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Chapter 3

Problems 3.1 through 3.8 are based on the following information:


The Ruffy Stuffed Toy Companys balance sheet at the end of 19x7 was as follows:
Assets
Cash
Accounts Receivable
Inventory
Total Current Assets
119,300
Property, Plant, and Equipment
Equipment
Less Accumulated Depreciation
<2,500>
Net Equipment
22,500
Furniture
Less Accumulated Depreciation
<2,000>
Net Furniture
Total Prop, Plant, Equip
Total Assets
155,800
Liabilities and Shareholders Equity
Payables
Accounts Payable
Salary Payable
3,000
Utilities Payable
1,500
Loans (Long-term debt)
25,000
Total Liabilities
Common Stock
45,000
Retained Earnings
Total Shareholders Equity
61,300
Total Liabilities
& Shareholders Equity
155,800

27,300
35,000
57,000
25,000
16,000
14,000
36,500

65,000

94,500
16,300

During 19x8, the Ruffy Stuffed Toy Company recorded the following transactions:
a. Early in the year, purchased a new toy stuffing machine for $9,000 cash and signed a 3-year note for the balance
of $12,000.
b. Had cash sales of $115,000 and sales on credit of $316,000.
c. Purchased raw materials from suppliers for $207,000.
d. Made payments of $225,000 to its raw materials suppliers.
e. Paid rent expenses totaling $43,000.
f. Paid insurance expenses totaling $23,000.
g. Paid utility bills totaling $7,500; $1,500 of this amount reversed the existing payable from 19x7.
h. Paid wages and salaries totaling $79,000; $3,000 of this amount reversed the payable from 19x7.
i. Paid other miscellaneous operating expenses totaling $4,000.
j. Collected $270,000 from its customers who made purchases on credit.
k. The interest rate on the Loan Payable is 10% per year. Interest was paid on 12/31/19x8.
Other information:
1. The equipment has been estimated to have a useful life of 20 years, with no salvage value. Two years have
been depreciated through 19x7.
2. The existing furniture has been estimated to have a useful life of 8 years (no salvage value), of which one year
has been depreciated through 19x7.
3. The new stuffing machine has been estimated to have a useful life of 7 years, and will probably have no
salvage value.
4. The tax rate is 35%, and assume that taxes are paid on 12/31/19x8.

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5.
6.
7.

Dividend payout, if possible, will be 10% of net income.


Cost of Goods Sold for the years sales were $250,000.
Ending Balance in accounts receivable =
Beginning Balance cash received from credit customers + sales on credit
8. Ending Balance in accounts payable =
Beginning Balance + purchases cash payments to suppliers
9. Ending Balance in Inventory =
Beginning Balance + purchases of raw material cost of goods sold
10. The companys stock price at market close on 12/31/19x8 was 4 5/8. It has 20,000 shares outstanding.
3.1
3.2
3.3
3.4

Construct the balance sheet for the Ruffy Stuffed Toy Company as of 12/31/19x8.
Construct the income statement for operations during the year 19x8.
Construct a cash flow statement for the year 19x8.
Calculate the following Profitability Ratios:
Return on Sales, Return on Assets, Return on Equity
3.5 Calculate the following Asset Turnover Ratios:
Receivables turnover, Inventory turnover, Asset turnover
3.6 Calculate the following Financial Leverage and Liquidity Ratios:
debt, times interest earned, current ratio, quick (acid) test
3.7 What is the Ruffys book value per share at the end of 19x8?
3.8 Calculate the firms price-to-earnings ratio and the ratio of its market share price to its book value per
share.
SOLUTION:
BALANCE SHEETS
Assets
Cash
Accounts Receivable
Inventory
Total Current Assets
Property, Plant, and Equipment
Equipment
Less Accumulated Depreciation
Net Equipment
Furniture
Less Accumulated Depreciation
Net
Furniture
Machine
Less Accumulated Depreciation
Net
Machine
Total Prop, Plant, Equip
Total Assets

19x7

19x8

27,300
35,000
57,000
119,300

10,896.25
81,000
14,000
105,896.25

25,000
(2500)
22,500
16,000
(2000)
14000

25,000
(3,750)
21,250
16,000
(4,000)
12,000
21,000
(3,000)
18,000

36,500

51,250

155,800

Liabilities and Shareholders Equity


Payables
Accounts Payable
Salary Payable
Utilities Payable
Note payable
Loans (Long-term Debt)
Total Liabilities
Common Stock
Retained Earnings
Total Shareholders Equity
Total Liabilities and Shareholders Equity

157,146.25

65,000
3,000
1,500
0
25,000
94,500
45,000
16,300
61,300

47,000
0
0
12000
25,000
84,000
45,000
28,146.25
73,146.25

155,800

157,146.25

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INCOME STATEMENT
431,000
250,000
181,000

Sales Revenue
COGS
Gross Margin
Expenses
Wages and Salaries Expense
Rent Expense
Insurance Expense
Utility Expense
Miscellaneous Operating Expense
Depreciation Expense

181,000
Income Before Interest and Tax
Interest Expense
Taxable Income
Taxes (0.35)

22,750
2,500
20,250
7,087.50

Net Income
Dividends (0.1)
Income after Dividends

13,162.50
1,316.25
11,846.25
CASH FLOW STATEMENT

Net Income
+Dep
- A/R increase
+ Inventory decrease
- A/P decrease
Total Cash Flow from Operations
- Investment in PPE
Total cash from investing
activities
- Dividends
+ Increase in Notes Payable
Total cash from financing
activities
Change in Cash Flow

35000
57000
69500

81000
14000
47000

13162.5
6,250
(46,000)
43,000
(22,500)
6087.5
21000
21000
1316.25
+12000
+10683.75
16403.75

RATIOS:
ROS
ROA
ROE
Receivables
Turnover
Inventory Turnover
Asset Turnover
Debt
Times Interest Earned
Current
Quick
P/E
Mkt to Book

76,000
43,000
23,000
6,000
4,000
6,250
158,250

22750
22750
13162.5
431000

431000
156473.13
67223.13
58000

0.0528
0.1454
0.1958
7.4310

250000
431000
84000
22750
105896.25
91,896.25
4.625
4.625

35500
156473.13
157146.25
2500
47000
47000
0.6581
3.6573

7.0423
2.7545
0.5345
9.1000
2.2531
1.9552
7.0278
1.2646

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3.9 You have the following information taken from the 1996 financial statements of Computronics
Corporation and Digitek Corporation: (All figures are in $ millions except per share amounts.)

Net income
Dividend payout ratio
EBIT
Interest expense
Average assets
Sales
Average shareholders equity
Market price of the common
stock:
at beginning of year
at end of year
Shares of common stock
outstanding

Computronix
153.7
40%
317.6
54.7
2,457.9
3,379.3
1,113.3

Digitek
239.0
20%
403.1
4.8
3,459.7
4,537.0
2,347.3

$15
$12
200 million

$38
$40
100 million

Compare and contrast the financial performance of the two companies using the financial ratios discussed in
this chapter.
SOLUTION:
To compute total shareholder returns we need to first compute dividends per share and then follow the definition
change in share price plus dividend divided by beginning share price:
For Computronix the dividend per share is (.4 x $153.7 million) /200 million shares = $.3074, and total shareholder
return is: ($12 $15 + .3074) /$15 = 17.95%
For Digitek the dividend per share is (.2 x $239 million) /100 million shares = $.478,and total shareholder return is:
($40 $38 + .478) /$38 = 6.52%
Ratios:
Total
Times
Shareholder
Interest
Firm
Return
ROE
ROA
ROS ATO Earned Debt/Equity
Computronix
Digitek

-17.95%
6.52%

13.8% 12.9% 9.4% 1.37


10.2% 11.7% 8.9% 1.31

5.806
83.979

1.21
0.47

Digitek offered a higher return to its shareholders than did Computronix: 6.52% vs. 17.95%, despite the
fact that Computronix had a higher ROE, a higher ROA, a higher ROS, and a higher ATO.
Average liabilities for Computronix were $1,344.6 million and for Digitek $1,112.4 million.
Times interest earned was 5.806 for Computronix and 83.979 for Digitek.

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3.10 Refer to the following financial statements:


INCOME STATEMENT

20x6

20x7

Sales

$1,200,000

$1,500,000

COGS

750,000

937,500

Gross Margin

450,000

562,500

Advertising Expense

50,000

62,500

Rent Expense

72,000

90,000

Salesperson Commission Expense

48,000

60,000

Utilities Expense

15,000

18,750

EBIT

265,000

331,250

Interest Expense

106,000

113,000

Taxable Income

159,000

218,250

20x8e

Operating Expenses

Taxes (35%)

55,650

76,388

Net Income

103,350

141,863

Dividends (40% payout)

41,340

56,745

Change in Retained Earnings

62,010

85,118

BALANCE SHEET
Assets
Cash

$300,000

$375,000

Receivables

200,000

250,000

Inventory

700,000

875,000

1,800,000

2,250,000

$3,000,000

$3,750,000

$300,000

$375,000

Short-term debt (10% interest)

500,000

989,882

Long-term debt (7% interest)

800,000

900,000

1,100,000

1,100,000

Property, Plant, Equipment


Total Assets
Liabilities and Shareholders Equity
Liabilities
Payables

Shareholders Equity
Common Stock
Retained Earnings
Total Liabilities and Equity

a.
b.
c.
d.
e.

300,000

385,118

$3,000,000

$3,750,000

Determine which items varied in constant proportion to sales between 20x6 and 20x7.
Determine the rate of growth in sales that was achieved from 20x6 to 20x7.
What was the firms return on equity for 20x7? Can you calculate it for 20x6?
What was the firms external (additional) funding requirement determined to be for 20x7? How was the
funding obtained?
Prepare pro forma statements for 20x8 with the following assumptions:

Rate of growth in sales = 15%

The firm intends to pay down $100,000 of its short-term debt on Jan. 1, 20x8.

Interest rates on debt are as stated in the balance sheet, and are applied to the

the start-of-year (20x8) balances for short-term and long-term debt. Remember that the firm
intends to pay down part of the short-term loan on 1/1/20x8.

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The firms dividend payout in 20x8 will be reduced to 30%.

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1.
2.

f.

How much additional funding will the firm need for 20x8?
The firm will close 40% of any additional funding gap by issuing new stock. It will then use up to
$100,000 of long-term debt, with the remainder coming from 9% short-term borrowing. Complete
the pro forma balance sheet for 20x8.
3. What would be the firms forecasted return on equity for 20x8?
Suppose the firm anticipates an increase in the corporate tax rate to 38%. Determine the amount of
additional funding that would be required if this change comes to pass.

SOLUTION:
a.
INCOME STATEMENT
Sales

20x6

20x7

20x6

20x7

$1,200,000

$1,500,000

100.0%

100.0%

COGS

750,000

937,500

62.5%

62.5%

Gross Margin

450,000

562,500

37.5%

37.5%

Advertising Expense

50,000

62,500

4.2%

4.2%

Rent Expense

72,000

90,000

6.0%

6.0%

Salesperson Commission Expense

48,000

60,000

4.0%

4.0%

Utilities Expense

15,000

18,750

1.3%

1.3%

EBIT

265,000

331,250

22.1%

22.1%

Interest Expense

106,000

113,000

8.8%

7.5%

Taxable Income

159,000

218,250

13.3%

14.6%

Taxes (35%)

55,650

76,388

4.6%

5.1%

Net Income

103,350

141,863

8.6%

9.5%

Dividends (40% payout)

41,340

56,745

3.4%

3.8%

Change in Retained Earnings

62,010

85,118

5.2%

5.7%

Operating Expenses

BALANCE SHEET

20x6

20x7

20x6

20x7

$300,000

$375,000

25.0%

25.0%

200,000

250,000

16.7%

16.7%

Assets
Cash
Receivables
Inventory

700,000

875,000

58.3%

58.3%

1,800,000

2,250,000

150.0%

150.0%

$3,000,000

$3,750,000

250.0%

250.0%

$300,000

$375,000

25.0%

25.0%

Short-term debt (10% interest)

500,000

989,882

41.7%

66.0%

Long-term debt (7% interest)

800,000

900,000

66.7%

60.0%

1,100,000

1,100,000

91.7%

73.3%

300,000

385,118

25.0%

25.7%

$3,000,000

$3,750,000

250.0%

250.0%

Property, Plant, Equipment


Total Assets
Liabilities and Shareholders Equity
Liabilities
Payables

Shareholders Equity
Common Stock
Retained Earnings
Total Liabilities and Equity

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b.
c.

d.
e.

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(1,500,000 1,200,000)/1,200,000 = .25 or 25%


9.83% = (141,863/((1,400,000 + 1,485,118)/2)). Since the denominator is the average of the period beginning
and ending shareholders equity, 20x5 ending shareholders equity would be needed to calculate ROE for
20x6. The retained earnings in 20x5 can be calculated:
RE19x5= 300,000 62,010 = 237,990. Assuming no additional stock was issued in 20x6, hence, Common
Stock19x5 = 1,100,000.
ROE = (103,350/((1,337,990 + 1,400,000)/2)) = 7.55%
$589,882. $489,882 was acquired from short-term debt and the remaining $100,000 from long-term debt.
INCOME STATEMENT

Sales
COGS
Gross Margin
Operating Expenses
Advertising Expense
Rent Expense
Salesperson Commission Expense
Utilities Expense
EBIT
Interest Expense
Taxable Income
Taxes (35%)
Net Income
Dividends (30% payout)
Change in Retained Earnings
BALANCE SHEET
Assets
Cash
Receivables
Inventory
Property, Plant, Equipment
Total Assets
Liabilities and Shareholders Equity
Liabilities
Payables
Short-term debt (10% interest)
Long-term debt (7% interest)
Shareholders Equity
Common Stock
Retained Earnings
Total Liabilities and Equity
1

20x8e
$1,725,000
1,078,125
646,875
$

72,450
103,500
69,000
22,425
379,500
151,9881
227,512
79,629
147,883
44,365
103,518

$ 431,250
288,075
1,005,675
2,587,500
$4,312,500

431,250
889,882

489,290
$4,312,500

Interest Expense calculated as .10*($889,882) + .07*(900,000)

1) Additional Funding = Change in Assets - Increase in RE Increase in Payables + Decrease in Short term debt
(10% interest) on 1/1/19x8
$502,078 =
562,500
104,172
56,250 +
100,000
Note that this equation takes into account the financing needed to pay down the $100,000 of the short-term debt on
Jan 1, 20x8.

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2) 20x8 balance for:
Short-term debt (10%):
Short-term debt (9%):
Long-term debt:
Common Stock:

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$889,882
$201,247 = ((502,078 x .6) 100,000)
$1,000,000 = $900,000 + $100,000
$1,300,831 = (40% x 502,078 + 1,100,000)

Liabilities and Shareholders Equity


Liabilities
Payables
Short-term debt (10% interest)
Short-term debt (9% interest)
Long-term debt (7% interest)
Shareholders Equity
Common Stock
Retained Earnings
Total Liabilities and Equity

20x8e
431,250
889,882
201,247
1,000,000
1,300,831
489,290
$4,312,500

Note that when using the pro forma statements to determine the required amount of additional (external) funding
needed, one important assumption is made: that the debt used to satisfy the funding is acquired in total at the end of
the year 20x8, though this may not be the case in real life. This assumption removes the circular reference problem
between debt and the associated interest expense, because it essentially holds the interest constant. Pb 3.14 below
deals with that issue.
3) Forecasted ROE for 20x8e = (148,883/((1,485,118 + 1,790,121)/2)) = 9.0%
f.

Additional funding required = 562,500 98,740 56,250 + 100,000 = $507,510


The external funding requirement is larger by $5,432, which is the reduction in the increase of retained
earnings brought about by the higher tax rate.

3.11 Take the pro forma statements (with tax rate = .35) developed in problem 3.10, and:
a. Revise them assuming a growth rate in sales from 19x7 to 19x8 of 10%. What is the additional funding
required for 19x8 under this scenario?
b. Now, develop pro forma statements for 19x9 assuming a growth rate in sales of 20% from 19x8 to 19x9.
What is the additional funding needed for 19x9? The firm plans to use 9 % short-term debt to cover this
entire amount.
SOLUTION:
a. Additional Funding = Change in Assets - Increase in R/E - Increase in Payables + Decrease in Short term
Debt (at 10% interest)
$341,489 =
375,000
96,011

37,500 + 100,000
Note that this equation takes into account the financing needed to pay down the $100,000
of the short-term debt on Jan. 1, 19x8.

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Chapter 3

INCOME STATEMENT
Sales (assuming 10% growth over 19x7)
COGS
Gross Margin
Operating Expenses
Advertising Expense
Rent Expense
Salesperson Commission Expense
Utilities Expense
EBIT
Interest Expense
Taxable Income
Taxes (35%)
Net Income
Dividends (30% payout)
Change in Retained Earnings

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19x8e
1,650,000
1,031,250
618,750
69,300
99,000
66,000
21,450
363,000
151,9881
211,012
73,854
137,158
41,147
96,011

BALANCE SHEET
Assets
Cash
Receivables
Inventory
Property, Plant, Equipment
Total Assets
Liabilities and Shareholders Equity
Liabilities
Payables
Short-term debt (10% interest)
Short-term debt (9% interest)
Long-term debt (7% interest)
Shareholders Equity
Common Stock
Retained Earnings
Total Liabilities and Equity
1

Interest Expense calculated on 19x8 beginning debt balances:


.10*($889,882) + .07*(900,000)
2
Calculated as: .40 x (341,489) +
1,100,000

$412,500
275,550
961,950
2,475,000
$4,125,000

$412,500
889,882
104,893
1,000,000
1,236,5962
481,129
$4,125,000

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b.
INCOME STATEMENT
Sales
COGS
Gross Margin
Operating Expenses
Advertising Expense
Rent Expense
Salesperson Commission Expense
Utilities Expense
EBIT
Interest Expense
Taxable Income
Taxes (35%)
Net Income
Dividends (30% payout)
Change in Retained Earnings

19x9e
$1,980,000
1,237,500
742,500
83,160
118,800
79,200
25,740
435,600
168,4291
267,171
93,510
173,661
52,098
121,563

BALANCE SHEET
Assets
Cash
Receivables
Inventory
Property, Plant, Equipment
Total Assets
Liabilities and Shareholders Equity
Liabilities
Payables
Short-term debt (10% interest)
Short-term debt (9% interest)
Long-term debt (7% interest)
Shareholders Equity
Common Stock
Retained Earnings
Total Liabilities and Equity
1

$495,000
330,660
1,154,340
2,970,000
$4,950,000

$495,000
889,882
725,8302
1,000,000
1,236,596
602,692
$4,950,000

Interest Expense calculated on 19x9 beginning debt balances:


.10*($889,882) + .07*($1,000,000) + .09*($104, 893)
2
Calculated as $104,893 balance from 19x8e + the 19x9e requirement ($620,937).
The additional funding requirement for 19x9 will be:
825,000 122,329 82,500 = $620,171

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3.12 Suppose that after analyzing the results of 19x8 and preparing pro forma statements for 19x9, the Give
Me Debt Company anticipates an increase in total assets of $50, an increase in retained earnings of $25, and
an increase in payables of $40. Assume that other than the payables, the firms liabilities include short-term
and long-term debt, and that its equity includes common stock and retained earnings.
a. The Chief Financial Officer of the company asks you to determine the required
amount of external funding in19x9. What do you tell the CFO?
b. What actions can Give Me Debt Co. undertake to address the situation you have found?
SOLUTION:
a. You tell the CFO that the company is over-funded by $15. That is, the difference between the increase in
assets ($50) and the increase in retained earnings plus the increase in payables is $15. (50 25 40 = 15)
b. The company can take some of the retained earnings and pay them out as dividends, or it could use it to
reduce any of the debt classes (payables, short-term debt, long-term debt).
3.13 Place the following planning events in their likely order of occurrence within the planning cycle:
___ Funding needs for implementation of tactical plans are estimated
___ The final firm-wide plan and budgets are completed
___ CEO and top management team establish strategic objectives for the firm
(ex: increase market share from 10% to 12%)
___ Line managers devise action plans to support strategic objectives
___ Revisions are made to the strategic plan and divisional budgets based on
feedback from divisional managers with regards to resource (money,
people) requirements
___ Decisions are made as to which sources of external financing to tap
___ Integration of divisional budgets into a preliminary firm-wide budget
by CEO and top management team
___ The firm determines the amount of required external financing
___ Tactical plans and budgets are reviewed with division management;
priorities are assigned to planned activities
___ Division managers review the strategic objectives with their line (or tactical)
management.
SOLUTION:
Place the following planning events in their likely order of occurrence within the planning cycle:
_4_ Funding needs for implementation of tactical plans are estimated
_8_ The final firm-wide plan and budgets are completed
_1_ CEO and top management team establish strategic objectives for the firm (ex: increase market share
from 10% to 12%)
_3_ Line managers devise action plans to support strategic objectives
_7_ Revisions are made to the strategic plan and divisional budgets based on feedback from divisional
managers with regards to resource (money, people) requirements
10_ Decisions are made as to which sources of external financing to tap
_6_ Integration of divisional budgets into a preliminary firm-wide budget by CEO and top management
team
_9_ The firm determines the amount of required external financing
_5_ Tactical plans and budgets are reviewed with division management; priorities are assigned to
planned activities
_2_ Division managers review the strategic objectives with their line (or tactical) management.

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3.14 Suppose that the sharply abbreviated actual 19x8 and pro forma 19x9 income statement and balance
sheet for Cones R Us, an ice-cream retailer, appear as follows:
INCOME STATEMENT
EBIT
Interest Expense
Taxable Income
Net Income (after taxes of .33)
Dividends
Change in Retained Earnings
BALANCE SHEET
Assets
Liabilities
Payables
Debt
Shareholders Equity

19x8

19x9e
$100
25
75
50
20
30

$800

$1000

80
300
420

100
450
450

The $25 interest expense projected for 19x9 is based on a rate of 8.33% applied to the outstanding debt
balance of $300 at the end of 19x8. Debt increases from $300 to $450 because of external financing that is
obtained to close the gap exhibited in the relationship:
Additional
Financing = Change in Assets - increase in retained earnings - increase in payables
Needed
a.

What problems are created in using the pro forma statements to determine the required amount of
additional (external) financing if the debt that will be used to satisfy the funding need is acquired in
total at the beginning of 19x9, rather than at the end of 19x9 as is implied in these statements?
b. Is this problem likely to be significant? Why?
SOLUTION:
a. The problem is the circular relationship between a means used to meet funding needs (debt) and a factor used
to determine the amount of that need (interest). Interest expense is a factor in determining net income and,
ultimately, the size of the change to retained earnings. The change in retained earnings is further used to
determine the amount of required additional financing. Some portion of the additional funding will be met by
increased debt, which creates additional interest expense. If this debt is assumed to be acquired at the start of
19x9, then the additional interest expense will be incurred in 19x9, which will change the addition to retained
earnings for that year, which will change the determination of the amount of additional funding required, hence
again changing the debt and the associated interest expense. Assuming the debt at the end of a year removes
the circular reference problem, because it essentially holds interest constant.
b.

The problem is not likely to be significant. As an illustration, with debt at 10% and taxes at 40%:
$200 Debt acquired
$200 Debt not acquired
at start of year
until end of year
($1200 balance)
($1000 balance)
EBIT
500
500
Interest
120
100
Taxable Income
380
400
Net Income
228
240
Dividends (10%)
22.80
24.00
Change in R/E
205.20
216.00

In this one iteration scenario, a $200 difference in debt produces a $20 difference in interest, with an eventual
$10.80 reduction in the change in retained earnings. On the second iteration, this lower retained earnings would
result in a larger additional funding need (by $10.80). If this is met exclusively by debt (acquired at the start of a

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period), total debt would be $1210.80, with associated interest of $121.08, or $1.08 larger than the first iteration.
The effect becomes negligible. In the context of preparation of pro forma statements, which use estimates (hence
containing varying amounts of error), the difference in approach is even less material.
3.15 Assume a firm has net income in 19x9 of $20 and its end-of-year 19x8 total assets were $450. Further
assume that the firm has a standing requirement to maintain a debt/equity ratio of 0.8, and that its managers
are prohibited from further borrowing or stock issuance.
a. What is this firms maximum sustainable growth rate?
b. If the firm pays $6 of the $20 net income as a dividend, and plans to maintain this payout ratio into the
future, now what is its maximum sustainable growth rate?
c. If the firm uses $12 of the $20 net income to repurchase some of its outstanding shares, and plans to
maintain the use of this ratio of net income for future repurchases, now what is its maximum sustainable
growth rate?
d. If the firm takes action as described in parts b) and c), what would its maximum sustainable growth rate
be?
SOLUTION:
a. Debt/Equity = .8; Assets = $450; Debt = $200; Equity = $250; growth rate = 20/250 =8%
b. growth rate = 8% x (1-6/20) = 5.6%
c. growth rate = 8% x (1-12/20) = 3.2%
d. growth rate = 8% x (1- 6/20 12/20) =0 .8%
3.16 Working capital management questions:
a. Suppose you own a firm that manufactures pool tables. Thirty days ago, you hired a consultant to
examine your business and suggest improvements. The consultants proposal, if implemented, would
allow your firm to shorten the time between each sale and the subsequent cash collection by 20 days,
slightly lengthen the time between inventory purchase and sale by only 5 days, but shorten the time
between inventory purchase and your firms payment of the bill by 15 days. Would you implement the
consultants proposal? Why?
b. In general, the principles of cash cycle time management call for a firm to shorten (minimize) the time it
takes to collect receivables, and lengthen (maximize) the time it takes to pay amounts it owes to suppliers.
Explain what trade-offs need to be managed if the firm offers discounts to customers who pay early, and
the firm also foregoes discounts offered by its suppliers by extending the time until it pays invoices.
c. Suppose it is 3/13/x2, and you just received your monthly credit card statement with a new balance of
$2000. The payment is due on 4/5/x2, but your spouse panics at the sight (and size) of the balance and
wants to pay it immediately. If you practice the principles of cash cycle time management in your
personal finances, when would you make the payment? Why? What danger exists in adopting this
strategy?
d. Some furniture companies conduct highly-advertised annual sale events in which customers can either
take an upfront discount for a cash (or credit card) purchase, or defer finance charges for up to one year
on their purchases by charging it to the companys credit account. Assume that the two options do not
present a time value of money advantage for the company. In terms of cash cycle management: (1) Why
does the company offer the discount? (2) Why might the company be willing to forego cash collection for
one year if a customer chooses to defer? What risk does the company assume in the deferment case that it
does not assume in the discount case?
e. Compare the frequency with which you think a firm may monitor its working capital situation, and
move to correct a problem, with the frequency of the firms planning exercise in forecasting future sales
and determining the need for additional financing.
f. If a firm were to monitor its working capital situation closely, what problem might it be looking to
avoid?

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SOLUTION:
a. Cash cycle time = Inventory period + receivables period - payables period
+5
-20
-15
The consultants proposal results in no net change to cash cycle time, so theres no reason to implement it.
b. By offering discounts to customers for early payment, the firm is shortening its receivables period, but also
giving away some money in the form of the discount. By waiting to pay its suppliers, the firm is extending its
payables period, but the net effect is to spend more money than is necessary to resolve open invoices. A
question to be asked: Is the firm earning more by holding its money over the period between when the discount
is forgone and the total invoice from a supplier comes due, than it is incurring in the form of the implicit
interest charge by paying later? Or, is there some circumstance which at the present time calls for the retention
of cash for as long as possible?
c. You would make the payment as close to the 4/5/x2 due date as you can without being late and incurring the
finance charges. Youd be lengthening your personal payables period by waiting for the due date rather than
paying immediately.
d. The company offers the discount to collect its cash as soon as possible, or to shorten its receivables period. The
company is willing to defer cash collection for one year because it will be moving inventory out of its stores, or
shortening its inventory period. This is a larger consideration if the inventory represents a model year that is
coming to a close and new inventory is soon to be delivered. The risk that a company assumes in the deferment
case is the risk of default. Since the customer will not pay for one year and has charged the purchase to a
company credit account, the company is exposed to the possibility that the customer will not pay when one year
passes. It does not have this exposure when the customer pays cash or uses another (external) credit account.
e.

f.

Working capital management is an operational activity that may be performed daily, weekly, or monthly. Firms
in trouble that are concerned about meeting their short-term obligations will monitor it more on a daily or
weekly basis, while stable firms may monitor it less frequently, perhaps monthly. The planning exercise and the
determination of required additional funding is normally done in earnest once a year, but the plan is revisited
throughout the year, perhaps quarterly, to compare actual results against estimated results and to decide upon
adjustments to the plan.
Illiquidity.

3.17 How would the following assets and liabilities be recorded on the balance sheets of their owners?
a. a lottery ticket
b. a successful song
c. an unsuccessful movie
SOLUTION:
a. It will not be recorded. The existence of a future economic benefit is very uncertain.
b. Though an economically significant asset, it will not be recorded on the accounting balance sheet.
c. Not recorded on balance sheet.

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3.18 Personal accounting


Show how the following events and transactions should appear on your personal income statement, balance
sheet, and cash flow statement.
a. On July 1, 200X, you receive $20,000 in gifts upon graduation from school and pay off a $10,000 student
loan.
b. On August 1, 200X, you get a job as a finance intern at General Financial Services Inc. You are
promised a salary of $4,000 per month, payable on the last day of each month.
c. On August 31, you receive your first statement of GFS salary and benefits showing the following items:
Gross salary
$4,000
Income tax withholding
1,400
Social Security and Medicare tax
500
Health care premium
150
Contribution to pension plan
200
Employer Social Security tax
300
Employer contribution to pension plan
200
Employer contribution to health care
150
Amount credited to employee checking account at GFS Bank
1,750
Total employer benefit
650
d. On September 1, you purchase a new car for $20,000. You make a down payment of $5,000 and borrow
the remaining $15,000 from GFS bank at a monthly interest rate of 1%. Your monthly payment is
$498.21 for 36 months.
e. As an individual or a household, why might you want to maintain a balance sheet? How often would you
update it? Should you mark-to-market or leave your assets and liabilities at their historical values?
SOLUTION:
a. The $20,000 in gifts increases your assets as well as your net worth by the same amount. It will not affect your
cash flow statement if its not in cash. It will not affect your personal income statement either.
The $10,000 paid to close your loan decreases your liabilities (debt), and your cash by the same amount. It will
not affect your net worth, nor your personal income statement.
b. No effect. Though the job might be an economically significant asset, in the sense that you expect it will bring
you some economic benefit in the future, you have not yet earned your future revenue since you havent started
yet.
c. Increase in cash of $1,750, increase in income of $1,750, increase in pension plan benefits asset of $400.
Pension plan benefits are part of your savings, hence they increase your net worth. The Social Security and
Medicare taxes, though might bring you some benefit in the future, this benefit is not related with the tax youre
paying now, hence most people will consider them simply as expenses, and never mention them in their
personal balance sheet. The health insurance premium and contribution from employer will appear as a
Prepaid insurance on the balance sheet before end of year, but will be expensed by the end of year.
d. Balance sheet effect: Car asset increases by $20,000. Cash decreases by $5,000. Debt increases by $15,000.
Every month, your cash drops by $498.21 and you incur an interest expense of 0.01 * (remaining principal of
debt), your remaining debt decreases by the difference between the $498.21 installment and the interest
expense paid. For example, in the first month of payment, you incur an interest expense of $150 on your
income statement, your cash decreases by $498.21 and your debt by $348.21.
e. You might want to keep a personal balance sheet for planning purposes, and to keep track of your assets,
liabilities and net worth (e.g. if you apply for a loan, you might need to present your kept records). You would
need to update it once a year, or as needed, depending on your purposes for keeping it. Obviously, you will
need to keep your records at market value. Historical values of assets and liabilities are not useful for personal
accounting.

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3.19 Uses of accounting information


You are thinking of taking a trip to Florida for your spring vacation, which begins two months from now. You
use Excites free preview Travel service on the www to find the cheapest round trip fare from Boston to Fort
Lauderdale. It tells you that the cheapest airline is AirTran. You have never heard of this airline before and
are concerned that it may have gone out of business before you can use your ticket two months from now.
How can you use financial data available on the www (e.g. at www.quicken.com) to investigate the risk to you
of buying an AirTran ticket? Which firms are in the relevant benchmark group for your purposes?
SOLUTION:
You can use relevant financial ratios available from the financial information disclosed, such as profitability,
turnover, financial leverage, liquidity and market value ratios. These ratios can then be compared with the ratios of a
comparable set of companies, namely other airline companies that are pure plays.