Chapter Problems and Answers PDF

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Chapter Problems and Answers...

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FIN1101 Problems and Solutions

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Chapter 1

Critical Thinking Problems

1.1

Describe the cash flows between a firm and its stakeholders. Cash flows are generated by a firm’s productive assets that were purchased through either issuing debt or raising equity. These assets generate revenues through the sale of goods and services. A portion of this revenue is then used to pay wages and salaries to employees, pay suppliers, pay taxes, and pay interest on the borrowed money. The leftover money, residual cash, is then either reinvested back in the business or is paid out to stockholders in the form of dividends.

1.2

What are the three fundamental decisions the finance team is concerned with, and how do they affect the firm’s balance sheet? The primary financial management decisions every company faces are capital budgeting decisions, financing decisions, and working capital management decisions. Capital budgeting addresses the question of which productive assets to buy; thus, it affects the asset side of the balance sheet. Financing decisions focus on raising the money the firm needs to buy productive assets. This is typically accomplished by selling long-term debt and equity. Finally, working capital decisions involve how firms manage their current assets and liabilities. The focus here is seeing that a firm has enough money to pay its bills and that any spare money is invested to earn to earn a return.

1.3

What is the difference between stockholders and stakeholders? Stockholders, also referred to as shareholders, are the owners of the company. A stakeholder, on the other hand, is anyone with a claim on the assets of the firm, including, but not limited to, shareholders. Stakeholders include the firm’s employees, suppliers, creditors, and the government.

1.4

Suppose that a group of accountants want to start their own accounting business. What organizational form would they most likely choose, and why?

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Most lawyers, accountants, and doctors form what are known as limited liability partnerships. These formations combine the tax advantages of partnerships with the limited liability of corporations. 1.5

Why would the owners of a business choose to form a corporation even though they will face double taxation? Because the benefits, such as limited liability and access to large amounts of capital at relatively low cost in the public markets, outweigh the cost of double taxation (as well as the higher costs associated with forming a corporation).

1.6

Explain why profit maximization is not the best goal for a company. What is a better goal? Although profit maximization appears to be the logical goal for any company, it has many drawbacks. First, profit can be defined in a number of different ways, and variations in net income for similar firms can vary widely. Second, accounting profits do not exactly equal cash flows. Third, profit maximization does not account for timing and ignores risk associated with cash flows. An appropriate goal for financial managers who do not have these objections is to maximize the value of the firm’s current stock price. In order to achieve this goal, management must make financial decisions so that the total value of cash inflows exceeds the total value of cash outflows.

1.7

What are some of the external and internal factors that affect a firm’s stock price? What is the difference between these two types of factors? External factors that affect the firm’s stock price are: (1) economic shocks, such as natural disasters or wars, (2) the state of the economy, such as the level of interest rates, and (3) the business environment, such as taxes or regulations. On one hand, external factors are variables over which the management has no control. On the other hand, internal factors that affect the stock price can be controlled by management to some degree, because they are firm specific, such as financial management decisions, product quality and cost, and the line of business management has selected to enter. Finally, perhaps the most important internal variable that determines the stock price is the expected cash flow stream: its magnitude, timing, and riskiness.

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1.8

Identify the sources of agency costs. What are some ways these costs can be controlled in a company? Agency costs are the costs that result from a conflict of interest between the agent and the principal. They can either be direct, such as lavish dinners or trips, or indirect, which are usually missed investment opportunities. A company can control these costs by tying management compensation to company’s performance or by establishing an independent board of directors. Outside factors that contribute to the minimization of agency costs are the threat of corporate raiders that can take over a company not performing up to expectations and the competitive nature of the management labor market.

1.9

What is the Sarbanes-Oxley Act, and what does it focus on? Why does it focus in these areas? The Sarbanes-Oxley Act is an act of Congress that was passed in 2002. This act was passed in the aftermath of several corporate scandals that occurred at the turn of the century. The act focuses on (1) reducing agency costs in corporations, (2) restoring ethical conduct within the business sector, and (3) improving the integrity of accounting reporting system within firms. Failures in these areas led to the corporate scandals that preceded passage of Sarbanes-Oxley.

1.10

Give an example of a conflict of interest in a business setting, other than the one involving the real estate agent discussed in the chapter text. For example, imagine a situation in which you are a financial officer at a growing software company and your firm has decided to hire outside consultants to formulate a global expansion strategy. Coincidentally, your wife works for one of the major consulting firms that your company is considering hiring. In this scenario, you have a conflict of interest, because instinctively, you might be inclined to give the business to your wife’s firm, because it will benefit your family’s financial situation if she lands the contract, regardless of whether or not it makes the best sense for your firm.

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Sample Test Problems 1.1 Why is value maximization superior to profit maximization as a goal for management? Solution: While profit maximization appears to be a logical goal at first glance, it has some serious drawbacks. First, the common notion of profit being the difference between revenues and expenses can be distorted by some creative accounting measures. Second, as we will see throughout the text, accounting profits are quite different from cash flows. Cash flows will be the focus of investors and therefore managers. Third, profit maximization does not recognize when cash flows occur. Finally, profit maximization as a goal ignores the risk involved in generating the cash flows. When analysts and investors determine the value of a firm’s stock, they consider (1) the size of the expected cash flows, (2) the timing of the cash flows, and (3) the riskiness of the cash flows. Thus, value maximization as a goal overcomes all the shortcomings we recognized with regard to profit maximization as a goal. 1.2 The major advantages of debt financing is: a.

It allows a firm to use creditors’ money.

b.

Interest payments are more predictable than dividend payments.

c.

Interest payments are not required when a firm is not doing well.

d.

Interest payments are tax deductible.

Solution: d (interest payments are tax deductible.) 1.3 Identify three fundamental decisions that a financial manager makes. Solution: 

Management decides what type of products or services to produce and what productive assets to purchase.



Managers also make financing decisions that concerns the mix of debt to equity, debt collection policies, and policies for paying suppliers, to mention a few.

1.4 What are agency costs? Explain. Solution: Agency costs are the costs that result from a conflict between a firm’s management and its owners or shareholders. When management acts in ways that 5

do not benefit shareholders, it results in agency costs. These costs could be either direct or indirect. When a management action results in a loss of cash flow to the firm, it is an indirect cost. Direct costs result from inappropriate actions or expenses by management that lower the firm’s income and cash flows. 1.5 Identify four of the seven mechanisms that can help better align the goals of managers to those of stockholders. Solution: Four mechanisms that can help align the behavior of managers with the goals of corporate shareholders are: (1) management compensation, (2) control of the firm, (3) management labor markets, and (4) an independent board of directors. (The other three are (5) large stockholders, (6) the takeover market, and (7) the legal and regulatory environment.) Firms have come up with compensation plans tied to the performance of the firm to give managers an incentive to make decisions consistent with the goal of shareholders’ wealth maximization. Another incentive comes in the form of a takeover threat by corporate raiders, which will lead to firing the current management being. A third incentive comes through the labor market, which will make it difficult for poorly performing management to find another job. Finally, the presence of independent directors on the firm’s board will prevent managers from acting solely in their own interest.

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Chapter 5

Critical Thinking Questions 5.1

Explain the phrase “A dollar today is worth more than a dollar tomorrow.” The implication is that if one was to receive a dollar today instead of in the future, the dollar could be invested and will be worth more than a dollar tomorrow because of the interest earned during that one day. This makes it more valuable than receiving a dollar tomorrow.

5.2

Explain the difference between future value and present value. Future value measures what one or more cash flows are worth at the end of a specified period, while present value measures what one or more cash flows that are to be received in the future will be worth today (at t = 0).

5.3

Explain the difference between compounding and discounting. The process of converting an amount given at the present time into a future value is called compounding. It is the process of earning interest over time. Discounting is the process of converting future cash flows to what its present value is. In other words, present value is the current value of the future cash flows that are discounted at an appropriate interest rate.

5.4

Explain how compound interest differs from simple interest. Suppose I invest $100 for three years at a rate of 10 percent. Simple interest would imply that I will earn $10 for each of the three years for a total of $30 interest. At the end of three years I would have $130. Compound interest recognizes that the interest earned in years 1 and 2 will also earn interest over the remaining period. Thus, the $10 earned in the first year would earn interest at 10 percent for the next two years, and the $10 earned in the second year would earn interest for the third year. Thus the total amount that I would have at the end of three years would be: 7

$ 100(1.10)3=$ 133 .10 . By compounding, I have earned an additional interest of $3.10. The total interest or compound interest is the $33.10 earned on the $100 invested, while the simple interest earned is equal to $30. 5.5

What is the key economic principle involved in calculating the present value and future value of multiple cash flows? Regardless of whether you are calculating the present value or the future value of a cash flow stream, the key idea is to discount or compound the cash flows to the same point in time.

5.6

Raymond Bartz is trying to choose between two equally risky annuities, each paying $5,000 per year for five years. One is an ordinary annuity, and the other is an annuity due. Which of the following statements is most correct? a. The present value of the ordinary annuity must exceed the present value of the annuity due, but the future value of an ordinary annuity may be less than the future value of the annuity due. b. The present value of the annuity due exceeds the present value of the ordinary annuity, while the future value of the annuity due is less than the future value of the ordinary annuity. c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity. d. If interest rates increase, the difference between the present value of the ordinary annuity and the present value of the annuity due remains the same. c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity.

5.7

Which of the following investments will have the highest future value at the end of three years? Assume that the effective annual rate for all investments is the same. a. You earn $3,000 at the end of three years (a total of one payment). 8

b. You earn $1,000 at the end of every year for the next three years (a total of three payments). c. You earn $1,000 at the beginning of every year for the next three years (a total of three payments). c. Earning $1,000 at the beginning of each year for the next three years will have the highest future value as it is an annuity due. 5.8

Explain whether or not each of the following statements is correct. a. A 15-year mortgage will have larger monthly payments than a 30-year mortgage of the same amount and same interest rate. This is a true statement. The 15-year mortgage will have higher monthly payments since more of the principal will have to be paid each month than in the case of a 30year mortgage. b. If an investment pays 10 percent interest compounded annually, its effective rate will also be 10 percent. This is true since the frequency of compounding is annual and hence the rate for a single period is the same as the rate for a year.

5.9

Why is the effective annual rate (EAR) superior to the annual percentage rate (APR) in measuring the true economic cost or return? When will the EAR and the APR be the same? Unlike the APR, which reflects annual compounding, the EAR takes into account the actual number of compounding periods. For example, suppose there are two investment alternatives that both pay an APR of 10 percent. Assume that the first pays interest annually and that the second pays interest quarterly. It would be a mistake to assume that both investments will provide the same return. The real return on the first one is 10 percent, but the second investment actually provides a return of 10.38 percent because of the quarterly compounding. Thus, this is the superior investment!

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The annual percentage rate (APR) will be the same as the effective annual rate only if the compounding period is annual, not otherwise. 5.10 Suppose three investments have equal lives and multiple cash flows. A high discount rate tends to favor: a. the investment with large cash flows early. b. the investment with large cash flows late. c. the investment with even cash flows. d. none of the investments since they have equal lives. a. The investment with large cash flows early will be worth more compared to the one with the large cash flows late. The cash flows that come in later will have a heavier penalty when using a higher discount rate. Thus the investment with large cash flows early will be favored.

Questions and Problems 5.1

Future value: Ted Rogers is investing $7,500 in a bank CD that pays a 6 percent annual interest. How much will the CD be worth at the end of five years?

LO 2 Solution: 0

5 years

├────────────────────┤ PV = $7,500

FV5 = ?

Amount invested today = PV = $7,500 Return expected from investment = i = 6% Duration of investment = n = 5 years Value of investment after 5 years = FV5

FV 5 = PV ×( 1+i )n=$ 7 , 500×( 1. 06 )5 ¿ $10,036 . 69

10

5.2

Future value: Your aunt is planning to invest in a bank deposit that will pay 7.5 percent interest semiannually. If she has $5,000 to invest, how much will she have at the end of four years?

LO 2 Solution: 0

4 years

├────────────────────┤ PV = $5,000

FV4 = ?

Amount invested today = PV = $5,000 Return expected from investment = i = 7.5% Duration of investment = n = 4 years Frequency of compounding = m = 2 Value of investment after 4 years = FV4 i   FV4  PV  1   m  

mn

0.075   $5, 000 1  2  

2 4

$5, 000 (1.0375)8 $6, 712.35

5.3

Future value: Your birthday is coming up, and instead of other presents, your parents promised to give you $1,000 in cash. Since you have a part time job and thus don’t need the cash immediately, you decide to invest the money in a bank CD that pays an annual rate of 5.2 percent, compounded quarterly, for the next two years. How much money can you expect to gain in this period of time?

LO 2 Solution: 0

2 years

├────────────────────┤ PV = -$1,000

FV2 = ?

Amount invested today = PV = $1,000 Return expected from investment = i = 5.2% Duration of investment = n = 2 years 11

Frequency of compounding = m = 4 Value of investment after 2 years = FV2

( )

(

i mn 0.052 =$ 1 ,000× 1+ FV 2 = PV × 1+ m 4 8 ¿$ 1 ,000×( 1 .013 ) ¿$1,108 . 86 5.4

)

4×2

Present value: Roy Gross is considering an investment that pays 7.6 percent. How much will he have to invest today so that the investment will be worth $25,000 in six years?

LO3 Solution: 0

6 years

├────────────────────┤ PV = ?

FV6 = $25,000

Value of investment after 6 years = FV5 = $25,000 Return expected from investment = i = 7.6% Duration of investment = n = 6 years Amount to be invested today = PV

FV $ 25 , 000 PV = n n = (1+i) (1. 076 )6 ¿ $16,108 . 92 5.5

Present value: Maria Addai has been offered a future payment of $750 two years from now. If she can earn 6.5 percent compounded annually on her investment, what should she pay for this investment today?

LO3 Solution: 0

2 years

├────────────────────┤ PV = ?

FV2 = $750 12

Value of investment after 2 years = FV2 = $750 Return expected from investment = i = 6.5% Duration of investment = n = 2 years Amount to be invested today = PV

FV n $ 750 = PV = n ( 1+i ) (1 .065 )2 ¿ $661 . 24 5.6

Present value: Tracy Chapman is saving to buy a house in five years time. She plans to put down 20 percent down at that time, and she believes that she will need $35,000 for the down payment. If Tracy can invest in a fund that pays 9.25 percent annually, how much will she need to invest today?

LO3 Solution: 0

5 years

├────────────────────┤ PV = ?

FV5 = $35,000

Amount needed for down payment after 5 years = FV5 = $35,000 Return expected from investment = i = 9.25% Duration of investment = n = 5 years Amount to be invested today = PV

FV $ 35 ,000 PV = n n = ( 1+i ) (1 .0925 )5 ¿ $22,488 . 52 5.7

Interest rate: You are in desperate need of cash and turn to your un...