Solution manual fundamentals of corporate finance 9e by ross jordan

To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Solutions Manual Fundamentals of Corporate Finance 9th edition Ross, Westerfield, and Jordan Updated 12-20-2008 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER INTRODUCTION TO CORPORATE FINANCE Answers to Concepts Review and Critical Thinking Questions Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding whether to issue new equity and use the proceeds to retire outstanding debt), and working capital management (modifying the firm‘s credit collection policy with its customers) Disadvantages: unlimited liability, limited life, difficulty in transferring ownership, hard to raise capital funds Some advantages: simpler, less regulation, the owners are also the managers, sometimes personal tax rates are better than corporate tax rates The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life In response to Sarbanes-Oxley, small firms have elected to go dark because of the costs of compliance The costs to comply with Sarbox can be several million dollars, which can be a large percentage of a small firms profits A major cost of going dark is less access to capital Since the firm is no longer publicly traded, it can no longer raise money in the public market Although the company will still have access to bank loans and the private equity market, the costs associated with raising funds in these markets are usually higher than the costs of raising funds in the public market The treasurer‘s office and the controller‘s office are the two primary organizational groups that report directly to the chief financial officer The controller‘s office handles cost and financial accounting, tax management, and management information systems, while the treasurer‘s office is responsible for cash and credit management, capital budgeting, and financial planning Therefore, the study of corporate finance is concentrated within the treasury group‘s functions To maximize the current market value (share price) of the equity of the firm (whether it‘s publiclytraded or not) 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 A primary market transaction To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com B-2 SOLUTIONS In auction markets like the NYSE, brokers and agents meet at a physical location (the exchange) to match buyers and sellers of assets Dealer markets like NASDAQ consist of dealers operating at dispersed locales who buy and sell assets themselves, communicating with other dealers either electronically or literally over-the-counter 10 Such organizations frequently pursue social or political missions, so many different goals are conceivable One goal that is often cited is revenue minimization; i.e., provide whatever goods and services are offered at the lowest possible cost to society A better approach might be to observe that even a not-for-profit business has equity Thus, one answer is that the appropriate goal is to maximize the value of the equity 11 Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term If this is correct, then the statement is false 12 An argument can be made either way At the one extreme, we could argue that in a market economy, all of these things are priced There is thus an optimal level of, for example, ethical and/or illegal behavior, and the framework of stock valuation explicitly includes these At the other extreme, we could argue that these are non-economic phenomena and are best handled through the political process A classic (and highly relevant) thought question that illustrates this debate goes something like this: ―A firm has estimated that the cost of improving the safety of one of its products is $30 million However, the firm believes that improving the safety of the product will only save $20 million in product liability claims What should the firm do?‖ 13 The goal will be the same, but the best course of action toward that goal may be different because of differing social, political, and economic institutions 14 The goal of management should be to maximize the share price for the current shareholders If management believes that it can improve the profitability of the firm so that the share price will exceed $35, then they should fight the offer from the outside company If management believes that this bidder or other unidentified bidders will actually pay more than $35 per share to acquire the company, then they should still fight the offer However, if the current management cannot increase the value of the firm beyond the bid price, and no other higher bids come in, then management is not acting in the interests of the shareholders by fighting the offer Since current managers often lose their jobs when the corporation is acquired, poorly monitored managers have an incentive to fight corporate takeovers in situations such as this 15 We would expect agency problems to be less severe in countries with a relatively small percentage of individual ownership Fewer individual owners should reduce the number of diverse opinions concerning corporate goals The high percentage of institutional ownership might lead to a higher degree of agreement between owners and managers on decisions concerning risky projects In addition, institutions may be better able to implement effective monitoring mechanisms on managers than can individual owners, based on the institutions‘ deeper resources and experiences with their own management The increase in institutional ownership of stock in the United States and the growing activism of these large shareholder groups may lead to a reduction in agency problems for U.S corporations and a more efficient market for corporate control CHAPTER B-3 16 How much is too much? Who is worth more, Ray Irani or Tiger Woods? The simplest answer is that there is a market for executives just as there is for all types of labor Executive compensation is the price that clears the market The same is true for athletes and performers Having said that, one aspect of executive compensation deserves comment A primary reason executive compensation has grown so dramatically is that companies have increasingly moved to stock-based compensation Such movement is obviously consistent with the attempt to better align stockholder and management interests In recent years, stock prices have soared, so management has cleaned up It is sometimes argued that much of this reward is simply due to rising stock prices in general, not managerial performance Perhaps in the future, executive compensation will be designed to reward only differential performance, i.e., stock price increases in excess of general market increases To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER FINANCIAL STATEMENTS, TAXES AND CASH FLOW Answers to Concepts Review and Critical Thinking Questions Liquidity measures how quickly and easily an asset can be converted to cash without significant loss in value It‘s desirable for firms to have high liquidity so that they have a large factor of safety in meeting short-term creditor demands However, since liquidity also has an opportunity cost associated with it—namely that higher returns can generally be found by investing the cash into productive assets—low liquidity levels are also desirable to the firm It‘s up to the firm‘s financial management staff to find a reasonable compromise between these opposing needs The recognition and matching principles in financial accounting call for revenues, and the costs associated with producing those revenues, to be ―booked‖ when the revenue process is essentially complete, not necessarily when the cash is collected or bills are paid Note that this way is not necessarily correct; it‘s the way accountants have chosen to it Historical costs can be objectively and precisely measured whereas market values can be difficult to estimate, and different analysts would come up with different numbers Thus, there is a tradeoff between relevance (market values) and objectivity (book values) Depreciation is a non-cash deduction that reflects adjustments made in asset book values in accordance with the matching principle in financial accounting Interest expense is a cash outlay, but it‘s a financing cost, not an operating cost 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 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 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 It‘s probably not a good sign for an established company, but it would be fairly ordinary for a startup, so it depends For example, if a company were to become more efficient in inventory management, the amount of inventory needed would decline The same might be true if it becomes better at collecting its receivables In general, anything that leads to a decline in ending NWC relative to beginning would have this effect Negative net capital spending would mean more long-lived assets were liquidated than purchased To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER B-5 If a company raises more money from selling stock than it pays in dividends in a particular period, its cash flow to stockholders will be negative If a company borrows more than it pays in interest, its cash flow to creditors will be negative 10 The adjustments discussed were purely accounting changes; they had no cash flow or market value consequences unless the new accounting information caused stockholders to revalue the derivatives 11 Enterprise value is the theoretical takeover price In the event of a takeover, an acquirer would have to take on the company's debt, but would pocket its cash Enterprise value differs significantly from simple market capitalization in several ways, and it may be a more accurate representation of a firm's value In a takeover, the value of a firm's debt would need to be paid by the buyer when taking over a company This enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation 12 In general, it appears that investors prefer companies that have a steady earnings stream If true, this encourages companies to manage earnings Under GAAP, there are numerous choices for the way a company reports its financial statements Although not the reason for the choices under GAAP, one outcome is the ability of a company to manage earnings, which is not an ethical decision Even though earnings and cash flow are often related, earnings management should have little effect on cash flow (except for tax implications) If the market is ―fooled‖ and prefers steady earnings, shareholder wealth can be increased, at least temporarily However, given the questionable ethics of this practice, the company (and shareholders) will lose value if the practice is discovered Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet Many problems require multiple steps Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred However, the final answer for each problem is found without rounding during any step in the problem Basic To find owner‘s equity, we must construct a balance sheet as follows: CA NFA TA Balance Sheet CL LTD OE $28,900 TL & OE $5,100 23,800 $4,300 7,400 ?? $28,900 We know that total liabilities and owner‘s equity (TL & OE) must equal total assets of $28,900 We also know that TL & OE is equal to current liabilities plus long-term debt plus owner‘s equity, so owner‘s equity is: OE = $28,900 – 7,400 – 4,300 = $17,200 NWC = CA – CL = $5,100 – 4,300 = $800 B-6 SOLUTIONS The income statement for the company is: Income Statement Sales $586,000 Costs 247,000 Depreciation 43,000 EBIT $296,000 Interest 32,000 EBT $264,000 Taxes(35%) 92,400 Net income $171,600 One equation for net income is: Net income = Dividends + Addition to retained earnings Rearranging, we get: Addition to retained earnings = Net income – Dividends = $171,600 – 73,000 = $98,600 EPS = Net income / Shares = $171,600 / 85,000 = $2.02 per share DPS = Dividends / Shares = $73,000 / 85,000 = $0.86 per share To find the book value of current assets, we use: NWC = CA – CL Rearranging to solve for current assets, we get: CA = NWC + CL = $380,000 + 1,400,000 = $1,480,000 The market value of current assets and fixed assets is given, so: Book value CA = $1,480,000 Book value NFA = $3,700,000 Book value assets = $5,180,000 Market value CA = $1,600,000 Market value NFA = $4,900,000 Market value assets = $6,500,000 Taxes = 0.15($50K) + 0.25($25K) + 0.34($25K) + 0.39($236K – 100K) = $75,290 The average tax rate is the total tax paid divided by net income, so: Average tax rate = $75,290 / $236,000 = 31.90% The marginal tax rate is the tax rate on the next $1 of earnings, so the marginal tax rate = 39% CHAPTER B-7 To calculate OCF, we first need the income statement: Income Statement Sales Costs Depreciation EBIT Interest Taxable income Taxes (35%) Net income $27,500 13,280 2,300 $11,920 1,105 $10,815 3,785 $ 7,030 OCF = EBIT + Depreciation – Taxes = $11,920 + 2,300 – 3,785 = $10,435 Net capital spending = NFAend – NFAbeg + Depreciation Net capital spending = $4,200,000 – 3,400,000 + 385,000 Net capital spending = $1,185,000 10 Change in NWC = NWCend – NWCbeg Change in NWC = (CAend – CLend) – (CAbeg – CLbeg) Change in NWC = ($2,250 – 1,710) – ($2,100 – 1,380) Change in NWC = $540 – 720 = –$180 11 Cash flow to creditors = Interest paid – Net new borrowing Cash flow to creditors = Interest paid – (LTDend – LTDbeg) Cash flow to creditors = $170,000 – ($2,900,000 – 2,600,000) Cash flow to creditors = –$130,000 12 Cash flow to stockholders = Dividends paid – Net new equity Cash flow to stockholders = Dividends paid – [(Commonend + APISend) – (Commonbeg + APISbeg)] Cash flow to stockholders = $490,000 – [($815,000 + 5,500,000) – ($740,000 + 5,200,000)] Cash flow to stockholders = $115,000 Note, APIS is the additional paid-in surplus 13 Cash flow from assets = Cash flow to creditors + Cash flow to stockholders = –$130,000 + 115,000 = –$15,000 Cash flow from assets = –$15,000 = OCF – Change in NWC – Net capital spending = –$15,000 = OCF – (–$85,000) – 940,000 Operating cash flow Operating cash flow = –$15,000 – 85,000 + 940,000 = $840,000 B-8 SOLUTIONS Intermediate 14 To find the OCF, we first calculate net income Income Statement Sales $196,000 Costs 104,000 Other expenses 6,800 Depreciation 9,100 EBIT $76,100 Interest 14,800 Taxable income $61,300 Taxes 21,455 Net income $39,845 Dividends Additions to RE $10,400 $29,445 a OCF = EBIT + Depreciation – Taxes = $76,100 + 9,100 – 21,455 = $63,745 b CFC = Interest – Net new LTD = $14,800 – (–7,300) = $22,100 Note that the net new long-term debt is negative because the company repaid part of its longterm debt c CFS = Dividends – Net new equity = $10,400 – 5,700 = $4,700 d We know that CFA = CFC + CFS, so: CFA = $22,100 + 4,700 = $26,800 CFA is also equal to OCF – Net capital spending – Change in NWC We already know OCF Net capital spending is equal to: Net capital spending = Increase in NFA + Depreciation = $27,000 + 9,100 = $36,100 Now we can use: CFA = OCF – Net capital spending – Change in NWC $26,800 = $63,745 – 36,100 – Change in NWC Solving for the change in NWC gives $845, meaning the company increased its NWC by $845 15 The solution to this question works the income statement backwards Starting at the bottom: Net income = Dividends + Addition to ret earnings = $1,500 + 5,100 = $6,600 CHAPTER B-9 Now, looking at the income statement: EBT – EBT × Tax rate = Net income Recognize that EBT × Tax rate is simply the calculation for taxes Solving this for EBT yields: EBT = NI / (1– tax rate) = $6,600 / (1 – 0.35) = $10,154 Now you can calculate: EBIT = EBT + Interest = $10,154 + 4,500 = $14,654 The last step is to use: EBIT = Sales – Costs – Depreciation $14,654 = $41,000 – 19,500 – Depreciation Solving for depreciation, we find that depreciation = $6,846 16 The balance sheet for the company looks like this: Cash Accounts receivable Inventory Current assets Tangible net fixed assets Intangible net fixed assets Total assets Balance Sheet $195,000 Accounts payable 137,000 Notes payable 264,000 Current liabilities $596,000 Long-term debt Total liabilities 2,800,000 780,000 Common stock Accumulated ret earnings $4,176,000 Total liab & owners‘ equity $405,000 160,000 $565,000 1,195,300 $1,760,300 ?? 1,934,000 $4,176,000 Total liabilities and owners‘ equity is: TL & OE = CL + LTD + Common stock + Retained earnings Solving for this equation for equity gives us: Common stock = $4,176,000 – 1,934,000 – 1,760,300 = $481,700 17 The market value of shareholders‘ equity cannot be negative A negative market value in this case would imply that the company would pay you to own the stock The market value of shareholders‘ equity can be stated as: Shareholders‘ equity = Max [(TA – TL), 0] So, if TA is $8,400, equity is equal to $1,100, and if TA is $6,700, equity is equal to $0 We should note here that the book value of shareholders‘ equity can be negative CHAPTER 26 B-393 Equity will remain the same as the pre-merger balance sheet of the acquiring firm Current assets and debt accounts will be the sum of the two firm‘s pre-merger balance sheet accounts, and the fixed assets will be the sum of the pre-merger fixed assets of the acquirer and the market value of fixed assets of the target firm The post-merger balance sheet will be: Meat Co., post-merger Current assets Net fixed assets Goodwill Total $12,600 44,500 6,800 Current liabilities Long-term debt Equity $63,900 $ 7,600 30,400 25,900 $63,900 In the pooling method, all accounts of both companies are added together to total the accounts in the new company, so the post-merger balance sheet will be: Silver Enterprises, post-merger Current assets Other assets Net fixed assets Total $ 4,600 1,380 18,400 Current liabilities Long-term debt Equity $24,380 $ 3,400 6,500 14,480 $24,380 Since the acquisition is funded by long-term debt, the post-merger balance sheet will have long-term debt equal to the original long-term debt of Silver‘s balance sheet plus the new long-term debt issue, so: Post-merger long-term debt = $6,500 + 11,000 = $17,500 Equity will remain the same as the pre-merger balance sheet of the acquiring firm Current assets, current liabilities, and other assets will be the sum of the two firm‘s pre-merger balance sheet accounts, and the fixed assets will be the sum of the pre-merger fixed assets of the acquirer and the market value of fixed assets of the target firm We can calculate the goodwill as the plug variable which makes the balance sheet balance The post-merger balance sheet will be: Silver Enterprises, post-merger Current assets Other assets Net fixed assets Goodwill Total $ 4,600 1,380 20,000 2,520 $28,500 Current liabilities Long-term debt Equity $ 3,400 17,500 7,600 $28,500 B-394 SOLUTIONS a The cash cost is the amount of cash offered, so the cash cost is $73 million To calculate the cost of the stock offer, we first need to calculate the value of the target to the acquirer The value of the target firm to the acquiring firm will be the market value of the target plus the PV of the incremental cash flows generated by the target firm The cash flows are a perpetuity, so V* = $58,000,000 + $2,400,000/.10 = $82,000,000 The cost of the stock offer is the percentage of the acquiring firm given up times the sum of the market value of the acquiring firm and the value of the target firm to the acquiring firm So, the equity cost will be: Equity cost = 40($107,000,000 + 82,000,000) = $75,600,000 b The NPV of each offer is the value of the target firm to the acquiring firm minus the cost of acquisition, so: NPV cash = $82,000,000 – 73,000,000 = $9,000,000 NPV stock = $82,000,000 – 75,600,000 = $6,400,000 c Since the NPV is greater with the cash offer the acquisition should be in cash a The EPS of the combined company will be the sum of the earnings of both companies divided by the shares in the combined company Since the stock offer is one share of the acquiring firm for three shares of the target firm, new shares in the acquiring firm will increase by one-third So, the new EPS will be: EPS = ($245,000 + 730,000)/[194,000 + (1/3)(92,337)] = $4.338 The market price of Pitt will remain unchanged if it is a zero NPV acquisition Using the PE ratio, we find the current market price of Pitt stock, which is: P = 22($730,000)/194,000 = $82.78 If the acquisition has a zero NPV, the stock price should remain unchanged Therefore, the new PE will be: P/E = $82.78/$4.338 = 19.09 b The value of Jolie to Pitt must be the market value of the company since the NPV of the acquisition is zero Therefore, the value is: V* = $245,000(10.4) = $2,548,000 The cost of the acquisition is the number of shares offered times the share price, so the cost is: Cost = (1/3)(92,337)($82.78) = $2,548,000 CHAPTER 26 B-395 So, the NPV of the acquisition is: NPV = = V* + V – Cost = $2,548,000 + V – 2,548,000 V = $0 Although there is no economic value to the takeover, it is possible that Pitt is motivated to purchase Jolie for other than financial reasons a The NPV of the merger is the market value of the target firm, plus the value of the synergy, minus the acquisition costs, so: NPV = 1,500($18) + $6,000 – 1,500($20.50) = $2,250 b Since the NPV goes directly to stockholders, the share price of the merged firm will be the market value of the acquiring firm plus the NPV of the acquisition, divided by the number of shares outstanding, so: Share price = [3,400($43) + $2,250]/3,400 = $43.66 c The merger premium is the premium per share times the number of shares of the target firm outstanding, so the merger premium is: Merger premium = 1,500($20.50 – 18) = $3,750 d The number of new shares will be the number of shares of the target times the exchange ratio, so: New shares created = 1,500(1/2) = 750 new shares The value of the merged firm will be the market value of the acquirer plus the market value of the target plus the synergy benefits, so: VBT = 3,400($43) + 1,500($18) + 6,000 = $179,200 The price per share of the merged firm will be the value of the merged firm divided by the total shares of the new firm, which is: P = $179,200/(3,400 + 750) = $43.18 e The NPV of the acquisition using a share exchange is the market value of the target firm plus synergy benefits, minus the cost The cost is the value per share of the merged firm times the number of shares offered to the target firm shareholders, so: NPV = 1,500($18) + $6,000 – 750($43.18) = $614.46 B-396 SOLUTIONS Intermediate 10 The cash offer is better for the target firm shareholders since they receive $20.50 per share In the share offer, the target firm‘s shareholders will receive: Equity offer value = (1/2)($18.00) = $9.00 per share From Problem 9, we know the value of the merged firm‘s assets will be $179,200 The number of shares in the new firm will be: Shares in new firm = 3,400 + 1,500x that is, the number of shares outstanding in the bidding firm, plus the number of shares outstanding in the target firm, times the exchange ratio This means the post merger share price will be: P = $179,200/(3,400 + 1,500x) To make the target firm‘s shareholders indifferent, they must receive the same wealth, so: 1,500(x)P = 1,500($20.50) This equation shows that the new offer is the shares outstanding in the target company times the exchange ratio times the new stock price The value under the cash offer is the shares outstanding times the cash offer price Solving this equation for P, we find: P = $20.50 / x Combining the two equations, we find: $179,200/(3,400 + 1,500x) = $20.50 / x x = 0.4695 There is a simpler solution that requires an economic understanding of the merger terms If the target firm‘s shareholders are indifferent, the bidding firm‘s shareholders are indifferent as well That is, the offer is a zero sum game Using the new stock price produced by the cash deal, we find: Exchange ratio = $20.50/$43.66 = 0.4695 11 The cost of the acquisition is: Cost = 200($11) = $2,200 Since the stock price of the acquiring firm is $34, the firm will have to give up: Shares offered = $2,200/$34 = 64.71 shares a The EPS of the merged firm will be the combined EPS of the existing firms divided by the new shares outstanding, so: EPS = ($1,400 + 500)/(500 + 64.71) = $3.36 CHAPTER 26 B-397 b The PE of the acquiring firm is: Original P/E = $34/($1,400/500) = 12.14 times Assuming the PE ratio does not change, the new stock price will be: New P = $3.36(12.14) = $40.86 c If the market correctly analyzes the earnings, the stock price will remain unchanged since this is a zero NPV acquisition, so: New P/E = $34/$3.36 = 10.11 times d The new share price will be the combined market value of the two existing companies divided by the number of shares outstanding in the merged company So: P = [(500)($34) + 200($8)]/(500 + 64.71) = $32.94 And the PE ratio of the merged company will be: P/E = $32.94/$3.36 = 9.79 times At the proposed bid price, this is a negative NPV acquisition for A since the share price declines They should revise their bid downward until the NPV is zero 12 Beginning with the fact that the NPV of a merger is the value of the target minus the cost, we get: NPV NPV NPV NPV 13 a = VB* – Cost = V + VB – Cost = V – (Cost – VB) = V – Merger premium The synergy will be the present value of the incremental cash flows of the proposed purchase Since the cash flows are perpetual, the synergy value is: Synergy value = $450,000 / 08 Synergy value = $5,625,000 b The value of Flash-in-the-Pan to Fly-by-Night is the synergy plus the current market value of Flash-in-the-Pan, which is: Value = $5,625,000 + 14,000,000 Value = $19,625,000 c The value of the cash option is the amount of cash paid, or $18.5 million The value of the stock acquisition is the percentage of ownership in the merged company, times the value of the merged company, so: Stock acquisition value = 35($19,625,000 + 31,000,000) Stock acquisition value = $17,718,750 B-398 SOLUTIONS d The NPV is the value of the acquisition minus the cost, so the NPV of each alternative is: NPV of cash offer = $19,625,000 – 18,500,000 NPV of cash offer = $1,125,000 NPV of stock offer = $19,625,000 – 17,718,780 NPV of stock offer = $1,906,250 e 14 a The acquirer should make the stock offer since its NPV is greater The number of shares after the acquisition will be the current number of shares outstanding for the acquiring firm, plus the number of new shares created for the acquisition, which is: Number of shares after acquisition = 9,000,000 + 2,500,000 Number of shares after acquisition = 11,500,000 And the share price will be the value of the combined company divided by the shares outstanding, which will be: New stock price = £300,000,000 / 11,500,000 New stock price = £26.09 b Let equal the fraction of ownership for the target shareholders in the new firm We can set the percentage of ownership in the new firm equal to the value of the cash offer, so: (£300,000,000) = £90,000,000 = 30 or 30% So, the shareholders of the target firm would be equally as well off if they received 30 percent of the stock in the new company as if they received the cash offer The ownership percentage of the target firm shareholders in the new firm can be expressed as: Ownership = New shares issued / (New shares issued + Current shares of acquiring firm) 30 = New shares issued / (New shares issued + 9,000,000) New shares issued = 3,857,143 To find the exchange ratio, we divide the new shares issued to the shareholders of the target firm by the existing number of shares in the target firm, so: Exchange ratio = New shares / Existing shares in target firm Exchange ratio = 3,857,143 / 90,000,000 Exchange ratio = 0.4821 An exchange ratio of 0.4821 shares of the merged company for each share of the target company owned would make the value of the stock offer equivalent to the value of the cash offer CHAPTER 26 B-399 Challenge 15 a To find the value of the target to the acquirer, we need to find the share price with the new growth rate We begin by finding the required return for shareholders of the target firm The earnings per share of the target are: EPSP = $680,000/500,000 = $1.36 per share The price per share is: PP = 11.5($1.36) = $15.64 And the dividends per share are: DPSP = $310,000/500,000 = $0.62 The current required return for Pulitzer shareholders, which incorporates the risk of the company is: RE = [$0.62(1.05)/$15.64] + 05 = 0916 The price per share of Pulitzer with the new growth rate is: PP = $0.62(1.07)/(.0916 – 07) = $30.68 The value of the target firm to the acquiring firm is the number of shares outstanding times the price per share under the new growth rate assumptions, so: VT* = 500,000($30.68) = $15,339,408.63 b The gain to the acquiring firm will be the value of the target firm to the acquiring firm minus the market value of the target, so: Gain = $15,339,408.63 – 500,000($15.64) = $7,519,408.63 c The NPV of the acquisition is the value of the target firm to the acquiring firm minus the cost of the acquisition, so: NPV = $15,339,408.63 – 500,000($18) = $6,339,408.63 d The most the acquiring firm should be willing to pay per share is the offer price per share plus the NPV per share, so: Maximum bid price = $18 + ($6,339,408.63/500,000) = $30.68 Notice, this is the same value we calculated earlier in part a as the value of the target to the acquirer B-400 SOLUTIONS e The price of the stock in the merged firm would be the market value of the acquiring firm plus the value of the target to the acquirer, divided by the number of shares in the merged firm, so: PFP = ($55,800,000 + 15,339,408.63)/(1,200,000 + 200,000) = $50.81 The NPV of the stock offer is the value of the target to the acquirer minus the value offered to the target shareholders The value offered to the target shareholders is the stock price of the merged firm times the number of shares offered, so: NPV = $15,339,408.63 – 200,000($50.81) = $5,176,635.97 f Yes, the acquisition should go forward, and Foxy should offer cash since the NPV is higher g Using the new growth rate in the dividend growth model, along with the dividend and required return we calculated earlier, the price of the target under these assumptions is: PP = $0.62(1.06)/(.0916 – 06) = $20.78 And the value of the target firm to the acquiring firm is: VP* = 500,000($20.78) = $10,390,828.95 The gain to the acquiring firm will be: Gain = $10,390,828.95 – 500,000($15.64) = $2,570,828.95 The NPV of the cash offer is now: NPV cash = $10,390,828.95 – 500,000($18) = $1,390,828.95 And the new price per share of the merged firm will be: PFP = [$55,800,000 + 10,390,828.95]/(1,200,000 + 200,000) = $47.28 And the NPV of the stock offer under the new assumption will be: NPV stock = $10,390,828.95 – 200,000($47.28) = $934,996.25 Even with the lower projected growth rate, the both offers still have a positive NPV, although both are significantly lower Foxy should purchase Pulitzer with the cash offer To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 27 LEASING Answers to Concepts Review and Critical Thinking Questions Some key differences are: (1) Lease payments are fully tax-deductible, but only the interest portion of the loan is; (2) The lessee does not own the asset and cannot depreciate it for tax purposes; (3) In the event of a default, the lessor cannot force bankruptcy; and (4) The lessee does not obtain title to the asset at the end of the lease (absent some additional arrangement) The less profitable one because leasing provides, among other things, a mechanism for transferring tax benefits from entities that value them less to entities that value them more Potential problems include: (1) Care must be taken in interpreting the IRR (a high or low IRR is preferred depending on the setup of the analysis); and (2) Care must be taken to ensure the IRR under examination is not the implicit interest rate just based on the lease payments a b c Leasing is a form of secured borrowing It reduces a firm‘s cost of capital only if it is cheaper than other forms of secured borrowing The reduction of uncertainty is not particularly relevant; what matters is the NAL The statement is not always true For example, a lease often requires an advance lease payment or security deposit and may be implicitly secured by other assets of the firm Leasing would probably not disappear, since it does reduce the uncertainty about salvage value and the transactions costs of transferring ownership However, the use of leasing would be greatly reduced A lease must be disclosed on the balance sheet if one of the following criteria is met: The lease transfers ownership of the asset by the end of the lease In this case, the firm essentially owns the asset and will have access to its residual value The lessee can purchase the asset at a price below its fair market value (bargain purchase option) when the lease ends The firm essentially owns the asset and will have access to most of its residual value The lease term is for 75% or more of the estimated economic life of the asset The firm basically has access to the majority of the benefits of the asset, without any responsibility for the consequences of its disposal The present value of the lease payments is 90% or more of the fair market value of the asset at the start of the lease The firm is essentially purchasing the asset on an installment basis The lease must meet the following IRS standards for the lease payments to be tax deductible: The lease term must be less than 80% of the economic life of the asset If the term is longer, the lease is considered to be a conditional sale The lease should not contain a bargain purchase option, which the IRS interprets as an equity interest in the asset The lease payment schedule should not provide for very high payments early and very low payments late in the life of the lease This would indicate that the lease is being used simply to avoid taxes To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com B-402 SOLUTIONS Renewal options should be reasonable and based on the fair market value of the asset at renewal time This indicates that the lease is for legitimate business purposes, not tax avoidance As the term implies, off-balance sheet financing involves financing arrangements that are not required to be reported on the firm‘s balance sheet Such activities, if reported at all, appear only in the footnotes to the statements Operating leases (those that not meet the criteria in problem 5) provide off-balance sheet financing For accounting purposes, total assets will be lower and some financial ratios may be artificially high Financial analysts are generally not fooled by such practices There are no economic consequences, since the cash flows of the firm are not affected by how the lease is treated for accounting purposes The lessee may not be able to take advantage of the depreciation tax shield and may not be able to obtain favorable lease arrangements for ―passing on‖ the tax shield benefits The lessee might also need the cash flow from the sale to meet immediate needs, but will be able to meet the lease obligation cash flows in the future Since the relevant cash flows are all aftertax, the aftertax discount rate is appropriate 10 Japan International‘s financial position was such that the package of leasing and buying probably resulted in the overall best aftertax cost In particular, Japan International may not have been in a position to use all of the tax credits and also may not have had the credit strength to borrow and buy the plane without facing a credit downgrade and/or substantially higher rates 11 There is the tax motive, but, beyond this, Genesis Lease Limited knows that, in the event of a default, Japan International would relinquish the plane, which would then be re-leased Fungible assets, such as planes, which can be readily reclaimed and redeployed are good candidates for leasing 12 The plane will be re-leased to Japan International or another air transportation firm, used by Genesis Lease Limited, or it will simply be sold There is an active market for used aircraft Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet Many problems require multiple steps Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred However, the final answer for each problem is found without rounding during any step in the problem Basic We will calculate cash flows from the depreciation tax shield first The depreciation tax shield is: Depreciation tax shield = ($5,800,000/4)(.35) = $507,500 The aftertax cost of the lease payments will be: Aftertax lease payment = ($1,450,000)(1 – 35) = $1,131,000 CHAPTER 27 B-403 So, the total cash flows from leasing are: OCF = $507,500 + 1,131,000 = $1,638,500 The aftertax cost of debt is: Aftertax debt cost = 08(1 – 35) = 052 Using all of this information, we can calculate the NAL as: NAL = $5,800,000 – $1,638,500(PVIFA5.20%,4) = $16,851.25 The NAL is positive so you should lease If we assume the lessor has the same cost of debt and the same tax rate, the NAL to the lessor is the negative of our company‘s NAL, so: NAL = – $16,851.25 To find the maximum lease payment that would satisfy both the lessor and the lessee, we need to find the payment that makes the NAL equal to zero Using the NAL equation and solving for the OCF, we find: NAL = = $5,800,000 – OCF(PVIFA5.20%,4) OCF = $1,643,274.35 The OCF for this lease is composed of the depreciation tax shield cash flow, as well as the aftertax lease payment Subtracting out the depreciation tax shield cash flow we calculated earlier, we find: Aftertax lease payment = $1,643,274.35 – 507,500 = $1,135,774.35 Since this is the aftertax lease payment, we can now calculate the breakeven pretax lease payment as: Breakeven lease payment = $1,135,774.35/(1 – 35) = $1,747,345.15 If the tax rate is zero, there is no depreciation tax shield foregone Also, the aftertax lease payment is the same as the pretax payment, and the aftertax cost of debt is the same as the pretax cost So: Cost of debt = 08 Annual cost of leasing = leasing payment = $1,450,000 The NAL to leasing with these assumptions is: NAL = $5,800,000 – $1,450,000(PVIFA8%,4) = $36,899.30 B-404 SOLUTIONS We already calculated the breakeven lease payment for the lessor in Problem Since the assumption about the lessor concerning the tax rate have not changed So, the lessor breaks even with a payment of $1,747,345.15 For the lessee, we need to calculate the breakeven lease payment which results in a zero NAL Using the assumptions in Problem 4, we find: NAL = = $5,800,000 – PMT(PVIFA8%,4) PMT = $1,751,140.67 So, the range of lease payments that would satisfy both the lessee and the lessor are: Total payment range = $1,747,345.15 to $1,751,140.67 The appropriate depreciation percentages for a 3-year MACRS class asset can be found in Chapter 10 The depreciation percentages are 3333, 4445, 1481, and 0741 The cash flows from leasing are: Year 1: ($5,800,000)(.3333)(.35) + $1,131,000 = $1,807,599 Year 2: ($5,800,000)(.4445)(.35) + $1,131,000 = $2,033,335 Year 3: ($5,800,000)(.1481)(.35) + $1,131,000 = $1,431,643 Year 4: ($5,800,000)(.0741)(.35) + $1,131,000 = $1,281,423 NAL = $5,800,000 – $1,807,599/1.052 – $2,033,335/1.0522 – $1,431,643/1.0523 – $1,281,423/1.0524 NAL = $31,441.66 The machine should not be leased This is because of the accelerated tax benefits due to depreciation, which represents a cost in the decision to lease compared to an advantage of the decision to purchase Intermediate The pretax cost savings are not relevant to the lease versus buy decision, since the firm will definitely use the equipment and realize the savings regardless of the financing choice made The depreciation tax shield is: Depreciation tax shield lost = ($8,000,000/5)(.34) = $544,000 And the aftertax lease payment is: Aftertax lease payment = $1,900,000(1 – 34) = $1,254,000 The aftertax cost of debt is: Aftertax debt cost = 09(1 – 34) = 0594 or 5.94% With these cash flows, the NAL is: NAL = $8,000,000 – 1,254,000 – $1,254,000(PVIFA5.94%,4) – $544,000(PVIFA5.94%,5) = $99,509.86 The equipment should be leased CHAPTER 27 B-405 To find the maximum payment, we find where the NAL is equal to zero, and solve for the payment Using X to represent the maximum payment: NAL = = $8,000,000 – X(1.0594)(PVIFA5.94%,5) – $544,000(PVIFA5.94%,5) X = $1,276,262.35 So the maximum pretax lease payment is: Pretax lease payment = $1,276,262.35/(1 – 34) = $1,933,730.84 The aftertax residual value of the asset is an opportunity cost to the leasing decision, occurring at the end of the project life (year 5) Also, the residual value is not really a debt-like cash flow, since there is uncertainty associated with it at year Nevertheless, although a higher discount rate may be appropriate, we‘ll use the aftertax cost of debt to discount the residual value as is common in practice Setting the NAL equal to zero: NAL = = $8,000,000 – X(1.0594)(PVIFA5.94%,5) – 544,000(PVIFA5.94%,5) – 500,000/1.05945 X = $1,192,437.06 So, the maximum pretax lease payment is: Pretax lease payment = $1,192,437.06/(1 – 34) = $1,806,722.81 The security deposit is a cash outflow at the beginning of the lease and a cash inflow at the end of the lease when it is returned The NAL with these assumptions is: NAL = $8,000,000 – 200,000 – 1,254,000 – $1,254,000(PVIFA5.94%,4) – $544,000(PVIFA5.94%,5) + $200,000/1.05945 NAL = $49,385.19 With the security deposit, the firm should still lease the equipment rather than buy it, because the NAL is greater than zero We could also solve this problem another way From Problem 7, we know that the NAL without the security deposit is $99,509.86, so, if we find the present value of the security deposit, we can simply add this to $99,509.86 The present value of the security deposit is: PV of security deposit = –$200,000 + $200,000/1.05945 = –$50,124.67 So, the NAL with the security deposit is: NAL = $99,509.86 – 50,124.67 = $49,385.19 10 a The different borrowing rates are irrelevant A basic tenant of capital budgeting is that the return of a project depends on the risk of the project Since the lease payments are affected by the riskiness of the lessee, the lessee‘s cost of debt is the appropriate interest rate for the analysis by both companies B-406 SOLUTIONS b Since the both companies have the same tax rate, there is only one lease payment that will result in a zero NAL for each company We will calculate cash flows from the depreciation tax shield first The depreciation tax shield is: Depreciation tax shield = ($330,000/3)(.34) = $37,400 The aftertax cost of debt is the lessee‘s cost of debt, which is: Aftertax debt cost = 09(1 – 34) = 0594 Using all of this information, we can calculate the lease payment as: NAL = = $330,000 – PMT(1 – 34)(PVIFA5.94%,3) + $37,400(PVIFA5.94%,3) PMT = $130,180.63 c Since the lessor‘s tax bracket is unchanged, the zero NAL lease payment is the same as we found in part b The lessee will not realize the depreciation tax shield, and the aftertax cost of debt will be the same as the pretax cost of debt So, the lessee‘s maximum lease payment will be: NAL = = –$330,000 + PMT(PVIFA9%,3) PMT = $130,368.07 Both parties have positive NAL for lease payments between $130,180.63 and $130,368.07 11 The APR of the loan is the lease factor times 2,400, so: APR = 0.00295(2,400) = 7.08% To calculate the lease payment we first need the net capitalization cost, which is the base capitalized cost plus any other costs, minus and down payment or rebates So, the net capitalized cost is: Net capitalized cost = $35,000 + 450 – 2,000 Net capitalized cost = $33,450 The depreciation charge is the net capitalized cost minus the residual value, divided by the term of the lease, which is: Depreciation charge = ($33,450 – 21,500) / 36 Depreciation charge = $331.94 Next, we can calculate the finance charge, which is the net capitalized cost plus the residual value, times the lease factor, or: Finance charge = ($33,450 + 21,500)(0.00295) Finance charge = $162.10 And the taxes on each monthly payment will be: Taxes = ($331.94 + 162.10)(0.07) Taxes = $34.58 CHAPTER 27 B-407 The monthly lease payment is the sum of the depreciation charge, the finance charge, and taxes, which will be: Lease payment = $331.94 + 162.10 + 34.58 Lease payment = $528.63 Challenge 12 With a four-year loan, the annual loan payment will be $5,800,000 = PMT(PVIFA8%,4) PMT = $1,751,140.67 The aftertax loan payment is found by: Aftertax payment = Pretax payment – Interest tax shield So, we need to find the interest tax shield To find this, we need a loan amortization table since the interest payment each year is the beginning balance times the loan interest rate of percent The interest tax shield is the interest payment times the tax rate The amortization table for this loan is: Year Beginning balance $5,800,000.00 4,512,859.33 3,122,747.42 1,621,426.54 Total payment $1,751,140.67 1,751,140.67 1,751,140.67 1,751,140.67 Interest payment $464,000.00 361,028.75 249,819.79 129,714.12 Principal payment $1,287,140.67 1,390,111.92 1,501,320.87 1,621,426.54 Ending balance $4,512,859.33 3,122,747.42 1,621,426.54 0.00 So, the total cash flows each year are: Year Beginning balance $1,751,140.67 – $5,800,000(.08)(.35) $1,751,140.67 – $4,512,859.33 (.08)(.35) $1,751,140.67 – $3,122,747.42 (.08)(.35) $1,751,140.67 – $1,621,426.54(.08)(.35) Aftertax loan payment $1,588,740.67 $1,624,780.60 $1,663,703.74 $1,705,740.72 OCF –$1,638,500 –$1,638,500 –$1,638,500 –$1,638,500 Total cash flow = –$49,759.33 = –$13,719.40 = $25,203.74 = $67,240.72 So, the NAL with the loan payments is: NAL = – $49,759.33/1.052 – $13,719.40/1.0522 + $25,203.74/1.0523 + $67,240.72/1.0524 NAL = $16,851.25 The NAL is the same because the present value of the aftertax loan payments, discounted at the aftertax cost of capital (which is the aftertax cost of debt) equals $5,800,000 ... interest obligations g Profit margin is the accounting measure of bottom-line profit per dollar of sales h Return on assets is a measure of bottom-line profit per dollar of total assets i Return... 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. .. goal of maximizing the share price of the equity of the firm A primary market transaction To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com B-2 SOLUTIONS