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# 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 owners 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

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?
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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?

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:
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## Fundamentals of Corporate Finance

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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 debtequity 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
pricesales ratio?
Net income
= 430,000 + 175,000 = 605,000

= Addition to RE + Dividends

per share

## 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

= TE / Shares

= 5,300,000 /

= 63 /

## = 63 / 2.88 = 21.87 times

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## Fundamentals of Corporate Finance

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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
and selling expenses, and depreciation expenses were 580,000,
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 Companys net income?
(b) What is its operating cash flow?
(c) Explain your results in (a) and (b).
Income Statement
Sales
730,000
COGS
580,000
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## Fundamentals of Corporate Finance

Second European Edition

a.

## A&S expenses 105,000

Depreciation 135,000
Operating Profit90,000
Interest
75,000
Profit before Tax165,000
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 firms long-term debt?
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:
2012 and 2013 Partial balance sheets
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## 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

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?
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?
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
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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. Youve
collected the following information from the grocery chains
financial statements:
(millions)
Sales

750

Net income

22.5

Total assets

420

Total debt

280

Evaluate the grocery chains claim. What is the basis for the
statement? Is this claim misleading? Why or why not?
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 stores profit margin, but a more

appropriate earnings measure for the firms 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
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## Fundamentals of Corporate Finance

Second European Edition

## Moet Hennessy Louis Vuitton SA follow. Use this information to attempt

Problems 2427.
Income statements for LVMH Moet Hennessy Louis Vuitton

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

Y/E
2013

Y/E
2012

17,193

16,481

6,012

5,786

11,181

10,695

7,553

7,140

126

116

17

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

Profit attributable to
shareholders

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

1,013

2,292

2,095

1,650

1,866

1,552

229

short-term debt

1,571

2,212

Receivables
other

## 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

18 liabilities

276

926

610

628

6,615

7,413

Non-current
liabilities

Property/plant/
equipment

6,081

3,738

2,477

Goodwill, net

4,423

3,113

2,843

Intangibles, net

8,523

989

938

Long-term
investments

591

Other long-term
assets

1,51
1

8 liabilities

12,06 11,38
4
1

21,1
29

## 20,2 Total liabilities

66

18,67 18,79
9
4

4,224

5,123

Shareholders
equity
Ordinary shares

147

147

capital

1,737

1,736

Retained earnings
(accumulated
deficit)

12,274

11,19
2

983

877

Treasury stock
common
_____

Total assets

31,4
83

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:
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## 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) Debtequity ratio
(i) Equity multiplier
(j) Times interest earned ratio
Profitability ratios:
(k) Profit margin
(l) Return on assets
(m)

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

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:
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## 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.
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 priceearnings ratio? What is the market-to-book ratio
at the end of 2012? If the companys growth rate is 9 per cent, what
is the PEG ratio?
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

## 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.
Tobins Q [LO2]What is Tobins 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 companys 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 companys debt is:
Total debt = Current liabilities + Non-Current Liabilities
Total debt = 18,679m
Now we can calculate Tobins Q, which is:
Tobins Q = (Market value of equity + Book value of debt) / Book value
of assets
Tobins Q = (22,134.48m + 18,679m) / 31,483m
Tobins 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.
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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?
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),
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