companies have tried this. If the market value of a piece of land falls,
the owner loses whether he sells or not. The market price of the land fell because
people thought the future income stream to the owners was worth less.
Continuing to hold the property forces the owner to accept the lower income.
Whether the loss is recognized or not might affect accounting earnings, but has
nothing to do with reality.
10. The accounting profits from Jonathan’s brewery are expected to be $40,000. These
accounting profits do not include the implicit cost of the entrepreneur’s time.
Jonathan’s time is worth at least $62,000, the current income he will have to forego to
manage the brewery. When these implicit opportunity costs are included net income
falls to:
$230,000 – $190,000 – $62,000 = –$22,000
This new venture will reduce Jonathan’s income not increase it.
12. a.
2
, Company A B C
End-of-year cash
Balance $150 million $30 million $120 million
b. It appears that company C retired more debt than it issued, repurchased more
stock than it issued, or some combination of the two.
c. I'd prefer to own company A. A appears to be a growing company as evidenced
by the sizable net cash used in investing activities, and its negative net cash flow
from operations may well be due to increasing accounts receivable and
inventories that naturally accompany sales growth. Company B appears not to be
growing, so its negative net cash flows from operations are probably due to losses
or to increasing receivables and inventories relative to sales, a trend denoting poor
management of current assets.
d. I don't think there is necessarily any cause for concern. It appears company C is a
mature, slow-growth company that is returning its unneeded operating cash flows
to investors in the form of debt repayment, share repurchase, dividends, or some
combination of these. This is a perfectly viable strategy in the absence of
attractive investment opportunities.
14. See Excel solutions at mhhe.com/higgins11e.
Chapter 2
2. a. Price-to-earnings ratios are highly dependent on future growth expectations. I
would thus expect high-growth Google to have the higher ratio than low-growth
Union Pacific.
b. The financial institution should have the higher debt-to-equity ratio because the
liquid, relatively safe nature of its assets enables it to borrow more money at
attractive rates. And in the case of banks, deposit insurance enables the institution
to collect low cost deposits. The principal asset of financial institutions tends to
be relatively safe loans that generate relatively predictable income streams. The
uncertain income stream of the high-tech company makes it less creditworthy.
c. The appliance manufacturer should have the higher profit margin because it adds
more value to its product than a grocer does and hence can charge a higher
markup over cost.
d. The jewelry store should have the higher current ratio. Jewelry stores typically
need to have a lot of expensive display inventory on hand and often offer time
payment plans to customers. Online bookstores, on the other hand, typically carry
little inventory and rely on credit card sales involving little accounts receivable.
3
, 4. a. ROE will most likely fall. The numerator of the ratio, net income, will decline
because the acquired company is losing money. Unless the acquiring firm’s
equity declines due to the acquisition, a highly unlikely event, ROE will decline.
b. This, however, is not important to the decision. This is another example of the
timing problem. If the technology company has great promise, it may make
complete sense to acquire the business even though it is currently losing money.
The proper way to evaluate the acquisition is by estimating the target’s fair
market value and acquiring it at a lower price. This is the topic of Chapter 9.
6. Your colleague's argument has a couple of holes in it. First, he has forgotten the
timing problem. The investment has consequences over many years, and it is
inappropriate to base the decision on only one year's results. As will be discussed
beginning in Chapter 7, the appropriate rate of return for evaluating investment
opportunities is not the division’s accounting ROI but a rate that specifically
incorporates the time value of money.
Second, your company’s performance appraisal system is faulty. Investment return
should be judged against a minimum acceptable return, not the division's historical
return. An irrational implication of the performance system used by your company is
that divisions with very low returns will want to make lots of investments because
many will promise returns higher than the division's ROI. Conversely, high return
divisions, such as yours, will find few opportunities beating the division’s ROI. We
will look at this issue again in Chapter 8 as part of our look at Economic Value
Added.
8. a. R&E Supplies, Inc.
Ratio Analysis
2011 2012 2013 2014
Profitability ratios:
Return on equity (%) 30.9 28.6 24.2 16.8
Return on assets (%) 11.3 10.3 7.7 5.0
Return on invested capital (%) 18.7 18.9 17.4 12.9
Profit margin (%) 3.3 2.9 2.4 1.4
Gross margin (%) 16.0 15.0 15.0 14.0
Turnover-control ratios:
Asset turnover (X) 3.4 3.6 3.2 3.5
Fixed-asset turnover (X) 87.4 111.0 54.6 71.8
4
