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C-45 CASE SOLUTIONS
Case Solutions
Fundamentals of Corporate Finance
Ross, Westerfield, and Jordan
9th edition
CHAPTER 2 C-5
CHAPTER 1
THE McGEE CAKE COMPANY
1. The advantages to a LLC are: 1) Reduction of personal liability. A sole proprietor has unlimited liability, which can include the potential loss of all personal assets. 2) Taxes. Forming an LLC may mean that more expenses can be considered business expenses and be deducted from the company’s income. 3) Improved credibility. The business may have increased credibility in the business world compared to a sole proprietorship. 4) Ability to attract investment. Corporations, even LLCs, can raise capital through the sale of equity. 5) Continuous life. Sole proprietorships have a limited life, while corporations have a potentially perpetual life. 6) Transfer of ownership. It is easier to transfer ownership in a corporation through the sale of stock.
The biggest disadvantage is the potential cost, although the cost of forming a LLC can be relatively small. There are also other potential costs, including more expansive record-keeping.
2. Forming a corporation has the same advantages as forming a LLC, but the costs are likely to be higher.
3. As a small company, changing to a LLC is probably the most advantageous decision at the current time. If the company grows, and Doc and Lyn are willing to sell more equity ownership, the company can reorganize as a corporation at a later date. Additionally, forming a LLC is likely to be less expensive than forming a corporation.
CHAPTER 2
CASH FLOWS AND FINANCIAL STATEMENTS AT SUNSET BOARDS
Below are the financial statements that you are asked to prepare.
1. The income statement for each year will look like this:
Income statement
2008
2009
Sales
$247,259
$301,392
Cost of goods sold
126,038
159,143
Selling & administrative
24,787
32,352
Depreciation
35,581
40,217
EBIT
$60,853
$69,680
Interest
7,735
8,866
EBT
$53,118
$60,814
Taxes
10,624
12,163
Net income
$42,494
$48,651
Dividends
$21,247
$24,326
Addition to retained earnings
21,247
24,326
2. The balance sheet for each year will be:
Balance sheet as of Dec. 31, 2008
Cash
$18,187
Accounts payable
$32,143
Accounts receivable
12,887
Notes payable
14,651
Inventory
27,119
Current liabilities
$46,794
Current assets
$58,193
Long-term debt
$79,235
Net fixed assets
$156,975
Owners' equity
89,139
Total assets
$215,168
Total liab. & equity
$215,168
In the first year, equity is not given. Therefore, we must calculate equity as a plug variable. Since total liabilities & equity is equal to total assets, equity can be calculated as:
Equity = $215,168 – 46,794 – 79,235
Equity = $89,139
Balance sheet as of Dec. 31, 2009
Cash
$27,478
Accounts payable
$36,404
Accounts receivable
16,717
Notes payable
15,997
Inventory
37,216
Current liabilities
$52,401
Current assets
$81,411
Long-term debt
$91,195
Net fixed assets
$191,250
Owners' equity
129,065
Total assets
$272,661
Total liab. & equity
$272,661
The owner’s equity for 2009 is the beginning of year owner’s equity, plus the addition to retained earnings, plus the new equity, so:
Equity = $89,139 + 24,326 + 15,600
Equity = $129,065
3. Using the OCF equation:
OCF = EBIT + Depreciation – Taxes
The OCF for each year is:
OCF2008 = $60,853 + 35,581 – 10,624
OCF2008 = $85,180
OCF2009 = $69,680 + 40,217 – 12,163
OCF2009 = $97,734
4. To calculate the cash flow from assets, we need to find the capital spending and change in net working capital. The capital spending for the year was:
Capital spending
Ending net fixed assets
$191,250
– Beginning net fixed assets
156,975
+ Depreciation
40,217
Net capital spending
$74,492
And the change in net working capital was:
Change in net working capital
Ending NWC
$29,010
– Beginning NWC
11,399
Change in NWC
$17,611
So, the cash flow from assets was:
Cash flow from assets
Operating cash flow
$97,734
– Net capital spending
74,492
– Change in NWC
17,611
Cash flow from assets
$ 5,631
5. The cash flow to creditors was:
Cash flow to creditors
Interest paid
$8,866
– Net new borrowing
11,960
Cash flow to creditors
–$3,094
6. The cash flow to stockholders was:
Cash flow to stockholders
Dividends paid
$24,326
– Net new equity raised
15,600
Cash flow to stockholders
$8,726
Answers to questions
1. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow from operations. The firm invested $17,611 in new net working capital and $74,492 in new fixed assets. The firm gave $5,631 to its stakeholders. It raised $3,094 from bondholders, and paid $8,726 to stockholders.
2. The expansion plans may be a little risky. The company does have a positive cash flow, but a large portion of the operating cash flow is already going to capital spending. The company has had to raise capital from creditors and stockholders for its current operations. So, the expansion plans may be too aggressive at this time. On the other hand, companies do need capital to grow. Before investing or loaning the company money, you would want to know where the current capital spending is going, and why the company is spending so much in this area already.
CHAPTER 3 C-11
CHAPTER 3
RATIOS ANALYSIS AT S&S AIR
1. The calculations for the ratios listed are:
Current ratio = $2,186,520 / $2,919,000
Current ratio = 0.75 times
Quick ratio = ($2,186,250 – 1,037,120) / $2,919,000
Quick ratio = 0.39 times
Cash ratio = $441,000 / $2,919,000
Cash ratio = 0.15 times
Total asset turnover = $30,499,420 / $18,308,920
Total asset turnover = 1.67 times
Inventory turnover = $22,224,580 / $1,037,120
Inventory turnover = 21.43 times
Receivables turnover = $30,499,420 / $708,400
Receivables turnover = 43.05 times
Total debt ratio = ($18,308,920 – 10,069,920) / $18,308,920
Total debt ratio = 0.45 times
Debt-equity ratio = ($2,919,000 + 5,320,000) / $10,069,920
Debt-equity ratio = 0.82 times
Equity multiplier = $18,308,920 / $10,069,920
Equity multiplier = 1.82 times
Times interest earned = $3,040,660 / $478,240
Times interest earned = 6.36 times
Cash coverage = ($3,040,660 + 1,366,680) / $478,420
Cash coverage = 9.22 times
Profit margin = $1,537,452 / $30,499,420
Profit margin = 5.04%
Return on assets = $1,537,452 / $18,308,920
Return on assets = 8.40%
Return on equity = $1,537,452 / $10,069,920
Return on equity = 15.27%
2. Boeing is probably not a good aspirant company. Even though both companies manufacture airplanes, S&S Air manufactures small airplanes, while Boeing manufactures large, commercial aircraft. These are two different markets. Additionally, Boeing is heavily involved in the defense industry, as well as Boeing Capital, which finances airplanes.
Bombardier is a Canadian company that builds business jets, short-range airliners and fire-fighting amphibious aircraft and also provides defense-related services. It is the third largest commercial aircraft manufacturer in the world. Embraer is a Brazilian manufacturer than manufactures commercial, military, and corporate airplanes. Additionally, the Brazilian government is a part owner of the company. Bombardier and Embraer are probably not good aspirant companies because of the diverse range of products and manufacture of larger aircraft.
Cirrus is the world's second largest manufacturer of single-engine, piston-powered aircraft. Its SR22 is the world's best selling plane in its class. The company is noted for its innovative small aircraft and is a good aspirant company.
Cessna is a well known manufacturer of small airplanes. The company produces business jets, freight- and passenger-hauling utility Caravans, personal and small-business single engine pistons. It may be a good aspirant company, however, its products could be considered too broad and diversified since S&S Air produces only small personal airplanes.
3. S&S is below the median industry ratios for the current and cash ratios. This implies the company has less liquidity than the industry in general. However, both ratios are above the lower quartile, so there are companies in the industry with lower liquidity ratios than S&S Air. The company may have more predictable cash flows, or more access to short-term borrowing. If you created an Inventory to Current liabilities ratio, S&S Air would have a ratio that is lower than the industry median. The current ratio is below the industry median, while the quick ratio is above the industry median. This implies that S&S Air has less inventory to current liabilities than the industry median. S&S Air has less inventory than the industry median, but more accounts receivable than the industry since the cash ratio is lower than the industry median.
The turnover ratios are all higher than the industry median; in fact, all three turnover ratios are above the upper quartile. This may mean that S&S Air is more efficient than the industry.
The financial leverage ratios are all below the industry median, but above the lower quartile. S&S Air generally has less debt than comparable companies, but still within the normal range.
The profit margin, ROA, and ROE are all slightly below the industry median, however, not dramatically lower. The company may want to examine its costs structure to determine if costs can be reduced, or price can be increased.
Overall, S&S Air’s performance seems good, although the liquidity ratios indicate that a closer look may be needed in this area.
Below is a list of possible reasons it may be good or bad that each ratio is higher or lower than the industry. Note that the list is not exhaustive, but merely one possible explanation for each ratio.
Ratio
Good
Bad
Current ratio
Better at managing current accounts.
May be having liquidity problems.
Quick ratio
Better at managing current accounts.
May be having liquidity problems.
Cash ratio
Better at managing current accounts.
May be having liquidity problems.
Total asset turnover
Better at utilizing assets.
Assets may be older and depreciated, requiring extensive investment soon.
Inventory turnover
Better at inventory management, possibly due to better procedures.
Could be experiencing inventory shortages.
Receivables turnover
Better at collecting receivables.
May have credit terms that are too strict. Decreasing receivables turnover may increase sales.
Total debt ratio
Less debt than industry median means the company is less likely to experience credit problems.
Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE.
Debt-equity ratio
Less debt than industry median means the company is less likely to experience credit problems.
Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE.
Equity multiplier
Less debt than industry median means the company is less likely to experience credit problems.
Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE.
TIE
Higher quality materials could be increasing costs.
The company may have more difficulty meeting interest payments in a downturn.
Cash coverage
Less debt than industry median means the company is less likely to experience credit problems.
Increasing the amount of debt can increase shareholder returns. Especially notice that it will increase ROE.
Profit margin
The PM is slightly below the industry median. It could be a result of higher quality materials or better manufacturing.
Company may be having trouble controlling costs.
ROA
Company may have newer assets than the industry.
Company may have newer assets than the industry.
ROE
Lower profit margin may be a result of higher quality.
Profit margin and EM are lower than industry, which results in the lower ROE.
CHAPTER 4 C-19
CHAPTER 4
PLANNING FOR GROWTH AT S&S AIR
1. To calculate the internal growth rate, we first need to find the ROA and the retention ratio, so:
ROA = NI / TA
ROA = $1,537,452 / $18,309,920
ROA = .0840 or 8.40%
b = Addition to RE / NI
b = $977,452 / $1,537,452
b = 0.64
Now we can use the internal growth rate equation to get:
Internal growth rate = (ROA × b) / [1 – (ROA × b)]
Internal growth rate = [0.0840(.64)] / [1 – 0.0840(.64)]
Internal growth rate = .0564 or 5.64%
To find the sustainable growth rate, we need the ROE, which is:
ROE = NI / TE
ROE = $1,537,452 / $10,069,920
ROE = .1527 or 15.27%
Using the retention ratio we previously calculated, the sustainable growth rate is:
Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]
Sustainable growth rate = [0.1527(.64)] / [1 – 0.1527(.64)]
Sustainable growth rate = .1075 or 10.75%
The internal growth rate is the growth rate the company can achieve with no outside financing of any sort. The sustainable growth rate is the growth rate the company can achieve by raising outside debt based on its retained earnings and current capital structure.
2. Pro forma financial statements for next year at a 12 percent growth rate are:
Income statement
Sales
$ 34,159,350
COGS
24,891,530
Other expenses
4,331,600
Depreciation
1,366,680
EBIT
$ 3,569,541
Interest
478,240
Taxable income
$ 3,091,301
Taxes (40%)
1,236,520
Net income
$ 1,854,780
Dividends
$ 675,583
Add to RE
1,179,197
Balance sheet
Assets
Liabilities & Equity
Current Assets
Current Liabilities
Cash
$ 493,920
Accounts Payable
$ 995,680
Accounts rec.
793,408
Notes Payable
2,030,000
Inventory
1,161,574
Total CL
$ 3,025,680
Total CA
$ 2,448,902
Long-term debt
$ 5,320,000
Shareholder Equity
Common stock
$ 350,000
Fixed assets
Retained earnings
10,899,117
Net PP&E
$ 18,057,088
Total Equity
$ 11,249,117
Total Assets
$ 20,505
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