CHAPTER 6 Discussion Questions 6-1. Rapidly expanding sales will require a buildup in assets to support the growth. In particular, more and more of the increase in current asset will be permanent in nature. A non-liquidating aggregate stock of current assets will be necessary to allow for floor displays, multiple items for selection, and other purposes. All of these ‘asset’ investments can drain the cash resources of the firm. 6-2. If sales and production can be matched, the level of inventory and the amount of current assets needed can be kept to a minimum; therefore, lower financing costs will be incurred. Matching sales and production has the advantage of maintaining smaller amounts of current assets than level production, and therefore less financing costs are incurred. However, if sales are seasonal or cyclical, workers will be laid off in a declining sales climate and machinery (capital assets) will be idle. Here lies the tradeoff between level and seasonal production: Full utilization of capital assets with skilled workers and more financing of current assets versus unused capacity, training and retraining workers, with lower financing for current assets. 6-3. A cash budget helps minimize current assets by providing a forecast of inflows and outflows of cash. It also encourages the development of a schedule as to when inventory is produced and maintained for sales (production schedule), and accounts receivables are collected. The cash budget allows us to forecast the level of each current asset and the timing of the buildup and reduction of each. 6-4. Only a financial manager with unusual insight and timing could design a plan in which asset buildup and the length of financing terms are perfectly matched. One would need to know exactly what parts of current assets are temporary and what parts are permanent. Furthermore, one is never quite sure how much short-term or long-term financing is available at appropriate rates at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis. 6-5. By establishing a long-term financing arrangement for temporary current assets, a firm is assured of having necessary funding in good times as well as bad, thus we say there is low risk. However, as indicated in Figure 6-12, long-term financing is generally more expensive than short-term financing and profits may be lower than those which could be achieved with a synchronized or normal financing arrangement for temporary current assets. 6-6. By financing a portion of permanent current assets on a short-term basis, we run the risk of inadequate financing in tight money periods. However, since short-term financing is less expensive than long-term funds, a firm tends to increase its profitability over the long run (assuming it survives). In answer to the preceding question, we stressed less risk and less return; here the emphasis is on risk and high return. 6-7. The term structure of interest rates shows the relative level of short-term and long-term interest rates at a point in time. It is often referred to as a yield curve. 6-8. Liquidity premium theory, the segmentation theory, and the expectations theory: The liquidity premium theory indicates that long-term rates should be higher than shortterm rates. This premium of long-term rates over short-term rates exists because shortterm securities have greater liquidity, and therefore higher rates have to be offered to potential long-term bond buyer for enticement to hold these less liquid and more price sensitive securities. The segmentation theory states that Treasury securities are divided into market segments by the various financial institutions investing in the market. The changing needs, desires, and strategies of these investors tend to strongly influence the nature and relationship of short- and long-term rates. The expectations hypothesis maintains that the yields on long-term securities are a function of short-term rates. The result of the hypothesis is that when long-term rates are much higher than short-term rates, the market is saying that it expects short-term rates to rise. When long-term rates are lower than short-term rates, the market is expecting shortterm rates to fall. 6-9. An inverted yield curve reflects investor expectations that interest rates will decline in the future. Furthermore, an inverted yield curve has usually preceded a recession. Lower interest rates are generally a reflection of lower inflation and lower inflation is usually the result of an economic slowdown. This information would be valuable for planning purposes. 6-10. The factors that could be discussed include inflation, inflationary pressures, monetary policy and the money supply, fiscal policy (including spending, taxation, and deficits/debt) and the demand for money, and international influences. A supply/demand diagram is useful for discussing the impacts. 6-11. Before interest rates drop, a bond trader would like to lock into longer term interest rates. The trader will see the value of longer term bonds appreciate faster than short term bonds for a given increase in interest rates. The action of the trader of buying longer term bonds, relative to short term bonds, will drive their price up and their yields down. The yield curve will become inverted. 6-12. Figure 6-12 shows the long-run view of short- and long-term interest rates. Normally, short-term rates are much more volatile than long-term rates. 6-13. Corporate liquidity has been decreasing since the early 1960s because of more sophisticated, profit-oriented financial management (at times the profit orientation has been taken too far). The use of the computer has allowed for more volume being conducted with smaller cash balances. Also, inflation has forced a diversion of funds away from liquid assets to handle ever-expanding inventory costs. Likewise decreasing profitability during recessions has diverted funds from liquid assets. Internet Resources and Questions 1. www.bankofcanada.ca/rates/interest-rates 2. www.bloomberg.com/markets/rates/index.html 3. www.rbc.com/economics/quicklink/index.html Problems 6-1. 6-2. Bondage Supply Company $750,000 .10 75,000 – 22,500 $ 52,500 Sales Profit margin Net income Dividends (30%) Increase in retained earnings $120,000 – 52,500 $67,500 Increase in assets Increase in retained earnings External funds needed Axle Supply Co. $300,000 .08 24,000 – 4,800 $ 19,200 Sales Profit margin Net income Dividends (20%) Increase in retained earnings $60,000 – 19,200 $40,800 6-3. Increase in assets Increase in retained earnings External funds needed Garza Electronics January February March Beginning Inventory 700 800 1,150 6-4. + Production + 600 + 600 + 600 – Sales – 500 – 250 – 1,000 = = = = Ending Inventory 800 1,150 750 Madonna’s Clothiers a. October November December January b. October November December January Units sold 2,000 4,000 8,000 6,000 Units produced 5,000 5,000 5,000 5,000 Ending inventory 3,000 4,000 1,000 0 Change in inventory +3,000 +1,000 –3,000 –1,000 Cost per unit ($7) $21,000 28,000 7,000 0 Ending inventory 3,000 4,000 1,000 0 Financing cost @ 8%/12 $140.00 186.67 46.67 0 $373.34 6-5. Bambino Sporting Goods a. March April May June b. March April May June 6-6. a. Units sold 3,000 7,000 11,000 9,000 Units produced 7,500 7.500 7,500 7,500 Ending inventory 4,500 5,000 1,500 0 Change in inventory +4,500 +500 –3,500 –1,500 Cost per unit ($20) $ 90,000 100,000 30,000 0 Ending inventory 4,500 5,000 1,500 0 Financing cost @ 6%/12 $450.00 500.00 150.00 0 $1,100.00 Front Page Video Games Production and inventory schedule in units Beginning Inventory 1 Sales 2 Ending = Inventory January + Production – 20,000 + 11,600 – 19,000 = 12,600 February 12,600 + 11,600 – 17,600 = 6,600 March 6,600 + 11,600 – 4,000 = 14,200 April 14,200 + 11,600 – 4,000 = 21,800 May 21,800 + 11,600 – 3,000 = 30,400 June 30,400 + 11,600 – 6,000 = 36,000 Beginning Inventory 1 2 Ending = Inventory Sales July + Production – 36,000 + 11,600 – 8,000 = 39,600 August 39,600 + 11,600 – 8,000 = 43,200 September 43,200 + 11,600 – 10,000 = 44,800 October 44,800 + 11,600 – 16,000 = 40,400 November 40,400 + 11,600 – 20,000 = 32,000 December 32,000 + 11,600 – 23,600 = 20,000 1 Total annual sales = $696,000 $696,000/ $5 per unit = 139,200 units 139,200 units/ 12 months = 11,600 per month 2 Monthly dollar sales/ $5 price = unit sales b. Cash Receipts Schedule January Sales (in dollars) February March April May June $95,000 $88,000 $20,000 $20,000 $15,000 $30,000 28,500 26,400 6,000 6,000 4,500 9,000 70% prior month’s sales 70,000* 66,500 61,600 14,000 14,000 10,500 Total cash receipts $98,500 $92,900 $67,600 $20,000 $18,500 $19,500 Nov. Dec. 30% cash sales *based on December sales of $100,000 July Sales (in dollars) August Sept. October $40,000 $40,000 $50,000 $80,000 $100,000 $118,000 30% cash sales 12,000 12,000 15,000 24,000 30,000 35,400 70% prior month’s sales 21,000 28,000 28,000 35,000 56,000 70,000 Total cash receipts $33,000 $40,000 $43,000 $59,000 $86,000 $105,400 c. Cash Payments Schedule Constant production January 11,600 units × $2 February March April May June $23,200 $23,200 $23,200 $23,200 $23,200 $23,200 Other cash payments 40,000 40,000 40,000 40,000 40,000 40,000 Total cash payments $63,200 $63,200 $63,200 $63,200 $63,200 $63,200 August Sept. Nov. Dec. $23,200 $23,200 $23,200 $23,200 $23,200 $23,200 Other cash payments 40,000 40,000 40,000 40,000 40,000 40,000 Total cash payments $63,200 $63,200 $63,200 $63,200 $63,200 $63,200 July 11,600 units × $2 October d. January Net cash flow Cash Budget February March April May June $35,300 $29,700 5,000 40,300 70,000 74,400 31,200 5,000 40,300 70,000 74,400 31,200 (13,500) (38,700) Monthly loan or (repayment) -0- -0- -0- -0- 18,500 43,700 Cumulative loan -0- -0- -0- -0- 18,500 62,200 40,300 70,000 74,400 31,200 5,000 5,000 Beginning cash Cumulative cash balance Ending cash balance July Net cash flow Beginning cash August $ 4,400 $(43,200) $(44,700) $(43,700) Sept. ($30,200) ($23,200) ($20,200) October Nov. Dec. ($4,200) $22,800 $42,200 5,000 5,000 5,000 5,000 5,000 5,000 (25,200) (18,200) (15,200) 800 27,800 47,200 Monthly loan or (repayment) 30,200 23,200 20,200 4,200 (22,800) (42,200) Cumulative loan 92,400 115,600 135,800 140,000 117,200 75,000 5,000 5,000 5,000 5,000 5,000 5,000 Cumulative cash balance Ending cash balance 6-7. Esquire Products, Inc. a. Production and inventory schedule in units Beginning Inventory 1 + Production – – = Ending Inventory 12,000 = 5,000 Sales 2 January 8,000 + 9,000 February 5,000 + 9,000 – 7,500 = 6,500 March 6,500 + 9,000 – 4,000 = 11,500 April 11,500 + 9,000 – 5,000 = 15,500 May 15,500 + 9,000 – 2,000 = 22,500 June 22,500 + 9,000 – 1,000 = 30,500 July 30,500 + 9,000 – 9,000 = 30,500 August 30,500 + 9,000 – 11,000 = 28,500 September 28,500 + 9,000 – 12,500 = 25,000 October 25,000 + 9,000 – 15,000 = 19,000 November 19,000 + 9,000 – 19,000 = 9,000 December 9,000 + 9,000 – 10,000 = 8,000 1 $216,000 sales/$2 price = 108,000 units 108,000 units/12 months = 9,000 units per month 2 Monthly dollar sales/$2 = number of units b. Cash Receipts Schedule (take dollar values from problem statement) January Sales (in dollars) February March April May June $24,000 $15,000 $ 8,000 $10,000 $4,000 $2,000 9,600 6,000 3,200 4,000 1,600 800 60% Prior month’s sales 12,000* 14,400 9,000 4,800 6,000 2,400 Total receipts $21,600 $20,400 $12,200 $ 8,800 $ 7,600 $ 3,200 Nov. Dec. 40% Cash sales *based on December sales of $20,000 July Sales (in dollars) August Sept. October $18,000 $22,000 $25,000 $30,000 $38,000 $20,000 40% Cash sales 7,200 8,800 10,000 12,000 15,200 8,000 60% Prior month’s sales 1,200 10,800 13,200 15,000 18,000 22,800 $ 8,400 $19,600 $23,200 $27,000 $33,200 $ 30,800 Total receipts c. Cash Payments Schedule: Constant production January 9,000 units × $1 Other cash payments Total payments Other cash payments Total payments March April May June $ 9,000 $ 9,000 $ 9,000 $ 9,000 $ 9,000 $ 9,000 7,000 7,000 7,000 7,000 7,000 7,000 $16,000 $16,000 $16,000 $16,000 $16,000 $16,000 August Sept. Nov. Dec. July 9,000 units × $1 February October $ 9,000 $ 9,000 $ 9,000 $ 9,000 $ 9,000 $ 9,000 7,000 7,000 7,000 7,000 7,000 7,000 $16,000 $16,000 $16,000 $16,000 $16,000 $16,000 d. January Cash flow Cash Budget February March April May June $ 5,600 $ 4,400 ($ 3,800) ($ 7,200) ($ 8,400) ($12,800) Beginning cash 3,000 8,600 13,000 9,200 3,000 3,000 Cumulative cash balance 8,600 13,000 9,200 2,000 (5,400) (9,800) Monthly loan or (repayment) -0- -0- -0- 1,000 8,400 12,800 Cumulative loan -0- -0- -0- 1,000 9,400 22,200 $8,600 $13,000 $9,200 $3,000 $3,000 $3,000 Ending cash balance July Cash flow August Sept. October Nov. Dec. ($ 7,600) $ 3,600 $ 7,200 $11,000 $17,200 $14,800 3,000 3,000 3,000 3,000 3,000 12,200 (4,600) 6,600 10,200 14,000 20,200 27,000 7,600 (3,600) (7,200) (11,000) (8,000) -0- Cumulative loan 29,800 26,200 19,000 8,000 -0- -0- Ending cash balance $3,000 $3,000 $3,000 $3,000 $12,200 $27,000 Beginning cash Cumulative cash balance Monthly loan or (repayment) e. Cash Assets Accounts Receivable Inventory Total Current January $ 8,600 $14,400 $ 5,000 $28,000 February 13,000 9,000 6,500 28,500 March 9,200 4,800 11,500 25,500 April 3,000 6,000 15,500 24,500 May 3,000 2,400 22,500 27,900 June 3,000 1,200 30,500 34,700 July 3,000 10,800 30,500 44,300 August 3,000 13,200 28,500 44,700 September 3,000 15,000 25,000 43,000 October 3,000 18,000 19,000 40,000 November 12,200 22,800 9,000 44,000 December 27,000 12,000 8,000 47,000 The instructor may wish to point out how current assets are at relatively high levels and illiquid during June through October. In November and particularly December, the asset levels remain high, but they become increasingly more liquid as inventory diminishes relative to cash. 6-8. Liz’s Health Food Stores a. Month Short-term financing On Monthly Rate Basis Amount Actual Interest January 8% 0.67% $8,000 $53.33 February 9% 0.75% 2,000 15.00 March 12% 1.00% 3,000 30.00 April 15% 1.25% 8,000 100.00 May 12% 1.00% 9,000 90.00 June 12% 1.00% 4,000 40.00 $328.33 b. Month Long-term financing On Monthly Rate Basis Amount Actual Interest January 12% 1% $8,000 $80.00 February 12% 1% 2,000 20.00 March 12% 1% 3,000 30.00 April 12% 1% 8,000 80.00 May 12% 1% 9,000 90.00 June 12% 1% 4,000 40.00 $340.00 Total dollar interest payments would be larger under the long-term financing plan as described in part b. 6-9. Liz’s Health Food Stores (Continued) Divide the total interest payments in part (a) of $328.33 by the total amount of funds extended $34,000 and multiply by 12. interest $328.33 = = 0.966% monthly rate principal $34,000 12 × .966% = 11.59% annual rate 6-10. Proctor Micro-Computers Ltd. Long-term rate: $1,200,000 × 0.095 × 2 years = $228,000 Short-term rate: $1,200,000 × 0.0655 × 1 year = $1,200,000 × 0.1095 × 1 year = $ 78,600 131,400 $210,000 The short-term rates appear less costly. 6-11. Biochemical Corp. Long-term rate: $500,000 × 0.106 × 3 years = $159,000 Short-term rate: $500,000 × 0.0725 × 1 year = $500,000 × 0.1150 × 1 year = $500,000 × 0.0815 × 1 year = $ 36,250 $ 57,500 40,750 $134,500 The short-term rates appear less costly. 6-12. Doris Daycare Centres Inc. a. If Rates Are Constant $200,000 borrowed × 10% per annum × 3 years Interest cost (long-term) $200,000 borrowed × 12% per annum × 3 years Interest cost (short-term) Interest savings if borrowing short-term b. If Short-term Rates Change 1st year $200,000 × .10 2nd year $200,000 × .15 3rd year $200,000 × .18 Total = = = = = $60,000 = 72,000 = $ 12,000 $20,000 $30,000 $36,000 $86,000 $86,000 ─ $72,000 = $14,000 Extra interest costs by borrowing short-term 6-13. Sherlock Homes Long-term financing equals: Permanent current assets Capital assets Short-term financing equals: Temporary current assets $1,500,000 2,000,000 $3,500,000 $1,000,000 Long-term interest expense = 13% × $3,500,000 = $455,000 Short-term interest expense = 8% × $1,000,000 = 80,000 Total interest expense $535,000 Earnings before interest and taxes $960,000 Interest expense Earnings before taxes Taxes (40%) Earnings aftertaxes 6-14. 535,000 425,000 170,000 $255,000 Sherlock Homes (Continued) Long-term interest expense = 8% × $3,500,000 = Short-term interest expense = 12% × 1,000,000 = Total interest expense $280,000 120,000 $400,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes $960,000 400,000 560,000 224,000 $336,000 The company has benefited because it is primarily financed by long-term financing, and long-term rates are now much lower than short-term rates, as rates have become inverted. 6-15. Exotic World Tours a. Long-term financing equals: Permanent current assets Capital assets Short-term financing equals: Temporary current assets (six months) Temporary current assets (six months) $ 800,000 1,600,000 $2,400,000 $1,200,000 500,000 Long-term interest expense = 5% × $2,400,000 = Short-term interest expense = 3% × $1,200,000 × 0.5 = Short-term interest expense = 3% × $500,000 × 0.5 = Total interest expense $ 120,000 18,000 7,500 $ 145,500 Earnings before interest and taxes $920,000 Interest expense Earnings before taxes Taxes (38%) Earnings after taxes 145,500 774,500 294,310 $480,190 b. Long-term financing equals: Permanent current assets Capital assets $ 800,000 1,600,000 $2,400,000 Short-term financing equals: Temporary current assets (six months) Temporary current assets (six months) $1,200,000 500,000 Long-term interest expense = 5% × $2,400,000 = Short-term interest expense = 3% × $1,200,000 × 0.5 = Short-term interest expense = 5% × $500,000 × 0.5 = Total interest expense $120,000 18,000 12,500 $150,500 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (38%) Earnings after taxes $920,000 150,500 769,500 292,410 $477,090 6-16. Collins Systems, Inc. a. Temporary current assets Permanent current assets Capital assets Total assets $300,000 200,000 400,000 $900,000 Conservative Amount $900,000 × .80 = $900,000 × .20 = % of Total $720,000 $180,000 Interest Rate × .15 = × .10 = Interest Expense $108,000 Long-term 18,000 Short-term Total interest charge $126,000 % of Interest Total Rate = $270,000× .15 = = $630,000× .10 = Total interest charge Interest Expense $40,500 Long-term 63,000 Short-term $103,500 Aggressive Amount $900,000 × .30 $900,000 × .70 b. EBIT – Int. EBT Tax 40% EAT Conservative $180,000 126,000 54,000 21,600 $ 32,400 Aggressive $180,000 103,500 76,500 30,600 $ 45,900 c. Reversed Conservative Amount $900,000 × .80 = $900,000 × .20 = % of Interest Total Rate $720,000 × .10 = $180,000 × .15 = Total interest charge Interest Expense $72,000 Long-term 27,000 Short-term $99,000 Aggressive Amount $900,000 × .30 $900,000 × .70 % of Total = $270,000 = $630,000 Interest Rate × .10 = × .15 = Interest Expense $ 27,000 Long-term 94,500 Short-term Total interest charge EBIT – Int EBT Tax 40% EAT 6-17. Conservative $180,000 99,000 81,000 32,400 $ 48,600 $121,500 Aggressive $180,000 121,500 58,500 23,400 $ 35,100 Lear, Inc. a. Current assets – permanent current assets = temporary current assets $800,000 – $350,000 = $450,000 Long-term interest expense = 10% [$600,000 + ½ ($350,000)] = 10% × ($775,000) = $77,500 Short-term interest expense = 5% [$450,000 + ½ ($350,000)] = 5% × ($625,000) = $31,250 Total interest expense = $77,500 + $31,250 = $108,750 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes $200,000 108,750 91,250 27,375 $ 63,875 b. Alternative financing plan L. T. interest expense = 10% [$600,000 + $350,000 + ½ ($450,000)] = 10% ($1,175,000) = $117,500 Short-term interest expense = 5% [½ ($450,000)] = 5% (225,000) = $11,250 Total interest expense = $117,500 + $11,250 = $128,750 Earnings before interest and taxes Interest Earnings before taxes Taxes (30%) Earnings after taxes $200,000 128,750 71,250 21,375 $ 49,875 c. The alternative financing plan which calls for more financing by high-cost debt is more expensive and reduces aftertax income by $14,000. However, we must not automatically reject this plan because of its higher cost since it has less risk. The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities. It will not be forced to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the short-term loan. 6-18. Warp Tense Ltd. a. Long-term financing (as share capital) equals: Permanent current assets Capital assets Short-term financing equals: Temporary current assets Share capital = $5,000,000 ÷ $25 = Short-term interest expense = 3% × $2,000,000 = $ 500,000 4,500,000 $5,000,000 $2,000,000 200,000 $60,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes Earnings per share b. Long-term financing (as share capital) equals: 55% of $7,000,000 (total assets) = Short-term financing equals: 45% of $7,000,000 (total assets) = Share capital = $3,850,000 ÷ $25 = Short-term interest expense = 3% × $3,150,000 = Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes Earnings per share $450,000 60,000 390,000 117,000 $273,000 $ 1.37 $3,850,000 $3,150,000 154,000 $94,500 $450,000 94,500 355,500 106,650 $248,850 $ 1.62 c. Short term rates @7% Hedged Share capital = $5,000,000 ÷ $25 = Short-term interest expense = 7% × $2,000,000 = 200,000 $140,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes $450,000 140,000 310,000 93,000 $217,000 Earnings per share $ 1.09 Capital structure (45% debt) Share capital = $3,850,000 ÷ $25 = Short-term interest expense = 7% × $3,150,000 = 154,000 $220,500 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes $450,000 220,500 229,500 68,850 $160,650 Earnings per share 6-19. $ 1.04 Incubus Guitars a. Long-term financing (50% equity/50% debt) equals: Permanent current assets Capital assets Short-term financing equals: Temporary current assets (9 months) Temporary current assets (3 months) $750,000 3,000,000 $3,750,000 $1,500,000 $0 Shares = $3,750,000 × 0.5 ÷ $10 = Long-term interest = 6% × $1,875,000 = Short-term interest = 4% × $1,500,000 × 9/12 = Total interest 187,500 $112,500 45,000 $157,500 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes $780,000 157,500 622,500 249,000 $373,500 Earnings per share $ 1.99 b. Long-term financing (50% equity/50% debt) equals: 80% of $3,000,000 (capital assets) = Short-term financing equals: $5,250,000 ─ $2,400,000 (9 months) = $3,750,000 ─ $2,400,000 (3 months) = $2,400,000 $2,850,000 $1,350,000 Shares = $2,400,000 × 0.5 ÷ $10 = Long-term interest = 6% × $1,200,000 = Short-term interest = 4% × $2,850,000 × 9/12 = Short-term interest = 4% × $1,350,000 × 3/12 = Total interest 120,000 $72,000 85,500 13,500 $171,000 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes $780,000 171,000 609,000 243,600 $365,400 Earnings per share $ 3.05 c. Short term rates @7% Long-term financing (50% equity/50% debt): Shares = $3,750,000 × 0.5 ÷ $10 = Long-term interest = 6% × $1,875,000 = Short-term interest = 7% × $1,500,000 × 9/12 = Total interest 187,500 $112,500 78,750 $191,250 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes $780,000 191,250 588,750 235,500 $353,250 Earnings per share Shares = $2,400,000 × 0.5 ÷ $10 = Long-term interest = 6% × $1,200,000 = Short-term interest = 7% × $2,850,000 × 9/12 = $ 1.88 120,000 $ 72,000 149,625 Short-term interest = 7% × $1,350,000 × 3/12 = Total interest 23,625 $245,250 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (40%) Earnings after taxes $780,000 245,250 534,750 213,900 $320,850 Earnings per share $ 2.67 6-20. Library assignment. Answers will vary with the state of the economy. 6-21. Expectations hypothesis 2 year security (4% + 5%)/ 2 = 3 year security (4% + 5% + 7%)/ 3 = 4 year security (4% + 5% + 7% + 9%)/ 4 = 4.5% 5.33% 6.25% OR: (1.04)(1.05) − 1 = .0450 = 4.5% (1.04)(1.05)(1.07 ) − 1 = .0533 = 5.33% 4 (1.04 )(1.05)(1.07 )(1.09 ) − 1 = 0.623 = 6.23% 3 6-22. Expectations hypothesis 2 year bond = 4% 2 year bond = (1st year bond + 2nd year bond) / 2 4% f2 = (6% + f 2 ) / 2 = 2% OR: (1.04)2 1 + f2 1 + f2 f2 f2 6-23. = (1.06) (1 + f 2 ) = (1.04)2 / 1.06 = 1.0204 = 0.0204 = 2.04% Expectations hypothesis 1 year rate = 2.60% 2 year rate = 3.26% 3 year rate = 3.39% 2nd year rate 3.26% 6.52% f2 = (1st year rate + 2nd year rate) / 2 = (2.60% + f 2 ) / 2 = 2.60 + f 2 = 3.92% OR: (1.0326)2 1 + f2 1 + f2 f2 f2 = (1.0260) (1 + f 2 ) = (1.0326)2 / 1.0260 = 1.0392 = 0.0392 = 3.92% 3rd year rate 3.39% 10.17% f3 = (1st year rate + 2nd year rate + 3rd year rate) / 3 = (2.60% + 3.92% + f 3 ) / 3 = 6.52% + f 3 = 3.65% OR: (1.0339)3 1 + f3 1 + f3 f3 f3 6-24. = (1.0260) (1.0392) (1 + f 3 ) = (1.0339)3 / (1.0260) (1.0392) = 1.0365 = 0.0365 = 3.65% Expectations hypothesis 1 year rate = 5.78% 2 year rate = 5.85% 3 year rate = 6.22% 2nd year rate 5.85% 11.70% f2 = (1st year rate + 2nd year rate) / 2 = (5.78% + f 2 ) / 2 = 5.78% + f 2 = 5.92% OR: (1.0585)2 1 + f2 1 + f2 f2 f2 = (1.0578) (1 + f 2 ) = (1.0585)2 / 1.0578 = 1.0592 = 0.0592 = 5.92% 3rd year rate 6.22% 18.66% f3 = (1st year rate + 2nd year rate + 3rd year rate) / 3 = (5.78% + 5.92% + f 3 ) / 3 = 11.63% + f 3 = 6.96% OR: (1.0622)3 1 + f3 1 + f3 f3 f3 6-25. = (1.0578) (1.0592) (1 + f 3 ) = (1.0622)3 / (1.0578) (1.0592) = 1.0696 = 0.0696 = 6.96% Austin Electronics State of Economy Sales Probability Strong $900,000 .15 Steady 650,000 .60 Weak 375,000 .25 Expected level of sales = 6-26. Expected Outcome $135,000 390,000 93,750 $618,750 Hogan Surgical Instruments Company a. Most aggressive Low liquidity Short-term financing Anticipated return $2,000,000 × 18% = 2,000,000 × 10% = $360,000 – 200,000 $160,000 b. Most conservative High liquidity Long-term financing Anticipated return $2,000,000 × 14% = 2,000,000 × 12% = $280,000 – 240,000 $ 40,000 c. Moderate approach Low liquidity Long-term financing $2,000,000 × 18% = 2,000,000 × 12% = $360,000 – 240,000 $120,000 High liquidity OR: $2,000,000 × 14% = $280,000 Short-term financing 2,000,000 × 10% = – 200,000 $ 80,000 d. You may not necessarily select the plan with the highest return. You must also consider the risk inherent in the plan. Of course, some firms are better able to take risks than others. The ultimate concern must be for maximizing the overall valuation of the firm through a judicious consideration of riskreturn options. 6-27. Atlas Sporting Goods, Inc. a. Most aggressive Low liquidity Short-term financing Anticipated return $800,000 × 15% = 800,000 × 8% = $120,000 – 64,000 $56,000 b. Most conservative High liquidity Long-term financing Anticipated return $800,000 × 12% = 800,000 × 10% = $96,000 – 80,000 $ 16,000 c. Moderate approach Low liquidity Long-term financing $800,000 × 15% = 800,000 × 10% = $120,000 – 80,000 $40,000 High liquidity Short-term financing OR: $800,000 × 12% = 800,000 × 8% = $96,000 – 64,000 $ 32,000 d. You may not necessarily select the plan with the highest return. You must also consider the risk inherent in the plan. Of course, some firms are better able to take risks than others. The ultimate concern must be for maximizing the overall valuation of the firm through a judicious consideration of riskreturn options. Mini Case Gale Force Corporation (Working Capital: Level vs., Seasonal Production) Purpose: This case forces the student to view the impact of level versus seasonal production on inventory levels, bank loan requirements, and profitability. It also considers the efficiencies (or inefficiencies) covered by the different production plans. The computations in the case are parallel Tables 1 to 5 in the text, with the only difference being that seasonal production rather than level production is being utilized. The case allows the student to properly track the movement of cash flow through the production process. a. New Tables 2 through 5, with Tim’s suggestion implemented, are shown in the following pages. Observe that the inventory level is now constant at 400 units or $800,000 a month because all units produced are sold. As a side point, note that there may be no apparent need now to maintain the 400 units a month in inventory that were on hand at the start of the cycle. The inventory level could be reduced to the level that management feels would be sufficient to cover emergencies (or maybe to zero, which is what the Japanese do in a “just-in-time” production concept). Though not required, you may wish to refer to the old and new Table 4 to make a special point. Note that Tim’s suggestion causes inventory balances to decrease over the time period and total current assets to fluctuate less, but the same balances occur at the end of September for inventory and total current assets. b. New Table 5 shows the new cumulative loan balances and the interest expenses incurred each month. Under the old system (level production), total interest expense (at 1% a month on the cumulative loan balance) was $254,250. Under the proposed system it decreases to $50,750 for a savings of $203,500. c. The first step is to compute total sales. Using the second row of Table 3 (either the old or new table), the total is $14,400,000. With an added expense burden of 0.5%, expenses will go up by $72,000. This is still far less than the interest savings of $203,500 computed in question 2, so the seasonal production plan is justified. ($203,500 – $72,000 = $131,500). Please note that the values are assumed to be computed on a pretax basis. Table 2: Production schedule and inventory (seasonal production) Beginning Inventory October 400 + Production + 150 November 400 + 75 – 75 = 400 December 400 + 25 – 25 = 400 January 400 + 0 – 0 = 400 February 400 + 0 – 0 = 400 March 400 + 300 – 300 = 400 April 400 + 500 – 500 = 400 May 400 + 1,000 – 1,000 = 400 June 400 + 1,000 – 1,000 = 400 July 400 + 1,000 – 1,000 = 400 August 400 + 500 – 500 = 400 September 400 + 250 – 250 = 400 1 – – Sales 150 = = Ending Inventory Inventory ($2,000 per unit) × 400 = $800,000 4001 Table 3: Cash Receipts Schedule: (sales price = $3,000/ unit) (in thousands) October November December January February March Sales forecast 150 75 25 0 0 300 Sales (in dollars) $450.0 $ 225.0 $75.0 -0- -0- $ 900.0 50% Cash sales 225.0 112.5 37.5 -0- -0- 450.0 * 375.0 225.0 112.5 37.5 -0- -0- Total receipts $600.0 $ 337.5 $ 150.0 *based on September sales of $750,000 April May June $ 37.5 $-0- $ 450.0 50% Prior month’s sales Sales forecast July August September 500 1,000 1,000 1,000 500 250 $1,500.0 $3,000.0 $3,000.0 $ 3,000.0 $1,500.0 $750.0 50% Cash sales 750.0 1,500.0 1,500.0 1,500.0 750.0 375.0 50% Prior month’s sales 450.0 750.0 1,500.0 15,00.0 1,500.0 750.0 $1,200.0 $2,250.0 $3,000.0 $3,000.0 $2,250.0 $1,125.0 Sales (in dollars) Total receipts Table 3: Cash Payments Schedule: (Production costs = $2,000/ unit) (in thousands) October November December January February March Production in units Production costs Overhead 150 75 25 $ 300.0 $ 150.0 $ 50.0 200.0 200.0 200.0 0 $ 0.0 200.0 0 300 0.0 $ 600.0 200.0 200.0 $ 200.0 $ 800.0 $ Dividends & Interest Taxes Total payments Production in units Production costs Other cash payments 150.0 $ 150.0 $ 650.0 $ 350.0 $ 250.0 $ 350.0 April May June July August September 500 1,000 1,000 1,000 500 250 $1,000.0 $2,000.0 $2,000.0 $2,000.0 $1,000.0 $ 500.0 200.0 200.0 200.0 200.0 200.0 200.0 Dividends & Interest 1,000.0 Taxes $ 150.0 Total payments $1,350.0 300.0 $2,200.0 $2,200.0 $2,500.0 $2,200.0 $ 700.0 Table 3: Cash Budget: (minimum required balance = $125,000) (in thousands) October November December January February March Cash flow $ -50.0 $ -12.5 $ -100.0 $ -312.5 $ -200.0 $ -350.0 125.0 125.0 125.0 125.0 125.0 125.0 Cumulative cash balance 75.0 112.5 25.0 -187.5 -75.0 -225.0 Monthly loan (repayment) 50.0 12.5 100.0 312.5 200.0 350.0 Cumulative loan 50.0 62.5 162.5 475.0 675.0 1,025.0 Ending cash balance $ 125.0 April $ 125.0 May $ 125.0 June $ 125.0 July Cash flow $ -150.0 $ 50.0 $ 800.0 $ 500.0 $ 50.0 $ 425.0 Beginning cash 125.0 125.0 125.0 125.0 300.0 350.0 Cumulative cash balance -25.0 175.0 925.0 625.0 350.0 775.0 Monthly loan (repayment) 150.0 -50.0 -800.0 -325.0 -0- -0- Cumulative loan 1,175.0 1,125.0 325.0 -0- -0- -0- Ending cash balance $ 125.0 $ 125.0 $ 125.0 $ 300.0 $ 350.0 $ 775.0 Beginning cash $ 125.0 $ 125.0 August September Table 4: Total Current Assets, First Year Cash *Accounts Receivable Inventory Total Current October $125.0 $ 225.0 $800 $1,150.0 November 125.0 112.5 800 1,037.5 December 125.0 37.5 800 962.5 January 125.0 0 800 925.0 February 125.0 0 800 925.0 March 125.0 450.0 800 1,375.0 April 125.0 750.0 800 1,675.0 May 125.0 1,500.0 800 2,425.0 June 125.0 1,500.0 800 2,425.0 July 300.0 1,500.0 800 2,600.0 August 350.0 750.0 800 1,900.0 September 775.0 375.0 800 1,950.0 *Equals 50 percent of monthly sales Table 5: Cumulative Loan Balance and Interest Expense (12% per year / 1% per month) October November December January February March Cumulative loan (thousands) $50.0 $62.5 $162.5 $475.0 $675.0 $1,025.0 Interest expense at 12% $ 500 $ 625 $1,625 $4,750 $6,750 $10,250 April May June July August September Cumulative loan (thousands) $1,175.0 $1,125.0 $325.0 -0- -0- -0- Interest expense at 12% $11,750 $11,250 $3,250 $0 $0 $0 Interest rate = Prime (8%) + 4% = 12% Total interest expense for the year = $50,750 Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015
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