Problem Set 1 Solution

1. What is the main reason that an agency problem exists in the corporate form of
organization? In this context, what kinds of problems can arise? (1.6)

In the corporate form of ownership, the shareholders are the owners of the firm. The
shareholders elect the directors of the corporation, who in turn appoint the firm’s
management. This separation of ownership from control in the corporate form of
organization is what causes agency problems to exist. Management may act in its own or
someone else’s best interests, rather than those of the shareholders. If such events occur,
they may contradict the goal of maximizing the share price of the equity of the firm.

2. Under standard accounting rules, it is possible for a company’s liabilities to exceed

its assets. When this occurs, the owner’s equity is negative. Can this happen with
market values? Why or why not? (2.5)

Market values can never be negative. Imagine a share of stock selling for –$20. This would
mean that if you placed an order for 100 shares, you would get the stock along with a check
for $2,000. How many shares do you want to buy? More generally, because of corporate
and individual bankruptcy laws, net worth for a person or a corporation cannot be negative,
implying that liabilities cannot exceed assets in market value.

3. In Comparing accounting net income and operating cash flow, what two items do
you find in net income that are not in operating cash flow? Explain what each is and
why it is excluded in operating cash flow. (2.4)
The major difference is the treatment of interest expense. The accounting statement of cash
flows treats interest as an operating cash flow, while the financial cash flows treat interest as
a financing cash flow. The logic of the accounting statement of cash flows is that since interest
appears on the income statement, which shows the operations for the period, it is an
operating cash flow. In reality, interest is a financing expense, which results from the
company’s choice of debt and equity. We will have more to say about this in a later chapter.
When comparing the two cash flow statements, the financial statement of cash flows is a
more appropriate measure of the company’s performance because of its treatment of
interest.

4. Suppose a company’s cash flow from assets was negative for a particular period. Is this
necessarily a good sign or a bad sign? (2.6)

For a successful company that is rapidly expanding, for example, capital outlays will be large,
possibly leading to negative cash flow from assets. In general, what matters is whether
the money is spent wisely, not whether cash flow from assets is positive or negative.
5. At the beginning of the year, a firm has current assets of $420 and current liabilities of
$380. At the end of the year, the current assets are $500 and the current liabilities are $410.
What is the change in net working capital?
A. -$80
B. -$50
C. $0
D. $50
E. $80

Change in net working capital = ($500 - $410) - ($420 - $380) = $50

6. Awnings Incorporated has beginning net fixed assets of $560 and ending net fixed assets
of $720. Assets valued at $210 were sold during the year. Depreciation was $50. What is the
amount of capital spending?
A. $110
B. $160
C. $210
D. $300
E. $420

Net capital spending = $720 - $560 + $50 = $210

7. At the beginning of the year, long-term debt of a firm is $310 and total debt is $350. At
the end of the year, long-term debt is $280 and total debt is $370. The interest paid is $50.
What is the amount of the cash flow to creditors?
A. -$30
B. $0
C. $20
D. $30
E. $80

Cash flow to creditors = $50 - ($280 - $310) = $80

8. Peggy Grey's Cookies has net income of $360. The firm pays out 40% of the net income to
its shareholders as dividends. During the year, the company sold $80 worth of common
stock. What is the cash flow to stockholders?
A. $64
B. $136
C. $144
D. $224
E. $296

Cash flow to stockholders = .40($360) - $80 = $64

9. Thompson's Jet Skis has operating cash flow of $218. Depreciation is $45 and interest
paid is $35. A net total of $69 was paid on long-term debt. The firm spent $180 on fixed
assets and increased net working capital by $38. What is the amount of the cash flow to
stockholders?
A. -$104
B. -$28
C. $28
D. $114
E. $142

Cash flow of the firm = $218 - $38 - $180 = $0; Cash flow to creditors = $35 - (-$69) = $104;
Cash flow to stockholders = $0 - $104 = -$104

-34 = 35 -69

Interest = 35 + 69 = 104

10. Note that in all of our cash flow computations to determine cash flow of the firm, we
never include the addition to retained earnings. Why not? Is this an oversight?

The addition to retained earnings is not a cash flow. It is simply an accounting entry that
reconciles the balance sheet. Any additions to retained earnings will show up as cash flow
changes in other balance sheet accounts.

11. Note that we added depreciation back to operating cash flow and to additions to fixed
assets. Why add it back twice? Isn't this double-counting?

In both cases, depreciation is added back because it was previously subtracted when
obtaining ending balances of net income and fixed assets. Also, since depreciation is a
noncash expense, we need to add it back in both instances, so there is no double counting.

12. What is operating cash flow and how does it different from the total cash flow to the
firm?
Several types of cash flow are relevant to understanding the financial situation of the firm.
Operating cash flow, defined as earnings before interest plus depreciation minus taxes,
measures the cash generated from operations not counting capital spending or working
capital requirements. It is usually positive; a firm is in trouble if operating cash flow is
negative for a long time because the firm is not generating enough cash to pay operating
costs. Total cash flow of the firm includes adjustments for capital spending and additions to
net working capital. It will frequently be negative. When a firm is growing at a rapid rate,
spending on inventory and fixed assets can be higher than operating cash flow.

We start with net income and add back non-cash expenses and adjust for changes in current
assets + liabilities (other than cash & notes payable). The result is operating cash flow)

13. Frederico's has a profit margin of 6%, a return on assets of 8%, and an equity multiplier
of 1.4. What is the return on equity?
A. 6.7%
B. 8.4%
C. 11.2%
D. 14.6%
E. 19.6%

Return on equity = 8% ´ 1.4 = 11.2%, using the Du Pont Identity

14. Samuelson's has a debt-equity ratio of 40%, sales of $8,000, net income of $600, and
total debt of $2,400. What is the return on equity?
A. 6.25%
B. 7.50%
C. 9.75%
D. 10.00%
E. 11.25%

Return on equity = $600 ÷ ($2,400 ÷ .40) = .10 = 10%

15. The inventory turnover ratio is measured as:
A. total sales minus inventory.
B. inventory times total sales.
C. cost of goods sold divided by inventory.
D. inventory times cost of goods sold.
E. inventory plus cost of goods sold.
16. If a firm bases its growth projection on the rate of sustainable growth, and shows
positive net income, then the:
A. fixed assets will have to increase at the same rate, regardless of the current capacity
level.
B. number of common shares outstanding will increase at the same rate of growth.
C. debt-equity ratio will have to increase.
D. debt-equity ratio will remain constant while retained earnings increase.
E. fixed assets, debt-equity ratio, and number of common shares outstanding will all
increase.

17. A firm has sales of $4,000, costs of $3,000, interest paid of $100, and depreciation of
$400. The tax rate is 34%. What is the value of the cash coverage ratio?
A. 3
B. 4
C. 6
D. 7
E. 10

Cash coverage ratio = ($4,000 - $3,000) ÷ $100 = 10

18. Rosita's Resources paid $250 in interest and $130 in dividends last year. The times
interest earned ratio is 3.8 and the depreciation expense is $80. What is the value of the
cash coverage ratio?
A. 2.71
B. 3.64
C. 4.12
D. 5.78
E. 6.10

EBIT = 3.8 ´ $250 = $950; Cash coverage ratio = ($950 + $80) ÷ $250 = 4.12

Note that EBIT calculation accounts for Depreciation.

19. Which of the following statements concerning the effective annual rate are correct?

I. When making financial decisions, you should compare effective annual rates rather than
annual percentage rates.
II. The more frequently interest is compounded, the higher the effective annual rate.
III. A quoted rate of 6% compounded continuously has a higher effective annual rate than if the
rate were compounded daily.
IV. When borrowing and choosing which loan to accept, you should select the offer with the
highest effective annual rate.

A. I and II only
B. I and IV only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV

20. The time value of money concept can be defined as:

A. the relationship between the supply and demand of money.

B. the relationship between money spent versus money received.
C. the relationship between a dollar to be received in the future and a dollar today.
D. the relationship between interest rate stated and amount paid.
E. None of these.

21. Discounting cash flows involves:

A. discounting only those cash flows that occur at least 10 years in the future.
B. estimating only the cash flows that occur in the first 4 years of a project.
C. multiplying expected future cash flows by the cost of capital.
D. discounting all expected future cash flows to reflect the time value of money.
E. taking the cash discount offered on trade merchandise.
22. Find the present value of $5,325 to be received in one period if the rate is 6.5%.

A. $5,000.00
B. $5,023.58
C. $5,644.50
D. $5,671.13
E. None of these.

23. If you have a choice to earn simple interest on $10,000 for three years at 8% or annually
compounded interest at 7.5% for three years which one will pay more and by how much?

A. Simple interest by $50.00

B. Compound interest by $22.97

C. Compound interest by $150.75

D. Compound interest by $150.00

E. None of these.
Simple Interest = $10,000 (.08)(3) = $2,400;
Compound Interest = $10,000((1.075)3 - 1) = $2,422.97;
Difference = $2,422.97 - $2,400 = $22.97
24. The stated interest payment, in dollars, made on a bond each period is called the
bond's:
A. coupon.
B. face value.
C. maturity.
D. yield to maturity.
E. coupon rate.

25. An asset characterized by cash flows that increase at a constant rate forever is called a:
A. growing perpetuity.
B. growing annuity.
C. common annuity.
D. perpetuity due.
E. preferred stock.

26. The bonds issued by Manson & Son bear a 6% coupon, payable semiannually. The bond
matures in 8 years and has a $1,000 face value. Currently, the bond sells at par. What is the
yield to maturity?
A. 5.87%
B. 5.97%
C. 6.00%
D. 6.09%
E. 6.17%
This cannot be solved directly, so it's easiest to just use the calculator method to get an
answer. You can then use the calculator answer as the rate in the formula just to verify that
your answer is correct.

Answer is 6.00%

27. A Corporate bond has an 8% coupon and pays interest annually. The face value is $1,000
and the current market price is $1,020.50. The bond matures in 20 years. What is the yield
to maturity?
A. 7.79%
B. 7.82%
C. 8.00%
D. 8.04%
E. 8.12%

This cannot be solved directly, so it's easiest to just use the calculator method to get an
answer. You can then use the calculator answer as the rate in the formula just to verify that
your answer is correct.

Answer is 7.79%

28. Otto Enterprises has a 15-year bond issue outstanding that pays a 9% coupon. The bond
is currently priced at $894.60 and has a par value of $1,000. Interest is paid semiannually.
What is the yield to maturity?
A. 8.67%
B. 10.13%
C. 10.16%
D. 10.40%
E. 10.45%
This cannot be solved directly, so it's easiest to just use the calculator method to get an
answer. You can then use the calculator answer as the rate in the formula just to verify that
your answer is correct.

Answer is 10.40% (rounded)

29. Chocolate and Rum, Inc. offers a 7% coupon bond with semiannual payments and a yield
to maturity of 7.73%. The bonds mature in 9 years. What is the market price of a $1,000
face value bond?
A. $953.28
B. $963.88
C. $1,108.16
D. $1,401.26
E. $1,401.86

30. Part of the Rock, Inc. has a 6% coupon bond that matures in 11 years. The bond pays
interest semiannually. What is the market price of a $1,000 face value bond if the yield to
maturity is 12.9%?
A. $434.59
B. $580.86
C. $600.34
D. $605.92
E. $947.87