CH-1-3 Goals and Governance of the Firm – Fundamentals of Corporate Finance : Book Guide

This Document Contains Chapters 1 to 3 Brealey 5CE Solutions to Chapter 1 1. real executive airplanes brand names financial stock investment capital budgeting financing 2. A firm might cut its labour force dramatically which could reduce immediate expenses and increase profits in the short term. Over the long term, however, the firm might not be able to serve its customers properly or it might alienate its remaining workers; if so, future profits will decrease, and the stock price will decrease in anticipation of these problems. Similarly, a firm can boost profits over the short term by using less costly materials even if this reduces the quality of the product. Once customers catch on, sales will decrease and profits will fall in the future. The stock price will fall. The moral of these examples is that, because stock prices reflect present and future profitability, the firm should not necessarily sacrifice future prospects for short-term gains. 3. The key advantage of separating ownership and management in a large corporation is that it gives the corporation permanence. The corporation continues to exist if managers are replaced or if stockholders sell their ownership interests to other investors. The corporation’s permanence is an essential characteristic in allowing corporations to obtain the large amounts of financing required by many business entities. Both public and private corporations are distinct legal entity, separate from its owners (ie., its shareholders). The key difference between public and private corporations are the rules governing the sale of their common shares. The common shares of a public corporation are listed for trading on a stock exchange and investors can freely buy and sell the corporation’s shares at the current stock price. The common shares of a private corporations are not listed for trading on a stock 1-1 This Document Contains Chapters 1 to 3 exchange. Shareholders of private corporations must negotiate directly with potential buyers and are subject to resale restrictions. To learn more about the risks associated with investing in private companies, see this website run by the British Columbia Securities Commission: http://www.investright.org/private_company_investing.aspx 4. A sole proprietorship is easy to set up with a minimum of legal work. The business itself is not taxed. For tax purposes, the income of the proprietorship is treated as the income of the proprietor. The main disadvantages of a proprietorship are the proprietor’s unlimited liability for the debts of the firm, and difficulty in raising large amounts of financing as the business grows. A partnership has the same tax advantage as the proprietorship. The partnership per se does not pay taxes. The partnership files a tax return, but all of the partnership income is allocated to the partners and treated as personal income. Also, it is fairly easy to set up a partnership. Because there can be many partners, a partnership can raise capital more easily than a proprietorship. However, like sole proprietors, partners have unlimited liability for the debts of the firm. In fact, each partner has unlimited liability for all the business’s debts, not just his or her share. Corporate organization has the advantage of limited liability. Its owners, the shareholders, are not personally responsible for the debts of the corporation. It also allows for separation of ownership and management, since shares in the firm can be traded without changing management. A public corporation has the added advantage of easier access to equity financing because its shares are traded in public stock markets. The major disadvantage of corporate organization is the double taxation of income. Corporations pay taxes on their income, and that income is taxed again when it is passed through to shareholders in the form of dividends. Another disadvantage of corporate organization is the extra time and cost required in order to manage a corporation’s legal affairs. These costs arise because the corporation must be chartered and is considered a distinct legal entity. Such administrative costs are significant only for small corporations, however. Furthermore, public corporations must provide investors with detailed financial information in their annual reports and inform investors about significant events. Disclosure takes time and resources and may also be costly in the sense that competitor firms learn what is going on too. LLP’s may be considered to be hybrid organizations to the extent that while individual partners have unlimited liability, they are not liable for the actions of their partners. 5. Double taxation means that a corporation’s income is taxed first at the corporate tax rate, and then, when the income is distributed to shareholders as dividends, the income is taxed again at the shareholder’s personal tax rate. 6. a, c, d. 1-2 7. On the website, www.td.com, the various businesses are listed in a table in the middle of the page. Click a business, such as TD Canada Trust, and the main business activities appear in a box under the table. To work as an investment banker, you would work for TD Securities, listed under the heading “Wholesale Banking”. Clicking on “TD Securities” and then on “Learn more” takes you to a webpage, www.tdsecurities.com/tds/content/AU_AboutUs1?language=en_CA that says: With more than 2,700 people in 15 14 offices around the world, TD Securities provides a wide range of capital market products and services to corporate, government and institutional clients who choose us for our knowledge, innovation and experience in the following key areas of finance: • Investment and Corporate Banking • Capital Markets • Interest Rate, Currency and Derivative Products • Commodities Our services include the underwriting and distribution of new debt and equity issues, providing advice on strategic acquisitions and divestitures, and executing daily trading and investment needs.With our history of delivering results, we’ve developed considerable strengths, including recognized trading expertise and street- level market intelligence that we use to consistently create value for our clients. To trade securities, join TD Asset Management, http://www.tdassetmanagement.com/Content/Homepage/p_Homepage.asp, “a highly diversified North American investment management firm with leading market positions in active, quantitative and passive portfolio management. The firm serves a large and diversified client base including pension funds, corporations, institutions, endowments, foundations and high net worth individuals. We also offer private money management services and manage retail mutual funds.” To work as retail investment advisor, join TD Waterhouse Private Client services, http://www.tdwaterhouse.ca/pcs/pia/index.jsp 1-3 8. a. A share of stock financial b. A personal IOU financial c. A trademark real d. A truck real e. Undeveloped land real f. The balance in the firm’s chequing account financial g. An experienced and hardworking sales force real h. A bank loan agreement financial 9. a. Real assets are items that are used to produce goods and services. Real assets include both tangible and intangible items. Tangible (physical) real assets include such items as machinery, building, and inventories. Intangible real assets include items such as research ideas, brand names and skilled work force. In contrast, financial assets are items that have value only because of their claim to cash flows generated by real assets. Many different types of financial assets exist, including bank loans, bonds, stocks, and options. b. Investment or capital budgeting decisions involve deciding which real assets to acquire. Financing decision involved arranging the money needed to pay for investments in the real assets. So, when making investment decisions you decide what to spend money on and when making financing decisions, you decide how to get the money to spend. c. Both capital budgeting and capital structure are long-term decisions. Capital budgeting decisions is the process of deciding the real asset investment plans. Capital structure decision is the process of deciding the mix of the long-term financing to use to fund the firm’s assets. Essentially, capital structure decision involve selecting between equity financing and long-term debt financing. 10. Capital budgeting decisions Should a new computer be purchased? Should the firm develop a new drug? Should the firm shut down an unprofitable factory? Financing decisions Should the firm borrow money from a bank or sell bonds? Should the firm issue preferred stock or common stock? Should the firm buy or lease a new machine that it is committed to acquiring? 11. The stock price reflects the value of both current and future dividends the shareholders will receive. In contrast, profits reflect performance in the current year only. Profit maximizers may try to improve this year’s profits at the expense of future profits. But 1-4 stock price maximizers will take account of the entire stream of cash flows that the firm can generate. They are more apt to be forward looking. 12. a. This action might appear, superficially, to be a grant to former employees and thus not consistent with value maximization. However, such ‘benevolent’ actions might enhance the firm’s reputation as a good place to work, might result in greater loyalty on the part of current employees, and might contribute to the firm’s recruiting efforts. Therefore, from a broader perspective, the action may be value maximizing. b. The reduction in dividends to allow increased reinvestment can be consistent with maximization of current market value. If the firm has attractive investment opportunities, and wants to save the expenses associated with issuing new shares to the public, then it could make sense to reduce the dividend in order to free up capital for the additional investments. c. The corporate jet would have to generate benefits in excess of its costs in order to be considered stock-price enhancing. Such benefits might include time savings for executives, and greater convenience and flexibility in travel. 13. a. Increased market share can be an inappropriate goal if it requires reducing prices to such an extent that the firm is harmed financially. Increasing market share can be part of a well-reasoned strategy, but one should always remember that market share is not a goal in itself. The owners of the firm want managers to maximize the value of their investment in the firm. b. Minimizing costs can also conflict with the goal of value maximization. For example, suppose a firm receives a large order for a product. The firm should be willing to pay overtime wages and to incur other costs in order to fulfill the order, as long as it can sell the additional product at a price greater than those costs. Even though costs per unit of output increase, the firm still comes out ahead if it agrees to fill the order. c. A policy of underpricing any competitor can lead the firm to sell goods at a price lower than the price that would maximize market value. Again, in some situations, this strategy might make sense, but it should not be the ultimate goal of the firm. It should be evaluated with respect to its effect on firm value. d. Expanding profits is a poorly defined goal of the firm. The text gives three reasons: (i) There may be a trade-off between accounting profits in one year versus accounting profits in another year. For example, writing off a bad investment may reduce this year’s profits but increase profits in future years. Which year’s profits should be maximized? 1-5 (ii) Investing more in the firm can increase profits, even if the increase in profits is insufficient to justify the additional investment. In this case the increased investment increases profits, but can reduce shareholder wealth. (iii) Profits can be affected by accounting rules, so a decision that increases profits using one set of rules may reduce profits using another. 14. The contingency arrangement aligns the interests of the lawyer with those of the client. Neither makes any money unless the case is won. If a client is unsure about the skill or integrity of the lawyer, this arrangement can make sense. First, the lawyer has an incentive to work hard. Second, if the lawyer turns out to be incompetent and loses the case, the client will not have to pay a bill. Third, the lawyer will not be tempted to accept a very weak case simply to generate bills. Fourth, there is no incentive for the lawyer to charge for hours not really worked. Once a client is more comfortable with the lawyer, and is less concerned with potential agency problems, a fee-for-service arrangement might make more sense. 15. The national chain has a great incentive to impose quality control on all of its outlets. If one store serves its customers poorly, that can result in lost future sales. The reputation of each restaurant in the chain depends on the quality in all the other stores. In contrast, if Joe’s serves mostly passing travelers who are unlikely to show up again, unsatisfied customers pose a far lower cost. They are unlikely to be seen again anyway, so reputation is not a valuable asset. The important distinction is not that Joe has one outlet while the national chain has many. Instead, it is the likelihood of repeat relations with customers and the value of reputation. If Joe’s were located in the center of town instead of on the highway, one would expect his clientele to be repeat customers from town. He would then have the same incentive to establish a good reputation as the chain. 16. While a compensation plan that depends solely on the firm’s performance would serve to motivate managers to work hard, it would also burden them with considerable personal risk tied to the fortunes of the firm. This would be unattractive to managers and might cause them to value their compensation packages less highly; it might also elicit excessive caution when evaluating business opportunities. 17. Takeover defenses make it harder for underperforming managers to be removed by dissatisfied shareholders, or by firms that might attempt to acquire the firm. By protecting such managers, these provisions exacerbate agency problems. 18. Traders can earn huge bonuses when their trades are very profitable, but if the trades lose large sums, as in the case of Barings Bank, the trader’s exposure is limited. This asymmetry can create an incentive to take big risks with the firm’s (i.e., the shareholders’) money. This is an agency problem. 1-6 19. a. A fixed salary means that compensation is (at least in the short run) independent of the firm’s success. b. A salary linked to profits ties the employee’s compensation to this measure of the success of the firm. However, profits are not a wholly reliable way to measure the success of the firm. The text points out that profits are subject to differing accounting rules, and reflect only the current year’s situation rather than the long- run prospects of the firm. c. A salary that is paid partly in the form of the company’s shares means that the manager earns the most when the shareholders’ wealth is maximized. This is therefore most likely to align the interests of managers and shareholders. d. Stock options create great incentives for managers to contribute to the firm’s success. In some cases, however, stock options can lead to agency problems. For example, a manager with many options might be tempted to take on a very risky project, reasoning that if the project succeeds the payoff will be huge, while if it fails, the losses are limited to the lost value of the options. Shareholders, in contrast, bear the losses as well as the gains on the project, and might be less willing to assume the risk. 20. Even if a shareholder could monitor and improve managers’ performance, and thereby increase the value of the firm, the payoff would be small, since the ownership share in a large corporation is very small. For example, if you own $10,000 of GM stock and can increase the value of the firm by 5 percent, a very ambitious goal, you benefit by only: (0.05 × $10,000) = $500. In contrast, a bank that has a multimillion-dollar loan outstanding to the firm has a large stake in making sure that the loan can be repaid. It is clearly worthwhile for the bank to spend considerable resources on monitoring the firm. 21. Long-term relationships can encourage ethical behavior. If you know that you will engage in business with another party on a repeated basis, you will be less likely to take advantage of your business partner if an opportunity to do so arises. When people say "what goes around comes around," they recognize that the way they deal with their associates will influence the way their associates treat them. When relationships are short-lived, however, the temptation to be unfair is greater since there is less reason to fear reprisal, and less opportunity for fair dealing to be reciprocated. 22. As the text notes, the first step in doing well is doing good by your customers. Businesses cannot prosper for long if they do not provide to their customers the products and services they desire. In addition, reputation effects often make it in the firm’s own interest to act ethically toward its business partners and employees since the firm’s ability to make deals and to hire skilled labour depends on its reputation for dealing fairly. 1-7 In some circumstances, when firms have incentives to act in a manner inconsistent with the public interest, taxes or fees can align private and public interests. For example, taxes or fees charged on pollution make it more costly for firms to pollute, thereby affecting the firm’s decisions regarding activities that cause pollution. Other “incentives” used by governments to align private interests with public interests include: legislation to provide for worker safety and product, or consumer, safety, building code requirements enforced by local governments, and pollution and gasoline mileage requirements imposed on automobile manufacturers. 23. Some customers might consider this practice unethical. They might view the firm as gouging its customers during heat waves. On the other hand, the firm might try to convince customers that this practice allows it to charge lower prices in cooler periods, and that over long periods of time, prices even out. Whether customers and firms have an “implicit contract” to charge and pay stable prices is something of a cultural issue. 24. This website provides information on the various types of business structures. However, to find out some details on rules and regulations, ask your students to go http://www.canadabusiness.ca/eng/guide/1282/. On this page are links to various provincial sites for registering sole proprietorships and partnerships and also registering corporations. On investigation, some links are better than others. Rules and regulations governing different forms of business share similarities and differences across provinces. For example, to learn about Prince Edward Island’s rules for sole proprietorships, partnerships and corporations, click on “Corporate Services - Business Name Registration (Prince Edward Island)” and then click on “Learn more” which takes you to the website of the Department of Justice and Public Safety, Government of Prince Edward Island. http://www.gov.pe.ca/jps/index.php3?number=1027252&lang=E. To get information about Partnership, click on “Business Name Registration – Partnership”. In Prince Edward Island, partnerships are governed by the Partnership Act. Within 3 months of forming a partnership, a declaration of partnership must be registered (cost $65) which is valid for three years. In Quebec however, a declaration of registration with the applicable fees is required within 60 days following the day on which the business is started. Provinces usually require that a name search be done prior to a business being registered as a partnership or sole proprietor (eg. Quebec or PEI). However, if a sole proprietor is starting a business under their first and last names, they may not be required to register the business. Registration requirements are usually less stringent or, at times, even exempt, for sole proprietorships named after the proprietor (first and last name). However, if the business name doing not include the owners full name then registration is usually required. Provinces have similar rules for forming corporations. Prior to incorporation, a name search is required. The search could be Canada wide or just within a particular province. Typically, provinces also require registration fees (eg. PEI or 1-8 Saskatchewan). Also corporations must file annual returns with the appropriate provincial authorities, failing to do so could result in the corporation’s name being struck from the Register of Corporations. In general, while provinces enjoy the authority to regulate businesses within their jurisdictions and may have differing statutes on occasion, closer examination indicates that the rules and regulation are actually quite similar. Turning to the question of how not-for-profit organizations differ from the for- profit structures, the same basic information on not-for-profit organizations is provided on each province’s website, under the heading “Not-for-Profit Organization vs. Other Business Structures”. The most basic information is found at “FAQs – LawNow” (http://www.law-nonprofit.org/faq.htm). The key point: a not-for-profit organization cannot be organized for commercial purposes and members, the not-for-profit equivalent of shareholders, must not benefit personally as investors. Unlike shareholders who are entitled to receive dividends from the profits generated in the pursuit of business, the members of a not-for-profit cannot receive any financial gain from the organization. Not-for-profits can be set up as not-for-profit corporations, providing separation between management and members and limited liability for its members. These benefits are similar to those for shareholder of for-profit corporations. More information on not-for-profit corporations is provided by Industry Canada, found at http://www.ic.gc.ca/eic/site/ic1.nsf/eng/h_00076.html 25. Careers in Finance. Here are examples of two areas of employment in finance: Corporate Finance- The “Corporate Finance” career refers to a broad range of finance jobs involved with operating a company. The main tasks of those in corporate finance including finding the money to run the business, investing in projects and working capital, acquisitions of other businesses, managing surplus cash and collection of bills. The list of jobs, click on “Job Options”, include the treasurer, the senior person responsible for managing the company’s finances. More junior positions include financial analysts who do much of the analytical work to evaluate alternatives, credit managers, who establish and implement policies for granting credit to customers and the collection of bills, and cash managers, who are responsible for managing the company’s cash. You might work for a large multinational company or a smaller player with high growth prospects. Responsibility can come fast and your problem-solving skills will be put to work quickly in corporate finance. Skills required for a successful career in corporate finance: The skill set for a successful corporate finance career includes strong problem solving skills, requiring 1-9 both analytical and intuitive analysis, ability to function in a team environment, excellent people skills and willingness to take initiative. NOTE: Although salary data is provided on the website, no date is given for these salary data. My sense is that this database has not been updated recently. I would not put a lot of faith in the salary figures. Commercial Banking- providing banking services to individuals, small businesses and large organizations. Jobs in banking can be exciting and offer excellent opportunities to learn about the variety of business activities in which today’s banks participate, interact with people, and build up a clientele. So, for instance, at the branch level you may be interacting constantly with customers as a teller. You may work in other areas of the bank’s business as well such as mortgage financing, loans, trade credit, leasing, credit card banking and international finance. Skills required for a successful career in the banking industry: You should have a good understanding of the bank’s overall business and how your role fits in with the needs of the business. Many large banks engage in a wide variety of international financing activities. It is not surprising, therefore, that individuals with “international” exposure, training, language skills, etc. tend to do well in such environments. Other attributes required to do well in the banking sector may include accounting and writing skills, integrity of character and a sound work ethic, good communication skills and people management skills, etc. Salary Range Bachelor’s degree - $24,000- $38,000 Master’s degree- $30,000- $50,000 (and above) 26. This question provides students with a website for exploring career information provided by the Government of Canada. The answer to the first part of the question is whatever the students learn about their interests and careers that are associated with these interests. From the homepage of the workingincanada.gc.ca, for instance type “Financial Managers” and click on the Financial Managers search result. You will find the description of the occupation with its NOC code and also some relevant job titles. From here, you can click on “Choose this occupation” and then choose your province or territory to get the detailed information about your selected occupation, such as job postings, average wage, outlook and prospects, licence and certification, main duties, job and skill requirements, and education and training. 1-10 Brealey 5CE Solutions to Chapter 2 1. The story of RIM provides three examples of financing sources: equity investments by the founders of the company, loans from friends and family, and loans by governments. Other sources include reinvested earnings of the company and loans from banks and other financial institutions. 2. Yes. When the corporation retains cash and reinvests in the firm’s operations, that cash is saved and invested on behalf of the firm’s shareholders. The reinvested cash could have been paid out to the shareholders. By not taking the cash, these investors have reinvested their savings in the corporation. Individuals can also save and invest in a corporation by lending to, or buying shares in, a financial intermediary such as a bank or mutual fund that subsequently invests in the corporation. 3. Money markets, where short-term debt instruments are bought and sold. Foreign-exchange markets. Most trading takes place in over-the-counter transactions between the major international banks. Commodities markets for agricultural commodities, fuels (including crude oil and natural gas) and metals (such as gold, silver and platinum). Derivatives markets, where options and other derivative instruments are traded. 4. Buy shares in an exchange-traded fund (ETF) or a mutual fund. Both ETFs and mutual funds pool savings from many individual investors and then invest in a diversified portfolio of securities. Each individual investor then owns a proportionate share of the ETF or mutual fund’s portfolio. 5. Defined contribution pension plans provide three key advantages as vehicles for retirement savings: • Professional management. • Diversification at low cost. • Pension plan contributions are tax-deductible, and taxes on the earnings in the fund are deferred until the fund’s assets are distributed to retired employees. 6. Yes. Insurance companies sell policies and then invest part of the proceeds in corporate bonds and stocks and in direct loans to corporations. The returns from these investments help pay for losses incurred by policyholders. 2-1 7. The largest institutional investors in bonds are insurance companies. Other major institutional investors in bonds are pension funds, mutual funds, and banks and other savings institutions. The largest institutional investors in shares are pension funds, mutual funds, and insurance companies. 8. The market price of gold can be observed from transactions in commodity markets. For example, gold is traded on the Comex division of the New York Mercantile Exchange. Look up the price of gold and compare it to $2,500/6 = $416.67 per ounce. 9. Financial markets provide extensive data that can be useful to financial managers. Examples include: • Prices for agricultural commodities, metals and fuels. • Interest rates for a wide array of loans and securities, including money market instruments, corporate and Canadian government bonds, and interest rates for loans and investments in foreign countries. • Foreign exchange rates. • Stock prices and overall market values for publicly listed corporations are determined by trading on the TSX, New York Stock Exchange, NASDAQ or stock markets in London, Frankfurt, Tokyo, etc. 10. The opportunity cost of capital is the expected rate of return offered by the best alternative investment opportunity. When the firm makes capital investments on behalf of the owners of the firm (i.e., the shareholders), it must consider the shareholders’ other investment opportunities. The firm should not invest unless the expected return on investment at least equals the expected return the shareholders could obtain on their own by investing in the financial markets. The opportunity cost of capital for a safe investment is the rate of return that shareholders could earn if they invested in risk-free securities, for example in Government of Canada Treasury Bills. 11. When stockholders have access to modern financial markets and institutions, stockholders can readily avail themselves of the functions served by these markets and institutions: for example, transporting cash across time, risk transfer and diversification, liquidity, and access to payment mechanisms. Therefore, the objective of value maximization makes sense for stockholders because this is the only task stockholders require of corporate management. In addition, the financial markets provide the pricing mechanism and the information stockholders require in order to assess the performance of the firm’s management in achieving this objective. 12. a. False. Financing could flow through an intermediary, for example. 2-2 b. False. Investors can buy shares in a private corporation, for example. c. True. Sale of insurance policies are the largest source of financing for insurance companies, which then invest a significant portion of the proceeds in corporate debt and equities. d. False. There is no centralized FOREX exchange. Foreign exchange is traded over-the-counter. e. False. The opportunity cost of capital is the expected rate of return that shareholders can obtain in the financial markets on investments with the same risk as the firm’s capital investments. f. False. The cost of capital is an opportunity cost determined by expected rates of return in financial markets. The opportunity cost of capital for risky investments is normally higher than the firm’s borrowing rate. 13. Liquidity is important because investors want to be able to convert their investments into cash quickly and easily when it becomes necessary or desirable to do so. Should personal circumstances or investment considerations lead an investor to conclude that it is desirable to sell a particular investment, the investor prefers to be able to sell the investment quickly and at a price that does not require a significant discount from market value. Liquidity is also important to mutual funds. When the mutual fund’s shareholders want to redeem their shares, the mutual fund is often forced to sell its securities. In order to maintain liquidity for its shareholders, the mutual fund requires liquid securities. 14. The key to the bank’s ability to provide liquidity to depositors is the bank’s ability to pool relatively small deposits from many investors into large, illiquid loans to corporate borrowers. A withdrawal by any one depositor can be satisfied from any of a number of sources, including new deposits, repayments of other loans made by the bank, bank reserves and the bank’s debt and equity financing. 15. a. Investor A buys shares in a mutual fund, which buys part of a new stock issue by a rapidly growing software company. b. Investor B buys shares issued by the Bank of Saskatchewan, which lends money to a regional department store chain. c. Investor C buys part of a new stock issue by the Regional Life Insurance Company, which invests in corporate bonds issued by Neighborhood Refineries, Inc. 2-3 16. Mutual funds and ETFs collect money from small investors and invest the money in corporate stocks or bonds, thus channeling savings from investors to corporations. The advantages of mutual funds and ETFs for individuals are diversification, professional investment management and record keeping. 17. In this situation, a “superior” rate of return is a rate of return that is greater than the rate of return investors could earn elsewhere in the financial markets from alternative investments with risk level equal to that of the “low-risk capital investment” described in the problem. Fritz (who is risk-averse) will applaud the investment because he can maintain the risk level he prefers while earning a “superior” return. Frieda (who is risk- tolerant) will applaud the investment because investors will be willing to pay more for the shares Frieda owns than they would have paid if the firm had not made this “low- risk capital investment.” Frieda would be likely to sell her shares to a more risk-averse investor, and use the proceeds of her sale to invest in shares of a company with a very high rate of return, and commensurate high level of risk. 18. If you believe that the rate of return is truly guaranteed to be 8 percent, then the investment is very low risk. The relevant opportunity cost of capital for this investment is the rate of return that investors can earn in the financial markets from the safest investments, such as Canadian government securities and top-quality (AAA) corporate debt issues of equivalent term to maturity, ie. 10 years. The highest quality investments in Table 2.2 are AA and paid 4.78% per year. AA-rated corporate debt is riskier than AAA-rate. Although not reported in the table, the interest rate on 10-year AAA corporate debt must lower than 4.78%. So, using the information from Table 2.2, the opportunity cost of capital is less than 4.78%. A better estimate of the opportunity cost of capital would to find the interest rates on AAA-rated corporate debt or Canadian government debt with the same maturity as the proposed investment. 19. a. Since the government guarantees the payoff for the investment, the opportunity cost of capital is the rate of return on Canadian Government Treasury bills with one year to maturity (i.e., one-year Treasury bills). b. The opportunity cost for the investment under consideration by Pollution Busters, Inc. is 20%, the expected rate of return available on an investment in carbon. The sequester is expected to pay $115,000 on a $100,000 investment, a gain of $15,000. If the $100,000 was invested in the London Carbon Exchange, the expected payback is .2×$100,000, or $20,000. The purchase of additional sequesters is not a worthwhile capital expenditure. The same risk investment in the London Carbon Exchange produces an additional $5,000 ($20,000 - $15,000). This can also be expressed in terms of rates of return. Purchase of the additional sequesters is not a worth while capital investment because the expected rate of return is only 15 percent (i.e., a $15,000 gain on a $100,000 investment, $15,000/$100,000 = .15 or 15%), less than the 20% opportunity cost of capital. 2-4 20. Mutual funds; pension funds; venture capital firms; credit unions and caisses populaires. 21. The link to the home page is http://ca.ishares.com/home.htm. As of September 2011, Barclays offers 45 Canadian ETFs, available for trading on the Toronto Stock Exchange. The 3 ETFs selected for examination here are: iShares™ CDN Composite Index Fund, iShares™ CDN Energy Sector Index Fund and iShares™ CDN Jantzi Social Index® Fund 1. iShares™ CDN Composite Index Fund Index that this fund replicates: S&P®/TSX® Capped Composite Index Fund fees: 0.25% of total assets As of July 31, 2011: One year rate of return = 13.03% Top 5 holdings as of August 29, 2011 % of funds Stock 4.78% ROYAL BANK OF CANADA 4.50% TORONTO-DOMINION BANK 3.84% BANK OF NOVA SCOTIA 3.32% POTASH CORP. OF SASKATCHEWAN INC. 3.32% BARRICK GOLD CORP 2. iShares™ CDN Energy Sector Index Fund Index that this fund replicates: S&P®/TSX® Capped Energy Index MER = .26% of total fund assets As of July 31, 2011: One year rate of return = 11.96% Top 5 Holdings as of August 29, 2011 % of funds Stock 4.78% ROYAL BANK OF CANADA 4.50% TORONTO-DOMINION BANK 3.84% BANK OF NOVA SCOTIA 3.32% POTASH CORP. OF SASKATCHEWAN INC. 3.32% BARRICK GOLD CORP. 3. iShares™ CDN Jantzi Social Index® Fund Index that this fund replicates: Jantzi Social Index MER =.53% of total fund assets As of July 31, 2011: One year rate of return = 8.43% Top Holdings as of August 29, 2011 2-5 % of funds Stock 9.56% ROYAL BANK OF CANADA 8.98% TORONTO-DOMINION BANK 7.73% BANK OF NOVA SCOTIA 6.70% POTASH CORP. OF SASKATCHEWAN INC. 6.58% SUNCOR ENERGY INC. 22. For the purpose of this solution, we provide 3 mutual funds from RBC Global Asset Management NOTE: Management Expense Ratio, MER, is the sum of management fee (the administrative costs and the wages and bonuses of fund managers) plus all other expense charged to fund (marketing expense) divided by the fund’s total assets. 1. RBC Asian Equity Fund Objectives: The Fund seeks capital appreciation through equity securities issued by companies located in or having a principal business interest in any or all of the countries of Asia. These countries include Hong Kong, South Korea, China, Taiwan, Australia, New Zealand, Singapore, Malaysia, Thailand, the Philippines, Indonesia and Vietnam. This fund is affected by changing conditions of the markets in which they invest and the rate of exchange of foreign currencies against the Canadian dollar. MER = 2.20% of fund’s total assets One-Year Return as at July 31, 2011: 7.38% Benchmark index: MSCI Far East ($ Cdn) Top Holdings as at April 30, 2011 Company Name Sector Geographic Area Asset Type % of Total Assets Hyundai Motor Company Limited Automotive South Korea Stock 1.52 Samsung Electronics Co. Electrical & Electronic South Korea Stock 1.49 LG Chemicals Ltd Chemicals South Korea Stock 1.41 Newcrest Mining Precious Metals Australia Stock 1.36 Daelim Industrial Misc. Industrial South Korea Stock 1.31 2-6 Products Taiwan Semiconductor Electrical & Electronic Taiwan Stock 1.31 FANUC Corporation Machinery Japan Stock 1.28 Commonwealth Bank of Australia Banks Australia Stock 1.27 Wesfarmers Limited Agriculture Australia Stock 1.27 2. RBC Canadian Index Fund Objectives: The Fund seeks to provide long-term capital growth by investing primarily in Canadian equity securities. The fund seeks to achieve returns similar to a generally recognized index of Canadian equity market performance, currently being The Toronto Stock Exchange 300 Total Return Index. MER = 0.70% of total fund assets One-Year Return as at July 31, 2011:12.60% Benchmark Index: S&P/TSX Total Return Top Holdings as at April 30, 2011 Symbol Company Name Sector Geographic Area Asset Type % of Total Assets RY-T Royal Bank of Canada Banks Canada Stock 5.25 TD-T TD Bank Banks Canada Stock 4.46 SU-T Suncor Energy Integrated Oils Canada Stock 4.23 BNS-T Bank of Nova Scotia Banks Canada Stock 3.84 CNQ-T Canadian Natural Resources Oil and Gas Producers Canada Stock 3.0 ABX-T Barrick Gold Corp. Precious Metals Canada Stock 2.97 POT-T Potash Corp. of Saskatchewan Chemicals Canada Stock 2.81 G-T Goldcorp Inc. Precious Metals Canada Stock 2.61 BMO-T Bank of Montreal Banks Canada Stock 2.17 CNR-T Canadian National Railway Transportation Canada Stock 2.08 2-7 3.RBC Jantzi Canadian Equity Fund Objectives: To provide long-term capital growth. The fund invests primarily in equity securities of Canadian companies and follows a socially responsible approach to investing. The fund may also invest in securities of comparable foreign companies. MER= 2.06% One-Year Return as at July 31, 2011: 10.03% Benchmark Index: S&P/TSX Total Return Top Holdings as at April 30, 2011 Symbol Company Name Sector Geographic Area Asset Type % of Total Assets RY-T Royal Bank of Canada Banks Canada Stock 5.39 SU-T Suncor Energy Integrated Oils Canada Stock 5.22 TD-T TD Bank Banks Canada Stock 4.91 CIBC, 1.00%, MAY/02/11 Bond 4.04 BNS-T Bank of Nova Scotia Banks Canada Stock 3.52 POW-T Power Corp of Canada Management and Diversified Canada Stock 2.84 CNQ-T Canadian Natural Resources Oil and Gas Producers Canada Stock 2.80 BAM.A- T Brookfield Asset Management Management and Diversified Canada Stock 2.56 TCK.B-T Teck Resources Integrated Mines Canada Stock 2.50 POT-T Potash Corp. of Saskatchewan Chemicals Canada Stock 2.43 23. If you go into the website of any of Canada’s large chartered banks (including The Royal Bank of Canada and Scotiabank) you will find that services are provided to three broad groups: individuals, small businesses, and corporations. The banks will typically provide a variety of banking, borrowing and investing, and insurance services to all three groups. Additional more sophisticated services, such as those pertaining to global banking services and industry solutions and international 2-8 banking are provided to corporations and small businesses. 24. The information may be compiled by clicking on “asset class”. You could also try “inside funds”Most of the information reported relates the performance of the fund. The “standard” tab reports the price per unit, price change from previous data and rates of return. The “short-term” tab gives the rates of return within the last 30 days and “long-term” tab gives the rates of return over 1 to 15 years. The “annual” tab reports the one-year rate of return for each of the past 7 years. The “quartile ranking” and the “5-star Ratings” both report how the funds performed relative to each other for various periods. For example, if the fund’s return was among the top 25% of funds in this category, its quartile ranking is 1. The five star ranking is Globe Fund’s ranking of the fund. Finally, the “key facts” tab reports certain details about the funds, including the dollar amount of its assets, its MER, the load type (fees charged when the funds are bought or sold), the minimum dollar amount an investor can invest and whether the fund qualifies to be included in an investor’s registered retirement savings plan, RSP. 25. We compare the iShares CDN Composite Index ETF with the RBC Canadian mutual fund: Fund Name Fund Type MER One year rate of return Benchmark Index iShares™ CDN Composite Index Fund ETF 0.25% 13.03% S&P®/TSX® Capped Composite Index RBC Canadian Index Mutual 0.7% 12.60% S&P/TSX Total Return Note the higher MER for the mutual fund than the EFT: 0.68% versus 0.25%. Both had similar one year rates of return..but the data was not taken as of the same date. iShares CDN Composite Index ETF RBC Canadian mutual fund Top Holdings as of August 29, 2011 Top Holdings as at April 30, 2011 % of funds Stock % of funds Stock 4.78% ROYAL BANK OF CANADA 5.25 Royal Bank of Canada 4.50% TORONTO-DOMINION BANK 4.46 TD Bank 3.84% BANK OF NOVA SCOTIA 4.23 Suncor Energy 3.32% POTASH CORP. OF SASKATCHEWAN INC. 3.84 Bank of Nova Scotia 3.32% BARRICK GOLD CORP 3.0 Canadian Natural Resources We compare iShares™ CDN Energy Sector Index Fund with the TD Energy 2-9 Fund: Fund Name Fund Type MER One year rate of return Benchmark Index iShares™ CDN Energy Sector Index Fund ETF .26% 11.96% S&P®/TSX® Capped Energy Index TD Energy Fund Mutual 2.21% 14.63% Globe Natural Resources Peer Index iShares™ CDN Energy Sector Index Fund TD Energy Fund Top 5 Holdings as of August 29, 2011 Top Holdings as at July 31, 2011 % of funds Stock % of funds Stock 4.78% ROYAL BANK OF CANADA 10.47% Suncor Energy 4.50% TORONTO-DOMINION BANK 5.12% Talisman Energy 3.84% BANK OF NOVA SCOTIA 4.65% Cenovus Energy 3.32% POTASH CORP. OF SASKATCHEWAN INC. 4.62% Canadian Natural Resources 3.32% BARRICK GOLD CORP. 3.7% Crescent Point Energy Fund Name Fund Type MER One year rate of return Benchmark Index iShares™ CDN Jantzi Social Index® Fund ETF .53% 8.43% Jantzi Social Index RBC Jantzi Canadian Equity Mutual 2.06% 10.03% S&P/TSX Total Return iShares™ CDN Jantzi Social Index® Fund RBC Jantzi Canadian Equity Top Holdings as at August 29, 2011 Top Holdings as at July 31, 2011 % of funds Stock % of Total Assets Stock 8.98% TORONTO-DOMINION BANK 5.39 Suncor Energy 7.73% BANK OF NOVA SCOTIA 5.22 TD Bank 2-10 6.70% POTASH CORP. OF SASKATCHEWAN INC. 4.91 CIBC, 1.00%, MAY/02/11 6.58% SUNCOR ENERGY INC. 4.04 Bank of Nova Scotia 8.98% TORONTO-DOMINION BANK 3.52 Power Corp of Canada 26. Even if the firm does not need to issue stock in any particular year, the stock market is still important to the financial manager. The stock price provides important information about how the market values the firm’s projects to the extent that the market price of stock is determined by expected present value of future cash flows. For example, if the stock price rises considerably, managers might conclude that the market believes the firm’s future prospects are bright. This might be a useful signal to go ahead with an investment such as an expansion of the firm’s business. In addition, the fact that shares can be traded in the secondary market makes them more attractive to investors since investors know that, when they wish to, they will be able to sell their shares. This in turn makes them more willing to buy shares in a primary offering, and thus improves the terms on which firms can raise money in the equity market. The financial manager is concerned with the price of the stock because the market value of stock is a measure of shareholder wealth. The financial manager’s goal is to maximize shareholder wealth. 2-11 Brealey 5CE Solutions to Chapter 3 1. Assets Liabilities & Shareholders’ Equity Cash and cash equivalents $ 10,000 Trade payables $ 17,000 Trade receivables 22,000 Long-term debt 170,000 Inventory 200,000 Store & property 100,000 Shareholders’ equity 145,000 Liabilities & Total assets $332,000 Shareholders’ equity $332,000 2. The statement of financial position shows the position of the firm at one point in time. It shows the amounts of assets and liabilities at that particular time. In this sense it is like a snapshot. The statement of comprehensive income shows the effect of business activities over the entire year. Since it captures events over an extended period, it is more like a video. The statement of cash flows is like the income statement in that it summarizes how cash is generated and used over the full year, so it too is like a video. 3. Profit (net earnings) can differ from cash inflows because some items included in the its computation do not entail immediate cash flows and some items generating immediate cash inflows are not included as earnings. For example, sales made on credit are counted as revenues even though cash is not collected until the customer makes a payment. When the cash is collected on those credit sales, it generates cash inflow but is not part of revenues or earnings. We can extend this question to include the difference between expenses and cash outflows. For example, depreciation expense reduces net earnings, but does not entail a cash outflow. Purchases of inventory require cash outlays, but are treated as investments in working capital, not as expenses. 4. Net working capital ought to be increasing. The firm will be building up stocks of inventory as it ramps up production. In addition, as sales increase, trade receivables will be increasing rapidly. While trade payables probably will also increase, the increase in trade receivables will tend to dominate since sales prices exceed input costs. 3-1 5. a. Federal taxes = .15 × 20,000 = $3,000 AB taxes = .1 × 20,000 = $2,000 Total taxes for Albertan = $3,000 + $2,000 = $5,000 Marginal tax rate for Albertan = .15 + .1 = .25, or 25%. Average tax rate for Albertan = 5,000/20,000 = .25, or 25%. NF taxes = .077 × 20,000 = $1,540 Total taxes for Newfoundlander = $3,000 + $1,540 = $4,540 Marginal tax rate for Nflder = .15 + .077 = .227, or 22.7%. Average tax rate for Nflder = 4,540/20,000 = .227, or 22.7%. b. Federal taxes = .15 × 41,544 + .22 × (60,000 − 41,544) = $10,291.92 AB taxes = .1 × 60,000 = $6,000 Total taxes for Albertan = $10,291.92 + $6,000 = $16,291.92 Marginal tax rate for Albertan = .22 + .1 = .32, or 32%. Average tax rate for Albertan = $16,291.92/60,000 = .2715, or 27.15%. NF taxes = .077 × 31,904 + .125 × (60,000 – 31,904) = $5,968.61 Total taxes for Newfoundlander = $10,291.92 + $5,968.61 = $16,260.53 Marginal tax rate for Nflder = .22 + .125 = .345, or 34.5%. Average tax rate for Nflder = 16,260.53/60,000 = .2710, or 27.1%. c. Federal taxes = .15 × 41,544 + .22 × (83,088 − 41,544) + .26 × (100,000 − 83,088) = $19,768.4 AB taxes = .1 × 100,000 = $10,000 Total taxes for Albertan = $19,768.4 + $10,000 = $29,768.4 Marginal tax rate for Albertan = .26 + .1 = .36, or 36%. Average tax rate for Albertan = 29,768.4/100,000 = .2977, or 29.77%. NF taxes = .077 × 31,904 + .125 × (63,807 – 31,904) + .133 × (100,000 – 63,807) = $11,258.15 Total taxes for Newfoundlander = $19,768.4+ $11,258.15 = $31,026.55 Marginal tax rate for Nflder = .26 + .133 = .393, or 39.3%. Average tax rate for Nflder = 31,026.55/100,000 = .3103, or 31.3%. 3-2 d. Federal taxes = .15 × 41,544 + .22 × (83,088 − 41,544) + .26 × (128,800 − 83,088) + .29 × (3,000,000 − 128,800) = $859,904.32 AB taxes = .1 × 3,000,000 = $300,000 Total taxes for Albertan =$859,904.32 + $300,000 = $1,159,904.32 Marginal tax rate for Albertan = .29 + .1 = .39, or 39%. Average tax rate for Albertan =1,159,904.32/3,000,000 = .3866, or 38.66%. NF taxes = .077 × 31,904 + .125 × (63,807 – 31,904) + .133 × (3,000,000 – 63,807) = $396,958.15 Total taxes for Newfoundlander = $859,904.32 + $396,958.15 =$1,256,862.47 Marginal tax rate for Nflder = .29 + .133 = .423, or 42.3%. Average tax rate for Nflder = 1,256,862.47/3,000,000 = .4190, or 41.9%. 6. Assuming taxable income of $100,000 and the company qualifies for the small business tax rate, the tax rate is 11% + 0% = 11%. Taxes = .11 × 100,000 = $11,000 Average tax rate = marginal tax rate = 11% 7. Tax on interest income = (.26 + .1667) × 1,500 = $640.05 After-tax interest income = 1,500 – 640.05= $859.95 Tax rate on interest income = 640.05/1,500 = .4267, or 42.67% Net federal tax on dividend income = .26 × (1.41 × 3,000) - .1644 × (1.41 × 3,000) = $404.39 Net provincial tax on dividend income = .1667 × (1.41 × 3,000) - .0829 × (1.41 × 3,000) = $354.47 Total tax on dividend income = $758.86 After-tax dividend income = 3,000 – 758.86 = $2,241.14 Tax rate on dividend income = 758.86/3,000 = .2530, or 25.3% Tax on capital gain = .5 × (.26 + .1667) × 2,000 = $426.7 After-tax capital gain income = 2,000 – 426.7 = $1,573.3 Tax rate on capital gains income = 426.7/2,000 = .2134, or 21.34% 3-3 8. a. Cash will increase. The sale of a non-cash current asset (inventory) generates cash. Working capital may not change if the cash received for the inventory equals the recorded value of the inventory. b. Cash will increase. The machine will bring in cash when it is sold, but the lease payments will be made over several years. c. The firm will use cash to buy back the shares from existing shareholders. Cash balance will decrease. 9. Initial retained earnings balance + net earnings – dividends = Closing retained earnings Rearrange this equation and solve for dividends: Dividends = Initial retained earnings balance – Closing retained earnings + net earnings So to calculate dividends paid by Brandex in 2013 = 2012 retained earnings – 2013 retained earnings + 2013 net earnings = $3,000,000 - $3,300,000 + $900,000 = $600,000 10. Note: We have ignored any personal deductions. Taxes owed on salary income: Federal taxes = .15 × 41,544 + .22 × (70,000 – 41,544) = $12,491.92 Provincial taxes = .0879 × 29,590 + .1495 × (59,180 – 29,590) + .1667 × (70,000 – 59,180) = $8,828.36 Total tax on salary = $12,491.92 + $8,828.36= $21,320.28 Taxes owed on the corporate income: Assume that company qualifies for the small business tax rate and is taxed at 11% + 5% = 16% Corporate taxes = .16 × (30,000) = $4,800 Total taxes = $21,320.28 + $4,800 = $26,120.28 If you rearrange income so that your salary and the firm’s profit are both $50,000 then: Federal taxes = .15 × 41,544 + .22 × (50,000 – 41,544) = $8,091.92 Provincial taxes = .0879 × 29,590 + .1495 × (50,000 – 29,590) = $5,652.26 Total tax on salary = $8,091.92 + $5,652.26= $13,744.18 Corporate taxes = .16 × $50,000 = $8,000 Total taxes = $13,744.18 + $8,000= $21,744.18 Total taxes are reduced by $26,120.28 − $21,744.18 = $4,376.1 3-4 Note: A key decision you must make is to determine how much money you need to live on. Is $50,000 enough to buy groceries, clothes, and all other personal spending you want to do? If the corporation spends money on your behalf, that benefit is taxed as if you had spent the money and the tax advantage of keeping the money in the company disappears. 11. a. Book value equals the $900,000 + $100,000 = $1,000,000, the sum that the founder of the firm has contributed in tangible assets plus the patent’s carrying value on the SFP. Market value equals the value of his patent plus the value of the production plant: $50,000,000 + $900,000 = $50,900,000. b. Price per share = $50.9 million/2 million shares = $25.45 Book value per share = $1 million/2 million shares = $.50 c. The price per share and the book value per share are different because the market value is the estimate of the value of the patent, whereas the book value is what is dictated on the SFP. 12. a.,b. Note: Because depreciation expense is already included in various costs it is not reported as separate line in the calculation of earnings before interest and taxes (EBIT) or calculation of net earnings (which is also called net income) Sales $10,000 Cost of sales (6,500) General and admin expenses ( 1,000) EBIT 2,500 Interest expense (500) Taxable income 2,000 Taxes (35%) (700) Net earnings $ 1,300 c. Note: We are assuming that cash balance did not change, allowing us to use change in working capital as the change in non-cash working capital. Since net working capital increased, this was a use of cash to make the investment in net working capital. Cash flow from operating activities starting from net earnings: = net earnings + depreciation expense + cash flow from (used in) non-cash working capital = 1,300 + 1,000 - 200 = $2,100 Cash flow from operating activities if start with profit before tax, taxable income: = taxable income + depreciation expense + cash flow from (used in) non-cash working capital - taxes = 2,000 + 1,000 - 200 - 700 = $2,100 3-5 d. Using Equation (3.3), cash flow from assets = cash flow from operating activities + cash flow from (used in) investments = 2,100 – 900 = $1,200 Note: Nothing in the problem indicated whether the interest expense should be considered an operating cash flow or a financing flow. With interest expense is treated as a financing flow, the cash flow values become: Cash flow from operating activities (adjusted) = net earnings + depreciation expense + interest expense + cash flow from (used in) non-cash working capital = 1,300 + 1,000 + 500 - 200 = $2,600 Cash flow from assets (adjusted) = cash flow from operating activities (adjusted) + cash flow from (used in) investments = 2,600 – 900 = $1,700 13. Yes, both of these statements are true. Since cash flow from operations is determined by cash inflows and outflows, whereas profit before tax is determined by the accrual method of accounting, there is no reason why one cannot be negative when the other is positive. For example, if depreciation expenses are large, then negative profit before tax might correspond to positive cash flow because depreciation is treated as an expense in calculating profit before tax, but does not represent a cash outlay. Conversely, if profit before tax is positive, but a large portion of sales are made on credit, cash flow can be negative since the credit sales are revenue, but they don’t yet generate cash. This is true for other types of working capital, such as inventory. Purchases of inventory do not show up on the income statement but use up cash. So it is possible for profit before tax to be positive but cash flow from operations to be negative when there is a large increase in net working capital. Look back to the tables under Profits vs. Cash Flow, and you will see that increases in trade receivables reduce cash provided by operations. 14. The calculations are presented in the following table. Sales occur in quarters 2 and 3, so this is when the cost of sales is recognized. Therefore, net income in quarters 1 and 4 is zero. In quarter 1, the production of the kits is treated as an investment in inventories. The level of inventories then falls as goods are sold in quarters 2 and 3. Trade receivables in quarters 2 and 3 equal the sales in those quarters since it takes one quarter for bills to be collected. Notice that cash flow in quarter 1 equals the cost of producing the kits, and in quarters 3 and 4, cash flow equals cash received for the kits sold previously. 3-6 a. Quarter 1 Quarter 2 Quarter 3 Quarter 4 Sales $ 0 $550 $600 $ 0 Cost of sales 0 500 500 0 Net income $ 0 $ 50 $100 $ 0 b., c. Inventories $1000 $ 500 $ 0 $ 0 Trade receivables 0 550 600 0 Net working capital $1000 $1050 $ 600 $ 0 Change in NWC from previous quarter $1000 $50 –$450 –$600 Cash flow = net income + change in net working capital: Net income $ 0 $ 50 $ 100 $ 0 Change in NWC $1000 $ 50 –$ 450 –$ 600 Cash flow –$1000 $ 0 $ 550 $ 600 15. Cash flow = Profits − ∆ Trade receivables − 10,000 + ∆ Trade payables + 5,000 − ∆ Inventory −(−2,000) Cash flow = Profits − 10,000 + 5,000 − (−2,000) = Profits − 3,000 Therefore, cash flow will be $3,000 less than profits. This corresponds to the increase of $3,000 in net working capital. 16. a. Assume that depreciation equals CCA. If the firm paid taxes of $2,000, and the average tax rate was 20%, then profit before tax must have been $2,000/.20 = $10,000. Therefore: net income = profit before tax − taxes = $8,000. b. Revenues ??? - Cost of goods sold 8,000 - Administrative expenses 3,000 - Depreciation expense 1,000 - Interest expense 1,000 Profit before tax $10,000 [from (a)] 3-7 We conclude that revenues were $23,000. c. Revenue $23,000 − Cost of goods sold 8,000 − Administrative expenses 3,000 − Depreciation expense 1,000 EBIT $11,000 17. a. Note: assume depreciation equals CCA Sales $14 million − Cost of goods sold 8 − Interest expense 1 − Depreciation expense 2 Taxable income 3 − Taxes (35%) 1.05 Net income $ 1.95 million Cash flow from operations = NI + depreciation – change in non-cash net working capital = $3.95 million Cash flow from assets = Cash flow from operations – capital expenditures = 3.95 – 1 = $2.95 million b. If depreciation were $1 million higher, taxable income would be $2 million, taxes would be .35 × 2, or $.7 million and net income would be 2 – .7, or $1.3 million. Thus, net income would be lower by $0.65 million. Cash flow from operations (= net income + depreciation) would be 1.3 + 3, or $4.3 million, higher by 4.3 – 3.95, or $0.35 million. Cash flow from assets (= net income + depreciation – increase in net working capital – capital expenditures) would also increase by $0.35 million. Cash flow increases because depreciation is not a cash outflow, but increasing the depreciation expense for tax purposes reduces taxes paid by $0.35 million. c. The impact on stock price is likely to be positive. Cash available to the firm would increase. The reduction in net income would be recognized as due purely to accounting changes, and not as reflecting any changes in the underlying profitability of the firm. d. If interest expense were $1 million higher, net income, operating cash flow and cash flow from assets would decrease by $0.65 million, i.e., by the $1 million increase in expenses less the $0.35 million reduction in taxes. This differs from part (b) because, in contrast to depreciation, interest expense represents an actual cash outlay. 3-8 18. April May June Sales $ 0 $150,000 $ 0 Cost of goods sold 0 100,000 0 ∆Trade receivables 0 150,000 −150,000 ∆Inventory 50,000 −50,000 0 ∆Trade payables 50,000 -50,000 0 Cash flow* 0 -100,000 150,000 Net income** $ 0 $ 50,000 $ 0 *Cash flow = Sales − COGS − ∆T/R −∆Inventory + ∆T/P ** Net income = Sales − COGS 19. a. Cash flow to bondholders = interest + debt repayment – new debt issued = 500,000 + 3,700,000 – 2,000,000 = $2,200,000 b. Cash flow to shareholders = dividends + share repurchases – new shares issued = 425,000 – 1,750,000 = –$1,325,000 c. Financing flow = cash flow to bondholders + cash flow to shareholders + increase in cash in the bank = $2,200,000 –$1,325,000 + $300,000 = $1,175,000 Since cash flow from assets must equal financing flow, the cash flow from assets also equals $1,175,000. 20. a. Shareholders’ equity = assets − liabilities. 2012 assets = 2012 Current assets + 2012 PP&E = 420 + 1,420 = $1,840 2012 liabilities = 2012 trade payables + 2012 long-term debt = 240+ 920 = $1,160 2012 Shareholder’s equity = 2012 assets – 2012 liabilities =1,840 - 1,160 = $680 The 2011 and 2012 completed SFP is here: Liabilities and Assets 2011 2012 Shareholders’ equity 2011 2012 Current assets 310 420 Trade payables 210 240 PP&E 1,200 1,420 Long-term debt 830 920 Total assets 1,510 1,840 Total liabilities 1,040 1,160 Shareholders’ equity 470 680 Total 1,510 1,840 b. If the firm issued no stock, the increase in shareholders’ equity must be due entirely to retained earnings. Recall that net income = increase in retained earnings + dividends. Since owners’ equity increased by $210, and dividends were $100, net income must have been $310. 3-9 c. Recall that PP&E are decreased by depreciation and increased by capital expenditures: Closing PP&E = opening PP&E – depreciation + capital expenditures. So: depreciation = capital expenditures – (Closing PP&E - opening PP&E) Change PP&E = (Closing PP&E - opening PP&E) Thus depreciation = capital expenditures – Change PP&E Change PP&E = 2012 PP&E – 2011 PP&E = 1,420 – 1,200= $220. Since PP&E increased by $220 and the firm purchased $300 of new fixed assets, the depreciation charge must have been $80 (= $300 – $220). d. Net working capital = current assets – current liabilities Net working capital in 2011 = $310 – $ 210 = $100 Net working capital in 2012 = $420 – $ 240 = $180 Change in net working capital between 2012 and 2011 = $180 – $100 = $80 So Nobel invested $80 in additional net working capital in 2012. e. Long-term debt at the end of the year equals long-term debt at the start of the year plus new issues minus retirements: Closing long-term debt = opening long-term debt + new debt issues – debt repayment. Thus debt repayment = new debt issues – change in long-term debt. Since long-term debt increased by $90 (= $920 – $830), and the firm issued $200 of new long-term debt, $110 (= $200 – $90) of outstanding debt must have been paid off. f. Cash flow from operations = Net income + depreciation – change in net working capital = 310 + 80 – 80= $310 Cash flow from assets = free cash flow = Cash flow from operations – capital expenditures = 310 – 300 = $10 g. Assume interest is an operating expense: Cash flow to bondholders and shareholders = financing flows = debt repayment – new debt issues + dividends – new share issues = 110 – 200 + 100 – 0 = $10 As required, cash flow from assets equals cash flow to bondholders and shareholders. In other words, the company generated $10 in cash from its assets and as a group, bondholders and shareholders received $10 in cash from the company. 3-10 21. a. Shareholders’ equity = Total assets − total liabilities 2011: equity = $ 890 − $650 = $240 2012: equity = $1,040 − $810 = $230 b. Net working capital = current assets − current liabilities 2011: NWC = $ 90 − $50 = $40 2012: NWC = $140 − $60 = $80 c. Assume that depreciation equals CCA. Taxable income = $1,950 − $1,030 − $350 − $240 = $330 Taxes paid = .35 × $330 = $115.50 Net income = $214.50 d. NOTE: We assume that interest is an operating expense. (Calculations with interest treated as a financing flow follow below.) Net income $214.50 Depreciation 350 Decrease (increase) in current assets ( 50) Increase (decrease) in current liabilities 10 Cash flow from operations $524.50 The increase in current assets uses cash, reducing cash flow. All of the other items generate cash and increase cash flow from operations. NOTE: If interest is assumed to be a financing flow, the cash flow from operations (adjusted) is: Net income $214.50 Depreciation 350 Interest expense 240 Decrease (increase) in current assets ( 50) Increase (decrease) in current liabilities 10 Cash flow from operations (adjusted) $764.50 e. Gross investment = Increase in net fixed assets + depreciation = $100 + $350 = $450 f. Current liabilities increased by $10. Therefore, current liabilities other than accounts payable must have increased by $45. g. NOTE: We assume that interest is an operating expense. (See below for calculation treating interest as a financing expense) Cash flow from assets = Free cash flow = Cash flow from operations – capital expenditures = 524.50 – 450 = $74.50 3-11 Cash Flow to Bondholders and Shareholders: Cash Flow to Bondholders = debt repayment – new debt issues Since the change in long-term debt = new debt issues – debt repayment, then Cash flow to bondholders = Debt repayment – new debt issues = – change in long-term debt = –(750 – 600) = –150 Cash Flow to Shareholders = dividends – new share issues Assume that no new share issues were made. Figure out how much dividends were paid by working backwards from the change in shareholders’ equity: Change in shareholders’ equity = new share issues + addition to retained earnings, Addition to retained earnings = change in shareholders’ equity – new share issues = 230 – 240 – 0 = –10 Dividends = Net income – addition to retained earnings = 214.50 – (–10) = $224.50 Cash Flow to Shareholders = dividends – new share issues = 224.5 – 0 = $224.50 Cash flow to bondholders and shareholders = –150 + 224.50 = $74.50 As required, cash flow from assets equal cash flow to bondholders and shareholders. The company, after all investments, generated $74.50 in cash which it distributed to its bondholders and shareholders. NOTE: The following are the calculations with interest treated as a financing flow: Cash flow from assets (adjusted) = Free cash flow = Cash flow from operations (adjusted)– capital expenditures = 764.50 – 450 = $314.50 Cash Flow to Bondholders and Shareholders: Cash Flow to Bondholders (adjusted) = Interest + debt repayment – new debt = 240 – (750 – 600) = 90 Cash Flow to Shareholders = dividends – new share issues = 224.50 – 0 Cash flow to Bondholders and Shareholders = 90 + 224.50 = $314.50 22. You can use the following link for the latest income tax rates for individuals: http://www.cra-arc.gc.ca/tx/ndvdls/fq/txrts-eng.html If you lived in Ontario, based on 2011 tax rates, your marginal and average tax rates will be as follows: Federal Tax = .15 x $41,544 + .22 x ($70,000 - $41,544) = $12,491.92 Provincial Tax = .0505 x $37,774 + .0915 x ($70,000 - $37,774) = $4,856.27 Total Tax = $12,491.92 + $4,856.27 = $17,348.19 Average Tax Rate = $17,348.19/$70,000 = .2478, or 24.78% Marginal Tax Rate = .22 + .0915 = .3115, or 31.15% 3-12 23. Assets Liabilities and Shareholders’ Equity 2012 2011 2012 2011 Cash and cash equivalents 300 800 Trade payables 350 300 Short term investments 550 430 Provisions 770 680 Trade receivables 450 400 Total current liabilities 1,120 980 Inventories 350 300 Long term debt 2,400 3,000 Total current assets 1,650 1,930 Total liabilities 3,520 3,980 Property, plant and equipment 5,800 5,000 Shareholders' Equity 3,930 2,950 Total assets 7,450 6,930 Total liabilities and shareholders' equity 7,450 6,930 Shareholders’ equity, 2011 = Total asset, 2011 – Total liabilities, 2011 = 6,930 – 3,980 = 2,950 Shareholders’ equity, 2012 = Total asset, 2012 – Total liabilities, 2012 = 7,450 – 3,520 = 3,930 24. Net working capital, 2011 = (800 + 430 + 400 + 300) − (300 + 680) = $950 Net working capital, 2012 = (300 + 550 + 450 + 350) − (350 + 770) = $530 Change in net working capital = Net working capital, 2012- Net working capital, 2011= 530-950= -$420 We define non-cash net working capital to be net working capital, excluding cash and cash equivalents, and short-term investments. All of these excluded items are considered part of the firm’s net cash position. Non-cash NWC, 2011 = (400 + 300) − (300 +680) = -$280 Non-cash NWC, 2012 = (450 + 350) − (350+770) =-$320 Change in non-cash net working capital = -$320 – (-$280) = -$40 3-13 25. Statement of Comprehensive Income in thousands of $'s 2012 2011 Revenues 4,100 4,000 Cost of goods sold -1,700 -1,600 Gross profit 2,400 2,400 Expenses Administrative expenses -550 -500 Depreciation -320 -300 Total expenses -870 -800 Operating profit 1,530 1,600 Finance expense -150 -150 Finance income 120 50 Profit before taxes 1,500 1,500 Income taxes -420 -400 Profit for the year 1,080 1,100 2012 Addition to retained earnings = 2012 Profits – 2012 dividend = 1,080 – 410 =670 Change in shareholders’ equity = 2012 shareholder’s equity – 2011 shareholders’ equity = 3,930 – 2,950 = 980 Since shareholders’ equity increased more than the addition to retained earnings the firm must have issued new equity in 2012 2012 equity issue = Change in shareholders’ equity – addition to retained earnings = 980 – 670 = 310 Statement of changes in equity 2012 Opening shareholders' equity 2,950 Profit for the year 1,080 Dividends paid -410 Issuance of new shares 310 Closing shareholders' equity 3,930 26. Earnings per share in 2011 = $1,100,000/500,000 shares = $2.2 Earnings per share in 2012 = $1,080,000/500,000 shares = $2.16 3-14 27. Average tax rate in 2011 = taxes/taxable income = $400/$1500 = .2666 = 26.7% Average tax rate in 2012 = $420/$1500 = .2 = 28.0% If Fincorp does not qualify for the small business tax rate, then all of its income is taxed at the same rate and its marginal tax rate equals its average tax rate. However, if Fincorp qualified for the small business tax rate on its first $400,000 of income, we would need more information to work out the marginal rate. In particular, we would need to know the applicable small business provincial tax rate. Together with the federal small business rate of 11 percent, we would figure out the taxes paid on the first $400,000 of income. Then, based on the remaining taxes and income, we could figure out the marginal rate applied to the last dollar of earnings. 28. Investment in plant and equipment = change in PP&E + depreciation. PP&E increased by $800,000 during 2012 (= 5,800,000 – 5,000,000), while depreciation expense in 2012 was $320,000. Therefore, investment in plant and equipment was 800,000 + 320,000, or $1,120,000. 3-15 29. Using Table 3.4 as a guide for the format of statement of cash flow: Statement of Cash Flows in thousands of $'s 2012 Cash flow from operating activities: Profit before taxes 1,500 Depreciation 320 Finance income -120 Finance expense 150 1,850 Change in non-cash working capital: Increase in trade receivables -50 Increase in inventories -50 Increase in trade payables 50 Increase in provisions 90 Cash generated from operations 1,890 Interest paid -150 Income taxes paid -420 Net cash inflow from operating activities 1,320 Cash flow from investing activities Purchase of property, plant and equipment -1,120 Net cash flow used in investing -1,120 Net cash flow before financing activities 200 Cash flow from financing activities Repayment of long term debt -600 Issuance of shares 310 Dividends paid -410 Net cash flow from financing activities -700 Net change in cash and cash equivalents -500 Cash and cash equivalents - beginning of year 800 Cash and cash equivalents - end of year 300 Note: because the finance income is due to the increase in value of the short-term investments, this is a non-cash flow. 3-16 30. Statement of Cash Flows in thousands of $'s 2012 Cash flow from operating activities Profit before taxes 1,500 Depreciation 320 Finance income -120 Finance expense 150 1,850 Change in non-cash working capital Increase in trade receivables -50 Increase in inventories -50 Increase in trade payables 50 Increase in Provisions 90 Cash generated from operations 1,890 Income taxes paid -420 Net cash flow from operations 1,470 31. a. Note: Cash flow from operations (adjusted) = cash flow from operations + interest expense = 1,320 +150 = 1,470 Cash Flow from Assets (adjusted) Cash flow from operations (adjusted) $1,470 Cash provided by (used in) investments (1,120) Cash flow from assets $ 350 Cash Flow to Bondholders Finance Interest $ 150 Repayment of long-term debt 600 Cash flow to bondholders $ 750 Cash Flow to Shareholders Issuance of new equity ($310) Dividends $ 410 Cash flow to shareholders $ 100 Financing Flow Cash flow to bondholders $ 750 Cash flow to shareholders 100 Increase (decrease) in cash and cash equivalents (500) Total financing flow $ 350 NOTE: Cash flow from assets equals the total financing flow! 3-17 b. After-tax interest expense = (1 - tax rate) × interest = (1 - .28) × 150= 108 Interest payments are deducted to calculate the corporation’s taxable income. The effective interest paid is the after-tax interest. We recognize that the effective interest payment is less than the amount sent to the bondholders because of the reduction in corporate taxes the company enjoys. By contrast, dividend payments are not tax-deductible for corporation. Instead we say that dividends are paid out after-tax corporate income. c. Note: to show that cash flow can be calculated different ways, this solution starts with profit for the year (also called net income) Cash Flow from Assets, Classifying After-tax Interest as a Financing Flow Profit for the year $ 1,080 Depreciation 320 Remove Finance income (is non cash) (120) After-tax interest 108 Cash provided (used) by non-cash net working capital 40 Cash (used) in capital expenditures (1,120) Cash flow from assets $ 308 Cash Flow to Bondholders After-tax interest payment $ 108 Repayment of long-term debt 600 Cash flow to bondholders $ 708 Cash Flow to Shareholders Issuance of new equity ($310) Dividends $ 410 Cash flow to shareholders $ 100 Financing Flow Cash flow to bondholders $ 708 Cash flow to shareholders 100 Increase (decrease) in cash and cash equivalents (500) Total financing flow $ 308 Treating interest expense as a financing flow, rather than an operating expense allows an analyst to compare the operating performance of companies with different capital structures. It allows the calculation of cash the company produced from its operations before it paid any cash to its suppliers of capital, whether it is debt or equity. 3-18 However, interest is a tax-deductible expense and reduces taxes. To fully remove the impact of financing choice on operating cash flows, the tax saving from interest must also be removed. Cash flow from assets must be reduced by the tax savings from the interest. In other words, taxes would be higher if the company did not pay interest. By using the after-tax interest expense, we remove the full effect of interest, allowing the cash flow from assets to truly reflect the cash flow generated by the assets, independent of how the company is financed. When we do this to Fincorp’s statements, we see that its assets generated $308 in 2012. However, when we ignore the tax savings from the interest, as we did in part a., we mistaken determine that Fincorp’s assets generated $350. What accounts for the difference of $42 ($350 - $308)? Fincorp would have paid .28 × $150, or $42 more in taxes had it not had the interest. This we do not count as an operating cash flow: we consider it a financing consequence. 32. Market value balance sheet, 2012 (Figures in thousands of dollars) Assets Liabilities and Shareholders’ Equity Cash & equivalents $ 300 Trade payables $ 350 Short-term investments 550 Provisions 770 Trade receivables 450 Long-term debt 2,400 Inventories 350 Total liabilities 3,520 PP&E 6,000 Shareholders’ equity 7,030 Employee Skills 2,900 Total liabilities plus Total assets $10,550 shareholders’ equity $10,550 * Shareholders’ equity = Total assets − total liabilities Price per share = $7,030,000/500,000 shares = $14.06 NOTE: Using question 26, assume there are 500,000 shares outstanding at the end of 2012. 33. Cash Flow from Assets, Classifying Interest as a Financing Flow Net income $ 63 Depreciation 140 Interest 38 Cash provided by (used in) non-cash operating net working capital (see below) (6) Cash provided by (used) in capital expenditures (228) Cash flow from assets $ 7 3-19 Details: Cash provided by (used in) non-cash operating net working capital Decrease (increase) in trade receivables (16) Decrease (increase) in inventories (2) Increase in accounts payable 12 Cash provided by (used in) non-cash operating net working capital (6) Cash provided by (used) in capital expenditures Capital expenditures = 2012 net property and equipment – 2011 net property and equipment + depreciation = 974 – 886 + 140 = 228 NOTE: Cash flow from assets can also be calculated top-down: Revenues $1301 COGS (1031) Taxes (29) Cash provided by (used in) non-cash operating net working capital (see below) (6) Cash provided by (used) in capital expenditures (228) Cash flow from assets $ 7 Financing Flow, Classifying Interest as a Financing Flow Interest $ 38 Increase in long-term debt (44) Dividends 22 New share issue (10) Increase (decrease) in cash and cash equivalents 1 Total cash flow to bondholders and shareholders $ 7 Details Increase in long-term debt = 464 - 420 = 44 New share issue = 110 - 100 = 10 Dividends = Net income – addition to retained earnings = Net income – (retained earnings 2012 – retained earnings 2011) = 63 – (382 – 341) = 22 34. Assume that company qualified for the small business tax rate and is taxed at 11% + 5% = 16%. Paying a salary of $50,000, the corporation has $50,000 of taxable income. Note that the dividend does not affect the corporation’s taxable income. Also assuming it is an eligible dividend. Corporate taxes = .16 × (50,000) = $8,000 3-20 Total taxable personal income = salary income + grossed-up dividend income = 50,000 + 1.41 × 20,000 = 78,200 Gross federal taxes = .15 × 41,544 + .22 × (78,200 – 41,544) = $14,295.92 Federal dividend tax credit = .1644 × 28,200 = $4,636.08 Net federal tax = $14,295.92 – $4,636.08 = $9,659.84 Gross prov. taxes = .0879 × 29,590 + .1495 × (59,180 – 29,590) + .1667 × (78,200 – 59,180) = $10,195.3 Provincial dividend tax credit = .0829 × 28,200 = $2,337.78 Net provincial tax = $10,195.3 – $2,337.78 = $7,857.52 Total tax on salary = $9,659.84 + $7,857.52 = $17,517.36 Total taxes = $17,517.36 + $8,000= $25,517.36 If you paid yourself $70,000 with no dividend, total taxes are $26,120.28 (from question 10). Why are taxes about $602.92 higher with $70,000 of salary than with $50,000 salary plus $20,000 of dividends? The individual gets the dividend tax credit and personal taxes are lower: personal taxes fall by $3802.92 (from $21,320.28 to $17,517.36). Since the dividend is not tax deductible at the corporate level, corporate taxes increase from $4,800 to $8,000, a $3,200 increase. Net effect is the decrease in personal taxes more than offsets the increase in the corporation taxes, causing an reduction of $602.92(= $3802.92 - $3200) in total taxes. 35. Internet: Using the internet to get an annual report. Tips: On www.sedar.com, the default format of annual reports is now pdf. Make sure students have access to the Adobe Acrobat reader. Also, some annual reports are long, with more than 80 pages and lots of colour graphics. These can take a long time to print or may only be printable in batches of a few pages, depending on the printer. To avoid some of these problems, instructors might choose to screen the list of companies and prepare a list of recommended companies to look at. Expected outcome: Students should be encouraged to read the entire annual report to learn about the company. The details of analyzing financial statements are left to Chapter 4. Still, at this point in the course, students should be able to summarize the basic information about the company, what it does, what assets it uses and how it finances those assets. 36. As of August 20, 2011, there are 9 stock exchanges covered by this site. The annual reports can be accessed by keying in your preference regarding stock exchange, industry, sector, or even by selecting a company alphabetically. For example, by choosing a large telecommunication company, the following items might be found: 3-21 Consolidated SFP/Balance Sheet: Assets: Current assets (accounts receivable, other current assets), property, plant and equipment, goodwill and intangible assets, investments, deferred charges, other long-term assets. Liabilities and Shareholders' Equity: Current liabilities (accounts payable and accrued liabilities, current portion of long-term debt and derivative instruments, other current liabilities), long-term debt, derivative instruments, other long-term liabilities, and Shareholders' Equity. Consolidated Statements of Income: Operating revenue (Sales), Operating expenses (including depreciation and amortization), Operating income, Interest on long-term debt (interest expense), Other income or expense (Loss on repayment of long-term debt, Foreign exchange gain, change in fair value of derivative instruments), Income before income taxes, Income tax expense, and net income. Consolidated Statements of Cash Flows: Operating activities: Net income, adjustments including depreciation and amortization, change in non-cash operating working capital items. Investing activities: Addition to property, plant and equipment, change in non-cash working capital items related to property, plant and equipment, acquisitions, Other. Financing activities: Issuance of long-term debt (increase), repayment of long-term debt (Decrease), Premium on repayment of long-term debt, issuance of capital stock on exercise of stock options, Dividends paid, Increase (decrease) in cash and cash equivalents. From the balance sheet, Accounts receivable shows how much the company was owed by its customers. Current liabilities indicate the portions owing in which the company needs to owe back within a year. In order to reach to EBIT, from the income statement, the operating income has to be added to the other income (expense) item. Alternatively, EBIT can be calculated by adding back the Interest on long-term debt to the Income before income taxes. In order to find the effect of change in working capital on cash, from the cash flow statement, change in working capital items shows if it added to cash or used it up. 3-22 Solution Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011