Finance Chapter 2
(-6 + 10) for three following years.
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2-12.Suppose that in 2010, Global launches an aggressive marketing campaign that boosts sales by 15%. However, their operating margin falls from 5.57% to 4.50%. Suppose that they have no other income, interest expenses are unchanged, and taxes are the same percentage of pretax income as in 2009.
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2-15.Quisco Systems has 6.5 billion shares outstanding and a share price of $18. Quisco is considering developing a new networking product in house at a cost of $500 million. Alternatively, Quisco can acquire a firm that already has the technology for $900 million worth (at the current price) of Quisco stock. Suppose that absent the expense of the new technology, Quisco will have EPS of $0.80.
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2-16.In January 2009, American Airlines (AMR) had a market capitalization of $1.7 billion, debt of $11.1 billion, and cash of $4.6 billion. American Airlines had revenues of $23.8 billion. British Airways (BABWF) had a market capitalization of $2.2 billion, debt of $4.7 billion, cash of $2.6 billion, and revenues of $13.1 billion.
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2-19.Consider a retailing firm with a net profit margin of 3.5%, a total asset turnover of 1.8, total assets of $44 million, and a book value of equity of $18 million.
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2-23.Suppose your firm receives a $5 million order on the last day of the year. You fill the order with $2 million worth of inventory. The customer picks up the entire order the same day and pays $1 million upfront in cash; you also issue a bill for the customer to pay the remaining balance of $4 million in 30 days. Suppose your firm's tax rate is 0% (i.e., ignore taxes). Determine the consequences of this transaction for each of the following:
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2-24.Nokela Industries purchases a $40 million cyclo-converter. The cyclo-converter will be depreciated by $10 million per year over four years, starting this year. Suppose Nokela's tax rate is 40%.
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2-4. Consider the following potential events that might have occurred to Global Conglomerate on December 30, 2009. For each one, indicate which line items in Global's balance sheet would be affected and by how much. Also indicate the change to Global's book value of equity.
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2-8.In March 2005, General Electric (GE) had a book value of equity of $113 billion, 10.6 billion shares outstanding, and a market price of $36 per share. GE also had cash of $13 billion, and total debt of $370 billion. Four years later, in early 2009, GE had a book value of equity of $105 billion, 10.5 billion shares outstanding with a market price of $10.80 per share, cash of $48 billion, and total debt of $524 billion. Over this period, what was the change in GE's
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c.book debt-equity ratio?
2005 Book Debt-to-Equity . 2009 Book Debt-to-Equity . The change over the period is: 4.99 - 3.27 = 1.72.
e.enterprise value?
2005 Enterprise Value = $381.6 - 13 + 370 = $738.6 billion. 2009 Enterprise Value = $113.4 - 48 + 524 = $589.4 billion. The change over the period is: $589.4 - 738.6 = - $149.2 billion.
a.market capitalization?
2005 Market Capitalization: 10.6 billion shares x $36.00/share = $381.6 billion. 2009 Market Capitalization: 10.5 billion shares x $10.80/share = $113.4. The change over the period is $113.4 - $381.6 = -$268.2 billion.
d.market debt-equity ratio?
2005 Market Debt-to-Equity . 2009 Market Debt-to-Equity . The change over the period is: 4.62 - 0.97 = 3.65.
b.market-to-book ratio?
2005 Market-to-Book . 2009 Market-to-Book . The change over the period is: 1.08 - 3.38 = -2.3.
a.What is the firm's current ROE?
3.5 x 1.8 x 44/18 = 15.4%
c.If, in addition, the firm increased its revenues by 20% (while maintaining this higher profit margin and without changing its assets or liabilities), what would be its ROE?
4 x (1.8*1.2) x 44/18 = 21.1%
b.If the firm increased its net profit margin to 4%, what would be its ROE?
4 x 1.8 x 44/18 = 17.6%
2-13.Suppose a firm's tax rate is 35%. What effect would a $10 million operating expense have on this year's earnings? What effect would it have on next year's earnings?
A $10 million operating expense would be immediately expensed, increasing operating expenses by $10 million. This would lead to a reduction in taxes of 35% × $10 million = $3.5 million. Thus, earnings would decline by 10 - 3.5 = $6.5 million. There would be no effect on next year's earnings.
2-21.Can a firm with positive net income run out of cash? Explain.
A firm can have positive net income but still run out of cash. For example, to expand its current production, a profitable company may spend more on investment activities than it generates from operating activities and financing activities. Net cash flow for that period would be negative, although its net income is positive. It could also run out of cash if it spends a lot on financing activities, perhaps by paying off other maturing long-term debt, repurchasing shares, or paying dividends.
d.A large customer owing $3 million for products it already received declared bankruptcy, leaving no possibility that Global would ever receive payment.
Accounts receivable would decrease by $3 million, as would the book value of equity.
Does this imply that the market price of Global's shares increased in 2009? Explain.
An increase in book value does not necessarily indicate an increase in Global's share price. The market value of a stock does not depend on the historical cost of the firm's assets, but on investors' expectation of the firm's future performance. There are many events that may affect Global's future profitability, and hence its share price, that do not show up on the balance sheet.
b.Is Clorox's market-to-book ratio meaningful? Is its book debt-equity ratio meaningful? Explain.
Because the book value of equity is negative in this case, Clorox's market-to-book ratio and its book debt-equity ratio are not meaningful. Its market debt-equity ratio may be used in comparison.
2-28.WorldCom reclassified $3.85 billion of operating expenses as capital expenditures. Explain the effect this reclassification would have on WorldCom's cash flows. (Hint: Consider taxes.) WorldCom's actions were illegal and clearly designed to deceive investors. But if a firm could legitimately choose how to classify an expense for tax purposes, which choice is truly better for the firm's investors?
By reclassifying $3.85 billion operating expenses as capital expenditures, WorldCom increased its net income but lowered its cash flow for that period. If a firm could legitimately choose how to classify an expense, expensing as much as possible in a profitable period rather than capitalizing them will save more on taxes, which results in higher cash flows, and thus is better for the firm's investors.
c.In July 2007, Dell had a quick ratio of 1.25 and a current ratio of 1.30. What can you say about the asset liquidity of Apple relative to Dell?
c. Apple has significantly more liquid assets than Dell relative to current liabilities.
Suppose a firm's tax rate is 35%. What effect would a $10 million capital expense have on this year's earnings if the capital is depreciated at a rate of $2 million per year for five years? What effect would it have on next year's earnings?
Capital expenses do not affect earnings directly. However, the depreciation of $2 million would appear each year as an operating expense. With a reduction in taxes of 2 × 35% = $0.7 million, earnings would be lower by 2 - 0.7 = $1.3 million for each of the next 5 years.
b.What impact will the cost of the purchase have on the firm's cash flow for the next four years?
Cash flow for the next four years: less $36 million (-6 + 10 - 40) this year, and add $4 million
e. cash
Cash: increase by $3 million (earnings) - $4 million (receivables) + $2 million (inventory) = $1 million (cash).
a.What impact will the cost of the purchase have on earnings for each of the next four years?
Earnings for the next 4 years would have to deduct the depreciation expense. After taxes, this would lead to a decline of 10 × (1 - 40%) = $6 million each year for the next 4 years.
b.Earnings
Earnings: increase by $3 million
Which firm may have more difficulty meeting its debt obligations? Explain.
Firm B has a lower coverage ratio and will have slightly more difficulty meeting its debt obligations than Firm A.
e.What was the change in Global Conglomerate's book value of equity from 2008 to 2009 according to Table 2.1?
Global Conglomerate's book value of equity increased by $1 million from 2008 to 2009.
2-22.What were Heinz's cumulative earnings over these four quarters? What were its cumulative cash flows from operating activities?
Heinz's cumulative earnings over these four quarters was $871 million. Its cumulative cash flows from operating activities was $1.19 billion
Which method of acquiring the technology has a smaller impact on earnings? Is this method cheaper? Explain.
If Quisco develops the product in-house, its earnings would fall by $500 × (1 - 35%) = $325 million. With no change to the number of shares outstanding, its EPS would decrease by to $0.75. (Assume the new product would not change this year's revenues.)
2-1. What four financial statements can be found in a firm's 10-K filing? What checks are there on the accuracy of these statements?
In a firm's 10-K filing, four financial statements can be found: the balance sheet, the income statement, the statement of cash flows, and the statement of stockholders' equity. Financial statements in form 10-K are required to be audited by a neutral third party, who checks and ensures that the financial statements are prepared according to GAAP and that the information contained is reliable.
c.Find online Clorox's other financial statements from that time. What was the cause of the change to Clorox's book value of equity at the end of 2004?
Information from the statement of cash flows helped explain that the decrease of book value of equity resulted from an increase in debt that was used to repurchase $2.110 billion worth of the firm's shares.
b.A warehouse fire destroyed $5 million worth of uninsured inventory.
Inventory would decrease by $5 million, as would the book value of equity.
d.Inventory
Inventory: decrease by $2 million
2-2.Who reads financial statements? List at least three different categories of people. For each category, provide an example of the type of information they might be interested in and discuss why.
Investors. Investors are concerned with the risk inherent in and return provided by their investments. Bondholders use the firm's financial statements to assess the ability of the company to make its debt payments. Stockholders use the statements to assess the firm's profitability and ability to make future dividend payments. Financial analysts gather financial information, analyze it, and make recommendations. Managers. Managers use financial statement to look at trends in their own business, and to compare their own results with that of competitors.
c.Global used $5 million in cash and $5 million in new long-term debt to purchase a $10 million building.
Long-term assets would increase by $10 million, cash would decrease by $5 million, and long-term liabilities would increase by $5 million. There would be no change to the book value of equity.
a.Global used $20 million of its available cash to repay $20 million of its long-term debt.
Long-term liabilities would decrease by $20 million, and cash would decrease by the same amount. The book value of equity would be unchanged.
d.Does Clorox's book value of equity in 2005 imply that the firm is unprofitable? Explain.
Negative book value of equity does not necessarily mean the firm is unprofitable. Loss in gross profit is only one possible cause. If a firm borrows to repurchase shares or invest in intangible assets (such as R&D), it can have a negative book value of equity.
b.What is Global's income in 2010?
Net Income = EBIT - Interest Expenses - Taxes = (9.66 - 7.7) × (1 - 26%) = $1.45 million
c.Receivables
Receivables: increase by $4 million
a.What is Global's EBIT in 2010?
Revenues in 2009 = 1.15 × 186.7 = $214.705 million EBIT = 4.50% × 214.705 = $9.66 million (there is no other income)
a.Revenues
Revenues: increase by $5 million
a.What change in the book value of Clorox's equity took place at the end of 2004?
The book value of Clorox's equity decreased by $2.101 billion compared with that at the end of previous quarter, and was negative.
c.Which of these comparisons is more meaningful? Explain.
The market capitalization to revenue ratio cannot be meaningfully compared when the firms have different amounts of leverage, as market capitalization measures only the value of the firm's equity. The enterprise value to revenue ratio is therefore more useful when firm's leverage is quite different, as it is here.
b.What conclusions can you draw by comparing the two ratios?
The market values, in a relative sense, the outlook of Abercrombie and Fitch more favorably than it does The Gap. For every dollar of equity invested in ANF, the market values that dollar today at $4.59 versus $3.09 for a dollar invested in the GPS. Equity investors are willing to pay relatively more today for shares of ANF than for GPS because they expect ANF to produce superior performance in the future.
e.Global's engineers discover a new manufacturing process that will cut the cost of its flagship product by over 50%.
This event would not affect the balance sheet.
f.A key competitor announces a radical new pricing policy that will drastically undercut Global's prices.
This event would not affect the balance sheet.
