Financial Management 1

CHAPTER 1

NATURE, PURPOSE, AND

SCOPE OF FINANCIAL MANAGEMENT

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. The goal of financial management is to make money and add value for the owner. The kinds of activities that
financial management deals with relate the three financial decisions that finance managers must make namely,
investing, financing and dividend decisions.

2. Refer to page 8 – Relationship between Financial Management and Accounting.

3. The owners’ perspective holds that the only appropriate goal is “to maximize shareholder wealth”. The competing
viewpoint is from the stakeholders’ perspective, which emphasizes social responsibility over profitability. This
view maintains that managers must maximize the total satisfaction of all stakeholders in a business. While strong
arguments speak in favor of both perspectives, financial practitioners and academics now tend to believe that the
manager’s primary responsibility should be to maximize shareholder wealth and give only secondary
consideration to other stakeholders’ welfare. The invisible hand of the market, acting through compensation and
the free price system, would ensure that only those activities most efficient and beneficial to society as a whole
would survive in the long run. Thus, those same activities would also profit the individual most. When companies
try to implement a goal other than profit maximization, their efforts tend to backfire. Consider the firm that tries
to maximize employment, the high number of employees raises costs. Soon the firm will find that its costs are too
high to allow it to compete against more efficient firms, especially in a global business environment. When the
firm fails, all employees are let go and employment ends up being minimized, not maximized.

4. Financially stable firms are good for stakeholders, such as employees, managers, customers and local
communities.

5. Theoretically, managers work for shareholders. In reality, because shareholders aren’t involved in day-to-day firm
activities, managers control the firm. Managers might be tempted to operate the firm in such a way as to benefit
themselves more than the shareholders. Corporate governance is the system of incentives and monitors that tries
to overcome this agency problem. Shareholders can align managers’ interest with stockholder interests by making
managers part owners of the firm. Then, various monitors follow the firm and report on its activities.

6. 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).

7. To maximize the current market value (share price) of the equity of the firm (whether it’s publicly-traded or not).

II. Multiple Choice Questions

1. C
2. B
3. D
4. D
5. D

CHAPTER 2

RELATIONSHIP OF FINANCIAL OBJECTIVES

TO ORGANIZATIONAL STRATEGY ANDOTHER ORGANIZATIONAL OBJECTIVES

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. 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
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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.

2. 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.

3. The board of directors should set CEO compensation dependent on how well the firm performs. The
compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed.
Compensation should be structured so that the CEO is rewarded on the basis of the stock’s performance over the
long run, not the stock’s price on an option exercise date. This means that options (or direct stock awards) should
be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If
the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based
on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic
value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value
cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stock’s market
price—but the price used should be an average over time rather than on a specific date.

4. Stockholder wealth maximization is a long-term goal. Companies, and consequently the stockholders, prosper by
management making decisions that will produce long-term earnings increases. Actions that are continually
shortsighted often “catch up” with a firm and, as a result, it may find itself unable to compete effectively against
its competitors. There has been much criticism in recent years that firms are too short-run profit-oriented. A
prime example is the auto industry, which has been accused of continuing to build large “gas guzzler”
automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models.

5. Useful motivational tools that will aid in aligning stockholders’ and management’s interests include: (1)
reasonable compensation packages, (2) direct intervention by shareholders, including firing managers who don’t
perform well, and (3) the threat of takeover.

The compensation package should be sufficient to attract and retain able managers but not go beyond what is
needed. Also, compensation packages should be structured so that managers are rewarded on the basis of the
stock’s performance over the long run, not the stock’s price on an option exercise date. This means that options
(or direct stock awards) should be phased in over a number of years so managers will have an incentive to keep
the stock price high over time. Since intrinsic value is not observable, compensation must be based on the stock’s
market price—but the price used should be an average over time rather than on a specific date.

Stockholders can intervene directly with managers. Today, the majority of stock is owned by institutional
investors and these institutional money managers have the clout to exercise considerable influence over firms’
operations. First, they can talk with managers and make suggestions about how the business should be run. In
effect, these institutional investors act as lobbyists for the body of stockholders. Second, any shareholder who has
owned ₱2,000 of a company’s stock for one year can sponsor a proposal that must be voted on at the annual
stockholders’ meeting, even if management opposes the proposal. Although shareholder-sponsored proposals are
non-binding, the results of such votes are clearly heard by top management.

If a firm’s stock is undervalued, then corporate raiders will see it to be a bargain and will attempt to capture the
firm in a hostile takeover. If the raid is successful, the target’s executives will almost certainly be fired. This
situation gives managers a strong incentive to take actions to maximize their stock’s price.

6. a. Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to create a more
attractive community that will make it easier to hire a productive work force. This corporate philanthropy
could be received by stockholders negatively, especially those stockholders not living in its headquarters city.
Stockholders are interested in actions that maximize share price, and if competing firms are not making
similar contributions, the “cost” of this philanthropy has to be borne by someone - the stockholders. Thus,
stock price could decrease.
b. Companies must make investments in the current period in order to generate future cash flows. Stockholders
should be aware of this, and assuming a correct analysis has been performed, they should react positively to the
decision. Assuming that the correct capital budgeting analysis has been made, the stock price should increase in
the future.
c. Government treasury bonds are considered safe investments, while common stocks are far more risky. If the
company were to switch the emergency funds from treasury bonds to stocks, stockholders should see this as
increasing the firm’s risk because stock returns are not guaranteed - sometimes they increase and sometimes
they decline. The firm might need the funds when the prices of their investments were low and not have the
needed emergency funds. Consequently, the firm’s stock price would probably fall.

7. Earnings per share in the current year will decline due to the cost of the investment made in the current year and
no significant performance impact in the short run. However, the company’s stock price should increase due to
the significant cost savings expected in the future.
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II. Multiple Choice Questions

6. D
7. C
8. D
9. A
10. D

CHAPTER 3

FUNCTIONS OF FINANCIAL MANAGEMENT

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. 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.

2. 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?”

3. 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.

4. How much is too much? Who is worth more, Ray Irani or Roger Federer? 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.

5. Refer to page 29.

6. Refer to page 30.

7. Refer to page 27.

II. Multiple Choice Questions

11. C
12. A
13. C
14. D
15. B
16. D

CHAPTER 4

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 Financial Management 1
FORMS OF BUSINESS ORGANIZATION

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND CASES

I. Questions

1. Refer to pages 35 through 40.

2. Of the three basic forms of business ownership, corporations have better access to capital. The ability to raise
capital in a sole proprietorship and partnership is limited to the personal capacity of the owner(s) to attract
potential creditors and other investors.

3. The founder can eventually lose control of the firm if the business continually incurs losses and uncontrolled
indebtedness. The founder can avoid losing control by ensuring that the business is operating profitably and
earnings are reinvested profitably.

4. 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.

II. Multiple Choice Questions

17. A
18. A
19. D

III. Cases

1. The advantages to a limited partnership are:

a) Reduction of personal liability. A sole proprietor has unlimited liability, which can include the potential
loss of all personal assets except for at least one partner who assumes unlimited liability.

b) Taxes. Forming a limited partnership may mean that more expenses can be considered business expenses
and be deducted from the company’s income.

c) Improved credibility. The business may have increased credibility in the business world compared to a
sole proprietorship.

d) Ability to attract investment. Limited partnerships can raise capital through the sale of equity or interest in
the firm.

e) Continuous life. Sole proprietorships have a limited life, as compared with limited partnerships which
have potentially longer life.

f) Transfer of ownership. It is easier to transfer ownership in a sole proprietorship than in a partnership.

The biggest disadvantage is the potential cost, although the cost of forming a limited partnership 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 limited partnership, except that costs are likely to be
higher and in a corporation, ownership is easier to transfer.

3. As a small company, changing to a limited partnership is probably the most advantageous decision at the current
time. If the company grows, and Dee and Lyn are willing to sell more equity ownership, the company can
reorganize as a corporation at a later date. Additionally, forming a limited partnership is likely to be less
expensive than forming a corporation.

CHAPTER 5

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APPLICATIONS OF MICROECONOMICS
THEORYAS A BASIS FOR UNDERSTANDING THE
KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. The amount of a commodity purchased per unit of time is a function of or depends on the price of the commodity,
money incomes, the prices of other (related) commodities, tastes and the number of buyers of the commodity in
the market. A change in any of the above factors will cause a change in the amount of the commodity purchased
per unit of time. The elasticity of demand measures the relative responsiveness in the amount purchased per unit
of time to a change in any one of the above factors, while keeping the others constant.

2. The price elasticity of demand measures the relative responsiveness in the quantity of a commodity demanded to
changes in its price. The income elasticity of demand measures the relative responsiveness in the amount
purchased to changes in money income. Similarly, the cross elasticity of demand measures the relative
responsiveness in the amount purchased to changes in the price of a related commodity. The above elasticity
concepts apply as much to the individual consumer’s response as to the market response. However, we are
primarily interested in the market responses.

3. The factors governing the size of the coefficient of price elasticity of demand are as follows:

a) Number and closeness of substitutes for the commodity. The more and better the available substitutes for a
commodity, the greater its price elasticity of demand is likely to be. Thus, when the price of tea rises,
consumers readily switch to good substitutes such as coffee and cocoa, so the coefficient of price
elasticity of demand for tea is likely to be high. On the other hand, since there are no good substitutes for
salt, its elasticity is likely to be very low.
b) Number of uses of the commodity. The greater the number of uses of a commodity, the greater is its price
elasticity. For instance, the elasticity of aluminum is likely to be much greater than that of butter since
butter can be used only as food while aluminum has hundreds of uses (e.g., aircraft, electrical wiring,
appliances and so on).

c) Expenditures on the commodity. The greater the percentage of income spent on a commodity, the greater
its elasticity is likely to be. Thus the demand for cars is likely to be much more price elastic than that for
shoes.

d) Adjustment time. The longer the allowed period of adjustment in the quantity of a commodity demanded,
the more elastic its demand is likely to be. This is so because it takes time for consumers to learn of new
prices and new products. In addition, even after a decision is made to switch to other products, some time
may pass before the switch is actually made.

e) Level of price. If the ruling price is toward the upper end of the demand curve, demand is likely to be
more elastic than if it were toward the lower end. This is always true for a negatively sloped straight-line
demand curve and is usually true for curvilinear demand curves.

4. The price elasticity of supply (es) measures the relative responsiveness or sensitivity in the quantity of a
commodity supplied to changes in its price only. Thus es, as e, measures movements along the same supply curve.

5. The longer the period of adjustment allowed for a change in the price of a commodity, the more elastic the supply
curve of the commodity is likely to be. This is so because it takes time for producers to respond to price changes.

6. The answer depends on the price elasticity of demand for taxi rides in Metro Manila. If the demand for taxi rides
is price inelastic, the decision was correct. If demand is elastic, then increasing taxi fares reduces the total revenue
of taxi owners. In order to see what happened to the total profits of taxi owners, we must compare this decrease in
total revenue with the change in total costs (higher wages for taxi drivers but fewer taxis and fewer taxi drivers).
Unfortunately, in the real world we often do not have (and it might be difficult) to get estimates of the elasticities
necessary to reach correct decisions.

7. A bad harvest is reflected in a decrease in supply (i.e., an upward shift in the market supply curve of agricultural
commodities). Given the market demand for agricultural commodities, this decrease in supply causes the
equilibrium price to rise. Since the demand is price inelastic, the total receipts of farmers as a group increase.
When the demand for an agricultural commodity is price inelastic, the same result can be achieved by reducing
the amount of land under cultivation for the commodity. This is done in some farm-aid programs.

8. a. An entrepreneur running his firm must include as part of his costs of production not only what he actually
pays out to hire labor, purchase raw and semi-finished materials, borrow money and rent land and buildings

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 Financial Management 1
(the explicit costs), but also the maximum salary that the entrepreneur could have earned working in a similar
capacity for someone else (say, as a manager of another firm). Similarly, the entrepreneur must include as part
of his costs of production the return in the best alternative use from the capital, land and on any other factor of
production that he owns and that he uses in his own enterprise. These resources owned and used by the firm
itself are not “free” resources. The implicit cost to the firm involved in using them is equal to the best
alternative foregone (i.e., what these same resources would have earned in their best alternative use).
Whenever we speak of costs in economics or draw cost curves, we always include both explicit and implicit
costs.

b. For the inputs which the firm purchases or hires, the firm must pay a price at least equal to what these same
inputs could earn in their best alternative use. Otherwise, the firm could not purchase them or retain them for
its use. Thus the cost to the firm involved in the use of any input, whether owned by the firm (implicit cost) or
purchased (explicit cost), is equal to what the same input could earn in its best alternative use. This is the
alternative or opportunity cost doctrine. We assume that factor prices remain constant regardless of the
quantity of each factor demanded by the firm per unit of time. That is, we assume that the firm is a perfect
competitor in the factor market.

9. A firm should combine inputs in order to minimize the cost of producing various level of output. The production
function of a firm together with the prices that the firm must pay for its factors of production or inputs determine
the firm’s cost curves.

10. Prices reflect marginal value, not total value. The marginal value of a good is the maximum amount a consumer
would be willing to pay for a specific unit. The height of the demand curve reflects the value consumers place on
each unit. The total value is the total benefit consumers derive from all units consumed. The area under the
demand curve for the number of units consumed reflects the total value. Water provides an example of a good
with high total value but low marginal value. With regard to the last question, are there more nurses or
professional wrestlers?

11. Neither markets nor the political process leaves the determination of winners and losers to chance. Under market
organization, business winners and losers are determined by the decentralized choices of millions of consumers
who use their million votes to reward firms that provide preferred goods at a low cost and penalize others who fail
to do so. Under political decision making, the winners and losers are determined by political officials who use
taxes, subsidies, regulations and mandates to favor some businesses and penalize others.

12. a. Profitable production increases the value of resources owned by people and leads to mutual gain for resource
suppliers, consumers and entrepreneurs.

b. Losses reduce the value of resources, which reduces the well-being of at least some people. There is no
conflict.

13. Business firms do have strong incentive to serve the interest of consumers, but this is not what motivates them.
Instead, they are motivated by self-interest and the pursuit of income, but they must provide consumers with a
quality product if they are going to be successful. Good intentions are not required for people to engage in actions
that are helpful to others.

II. Multiple Choice Questions

20. A 12. D
21. D 13. C
22. C 14. C
23. B 15. D
24. A 16. D
25. D 17. B
26. C 18. D
27. B 19. B
28. A 20. D
29. A 21. C
30. C 22. D

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 Financial Management 1

CHAPTER 6

APPLICATIONS OF MACROECONOMICS
THEORYAS A BASIS FOR UNDERSTANDING THE
KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. The four broad classification of factors of production are:

a) Labor – (Effort and skill of a carpenter; The ability of an actor)
b) Land – (Trees; Water)
c) Capital – (Tractor; Factory building)
d) Business Know-How

2. A mixed economy involves reliance on both the market and command mechanisms. Most coordination is carried
through the market mechanism but there are many economic decisions which are either made by or regulated by
the government.

3. Scarcity is the universal condition that human wants always exceed the resources available to satisfy them. The
fact that goods and services are scarce means that individuals cannot have all of everything they want. It is
therefore necessary to choose among alternatives. Scarcity is a problem of essentially infinite wants and limited
resources. While cooperation is one way to organize our activity or confront the problem of scarcity, it cannot
eliminate it and therefore cannot eliminate economic problems.

4. Wants reflect our unlimited desires for goods and services without regard to our ability or willingness to make the
sacrifices necessary to obtain them. The existence of scarcity means that many of those wants will not be
satisfied. On the other hand, demands refer to plans to buy and therefore reflect decisions about which wants to
satisfy.

5. Any “three” events that are consistent with the following will increase the demand for peanut butter.

a) An increase in consumer income (assuming that peanut butter is a normal good)

b) An increase in population size
c) A change in tastes that now makes peanut butter more desirable

Any of these will increase the demand for peanut butter and will thus cause the price of peanut butter to rise and
the quantity of peanut butter traded to increase.

6. The existence of s surplus means that, at the current price, the quantity supplied is greater than the quantity
demanded. Thus, to eliminate the surplus, either the quantity demanded must increase or the quantity supplied
must decrease (or both). As the price falls, we get exactly the necessary results; the quantity demanded increases
and the quantity supplied decreases (due to the laws of demand and supply).

7. Due to the tremendous pace of technological advance, not only has the demand for personal computers been
increasing, but the supply has been increasing as well. Indeed, supply has been increasing much more rapidly than
demand, which has resulted in falling prices. Thus, much (but not all) of the increase in sales of personal
computers reflects a movement along a demand curve rather that a shift in demand.

8. This argument confuses a movement along an unchanging demand curve with a shift in the demand curve. The
proper analysis is; the increase in the tax on crude oil will increase the cost of the primary resource used in
production of gasoline and thus shift the supply curve for gasoline to the left. This will cause the equilibrium price
of gasoline to increase and thus the quantity of gasoline demanded will decrease – demand itself will not decrease
(i.e., the demand curve will not shift). The decrease in supply causes a movement along an unchanged demand
curve.

9. The value of money is the quantity of goods and services that can be purchased with one unit of money. Since
inflation means that prices are rising on average, it means that one unit of money will buy less. Thus the value of
money falls when there is inflation.

10. Because both borrowers and lenders realize that inflation reduces the value of money, loan agreements will
specify a rate of interest that reflects the anticipated rate of inflation. In particular, if they expect a high rate of
inflation, they will agree to a higher interest rate. If the rate of inflation turns out to be less anticipated, borrowers

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 Financial Management 1
are hurt and lenders benefit since the agreed upon interest rate, after adjusting for inflation will be higher than
expected.

11. When an expenditure is made, firms receive money payments. The amount received by firms in the aggregate is
aggregate expenditure. All that firms receive is distributed as income to households who own the factors of
production. Remember that profit is income. Since the aggregate amount firms receive is expenditure and firms
pay out all they receive as income, in the aggregate economy, income equals expenditure.

12. Macroeconomic equilibrium occurs when the quantity of real GDP demanded is equal to the quantity of real GDP
supplied. Graphically, macroeconomic equilibrium occurs at the intersection of the aggregate demand and short-
run aggregate supply curves.

13. The price level can rise as the result of either an increase in aggregate demand or as the result of a decrease in
aggregate supply. Indeed both of these forces have contributed to periods in which the price level rose. The steady
and persistent increases in the price level, however, have been due to steady and persistent increases in aggregate
demand. The most important reason for this behavior of aggregate demand is persistent increases in the quantity
of money.

14. A unit of account is an agreed measure in which prices of goods and services are stated. Money serves as a unit of
account when all prices are stated in terms of units of money (e.g., peso, dollars and so on).

15. Financial intermediaries create liquidity by borrowing short and lending long. They borrow funds by creating
deposits which they promise to repay on short notice but loan funds for long periods of time. The deposits they
create are much more liquid than the assets that result from the ultimate loan contracts. Indeed, some of the
deposits created by banks are money and are thus perfectly liquid.

16. The three main policy tools of the Central Bank are:
a) Required reserve ratios
b) Discount rate
c) Open market operations

17. An open market purchase of government securities by the BSP increases the monetary base by increasing one of
its components – bank’s deposits at the BSP. The process by which this takes place depends on whether the
securities are purchased from banks or from the nonbank public. If the purchase is from banks, the process is
direct – the BSP pays for the securities by crediting the bank’s deposit at the BSP, which directly increases the
monetary base. If the purchase is from the nonbank public, the BSP pays by writing checks on itself which the
sellers of the securities deposit in their banks. The banks in turn present the checks to the BSP, which credits the
bank’s deposits at the BSP. Thus, in either case, the monetary base increases by the amount of the open market
purchase.

18. The three main motives for holding money are:

a) The transactions motive
b) The precautionary motive
c) The speculative motive

19. If the demand for real money is very sensitive to changes in the interest rate, the demand curve for real money is
very flat. Thus, when the money supply increases and the supply curve for real money shifts to the right, the
resulting change in the equilibrium interest rate will be small. A small interest rate change will lead to small
change in investment, a small change in aggregate planned expenditure and thus an increase in aggregate demand.

II. Multiple Choice Questions

1. D 12. A 23. B 34. B 45. A

2. A 13. C 24. D 35. A 46. B
3. D 14. D 25. C 36. C 47. B
4. D 15. B 26. D 37. D 48. C
5. D 16. B 27. C 38. C 49. A
6. C 17. A 28. A 39. B 50. D
7. D 18. D 29. C 40. D 51. B
8. D 19. B 30. D 41. A 52. C
9. C 20. C 31. D 42. B 53. C
10. D 21. A 32. C 43. D 54. B
11. B 22. D 33. D 44. A 55. C

CHAPTER 7

COMPETITION AND POLICIES TOWARDS

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 Financial Management 1
MONOPOLIES AND OLIGOPOLIES,
PRIVATIZATION AND DEREGULATION

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. Pure monopoly refers to the case where:

a) there is a single firm selling the commodity,
b) there are no close substitutes for the commodity, and
c) entry into the industry is very difficult or impossible.

If we further assume that the monopolist has perfect knowledge of present and future prices and costs, we have
perfect monopoly.

2. The firm may control the entire supply of raw materials required to produce the commodity. For example, up to
World War II, Alcoa (a U.S. company) owned or controlled almost every source of bauxite – the raw material
necessary to produce aluminum in the U.S. and thus had a complete monopoly over the production of aluminum
in the U.S.

The firm may own a patent which precludes other firms from producing the same commodity. For example, when
cellophane was first introduced, Dupont had monopoly power in its production based on patents.

A monopoly may be established by a government franchise. In this case, the firm is set up as the sole producer
and distributor of a good or service but is subjected to governmental control in certain aspects of its operation.

In some industries, increasing returns to scale may operate over a sufficiently large range of outputs as to leave
only one firm to produce the equilibrium industry output. These are called natural monopolies and are fairly
common in the areas of public utilities and transportation. What the government usually does in these cases is to
allow the monopolist to operate but subjects him to government control.
3. a. Monopolistic competition refers to the market organization in which there are many sellers of a differentiated
product. Monopolistic competition is very common in the retail and service sectors of our economy.
Examples of monopolistic competition are the numerous barber shops, gasoline stations, grocery stores, liquor
stores, drug stores and so on located in close proximity to one another.

b. The competitive element results from the fact that in a monopolistically competitive industry (as in perfectly
competitive industry) there are so many firms that the activities of each have no perceptible effect on the other
firms in the industry. The monopoly element results because the many sellers in the industry sell a
differentiated rather than a homogeneous product.

c. Technically speaking, we cannot define the industry under monopolistic competition because each firm
produces a somewhat different product. All we can do is to group together firms producing closely related
commodities and refer to them as a “product group”. However, because of the product differentiation, we
cannot construct the “industry” D and S curves and we do not have a single equilibrium price but a cluster of
prices. Thus, our graphical analysis must be confined to the typical or representative firm.

4. a. Oligopoly is the form of market organization in which there are few sellers of a commodity. If there are only
two sellers, we have a duopoly. If the product is homogeneous (e.g., steel, cement and copper) we have a pure
oligopoly. For simplicity, we deal mostly with a pure duopoly. Oligopoly is the most prevalent form of
market organization in the manufacturing sector of modern economies and arises for the same general reasons
as monopoly (i.e., economies of scale, control over an essential resource, government licensing and patents).

b. The interdependence among the firms in the industry is the single most important characteristic setting
oligopoly apart from other market structures. This interdependence is the natural result of fewness. That is,
since there are few firms in an oligopolistic industry, when one of them lowers its price, undertakes a
successful advertising campaign, or introduces a better model, the demand curve faced by other oligopolists
will shift down so the other oligopolist react.
c. Oligopoly theory achieves specific cases or models. These few models, however, do accomplish three things:
(1) they show clearly the nature of oligopolistic interdependence, (2) they point out the gaps that a satisfactory
theory of oligopoly must fill, and (3) they give some indication as to how very difficult this branch of
microeconomics really is and how long we may have to wait to get a general theory of oligopoly. In short,
oligopoly theory is one of the least satisfactory segments of microeconomics.

5. a. The natural barriers to entry into such oligopolistic industries as the car, aluminum and steel industries are the
smallness of the market in relation to efficient operation and the huge amounts of capital and specialized input
required to start efficient operation. Some of the artificial barriers to entry are economies of scale, control

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 Financial Management 1
over an essential resource, government licensing and patents. When entry is blocked or at least restricted, the
firms in an oligopolistic industry can earn long-run profits.

b. In the long run, oligopoly may lead to the following harmful effects: (1) as in monopoly, price usually
exceeds LAC in oligopolistic markets, (2) the oligopolist usually does not produce at the lowest point on his
LAC curve, (3) P > LMC, so there is an under allocation of the economy’s resources to the firms in the
oligopolistic industry, and (4) when oligopolist produce a differentiated product, too much may be spent on
advertising and model changes.

c. For technological reasons, many products such as cars, steel and aluminum cannot possibly be produced
under conditions of perfect competition or their cost of production would be prohibitive. In addition,
oligopolists spend a great deal of their profits on research and development and many economists believe that
this leads to much faster technological advance and higher standards of living than if the industry were
organized along perfectly competitive lines. Finally, some advertising is useful since it informs consumers
and some product differentiation has the economic value of satisfying the different tastes of different
consumers.

6. The concept is diametrically opposed to the economist’s view of perfect competition. It describes a competitive
market which stresses the rivalry among firms. The economist’s view stresses the impersonality of a perfectly
competitive market. That is, according to the economist, in a perfectly competitive market there are so many
sellers and buyers of a commodity, each so small in relation to the market as not to regard others as competitors or
rivals at all. The outputs of all firms in the market are homogeneous and so there is no rivalry among firms based
on advertising, quality and style differences.

7. a. Within the limitations imposed by its given scale of plant, the firm can vary the amount of the
commodity produced in the short run by varying its use of the variable inputs.

b. Since the perfectly competitive firm faces an infinitely elastic demand curve, it can sell any amount of the
commodity at the given market price.

c. The crucial assumption we make in order to determine the equilibrium output of the firm (i.e., how much the
firm wants to produce and sell per time period) is that the firm wants to maximize its total profits. It should be
noted that not all firms seek to maximize total profits or minimize total losses at all times. However, the
assumption of profit maximization is essential if we are to have general theory of the firm, and in general it
leads to more accurate predictions of business behavior than any alternative assumption. The short-run
equilibrium of the firm can be looked at from a total revenue (total cost approach) or from a marginal revenue
(marginal cost approach).

8. Most economists would answer this question in the affirmative. If some firms appear to have lower costs than
other firms, this is due to the fact that they use superior resources or inputs such as more fertile land or superior
management. These superior resources under the threat of leaving to work for other firms can extract from the
firms using them the higher price or return commensurate with their productivity. In any event, the firm should
price all resources it owns, and the forces of competition will force the firm to price all resources it does not own
at their opportunity cost. So it is the owners of such superior resources who receive the benefit in the form of
higher prices, or returns from their greater productivity rather than the firms employing them in the form of lower
costs. This results in all firms having identical cost curves. Therefore, all firms just break-even when the perfectly
competitive industry is in long-run equilibrium.

9. In a highly competitive industry such as agriculture, lower resource prices might improve the rate of profit in the
short run, but in the long run, competition will drive prices down until economic profit is eliminated. Thus, lower
resource prices will do little to improve the long-run profitability in such industries.

10. The market price will decline because the profits will attract new firms and capital investment into the market and
supply will increase, driving down the price until the profits are eliminated.

11. a. Increase
b. Increase
c. Increase; firm will earn economic profit
d. Rise (compared with its initial level) if coffee is an increasing-cost industry, but return to initial price if it is a
constant-cost industry
e. Increase even more than it did in the short run
f. Economic profit will return to zero

12. a. Decline
b. Increase
c. Decline
d. Decline

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 Financial Management 1

13. If demand falls or prices go down, this may not necessarily put an end to all the business firms in the industry.
The closure of some firms may be beneficial to the other firms because the latter can absorb the unfulfilled orders
of the former. The increase in volume of business could result to profitable operations of the remaining firms.

14. Competition virtually forces firms to operate efficiently and produce goods and services that consumers value
highly relative to cost. Firms that fail to do so will find it difficult to compete, and eventually losses will drive
them from the market.

15. Refer to page 120.

16. Refer to pages 121 and 122.

17. Refer to pages 122 and 123.

II. Multiple Choice Questions

1. C 6. D 11. B
2. A 7. C 12. D
3. D 8. A 13. A
4. A 9. D 14. A
5. B 10. D 15. D

CHAPTER 8

UNDERSTANDING THE ROLE OF THE FINANCIAL MARKETS AND INSTITUTIONS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1.
 Spot markets – the markets in which assets are bought or sold for “on-the-spot” delivery; Future markets
– the markets in which participants agree today to buy or sell an asset at some future date.

 Money markets – the financial markets in which funds are borrowed or loaned for short periods (less than
one year); Capital markets – the financial markets for stocks and for intermediate or long-term debt (one
year or longer).

 Primary markets – markets in which corporations raise capital by issuing new securities; Secondary
markets – markets in which securities and other financial assets are traded among investors after they
have been issued by corporations.

 Private markets – markets in which transactions are worked out directly between two parties; Public
markets – markets in which standardized contracts are traded on organized exchanges.

 Derivatives – any financial asset whose value is derived from the value of some other “underlying” asset.

 Investment banks – an organization that underwrites and distributes new investment securities and helps
businesses obtain financing; Commercial banks – the traditional department store of finance serving a
variety of savers and borrowers; Financial services corporations – a firm that offers a wide range of
financial services, including investment banking, brokerage operations, insurance and commercial
banking.

 Mutual funds – organizations that pool investor funds to purchase financial instruments and thus reduce
risks through diversification; Money market funds – mutual funds that invest in short-term, low-risk
securities and allow investors to write checks against their accounts.

 Physical location exchanges – formal organizations having tangible physical locations that conduct
auction markets in designated (listed) securities; Over-the-Counter (OTC) market – a large collection of
brokers and dealers connected electronically by telephones and computers that provides for trading in
unlisted securities; Dealer market – includes all facilities that are needed to conduct security transactions
not conducted on the physical location exchanges.

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 Financial Management 1
 Closely held corporation – a corporation that is owned by a few individuals who are typically associated
with the firm’s management; Publicly owned corporation – a corporation that is owned by a relatively
large number of individuals who are not actively involved in the firm’s management.

 Going public – the act of selling stock to the public at large by a closely held corporation or its principal
stockholders; Initial public offering (IPO) market – the market for stocks of companies that are in the
process of going public.

2. In a well-functioning economy, capital will flow efficiently from those who supply capital to those who demand
it. This transfer of capital can take place in three different ways:

a. Direct transfers of money and securities occur when a business sells its stocks or bonds directly to savers,
without going through any type of financial institution. The business delivers its securities to savers, who
in turn give the firm the money it needs.

b. Transfers may also go through an investment banking house which underwrites the issue. An underwriter
serves as a middleman and facilitates the issuance of securities. The company sells its stocks or bonds to
the investment bank, which in turn sells these same securities to savers. The businesses’ securities and
the savers’ money merely “pass through” the investment banking house.

c. Transfers can also be made through a financial intermediary. Here, the intermediary obtains funds from
savers in exchange for its own securities. The intermediary uses this money to buy and hold businesses’
securities. Intermediaries literally create new forms of capital. The existence of intermediaries greatly
increases the efficiency of money and capital markets.

3. A money market transaction occurs in the financial market in which funds are borrowed or loaned for short
periods (less than one year). A capital market transaction occurs in the financial market in which stocks and
intermediate or long-term debt (one year or longer) are issued.

a. A BSP Treasury bill is an example of money market securities.

b. Long-term corporate bonds are examples of capital market securities.

c. Common or ordinary stocks are examples of capital market securities.

d. Preferred stocks are examples of capital market securities.

e. Dealer commercial paper is an example of money market securities.

4. If people lost faith in the safety of financial institutions, it would be difficult for firms to raise capital. Thus,
capital investment would slow down, unemployment would raise, the output of goods and services would fall, and
in general, our standard of living would decline.

5. Financial markets have experienced many changes during the last two decades. Technological advances in
computers and telecommunications, along with the globalization of banking and commerce, have led to
deregulation and this has increased competition throughout the world. The result is a much more efficient,
internationally linked market, but one that is far more complex than existed a few years ago. While these
developments have been largely positive, they have also created problems for policy makers. Large amounts of
capital move quickly around the world in response to changes in interest and exchange rates, and these
movements can disrupt local institutions and economies. The subprime mortgage crisis illustrates how problems
in one country quickly affect the economies of other nations.

Globalization has exposed the need for greater cooperation among regulators at the international level. Factors
that complicate coordination include (1) the differing structures among nations’ banking and securities industries,
(2) the trend in Europe toward financial services conglomerates, and (3) reluctance on the part of individual
countries to give up control over their national monetary policies. Regulators are unanimous about the need to
close the gaps in the supervision of worldwide markets.

Another important trend in recent years has been the increased use of derivatives. The market for derivatives has
grown faster than any other market in recent years, providing corporations with new opportunities but also
exposing them to new risks. Derivatives can be used either to reduce risks or to speculate. It’s not clear whether
recent innovations have “increased or decreased the inherent stability of the financial system”.

6. Money markets refer to those markets dealing with short-term securities that have a life of one year or less.
Capital markets refer to securities with a life of more than one year.

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 Financial Management 1
7. A primary market refers to the use of the financial markets to raise new funds. After the securities are sold to the
public (i.e., institutions and individuals), they trade in the secondary market between investors. It is in the
secondary market that prices are continually changing as investors buy and sell securities based on the
expectations of corporate prospects.

8. Given companies with equal risk, those companies with expectations of high return will have higher common
stock prices relative to those companies with poor expectations.

9. Restructuring can result in changes in the capital structure (liabilities and owners’ equity on the balance sheet). It
can also result in the selling of low-profit-margin divisions with the proceeds reinvested in better investment
opportunities, and sometimes restructuring results in the removal of the current management team or large
reductions in the work force. Restructuring has also included mergers and acquisitions.

II. Multiple Choice Questions

1. A 5. D
2. B 6. D
3. D 7. A
4. B 8. D

III. Matching Quiz

1. i. financial capital
2. e. inflation
3. f. primary market
4. c. money market
5. a. restructuring
6. h. disinflation
7. b. capital market
8. g. secondary market
9. d. real capital

CHAPTER 9

INTERNATIONAL TRADE

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS

I. Questions

1. Factors affecting the value of a currency are (1) inflation, (2) interest rates, (3) balance of payments, and (4)
government intervention or policies. Other factors that have an influence include the stock market, gold prices,
demand for oil, political turmoil and labor strikes. All of the above factors will not affect each currency in the
same way at any given point in time.

2. When a country sell (exports) more goods and services to foreign countries than it purchases (imports), it will
have a surplus in its balance of trade. Since foreigners are expected to pay their bills for the exporter’s goods in
the exporter’s currency, the demand for that currency and its value will go up. On the other hand, continuous
deficits in balance of payments are expected to depress the value of the currency of a country because such
deficits would increase the supply of that currency relative to the demand. Of course, a number of other factors
may also influence these patterns.

3. The spot rate for a currency is the exchange rate at which the currency is traded for immediate delivery. An
exchange rate established for future delivery is a forward rate.

4. The foreign-located assets and liabilities of a multinational corporation (MNC) which are denominated in foreign
currency exchange rates is called translation exposure. The amount of loss or gain resulting from this form of
exposure and the treatment of it in the parent company’s books depends upon the accounting rules established by
the parent company’s government.

5. In studying exposure to political risk, a company may hire outside consultants or form their own advisory
committee consisting of top level managers from headquarters and subsidiaries.

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 Financial Management 1

Strategic steps to guard against such risks include:

a) Establish a joint venture with a local entrepreneur.
b) Enter into a joint venture with firms from other countries.
c) Purchase insurance.

6. LIBOR (London Interbank Offered Rate) is an interbank rate applicable for large deposits in the Eurodollar
market. It is a benchmark rate just like the prime rate in the U.S. Interest rates in Eurodollar loans are determined
by adding premiums to this basic rate. Generally, LIBOR is lower than the U.S. prime rate.

II. Multiple Choice Questions

1. C 12. A 23. A
2. D 13. C 24. B
3. D 14. C 25. A
4. B 15. B 26. C
5. B 16. D 27. D
6. B 17. C 28. C
7. D 18. D 29. D
8. B 19. B 30. A
9. C 20. A 31. A
10. A 21. C 32. C
11. D 22. B

CHAPTER 10

THE TIME VALUE OF MONEY

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The future value represents the expected worth of a single amount, whereas the present value represents the
current worth.

FVn = PV (1 + i) n - Future Value

PV = FVn 1 - Present Value

(1 + i) n

2. The present value of a single amount is the discounted value for one future payment, whereas the present value of
an annuity represents the discounted value of a series of consecutive payments of equal amount.

3. Money has a time value because funds received today can be reinvested to reach a greater value in the future. A
person would rather receive ₱1 today than ₱1 in ten years, because a peso invested today, invested at 6 percent is
worth ₱1.791 after ten years.

4. Inflation makes a peso today worth more than a peso in the future. Because inflation tends to erode the purchasing
power of money, funds received today will be worth more than the same amount received in the future.

5. The greater the number of compounding periods, the larger the future value. The investor should choose daily
compounding over monthly or quarterly.

6. Different financial applications of the time value of money are:

a) Equipment purchase or new product decision.

b) Present value of a contract providing future payments.
c) Future worth of an investment.
d) Regular payment necessary to provide a future sum.
e) Regular payment necessary to amortize a loan.
II. Problems

Problem 1 (Use Table 2)

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 Financial Management 1
PV = FVn (PVIFi,n)

a) ₱ 8,000 x .558 = ₱4,464

b) ₱16,000 x .567 = ₱9,072
c) ₱25,000 x .315 = ₱7,875
d) ₱ 1,000 x .001 = ₱1

Problem 2 (Use Table 1)

FVn = PV (FVIFi,n)

a) ₱12,000 x 1.501 = ₱18,012

b) ₱12,000 x 5.474 = ₱65,688
c) ₱12,000 x 10.835 = ₱130,020
d) ₱12,000 x 11.467 = ₱137,604 (5%, 50 periods)

Problem 3 (Use Table 2 and Table 4)

PV = FVn (PVIFi,n)

a) ₱12,000 x .507 = ₱6,084

b) ₱15,000 x .315 = ₱4,725

PVOA n = A (PVIFA i,n)

c) ₱ 5,000 x 6.710 = ₱33,550

d) ₱40,000 x 17.159 = ₱686,360

Problem 4 (Use Table 3)

FVOAn = A (FVIFAi,n)

a) ₱8,000 x 9.20 = ₱73,600

b) ₱8,000 x 581.83 = ₱4,654,640

Problem 5 (Use Table 4)

PVOA n = A (PVIFA i,n)

PVOA 14 = (₱6,500) x (8.244) = ₱53,586

Problem 6 (Use Table 2)

PV = FVn (PVIFi,n)

= (₱30,000) x (.593) = ₱17,790

Problem 7 (Use Table 4 and Table 2)

a. PVOA n = A (PVIFA i,n)

= (₱45,000) x (6.145) = ₱276,525

b. PV = FVn (PVIFi,n)

= (₱276,525) x (.826) = ₱228,410

Problem 8 (Use Table 2 and Table 3)

a. PV = FVn (PVIFi,n)

= (₱23,956) x (.544) = ₱13,032.06

b. A = FVOAn ÷ FVIFAi,n

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 Financial Management 1
= ₱23,956 ÷ 11.978 = ₱2,000

Problem 9 (Use Table 3)

FVOAn = A (FVIFAi,n)

= (₱1,500) x (13.181) = ₱19,771.50

Problem 10 (Use Table 1)

If the sum is doubling, then the tabular value must equal to 2. In Table 1, looking down the 8% column, we find the
factor closest to 2 (1.999) on the 9-year row. The factor closest to 3 (2.937) is on the 14-year row.

Problem 11 (Use Table 2)

PV = FVn (PVIFi,n)

a) PV = (₱5,000) (PVIF0.05,4) = (₱5,000) (0.823) = ₱4,115

b) PV = (₱5,000) (PVIF0.10,4) = (₱5,000) (0.683) = ₱3,415

c) PV = (₱5,000) (PVIF0.15,4) = (₱5,000) (0.572) = ₱2,860

Problem 12 (Use Table 2)

PV = FVn (PVIFi,n)

a) PV1 = (₱5,000) (PVIF0.20,1) = (₱5,000) (0.833) = ₱ 4,165.00

b) PV2 = (₱6,000) (PVIF0.20,2) = (₱6,000) (0.694) = ₱ 4,164.00

c) PV3 = (₱7,500) (PVIF0.20,3) = (₱7,500) (0.579) = ₱ 4,342.50

d) PV4 = (₱7,500) (PVIF0.20,4) = (₱7,500) (0.482) = ₱ 3,615.00

e) PV5 = (₱9,500) (PVIF0.20,5) = (₱9,500) (0.402) = ₱ 3,819.00

Total Present Value = ₱20,105.50

Problem 13 (Use Table 4)

Rewrite the Equation PVOA n = A (PVIFA i,n) to solve for the interest rate. Dividing both sides of the equation by A
gives a new equation: PVIFA i,n = PVOA n ÷ A. Now, solve the new equation as follows:

PVIFA i,6 = ₱20,000 ÷ ₱5,142.71 = 3.889

Look up PVIFA of 3.889 for six years in Table 4 and the result is an interest rate of 14 percent.

Problem 14 (Use the Equation: PV of a perpetuity = A ÷ i)

a) PV of a perpetuity = ₱500 ÷ 0.05 = ₱10,000

b) PV of a perpetuity = ₱500 ÷ 0.10 = ₱ 5,000

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 Financial Management 1
Problem 15 (Use Table 1)

The ending amount of ₱2,839 is divided by the beginning amount of ₱1,000 to produce a FVIF for ten years.

FVIFi,n = FVn ÷ PV

FVIFi,10 = ₱2,839 ÷ ₱1,000 = 2.839

Look up the value of i for an FVIF of 2.839 in Table 1 for ten years and the result is an annual compound growth rate
of 11 percent.

III. Multiple Choice Questions

1. C 6. B 11. A
2. C 7. C 12. D
3. C 8. A 13. B
4. C 9. B 14. A
5. D 10. D 15. A

CHAPTER 11

UNDERSTANDING FINANCIAL STATEMENTS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The four financial statements contained in most annual reports are the balance sheet statement, statement of
comprehensive income, statement of stockholders’ equity, and statement of cash flows.

2. Bankers and investors use financial statements to make intelligent decisions about what firms to extend credit or
in which to invest, managers need financial statements to operate their businesses efficiently, and taxing
authorities need them to assess taxes in a reasonable way.

3. No, because the ₱20 million of retained earnings would probably not be held as cash. The retained earnings
figure represents the reinvestment of earnings by the firm over its life. Consequently, the ₱20 million would be
an investment in all of the firm’s assets.

4. The balance sheet shows the firm’s financial position on a specific date, for example, December 31, 2011. It
shows each account balance at that particular point in time. For example, the cash account shown on the balance
sheet would represent the cash the firm has on hand and in the bank on December 31, 2011. The income
statement, on the other hand, reports on the firm’s operations over a period of time, for example, over the last 12
months. It reports revenues and expenses that the firm has incurred over that particular time period. For example,
the sales figures reported on the income statement for the period ending December 31, 2011, would represent the
firm’s sales over the period from January 1, 2011, through December 31, 2011, not just sales for December 31,
2011.

5. Investors need to be cautious when they review financial statements. While companies are required to follow the
financial reporting standard, managers still have quite a lot of discretion in deciding how and when to report
certain transactions. Consequently, two firms in exactly the same operating situation may report financial
statements that convey different impressions about their financial strength. Some variations may stem from
legitimate differences of opinion about the correct way to record transactions. In other cases, managers may
choose to report numbers in a way that helps them present either higher earnings or more stable earnings over
time. As long as they follow the financial reporting standard, such actions are not illegal, but these differences
make it harder for investors to compare companies and gauge their true performances.

Unfortunately, there have also been cases where managers overstepped the bounds and reported fraudulent
statements. Indeed, a number of high-profile executives have faced criminal charges because of their misleading
accounting practices.

6. The earnings (less dividends) reported in the income statement is transferred to the ownership section of the
balance sheet as retained earnings. Thus, what we earn in the income statement becomes part of the ownership
interest in the balance sheet.

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 Financial Management 1

7. The balance sheet is based on historical costs. When prices are rising rapidly, historical cost data may lose much
of their meaning particularly for plant, equipment and inventory.

8. The income statement and balance sheet are based on the accrual method of accounting, which attempts to match
revenues and expenses in the period in which they occur. However, accrual accounting does not attempt to
properly assess the cash flow position of the firm. The statement of cash flows fulfills this need.

9. The three primary sections of the statement of cash flows are:

a) Cash flows from operating activities

b) Cash flows from investing activities

c) Cash flows from financing activities

The payment of cash dividends falls into the financing activities category.

10. Free cash flow is equal to cash flow from operating activities:

Minus: Capital expenditures required to maintain the productive capacity of the firm

Minus: Dividends (required to maintain the payout on common stock and to cover any preferred stock
obligation)

The analyst or banker normally looks at free cash flow to determine whether there are sufficient excess funds to
pay back the loan associated with the leveraged buy-out.

11. Interest expense is a tax deductible item to the corporation, while dividend payments are not. The net cost to the
corporation of interest expense is the amount paid multiplied by the difference of one minus the applicable tax
rate.

12. CURRENT (C) ; NONCURRENT – (NC)

Retained earnings NC Bonds payable NC

Accounts payable C Accrued wages payable C
Prepaid expenses C Accounts receivable C
Plant and equipment NC Capital in excess of par NC
Inventory C Preferred stock NC
Common stock NC Marketable securities C

13. Sales
Cost of Goods Sold
Gross profit
Selling and administrative expense
Depreciation expense
Operating profit
Interest expense
Earnings before taxes
Taxes
Earnings after taxes
Preferred stock dividends
Earnings Available to Common Stockholders
Shares Outstanding
Earnings per share

14.
Increase in accounts receivable Decreases cash flow (use)
Increase in notes payable Increases cash flow (source)
Depreciation expense Increases cash flow (source)
Increase in investments Decreases cash flow (use)
Decrease in accounts payable Decreases cash flow (use)
Decrease in prepaid expenses Increases cash flow (source)
Increase in inventory Decreases cash flow (use)

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 Financial Management 1
Dividend payment Decreases cash flow (use)
Increase in accrued expenses Increases cash flow (source)

15.
1. Balance Sheet (BS) 5. Current Liabilities (CL)
2. Income Statement (IS) 6. Long-term Liabilities (LL)
3. Current Assets (CA) 7. Stockholders’ Equity (SE)
4. Fixed Assets (FA)

Indicate whether If on Balance Item

Items is on Sheet,
Balance Sheet Designate
(BS) or Income which
Statement (IS) Category
BS SE Retained earnings
IS Income tax expense
BS CA Accounts receivable
BS SE Common stock
BS SE Capital in excess of par value
BS LL Bonds payable
BS CL Notes payable
IS Net income
IS Selling and administrative expenses
BS CA Inventories
BS CL Accrued expenses
BS CA Cash
BS FA Plant and equipment
IS Sales
IS Operating expenses
BS CA Marketable securities
BS CL Accounts payable
IS Interest expense
BS CL Income tax payable
II. Problems

Problem 1 (Balance Sheet)

From the data given in the problem, we know the following:

Current assets ₱ 500,000 Accounts payable and

accruals
₱ 100,000
Net plant and Notes payable 150,000
equipment
2,000,000 Current liabilities ₱ 250,000
Long-term debt 750,000
Total common equity 1,500,000
Total liabilities and
equity
Total assets ₱2,500,000 ₱2,500,000

a. We are given that the firm’s total assets equal ₱2,500,000. Since both sides of the balance sheet must equal,
total liabilities and equity must equal total assets = ₱2,500,000.

b. Total assets = Current assets + Net plant and equipment

₱2,500,000 = Current assets + ₱2,000,000 Current assets = ₱2,500,000 –
₱2,000,000
Current assets = ₱500,000

c. Total liabilities and equity = Current liabilities + Long-term debt + Total common equity
₱2,500,000 = Current liabilities + ₱750,000 + ₱1,500,000
₱2,500,000 = Current liabilities + ₱2,250,000

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 Financial Management 1
Current liabilities = ₱2,500,000 – ₱2,250,000
Current liabilities = ₱250,000

d. Current liabilities = Accounts payable and accruals + Notes payable

₱250,000 = Accounts payable and accruals + ₱150,000
Accounts payable and accruals = ₱250,000 – ₱150,000
Accounts payable and accruals = ₱100,000

e. Net working capital = Current assets – Current liabilities

Net working capital = ₱500,000 – ₱250,000
Net working capital = ₱250,000

f. Net operating working capital = Current assets – (Current liabilities – Notes payable)
Net operating working capital = ₱500,000 – (250,000 – ₱150,000)
Net operating working capital = ₱400,000

Problem 2 (Statement of Stockholders’ Equity)

NI = ₱50,000,000; R/EY/E = ₱810,000,000; R/EB/Y = ₱780,000,000; Dividends = ?

R/EB/Y + NI – Div = R/EY/E

₱780,000,000 + ₱50,000,000 – Div = ₱810,000,000
₱830,000,000 – Div = ₱810,000,000
₱20,000,000 = Div.

Problem 3 (Book Value and P/E ratio)

Jennifer’s Apparel

a. Total assets ₱800,000

Current liabilities 150,000
Long-term liabilities 120,000
Stockholders’ equity ₱530,000
Preferred stock 65,000
Net worth assigned to common ₱465,000

Common shares outstanding 30,000

Book value (net worth) per share ₱15.50

b. Earnings available to common ₱48,000

Shares outstanding 30,000
Earnings per share ₱1.60

P/E ratio x Earnings per share = Price

15 x ₱1.60 = ₱2400

c. Market value per share (price) to Book value per share

₱24.00 ÷ ₱15.50 = 1.55

d. 2 x Book value per share = Price

2 x ₱15.50 = ₱31.00

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 Financial Management 1
Price
= P/E
Earnings per share

₱31.00
= 19.375 P/E ratio round to 19
₱1.60

Problem 4 (Determination of Profitability)

Red Book Inc.

Statement of Comprehensive Income

Sales (1,300 books at ₱650 each) ₱845,000

Cost of goods sold (1,300 books at ₱450 each) 585,000
Gross Profit 260,000
Selling expense 20,000
Depreciation expense 60,000
Operating profit 180,000
Interest expense 35,000
Earnings before taxes 145,000
Taxes @ 20% 29,000
Earnings after taxes ₱116,000

Problem 5 (Determination of Profitability)

Toyota Auto Shop

Statement of Comprehensive Income

a. Sales ₱700,000
Cost of goods sold (70% of sales) 490,000
Gross profit 210,000
Selling and administrative expense
(12% of sales) 84,000
Depreciation 10,000
Operating profit 116,000
Interest expense 8,000
Earnings before taxes 108,000
Taxes @ 30% 32,400
Earnings after taxes ₱ 75,600
b. Sales ₱750,000
Cost of goods sold (66% of sales) 495,000
Gross profit 255,000
Selling and administrative expense
(14% of sales) 105,000
Depreciation 10,000
Operating profit 140,000
Interest expense 15,000
Earnings before taxes 125,000
Taxes @ 30% 37,500
Earnings after taxes ₱87,500

Analysis: Ms. Lim’s idea will increase profitability.

Problem 6 (Determination of Earnings and Earnings per Share)

Angelique Corporation

a. Retained earnings, Dec. 31, 2012 ₱450,000

Less: Retained earnings, Dec. 31, 2011 400,000
Change in retained earnings 50,000
Add: Common stock dividends 25,000
Earnings available to common stockholders ₱ 75,000

₱75,000
b. Earnings per share = = ₱3.75 per share
20,000 shares

Problem 7 (Construction of Income Statement and Balance Sheet)

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 Financial Management 1
Shadow Corporation
2012 Income Statement

a. Sales ₱220,000
Cost of goods sold (60%) 132,000
Gross profit 88,000
Selling and administrative expense 22,000
Depreciation expense (8%) 20,0001
Operating profit (EBIT) 46,000
Interest expense 8,0002
Earnings before taxes 38,000
Taxes (20%) 7,600
1 8% x ₱250,000 = ₱20,000 Earnings after taxes (EAT) 30,400
Preferred
2 (10% x ₱20,000) + (12% stock
x ₱50,000) dividends
= ₱8,000 2,000
Earnings available to common stockholder ₱24,800

Shares outstanding 10,000

Earnings per share ₱2.84

Shadow Corporation
2012 Statement of Retained Earnings

b. Retained earnings balance, Jan. 1, 2011 ₱ 80,000

Add: Earnings available to common
stockholders, 2011 28,400
Deduct: Cash dividend declared in 2011 8,400
Retained earnings balance, Dec. 31, 2012 ₱100,000

Shadow Corporation
2012 Balance Sheet

c. Assets
Current assets
Cash ₱10,000
Accounts receivable 16,500
Inventory 27,500
Prepaid expenses 12,000
Total current assets ₱66,000
Fixed assets
Gross plant 285,000
Accumulated depreciation (70,000)3
Net plant 215,000
Total assets ₱281,000

Liabilities and Owners’ equity

Liabilities:
Accounts payable ₱15,000
Notes payable 26,000
Bonds payable 40,000
Total liabilities ₱81,000
Owners’ equity:
Common stock
3 ₱50,000 + ₱20,000 = ₱70,000 ₱ 75,000
Paid in capital in excess of par 25,000
Retained earnings 100,000
Total equity ₱200,000
Total liabilities and equity ₱281,000

Problem 8 (Statement of Cash Flows)

Maris Corporation
Statement of Cash Flows
For the Year Ended December 31, 2012

Cash flows from operating activities:

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 Financial Management 1
Net income (earnings after taxes) ₱250,000
Adjustments to determine cash flow
from operating activities:
Add back depreciation 230,000
Increase in accounts receivable (10,000)
Increase in inventory (30,000)
Decrease in prepaid expenses 30,000
Increase in accounts payable 250,000
Decrease in accrued expenses (20,000)
Total adjustments 450,000
Net cash flows from operating activities ₱700,000

Cash flows from investing activities:

Decrease in investments 10,000
Increase in plant and equipment (600,000)
Net cash flows from investing activities (590,000)

Cash flows from financing activities:

Increase in bonds payable 60,000
Preferred stock dividends paid (10,000)
Common stock dividends paid (140,000)
Net cash flows from financing activities (90,000)

Net increase (decrease) in cash flows ₱20,000

Analysis: It should be observe that the increase in cash flows of ₱20,000 equals the ₱20,000 change in the cash
account on the balance sheet. This indicates the statement is correct.

a. Cash flows from operating activities far exceeds net income. This occurs primarily because we add
back depreciation of ₱230,000 and accounts payable increase by ₱250,000. Thus, the reader of the cash
flow statement gets important insights as to how much cash flow was developed from daily operations.

b. The buildup in plant and equipment of ₱600,000 (gross) and ₱370,000 (net) has been financed, in part,
by the large increase in accounts payable (₱250,000). This is not a very satisfactory situation. Short-
term sources of funds can always dry up while fixed asset needs are permanent in nature. The firm may
wish to consider more long-term financing such as a mortgage, to go along with profits, the increase in
bonds payable and the add back of depreciation.

c. The book value per common share for both 2011 and 2012 are:

Book value Stockholders’ equity − Preferred stock

=
per share Common shares outstanding

Book value per (₱1,390,000 − ₱90,000)

=
share (2011) 150,000

₱1,300,000
=
150,000

(2011) = ₱8.67

Book value per (₱1,490,000 − ₱90,000)

=
share (2012) 150,000

₱1,400,000
=
150,000

(2012) = ₱9.33

d. The firm’s P/E ratio for 2012 is:

Market value = 2.8 x ₱9.33 = ₱26.12

P/E ratio = ₱26.12 ÷ ₱1.60 = 16.325 round to 16

Problem 9 (Preparing a Balance Sheet)

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 Financial Management 1

SM Farms
Balance Sheet
September 30, 2012

a. Assets
Cash ₱16,710
Accounts receivable 22,365
Land 550,000
Barns and sheds 78,300
Citrus trees 76,650
Livestock 120,780
Irrigation system 20,125
Farm machinery 42,970
Fences and gates 33,570
Total assets ₱961,470

Liabilities and Owners’ equity

Liabilities:
Notes payable ₱530,000
Accounts payable 77,095
Property taxes payable 9,135
Wages payable 1,820
Total liabilities ₱618,050
Owners’ equity:
Share capital ₱250,000
Retained earnings* 93,420
Total liabilities and equity ₱961,470

b. The loss of an asset, barns and Sheds, from a typhoon would

cause a decrease in total assets. When total assets are decreased,
the balance sheet total of liabilities and equity must also
decrease. Since there is no change in liabilities as a result of the
* Total assets, ₱961,470, minus total liabilities,
destruction of an ₱618,050,
asset, theless share capital,
decrease on the₱250,000.
right
hand side of the balance sheet must be in the retained
earnings account. The amount of the decrease in Barns and Sheds, in the equity, and in both balance sheet
totals is ₱23,800.

Problem 10 (Preparing a Balance Sheet and Cash Flow Statement; Effects of Business Transactions)

The Tasty Bakery

Balance Sheet
August 1, 2012

a. Assets Liabilities and Owners’ equity

Cash ₱6,940 Liabilities:
Accounts Notes payable ₱ 74,900
receivable 11,260 Accounts
Supplies 7,000 payable 16,200
Land 67,000 Salaries payable 8,900
Building 84,000 Total liabilities 100,000
Equipment Equity:
and fixtures 44,500 Share capital 80,000
Retained earnings 40,700
Total liabilities
Total assets ₱220,700 and owners’ equity ₱220,700

The Tasty Bakery

Balance Sheet
August 3, 2012

b. Assets Liabilities and Owners’ equity

Cash ₱14,490 Liabilities:
Accounts Notes payable ₱ 74,900
receivable 11,260 Accounts
Supplies 8,250 payable 7,200
Land 67,000 Salaries payable 8,900

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 Financial Management 1
Building 84,000 Total liabilities 91,000
Equipment Equity:
and fixtures 51,700 Share capital 105,000
Retained earnings 40,700
Total liabilities
Total assets ₱236,700 and owners’ equity ₱236,700
The Tasty Bakery
Statement of Cash Flows
For the Period August 1 – 3, 2012

Cash flows from operating activities:

Cash payment of accounts payable ₱(16,200)
Cash purchase of supplies (1,250)
Cash used in operating activities ₱(17,450)

Cash flows from investing activities:

None

Cash flows from financing activities:

Sale of share capital 25,000

Increase in cash 7,550

Cash balance, August 1, 2012 6,940
Cash balance, August 3, 2012 ₱ 14,490

c. The Tasty Bakery is in a stronger financial position on August 3 than it was on August 1.

On August 1, the highly liquid assets (cash and accounts receivable) total only ₱18,200 but the company has
₱25,100 in debts due in the near future (accounts payable plus salaries payable).

On August 3, after additional infusion of cash from the sale of stock, the liquid assets total ₱25,750, and debts
due in the near future amount to ₱16,100.

Note to Instructor: The analysis of financial position strength in requirement (c) is based solely upon the
balance sheets at August 1 and August 3. Hopefully, students will raise many legitimate issues regarding
necessity of information about operations, rate at which cash flows into the business, etc. In this problem, the
improvement in financial position results solely from the sale of share capital.

Problem 11 (Preparing Financial Statements; Effects of Business Transactions)

The First Malt Shop

Balance Sheet
September 30, 2012

a. Assets Liabilities and Owners’ equity

Cash ₱ 7,400 Liabilities:
Accounts Notes payable* ₱ 70,000
receivable 1,250 Accounts
Supplies 3,440 payable 8,500
Land 55,000 Total liabilities 78,500
Building 45,500 Equity:
Furniture Share capital 50,000
and fixtures 20,000 Retained earnings 4,090
Total liabilities
Total assets ₱132,590 and owners’ equity ₱132,590

*Total assets, ₱132,590, less equity, ₱54,090, less accounts payable, ₱8,500, equals notes payable.

The First Malt Shop

Balance Sheet
October 6, 2012

b. Assets Liabilities and Owners’ equity

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 Financial Management 1
Cash ₱ 29,400 Liabilities:
Accounts Notes payable ₱ 70,000
receivable 1,250 Accounts
Supplies 4,440 payable 18,000
Land 55,000 Total liabilities 88,000
Building 45,500 Equity:
Furniture Share capital 80,000
and fixtures 38,000 Retained earnings 5,590
Total liabilities
Total assets ₱173,590 and owners’ equity ₱173,590

The First Malt Shop

Income Statement
For the Period October 1 – 6, 2012

Revenues ₱ 5,500
Expenses (4,000)
Net income ₱ 1,500

The First Malt Shop

Statement of Cash Flows
For the Period October 1 – 6, 2012

Cash flows from operating activities:

Cash received from revenues ₱5,500
Cash paid for expenses (4,000)
Cash paid for accounts payable (8,500)
Cash for paid supplies (1,000)
Cash used in operating activities ₱(8,000)

Cash flows from investing activities:

None

Cash flows from financing activities:

Cash received from sale of share capital ₱30,000

Increase in cash ₱22,000

Cash balance, October 1, 2012 7,400
Cash balance, October 6, 2012 ₱29,400

c. The First Malt Shop is in a stronger financial position on October 6 than on September 30. On September 30,
the company had highly liquid assets (cash and accounts receivable) of ₱8,650, which barely exceeded the
₱8,500 in liabilities (accounts payable) due in the near future. On October 6, after the additional investment of
cash by shareholders, the company’s cash alone exceeded its short-term obligations.

CHAPTER 12

ANALYSIS OF FINANCIAL STATEMENTS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The emphasis of the various types of analysts is by no means uniform nor should it be. Management is interested
in all types of ratios for two reasons. First, the ratios point out weaknesses that should be strengthened; second,
management recognizes that the other parties are interested in all the ratios and that financial appearances must be
kept up if the firm is to be regarded highly by creditors and equity investors. Equity investors (stockholders) are
interested primarily in profitability, but they examine the other ratios to get information on the riskiness of equity
commitments. Credit analysts are more interested in the debt, TIE, and EBITDA coverage ratios, as well as the
profitability ratios. Short-term creditors emphasize liquidity and look most carefully at the current ratio.

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 Financial Management 1
2. The inventory turnover ratio is important to a grocery store because of the much larger inventory required and
because some of that inventory is perishable. An insurance company would have no inventory to speak of since
its line of business is selling insurance policies or other similar financial products—contracts written on paper and
entered into between the company and the insured. This question demonstrates that the student should not take a
routine approach to financial analysis but rather should examine the business that he or she is analyzing.

3. Differences in the amounts of assets necessary to generate a dollar of sales cause asset turnover ratios to vary
among industries. For example, a steel company needs a greater number of dollars in assets to produce a dollar in
sales than does a grocery store chain. Also, profit margins and turnover ratios may vary due to differences in the
amount of expenses incurred to produce sales. For example, one would expect a grocery store chain to spend
more per dollar of sales than does a steel company. Often, a large turnover will be associated with a low profit
margin, and vice versa.

4. ROE is calculated as the return on assets multiplied by the equity multiplier. The equity multiplier, defined as
total assets divided by common equity, is a measure of debt utilization; the more debt a firm uses, the lower its
equity, and the higher the equity multiplier. Thus, using more debt will increase the equity multiplier, resulting in
a higher ROE.

5. Return on investment relates to income earned on the capital invested in the business firm. Unsatisfactory ROI
could possibly lead to withdrawal of capital provided by investors which could result to the demise of the
business.

6. Refer to pages 247, 248 and 252.

7. Example: If a company defers or postpones a regular maintenance and repair activity with a view of reducing
current year’s expenses. Such act may in the long-run bring about unfavorable outcomes such as delays in
production, poor product quality, etc.

8. Liquidity is the firm’s ability to meet cash needs as they arise such as payment of accounts payable, bank loans
and operating expenses. Liquidity is crucial to the firm’s survival because if the company is unable to fulfill its
obligations, operations could be disrupted that could result to its closure.

9. Short-term lenders – liquidity because their concern is with the firm’s ability to pay short-term obligations as they
come due.

Long-term lenders – leverage because they are concerned with the relationship of debt to total assets. They also
will examine profitability to insure that interest payments can be made.

Stockholders – profitability because they are concerned with the secondary consideration given to debt utilization,
liquidity and other ratios. Since stockholders are the ultimate owners of the firm, they are primarily concerned
with profits or the return on their investment.

10. If the accounts receivable turnover ratio is decreasing, accounts receivable will be on the books for a longer
period of time. This means the average collection period will be increasing.

11. The fixed charge coverage ratio measures the firm’s ability to meet all fixed obligations rather that interest
payments alone, on the assumption that failure to meet any financial obligation will endanger the position of the
firm.

12. No rule-of-thumb ratio is valid for all corporations. There is simply too much difference between industries or
time periods in which ratios are computed. Nevertheless, rules-of-thumb ratios do offer some initial insight into
the operations of the firm, and when used with caution by the analyst can provide information.

13. a. Return on investment = Net income/Total assets

Inflation may cause net income to be overstated and total assets to be understated. Too high a ratio could
be reported.

b. Inventory turnover = Sales/Inventory

Inflation may cause sales to be overstated. If the firm uses FIFO accounting, inventory will also reflect
“inflation-influenced” pesos and the net effect will be nil. If the firm uses LIFO accounting, inventory
will be stated in old pesos and too high a ratio could be reported.

c. Fixed asset turnover = Sales/Fixed assets

Fixed assets will be understated relative to sales and too high a ratio could be reported.

d. Debt to total assets = Total debt/Total assets

Since both are based on historical costs, no major inflationary impact will take place in the ratio.

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 Financial Management 1

14. Disinflation tends to lower reported earnings as inflation-induced income is squeezed out of the firm’s income
statement. This is particularly true for firms in highly cyclical industries where prices tend to rise and fall quickly.

15. Because it is possible that prior inflationary pressures will no longer seriously impair the purchasing power of the
peso. Lessening inflation also means that the required return that investors demand on financial assets will be
going down, and with this lower demanded return, future earnings or interest should receive a higher current
evaluation.

II. Problems

Problem 1 (Day Sales Outstanding)

DSO = 40 days; S = ₱7,300,000; AR = ?

AR AR
DSO = S 40 = ₱7,300,000
365 365

40 = AR/₱20,000 AR = (₱20,000) (40) = ₱800,000

Problem 2 (Debt Ratio)

A/E = 2.4; D/A = ?

D  1 
= 1  
A  A/E 
D  1 
= 1  
A  2.4 
D
= 0.5833 = 58.33%.
A

Problem 3 (Market/Book Ratio)

TA = ₱10,000,000,000; LT debt = ₱3,000,000,000

CL = ₱1,000,000,000; CE = ₱6,000,000,000
Share outstanding = 800,000,000; Stock price = ₱32; M/B = ?

₱6,000,000,000
Book Value = 800,000,000 = ₱7.50

₱32.00
MB = ₱7.50 = 4.2667

Problem 4 (Price/Earnings Ratio)

EPS = ₱2.00; BVPS = ₱20; M/B = 1.2; P/E = ?

M/B = 1.2×
P/₱20 = 1.2×
P = (₱20) ( 1.2×)
P = ₱24.00

P/E = ₱24.00/₱2.00 = 12.0

Problem 5 (DuPont and ROE)

AR
PM = 2%; EM = 2.0; Sales = ₱100,000,000; Assets = ₱50,000,000;
S
ROE = ?
365
ROE = PM x TATO x EM

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 Financial Management 1
= NI/S x S/TA x A/E
= 2% x ₱100,000,000/₱50,000,000 x 2
ROE = 8%

Problem 6 (DuPont and Net Income)

Step 1: Calculate total assets from information given.

Sales = ₱6,000,000
3.2 × = Sales/TA
3.2 × = ₱6,000,000/Assets
Assets = ₱6,000,000/3.2 ×
Assets = ₱1,875,000

Step 2: Calculate net income. There is 50% debt and 50% equity, so, Equity = ₱1,875,000 x 0.5 = ₱937,500.

ROE = NI/S x S/TA x TA/E

0.12 = NI/₱6,000,000 x 3.2 x ₱1,875,000/₱937,500
0.12 = 6.4NI/₱6,000,000
6.4NI = (₱60,000) (0.12)
NI = ₱720,000/6.4
NI = ₱112,500

Problem 7 (Basic Earning Power)

ROA = 8%; NI = ₱600,000; TA = ?

ROA = NI/TA
8% = ₱600,000/TA
TA = ₱600,000/8%
TA = ₱7,500,000

To calculate BEP, we still need EBIT. To calculate EBIT, construct a partial income statement.

EBIT ₱1,148,077 (₱225,000 + ₱923,077)

Interest 225,000 Given
EBT 923,077 (₱600,000/0.65)
Taxes (35%) 323,077
NI ₱ 600,000

BEP = EBIT/TA
= ₱1,148,077/₱7,500,000
= (0.1531)
BEP = 15.31%

Problem 8 (Ratio Calculations)

We are given ROA = 3% and Sales/Total assets = 1.5

From the DuPont equation:

ROA = Profit margin x Total assets turnover

3% = Profit margin (1.5)
Profit margin = 3%/1.5
Profit margin = 2%

We can also calculate the company’s debt-to-assets ratio in a similar manner, given the facts of the problem. We
are given ROA (NI/A) and ROE (NI/E); if we use the reciprocal of ROE we have the following equation:

E NI E D E
=  and = 1  , so
A A NI A A
E 1
= 3% 
A 0.05
E
= 60% .
A
D
= 1  0.60 = 0.40 = 40%.
A

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 Financial Management 1

Alternatively, using the DuPont equation:

ROE = ROA x EM
5% = 3% x EM
EM = 5%/3% = 5/3 = TA/E

Take reciprocal: E/TA = 3/5 = 60%, therefore, D/A = 1 – 0.60 = 0.40 or 40%. Thus, the firm’s profit margin =
2% and its debt-to-assets ratio = 40%.

Problem 9 (Ratio Calculations)

TA = ₱12,000,000,000; T = 40%; EBIT/TA = 15%; ROA = 5%; TIE = ?

EBIT
₱12,000,000,000 = 0.15 EBIT = ₱1,800,000,000

NI
₱12,000,000,000 = 0.05 NI = ₱600,000,000

Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio.

INT = EBIT – EBT

EBIT ₱1,800,000,000 See above.
= ₱1,800,000,000 – ₱1,000,000,000
INT 800,000,000
EBT ₱1,000,000,000 EBT = ₱600,000,000/0.6
Taxes (40%) 400,000,000
NI ₱ 600,000,000 See above.

TIE = EBIT/INT
= ₱1,800,000,000/₱800,000,000
TIE = 2.25×
Problem 10 (Return on Equity)

ROE = Profit margin x TA turnover x Equity multiplier

= NI/Sales x Sales/TA x TA/Equity

Now we need to determine the inputs for the DuPont equation from the data that were given. On the left we set up an
income statement, and we put numbers in it on the right:

Sales (given) ₱10,000,000

– Cost N/A
EBIT (given) ₱ 1,000,000
– INT (given) 300,000
EBT ₱ 700,000
– Taxes (34%) 238,000
NI ₱ 462,000

Now we can use some ratios to get some more data:

Total assets turnover = 2 = S/TA; TA = S/2 = ₱10,000,000/2
Total asset turnover = ₱5,000,000

D/A = 60%; so E/A = 40%; and, therefore,

Equity multiplier = TA/E = 1/ (E/A) = 1/0.4 = 2.5

Now we can complete the DuPont equation to determine ROE:

ROE = ₱462,000/₱10,000,000 x ₱10,000,000/₱5,000,000 x 2.5
ROE = 0.231 = 23.1%

Problem 11 (Current Ratio)

₱1,312,500
Present current ratio = ₱525,000 = 2.5

₱1,312,500 + NP
₱525,000 + NP
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 Financial Management 1
Minimum current ratio = = 2.0

₱1,312,500 + NP = ₱1,050,000 + 2NP

NP = ₱262,500

Short-term debt can increase by a maximum of ₱262,500 without violating a 2 to 1 current ratio, assuming that the
entire increase in notes payable is used to increase current assets. Since we assumed that the additional funds would
be used to increase inventory, the inventory account will increase to ₱637,500 and current assets will total
₱1,575,000, and current liabilities will total ₱787,500.

Problem 12 (DSO and Accounts Receivable)

Step 1: Solve for current annual sales using the DSO equation:
55 = ₱750,000/ (Sales/365)
55Sales = ₱273,750,000
Sales = ₱273,750,000/55
Sales = ₱4,977,272.73

Step 2: If sales fall by 15%, the new sales level will be ₱4,977,272.73 (0.85) = ₱4,230,681.82. Again, using the
DSO equation, solve for the new accounts receivable figure as follows:

35 = AR/ (₱4,230,681.82/365)
35 = AR/₱11,590.91
AR= (₱11,590.91) (35)
AR= ₱405,681.82  ₱405,682

Problem 13 (Balance Sheet Analysis)

1. Total debt = (0.50) (Total assets) = (0.50) (₱300,000) = ₱150,000

2. Accounts payable = Total debt – Long-term debt

= ₱150,000 – ₱60,000
Accounts payable = ₱90,000

3. Common stock = Total liabilities and equity – Debt – Retained earnings

Common stock = ₱300,000 – ₱150,000 – ₱97,500 = ₱52,500

4. Sales = (1.5) (Total assets) = (1.5) (₱300,000) = ₱450,000

5. Inventories = Sales/5 = ₱450,000/5 = ₱90,000

6. Accounts receivable = (Sales/365) (DSO)

= (₱450,000/365) (36.5)
Accounts receivable = ₱45,000
7. Cash + Accounts receivable + Inventories = (1.8) (Accounts payable)
Cash + ₱45,000 + ₱90,000 = (1.8) (₱90,000)
Cash + ₱135,000 = ₱162,000
Cash = ₱27,000

8. Fixed assets = Total assets – (Cash + Accounts receivable + Inventories)

Fixed assets = ₱300,000 – (₱27,000 + ₱45,000 + ₱90,000) = ₱138,000

9. Cost of goods sold = (Sales) (1 – 0.25) = (₱450,000) (0.75) = ₱337,500

Problem 14 (Ratio Analysis)

a. Amounts in thousands
Firm Industry
average
Current = Current assets = ₱655,000 = 1.98 2.0

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 Financial Management 1
ratio Current liabilities ₱330,000

Current assets − ₱655,000 −

Quick ratio = Inventories = ₱241,500 = 1.25 1.3
Current liabilities ₱330,000

Accounts receivable ₱336,000 76.3

DSO = = = 35 days
Sales/365 ₱4,404.11 days

Inventory Sales ₱1,607,500

turnover
=
Inventories
=
₱241,500
= 6.66 6.7

T.A. Sales ₱1,607,500

turnover
=
Total assets
=
₱947,500
= 1.70 3.0

Profit Net income ₱27,300

= = = 1.7% 1.2%
margin Sales ₱1,607,500

Net income ₱27,300

ROA = = = 2.9% 3.6%
Total assets ₱947,500

Net income ₱27,300

ROE = = = 7.6% 9.0%
Common equity ₱361,000

Total debt ₱586,500

Debt ratio = = = 61.9% 60.0%
Total assets ₱947,500

b. For the firm;

₱947,500
ROE = PM x TA turnover x EM = 1.7% x 1.7 x ₱361,000 = 7.6%

For the industry, ROE = 1.2% x 3 x 2.5 = 9%

Note: To find the industry ratio of assets to common equity, recognize that 1 – (Total debt/Total assets) =
Common equity/Total assets. So, Common equity/Total assets = 40%, and 1/0.40 = 2.5 = Total assets/Common
equity.

c. The firm’s days sales outstanding ratio is more than twice as long as the industry average, indicating that the firm
should tighten credit or enforce a more stringent collection policy. The total assets turnover ratio is well below the
industry average so sales should be increased, assets decreased or both. While the company’s profit margin is
higher than the industry average, its other profitability ratios are low compared to the industry – net income
should be higher given the amount of equity and assets. However, the company seems to be in average liquidity
position and financial leverage is similar to others in the industry.

d. If 2011 represents a period of supernormal growth for the firm, ratios based on this year will be distorted and a
comparison between them and industry averages will have little meaning. Potential investors who look only at
2011 ratios will be misled, and a return to normal conditions in 2012 could hurt the firm’s stock price.

Problem 15 (Ratio Analysis)

Ratio Analysis 2011 2010 Industry Average

Liquidity
Current ratio 2.33 2.11 2.7
Asset Management
Inventory turnover 4.74 4.47 7.0
Days sales outstanding 37.79 32.94 32
Fixed assets turnover 9.84 7.89 13.0
Total assets turnover 2.31 2.18 2.6
Profitability
Return on assets 1.00% 5.76% 9.1%
Return on equity 2.22% 11.47% 18.2%
Profit margin 0.43% 2.64% 3.5%
Debt Management
Debt-to-assets ratio 54.81% 49.81% 50.0%
Market Value
P/E ratio 15.43 5.65 6.0
Price/cash flow ratio 1.60 2.16 3.5

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 Financial Management 1
a. Mango’s liquidity position has improved from 2010 to 2011; however, its current ratio is still below the industry
average of 2.7.

b. Mango’s inventory turnover, fixed assets turnover, and total assets turnover have improved from 2010 to 2011;
however, they are still below industry averages. The firm's days sales outstanding ratio has increased from 2010
to 2011—which is bad. In 2010, its DSO was close to the industry average. In 2011, its DSO is somewhat
higher. If the firm's credit policy has not changed, it needs to look at its receivables and determine whether it has
any uncollectibles. If it does have uncollectible receivables, this will make its current ratio look worse than what
was calculated above.

c. Mango’s debt ratio has increased from 2010 to 2011, which is bad. In 2010, its debt ratio was right at the industry
average, but in 2011 it is higher than the industry average. Given its weak current and asset management ratios,
the firm should strengthen its balance sheet by paying down liabilities.

d. Mango’s profitability ratios have declined substantially from 2010 to 2011, and they are substantially below the
industry averages. Mango needs to reduce its costs, increase sales, or both.

e. Mango’s P/E ratio has increased from 2010 to 2011, but only because its net income has declined significantly
from the prior year. Its P/CF ratio has declined from the prior year and is well below the industry average. These
ratios reflect the same information as Corrigan's profitability ratios. Corrigan needs to reduce costs to increase
profit, lower its debt ratio, increase sales, and improve its asset management.

f. ROE = PM × TA Turnover × Equity Multiplier

2011 2.22% 0.43% 2.31 2.21
2010 11.47% 2.64% 2.18 1.99
Industry Avg. 18.20% 3.50% 2.60 2.00

Looking at the DuPont equation, Mango's profit margin is significantly lower than the industry average and it has
declined substantially from 2010 to 2011. The firm's total assets turnover has improved slightly from 2010 to
2011, but it's still below the industry average. The firm's equity multiplier has increased from 2010 to 2011 and is
higher than the industry average. This indicates that the firm's debt ratio is increasing and it is higher than the
industry average.

Mango should increase its net income by reducing costs, lower its debt ratio, and improve its asset management
by either using less assets for the same amount of sales or increase sales.

g. If Mango initiated cost-cutting measures, this would increase its net income. This would improve its profitability
ratios and market value ratios. If Mango also reduced its levels of inventory, this would improve its current
ratio—as this would reduce liabilities as well. This would also improve its inventory turnover and total assets
turnover ratio. Reducing costs and lowering inventory would also improve its debt ratio.

Problem 16 (Profitability Ratios)

Esther Company

Sales ₱960,000
Assets = = = ₱400,000
Total asset turnover 2.4

Sales ₱960,000
Net income = = = ₱67,200
Profit margin 0.07

ROA(invest- Net income ₱ 67,200

= = = 16.80%
ment) Total assets ₱400,000

Problem 17 (Overall Ratio Analysis)

Bryan Corporation

a. Current Current assets ₱570,000

= = = 1.90
ratio Current liabilities ₱300,000

(Current assets −
b. Quick ratio = Inventory) = ₱330,000 = 1.10
Profit margin ₱300,000

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 Financial Management 1
c. Debt to total Total debt ₱ 418,000
= = = 44%
assets Total assets ₱950,000

d. Asset Sales ₱ 3,040,000

= = = 3.20
turnover Total assets ₱ 950,000

Accounts ₱ 280,000
e. Average
receivable (₱3,040,000 x 0.75)
collection = =
Average daily 360 days
period
credit sales

₱ 280,000
= = 44.21 days
₱6,333 per day

Problem 18 (Profitability Ratios)

Alpha Industries

a. Total asset turnover x Profit margin = Return on total assets

1.4 x ? = 8.4%
Profit margin = 8.4%/1.4 = 6.0%

b. 12 x 7% = 8.4%

It did not change at all because the increase in profit margin made up for the decrease in the asset turnover.

Problem 19 (DuPont System of Analysis)

King Company

Return on assets
a. Return on (investment) 12%
= =
equity (1 – Debt /Assets) (1 – 0.40)

12%
= = 20%
0.60
b. The same as return on assets (12%).

Problem 20 (Average Collection Period)

Accounts ₱ 180,000
Average
receivable (₱1,200,000 x 0.90)
collection = =
Average daily 360 days
period
credit sales

₱ 180,000
= = 60 days
₱3,000 per day

Problem 21 (Average Daily Sales)

Charlie Corporation

Average daily Credit sales

=
credit sales 360

To determine credit sales, multiply accounts receivable by accounts

receivable turnover.

₱90,000 x 12 = ₱1,080,000

Average daily ₱1,080,000

= = ₱3,000
credit sales 360

Problem 22 (DuPont System of Analysis)

Jerry Company

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 Financial Management 1
a. Net income = Sales x Profit margin
= ₱4,000,000 x 3.5%
= ₱140,000

Stockholders’ equity = Total assets − Total liabilities

Total assets = Sales /Total asset turnover

= ₱4,000,000/2.5
Total assets = ₱1,600,000

Total liabilities = Current liabilities + Long-term liabilities

= ₱100,000 + ₱300,000
Total liabilities = ₱400,000

Stockholders’ equity = ₱1,600,000 − ₱400,000

= ₱1,200,000

Return on Net income ₱ 140,000

stockholders’ = Stockholders’ = ₱1,200,000 = 11.67%
equity equity

b. The value for sales will be:

Sales = Total assets x Total asset turnover

= ₱1,600,000 x 3
Sales = ₱4,800,000

Net income = Sales x Profit margin

= ₱4,800,000 x 3.5%
Net income = ₱168,000

Return on Net income ₱ 168,000

stockholders’ = Stockholders’ = ₱1,200,000 = 14%
equity equity

Problem 23 (Analysis by Divisions)

Global Corporation

a. Medical supplies Heavy machinery Electronics

Net income/
Sales 6.0% 3.8% 8.0%

The heavy machinery division has the lowest return on sales.

b. Medical supplies Heavy machinery Electronics

Net income/
Total assets 15.0% 2.375% 10.67%

The medical supplies division has the highest return on assets.

c. Corporate net income ₱1,200,000 + ₱190,000 + ₱320,000

=
Corporate total assets ₱8,000,000 + ₱8,000,000 + ₱3,000,000

₱ 1,710,000
=
₱19,000,000

Return on assets = 9.0%

d. Return on redeployed assets in heavy machinery.

15% x ₱8,000,000 = ₱1,200,000

Corporate net income ₱1,200,000 + ₱1,200,000 + ₱320,000

=
Corporate total assets ₱19,000,000

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 Financial Management 1
₱ 2,720,000
=
₱19,000,000

Return on assets = 14.32%

Problem 24 (Using Ratios to Construct Financial Statements)

Inventory = ₱420,000/7
= ₱60,000

Current assets = ₱2 x ₱80,000

= ₱160,000

Accounts receivable = (₱420,000/360) x 36

= ₱42,000

Cash = ₱160,000 − ₱60,000 − ₱42,000

= ₱58,000

Current assets
Cash ₱ 58,000
Accounts receivable ₱ 42,000
Inventory ₱ 60,000
Total current assets ₱160,000

Problem 25 (Using Ratios to Construct Financial Statements)

Shannon Corporation

Sales/Total assets = 2.5 times

Total assets = ₱750,000/2.5 = ₱300,000

Cash = 2% of total assets

Cash = 2% x ₱300,000 = ₱6,000

Sales/Accounts receivable = 10 times

Accounts receivable = ₱750,000/10 = ₱75,000

Sales/Inventory = 15 times
Inventory = ₱750,000/15 = ₱50,000

Fixed assets = Total assets − Current assets

Total current asset = ₱6,000 + ₱75,000 + ₱50,000 = ₱131,000
Fixed assets = ₱300,000 − ₱131,000 = ₱169,000

Current assets/current debt = 2

Current debt = Current assets/2 = ₱131,000/2 = ₱65,500

Total debt/total assets = 45%

Total debt = .45 x ₱300,000 = ₱135,000

Long-term debt = Total debt − Current debt

Long-term debt = ₱135,000 − ₱65,500 = ₱69,500

Net worth = Total assets − Total debt

Net worth = ₱300,000 − ₱135,000 = ₱165,000

Shannon Corporation
Balance Sheet as of December 31, 2011

Cash ₱ 6,000 Current debt ₱65,500

Accounts receivable 75,000 Long-term debt 69,500
Inventory 50,000 Total debt 135,000
Total current assets 131,000 Net worth 165,000
Fixed assets 169,000 Total debt and
Total assets ₱300,000 Stockholders’ equity ₱300,000
Problem 26 (Using Ratios to Determine Account Balances)

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 Financial Management 1

Cathy Corporation

a. Accounts receivable = Sales/Receivables turnover

= ₱3,000,000/6x = ₱500,000

b. Marketable securities = Current assets − (Cash + Accounts

receivable + Inventory)

Current assets = Current ratio x Current liabilities

= 2.5 x ₱700,000 = ₱1,750,000

Marketable securities = ₱1,750,000 − (₱150,000 + ₱500,000 +

₱850,000)
Marketable securities = ₱1,750,000 − ₱1,500,000 = ₱250,000

c. Fixed assets = Total assets − Current assets

Total assets = Sales/Asset turnover

= ₱3,000,000/1.2x = ₱2,500,000

Fixed assets = ₱2,500,000 − ₱1,750,000 = ₱750,000

d. Long-term debt = Total debt − Current liabilities

Total debt = Debt to assets x Total assets

= 40% x ₱2,500,000 = ₱1,000,00

Long-term debt = ₱1,000,000 − ₱700,000 = ₱300,000

Problem 27 (Using Ratios to Construct Financial Statements)

Ruby Inc.

Sales/Total assets = 2
Total assets = ₱20,000,000/2 = ₱10,000,000

Total debt/Total assets = 30%

Total debt = ₱10,000,000 x .3 = ₱3,000,000

Sales/Inventory = 5.0x
Inventory = ₱20,000,000/5x = ₱4,000,000

Average daily sales = ₱20,000,000/360 days

= ₱55,556 per day

Accounts receivable = 18 days x ₱55,556 = ₱1,000,000 (or)

= (₱20,000,000)/(360/18) = ₱1,000,000

Fixed assets = ₱20,000,000/5x = ₱4,000,000

Current assets = Total assets − Fixed assets

= ₱10,000,000 − ₱4,000,000 = ₱6,000,000

Cash = Current assets − Accounts receivable −

Inventory
= ₱6,000,000 − ₱1,000,000 − ₱4,000,000
Cash = ₱1,000,000

Current liabilities = Current assets/3x

Current liabilities = ₱6,000,000/3 = ₱2,000,000

Long-term debt = Total debt − Current debt

Long-term debt = ₱3,000,000 − ₱2,000,000 = ₱1,000,000

Equity = Total assets − Total debt

Equity = ₱10,000,000 − ₱3,000,000 = ₱7,000,000

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 Financial Management 1

Ruby Inc.

Cash ₱ 1,000,000 Current debt ₱ 2,000,000

Accounts receivable 1,000,000 Long-term debt 1,000,000
Inventory 4,000,000 Total debt 3,000,000
Total current assets 6,000,000
Fixed assets 4,000,000 Equity 7,000,000
Total assets ₱10,000,000 Total debt and equity ₱10,000,000

Problem 28 (Ratio Computation and Analysis)

One way of analyzing the situation for each company is to compare the respective ratios for each one, examining
those ratios which would be most important to a supplier or short-term lender and a stockholder.

Black Corporation White Corporation

Profit margin 7.4% 5.25%
Return on assets 18.5% 12.00%
Return on equity 28.9% 34.4%
Receivable turnover 15.63x 14.29x
Average collection period 23.04 days 25.2 days
Inventory turnover 25x 13.3x
Fixed asset turnover 3.57x 4x
Total asset turnover 2.5x 2.29x
Current ratio 1.5x 2.5x
Quick ratio 1.0x 1.5x
Debt to total assets 36% 65.1%
Times interest earned 24.13x 6x
Fixed charge coverage 13.33x 4.75x
Fixed charge coverage
calculation (200/15) (133/28)

a. Since suppliers and short-term lenders are more concerned with liquidity ratios, White Corporation would get the
nod as having the best ratios in this category. One could argue, however, that White had benefited from having its
debt primarily long term rather than short term. Nevertheless, it appears to have better liquidity ratios.

b. Stockholders are most concerned with profitability. In this category, Black Corporation has much better ratios
than White Corporation. White does have a higher return on equity than Black, but this is due to its much larger
use of debt. Its return on equity is higher than Blacks’ because it has taken more financial risk. In terms of other
ratios, Black has its interest and fixed charges well covered and in general its long-term ratios and outlook are
better than White. Black has asset utilization ratios equal to or better than White and its lower liquidity ratios
could reflect better short-term asset management, and that point was covered in part (a).
Note: Remember that to make actual financial decisions, more than one year’s comparative data is usually
required. Industry comparisons should also be made.

CHAPTER 13

CASH FLOW ANALYSIS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The only way depreciation generates cash flows for the company is by serving as a tax shield against reported
income. This non-cash deduction may provide cash flow equal to the tax rate times the depreciation charged. This
much in taxes will be saved, while no cash payments occur.

2. Refer to pages 278 through 280.

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 Financial Management 1
3. Refer to pages 277 and 278.

II. Multiple Choice Questions

1. D 5. A 9. C 13. A
2. C 6. B 10. A 14. B
3. D 7. A 11. B 15. A
4. D 8. D 12. D 16. D

III. Problems

Problem 1 (Statement of Cash Flows)

Cash flow from

Operating activities ₱(817,000) Outflow
Investing activities (2,567,000) Outflow
Financing activities 3,459,000 Inflow
Increase in Cash ₱ 75,000

Cash balance, beginning ₱ 950,000

Cash balance, end 1,025,000
Increase in Cash ₱ 75,000

Note: The problem did not indicate whether the cash flows from investing and financing activities represented net
inflow or outflow. It is assumed that following normal course of operations, investments will represent usage or
outflow of cash and financing will represent sourcing or inflow of cash. Hence since the cash account posted a net
increase of ₱75,000, operating activities must have used up a net cash flow of ₱817,000.

Problem 2 (Free Cash Flow)

EBIT ₱62,000,000
Less: Taxes 17,000,000
EAT ₱45,000,000
Add: Depreciation 5,000,000
Operating Cash Flow ₱50,000,000

Free Cash Flow = Operating cash flow – Investment in operating capital

= ₱50,000,000 – [₱32,000,000 + (₱20,000,000 −₱12,000,000)]
Free Cash Flow = ₱50,000,000 − ₱40,000,000 = ₱10,000,000

Problem 3 (Free Cash Flow)

Free Cash Flow = Operating cash flow – Investment in operating capital
₱23,000,000 = OCF − ₱13,000,000
OCF = ₱36,000,000

EBIT ₱45,000,000
Less: Taxes 17,000,000
EAT ₱28,000,000
Add: Depreciation 8,000,000
Operating Cash Flow ₱36,000,000

Problem 4 (Statement of Cash Flows)

Notes payable, beginning ₱208,000,000
Payment 23,000,000
Notes payable, end ₱185,000,000

Problem 5 (Free Cash Flow)

Problem 6 (Free Cash Flow)

Problem 7 (Working with Financial Statements)

CHAPTER 14

OPERATING AND FINANCIAL LEVERAGE

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 Financial Management 1

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The contribution margin (CM) ratio is the ratio of the total contribution margin to total sales revenue. It can be
used in a variety of ways. For example, the change in total contribution margin from a given change in total sales
revenue can be estimated by multiplying the change in total sales revenue by the CM ratio. If fixed costs do not
change, then a dollar increase in contribution margin results in a dollar increase in net operating income. The CM
ratio can also be used in target profit and break-even analysis.

2. Incremental analysis focuses on the changes in revenues and costs that will result from a particular action.

3. Operating leverage measures the impact on net operating income of a given percentage change in sales. The
degree of operating leverage at a given level of sales is computed by dividing the contribution margin at that level
of sales by the net operating income at that level of sales.

4. The break-even point is the level of sales at which profits are zero.

5. (a) If the selling price decreased, then the total revenue line would rise less steeply, and the break-even point
would occur at a higher unit volume. (b) If the fixed cost increased, then both the fixed cost line and the total cost
line would shift upward and the break-even point would occur at a higher unit volume. (c) If the variable cost
increased, then the total cost line would rise more steeply and the break-even point would occur at a higher unit
volume.

6. The margin of safety is the excess of budgeted (or actual) sales over the break-even volume of sales. It states the
amount by which sales can drop before losses begin to be incurred.

7. The sales mix is the relative proportions in which a company’s products are sold. The usual assumption in cost-
volume-profit analysis is that the sales mix will not change.
8. A higher break-even point and a lower net operating income could result if the sales mix shifted from high
contribution margin products to low contribution margin products. Such a shift would cause the average
contribution margin ratio in the company to decline, resulting in less total contribution margin for a given amount
of sales. Thus, net operating income would decline. With a lower contribution margin ratio, the break-even point
would be higher because more sales would be required to cover the same amount of fixed costs.

9. A utility is in a stable, predictable industry and therefore can afford to use more financial leverage than an
automobile company, which is generally subject to the influences of the business cycle. An automobile
manufacturer may not be able to service a large amount of debt when there is a downturn in the economy.

10. A labor-intensive company will have low-fixed costs and a correspondingly low break-even point. However, the
impact of operating leverage on the firm is small and there will be little magnification of profits as volume
increases. A capital-intensive firm, on the other hand, will have a higher break-even point and enjoy the positive
influences of operating leverage as volume increases.

11. For break-even analysis based on accounting flows, depreciation is considered part of fixed costs. For cash flow
purposes, it is eliminated from fixed costs. The accounting flows perspective is longer-term in nature because we
must consider the problems of equipment replacement.

12. Both operating and financial leverage imply that the firm will employ a heavy component of fixed cost resources.
This is inherently risky because the obligation to make payments remains regardless of the condition of the
company or the economy.

13. Debt can only be used up to a point. Beyond that, financial leverage tends to increase the overall costs of
financing to the firm as well as encourage creditors to place restrictions on the firm. The limitations of using
financial leverage tend to be the greatest in industries that are highly cyclical in nature.

14. The higher the interest rate on new debt, the less attractive financial leverage is to the firm.

15. Operating leverage primarily affects thee operating income of the firm. At this point, financial leverage takes over
and determines the overall impact on earnings per share.

16. At progressively higher levels of operation than the break-even point, the percentage change in operating income
as a result of a percentage change in unit volume diminishes. The reason is primarily mathematical - as we move
to increasingly higher levels of operating income, the percentage change from the higher base is likely to be less.

17. The point of equality only measures indifference based on earnings per share. Since, our ultimate goal is market
value maximization; we must also be concerned with how these earnings are valued. Two plans that have the

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 Financial Management 1
same earnings per share may call for different price-earnings ratios, particularly when there is a differential risk
component involved because of debt.

II. Multiple Choice Questions

1. A 11. C 21. B 31. A

2. A 12. B 22. D 32. B
3. B 13. B 23. B 33. A
4. D 14. D 24. B 34. D
5. B 15. A 25. B 35. B
6. C 16. B 26. D 36. B
7. D 17. D 27. A 37. A
8. C 18. B 28. A 38. D
9. D 19. A 29. A 39. D
10. B 20. C 30. D

III. Problems

Problem 1 (Computing and Using the CM Ratio)

1. The company’s contribution margin (CM) ratio is:

2. The change in Total sales.................................................. ₱200,000 net operating income

from an Total variable expenses ............................. 120,000 increase in total sales of
₱1,000 can be = Total contribution margin ...................... 80,000 estimated by using the
CM ratio as ÷ Total sales .............................................. ₱200,000 follows:
= CM ratio ................................................. 40%
₱1,000
Change in total sales .........................................................................
× CM ratio.........................................................................................
40 %
= Estimated change in net operating income .................................... ₱ 400

This computation can be verified as follows:

Total sales ........................................ ₱200,000

÷ Total units sold ............................. 50,000 units
= Selling price per unit..................... ₱4.00 per unit

Increase in total sales ....................... ₱1,000

÷ Selling price per unit..................... ₱4.00 per unit
= Increase in unit sales ..................... 250 units
Original total unit sales .................... 50,000 units
New total unit sales .......................... 50,250 units

Original New
Total unit sales ................................. 50,000 50,250
Sales ................................................. ₱200,000 ₱201,000
Variable expenses ............................. 120,000 120,600
Contribution margin ......................... 80,000 80,400
Fixed expenses ................................. 65,000 65,000
Net operating income ....................... ₱ 15,000 ₱ 15,400

Problem 2 (Compute the Break-even Point)

1. The equation method yields the break-even point in unit sales, Q, as follows:

Profit = Unit CM × Q − Fixed expenses

₱0 = (₱15 − ₱12) × Q − ₱4,200
₱0 = (₱3) × Q − ₱4,200
₱3Q = ₱4,200
Q = ₱4,200 ÷ ₱3
Q = 1,400 baskets

2. The equation method can be used to compute the break-even point in sales pesos as follows:

Unit contribution margin

CM =
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 Financial Management 1
Unit selling price

CM = ₱3/₱15 = 0.20

Profit = CM ratio × Sales − Fixed expenses

₱0 = 0.20 × Sales − ₱4,200
0.20 × Sales = ₱4,200
Sales = ₱4,200 ÷ 0.20
Sales = ₱21,000

3. The formula method gives an answer that is identical to the equation method for the break-even point in unit sales:

Fixed expenses
Unit sales to break even =
Unit CM

Unit sales to break even = ₱4,200/₱3 = 1,400 baskets

4. The formula method also gives an answer that is identical to the equation method for the break-even point in peso
sales:

Fixed expenses
Peso sales to break even =
CM ratio

Peso sales to break even = ₱4,200/0.20 = ₱21,000

Problem 3 (Compute the Margin of Safety)

1. To compute the margin of safety, we must first compute the break-even unit sales.

Profit = Unit CM × Q − Fixed expenses

₱0 = (₱30 − ₱20) × Q − ₱7,500
₱0 = (₱10) × Q − ₱7,500
₱10Q = ₱7,500
Q = ₱7,500 ÷ ₱10
Q = 750 units

Sales (at the budgeted volume of 1,000 units) ........... ₱30,000

Less break-even sales (at 750 units) .......................... 22,500
Margin of safety (in pesos) ........................................ ₱ 7,500

2. The margin of safety as a percentage of sales is as follows:

Margin of safety (in pesos) ........................................ ₱ 7,500

÷ Sales ........................................................................ ₱30,000
Margin of safety percentage ...................................... 25%

Problem 4 (Compute and Use the Degree of Operating Leverage)

1. The company’s degree of operating leverage would be computed as follows:

Contribution margin ................................................... ₱48,000

÷ Net operating income .............................................. ₱10,000
Degree of operating leverage ..................................... 4.8

2. A 5% increase in sales should result in a 24% increase in net operating income, computed as follows:

Degree of operating leverage ..................................... 4.8

× Percent increase in sales ......................................... 5%
Estimated percent increase in net operating income .. 24%

3. The new income statement reflecting the change in sales is:

Amount Percent of Sales

Sales .............................................. ₱84,000 100%

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 Financial Management 1
Variable expenses ......................... 33,600 40%
Contribution margin ...................... 50,400 60%
Fixed expenses .............................. 38,000
Net operating income .................... ₱12,400

Net operating income reflecting change in sales ....... ₱12,400

Original net operating income ................................... ₱10,000
Percent change in net operating income .................... 24%

Problem 5 (Target Profit and Break-Even Analysis; Margin of Safety; CM Ratio)

1. Profit = Unit CM × Q − Fixed expenses

₱0 = (₱30 − ₱12) × Q − $216,000
₱0 = (₱18) × Q − ₱216,000
₱18Q = ₱216,000
Q = ₱216,000 ÷ ₱18
Q = 12,000 units, or at ₱30 per unit, ₱360,000

Alternative solution:

Fixed expenses
Unit sales to break even =
Unit CM

Unit sales to break even = ₱216,000/₱18 = 12,000 units

or at ₱30 per unit, ₱360,000

2. The contribution margin is ₱216,000 because the contribution margin is equal to the fixed expenses at the break-
even point.

Target profit + Fixed expenses

Unit sold to attain target profit =
Unit CM

₱90,000 + ₱216,000
Unit sold to attain target profit =
₱18

Unit sold to attain target profit = 17,000 units

3. Total Unit
Sales (17,000 units × ₱30 per unit) ............ ₱510,000 ₱30
Variable expenses
(17,000 units × ₱12 per unit) ................. 204,000 12
Contribution margin ................................... 306,000 ₱18
Fixed expenses ........................................... 216,000
Net operating income ................................. ₱ 90,000

4. Margin of safety in peso terms:

Margin of safety in pesos = Total sales − Break even sales

Margin of safety in pesos = ₱450,000 − ₱360,000 = ₱90,000

Margin of safety in percentage terms:

Margin of safety in pesos

Margin of safety percentage =
Total sales

Margin of safety percentage = ₱90,000/₱450,000 = 20%

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 Financial Management 1

5. The CM ratio is 60%.

Expected total contribution margin: (₱500,000 × 60%) ... ₱300,000

Present total contribution margin: (₱450,000 × 60%) ...... 270,000
Increased contribution margin .......................................... ₱ 30,000

Alternative solution:

₱50,000 incremental sales × 60% CM ratio = ₱30,000

Given that the company’s fixed expenses will not change, monthly net operating income will also increase by
₱30,000.

Problem 6 (Operating Leverage)

1. Total Per Unit

Sales (15,000 games) ................. ₱3,000,000 ₱200
Variable expenses ...................... 900,000 60
Contribution margin .............................. 2,100,000 ₱140
Fixed expenses ...................................... 1,820,000
Net operating income ............................ ₱ 280,000

The degree of operating leverage is:

Contribution margin
Degree of operating leverage =
Net operating income

Degree of operating leverage = ₱2,100,000/₱280,000 = 7.5

2. a. Sales of 18,000 games represent a 20% increase over last year’s sales. Because the degree of operating
leverage is 7.5, net operating income should increase by 7.5 times as much, or by 150% (7.5 × 20%).

b. The expected total amount of net operating income for next year would be:

Last year’s net operating income ............................ ₱280,000

Expected increase in net operating income
next year (150% × ₱280,000) .............................. 420,000
Total expected net operating income....................... ₱700,000

Problem 7 (Multiproduct Break-even Analysis)

1.
Super Fast Dynamic Shot Total Company
Amount % Amount % Amount %
Sales ............................. ₱150,000 100 ₱250,000 100 ₱400,000 100.0
Variable expenses ........ 30,000 20 160,000 64 190,000 47.5
Contribution margin ..... ₱120,000 80 ₱ 90,000 36 210,000 52.5*
Fixed expenses ............. 183,750
Net operating income ... ₱ 26,250
2. The break-even point for the company as a whole is:
*₱210,000 ÷ ₱400,000 = 52.5%
Fixed expenses
Peso sales to break even =
Overall CM ratio

₱183,750
Peso sales to break even = = ₱350,000
0.525

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 Financial Management 1
3. The additional contribution margin from the additional sales is computed as follows:

₱100,000 × 52.5% CM ratio = ₱52,500

Assuming no change in fixed expenses, all of this additional contribution margin of ₱52,500 should drop to the
bottom line as increased net operating income.

This answer assumes no change in selling prices, variable costs per unit, fixed expense, or sales mix.

Problem 8 (Break-even Analysis)

₱2,000,000
a. BE = = 4,000 units
₱1,200 − ₱700

Profit + FC ₱1,500,000 + ₱2,000,000

b. Q = =
(P − VC) ₱1,200 − ₱700

₱3,500,000
Q= = 7,000 units
₱500

Problem 9 (Break-even Analysis)

₱70,000 ₱70,000
BE (before) = = = 50,000 units
₱4.00 − ₱2.60 ₱1.40

₱105,000 ₱105,000
BE (after) = = = 60,000 units
₱4.00 − ₱2.25 ₱1.75

The break-even point will go up.

Problem 10 (Degree of Leverage)

Q = 20,000, P = ₱60, VC = ₱30, FC = ₱400,000, I = ₱50,000

Q (P − VC) 20,000 (₱60 − ₱30)

a. DOL = =
Q (P − VC) − FC 20,000 (₱60 − ₱30) − ₱400,000

20,000 (₱30) ₱600,000

= =
20,000 (₱30) − ₱400,000 ₱600,000 − ₱400,000

₱600,000
DOL = = 3x
₱200,000

EBIT ₱200,000
b. DFL = =
EBIT − I ₱200,000 − ₱50,000

₱200,000
DFL = = 1.33x
₱150,000

Q (P − VC)
c. DCL =
Q (P − VC) − FC − I

20,000 (₱60 − ₱30)

=
20,000 (₱60 − ₱30) − ₱400,000 − ₱50,000

₱600,000
=
₱600,000 − ₱400,000 − ₱50,000

₱600,000
DCL = = 4x
₱150,000

₱400,000 ₱400,000
d. BE = = = 13,333 units
₱60 − ₱30 ₱30

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Problem 11 (Break-even Point and Degree of Leverage)

₱80,000 ₱80,000
a. BE = = = 16,000 pieces
₱15 − ₱10 ₱5

b. 15,000 pieces 30,000 pieces

Sales @ ₱15 per piece ₱225,000 ₱450,000
Less: Variable costs (₱10) (150,000) (300,000)
Fixed costs (80,000) (80,000)
Profit or Loss (₱5,000) (₱70,000)

Q (P − VC)
c. DOL =
Q (P − VC) − FC

20,000 (₱15 – ₱10)

DOL at 20,000 =
20,000 (₱15 − ₱10) − ₱80,000

₱100,000
DOL at 20,000 = = 5x
₱20,000

30,000 (₱15 – ₱10)

DOL at 30,000 =
30,000 (₱15 − ₱10) − ₱80,000

₱150,000
DOL at 30,000 = = 2.14x
₱70,000

Leverage goes down because we are further away from the break-even point, thus the firm is operating on a
larger profit base and leverage is reduced.
EBIT
d. DFL =
EBIT − I

First, determine the profit or loss (EBIT) at 20,000 pieces. As indicated in part (b), the profit (EBIT) at 30,000
pieces is ₱70,000.

20,000 pieces
Sales @ ₱15 per piece ₱300,000
Less: Variable costs (₱10) (200,000)
Fixed costs (80,000)
Profit or Loss (₱20,000)

₱20,000
DFL at 20,000 =
₱20,000 − ₱10,000

₱20,000
DFL at 20,000 = = 2x
₱10,000
₱70,000
DFL at 30,000 =
₱70,000 − ₱10,000

₱70,000
DFL at 30,000 = = 1.17x
₱60,000

Q (P − VC)
e. DCL =
Q (P − VC) − FC − I

20,000 (₱15 − ₱10)

DCL at 20,000 =
20,000 (₱15 − ₱10) − ₱80,000 − ₱10,000

₱100,000
DCL at 20,000 = = 10x
₱10,000

30,000 (₱15 − ₱10)

DCL at 30,000 =
30,000 (₱15 − ₱10) − ₱80,000 − ₱10,000

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₱150,000
DCL at 30,000 = = 2.50x
₱60,000

Problem 12 (Japanese Firm and Combined Leverage)

Q (P − VC)
DCL =
Q (P − VC) − FC − I

125,000 (₱25 − ₱5)

=
125,000 (₱25 − ₱5) − ₱1,800,000 − ₱400,000

125,000 (₱20)
=
125,000 (₱20) − ₱2,200,000

₱2,500,000
DCL = = 8.33x
₱2,500,000 − ₱2,200,000

Problem 13 (Leverage and Sensitivity Analysis)

Income Statements

a. Return on assets = 10% EBIT = ₱1,200,000

Current Plan D Plan E

EBIT ₱1,200,000 ₱1,200,000 ₱1,200,000
Less: Interest 600,0001 960,0002 300,0003
EBT 600,000 240,000 900,000
Less: Taxes (45%) 270,000 108,000 405,000
EAT 330,000 132,000 495,000
Common shares 750,0004 375,000 1,125,000
EPS ₱.44 ₱.35 ₱.44

(1) ₱6,000,000 debt @ 10%

(2) ₱600,000 interest + (₱3,000,000 debt @ 12%)
(3) (₱6,000,000 − ₱3,000,000 debt retired) x 10%
(4) (₱6,000,000 common equity) ÷ (₱8 par value) = 750,000 shares

Plan E and the original plan provide the same earnings per share because the cost of debt at 10 percent is equal to
the operating return on assets of 10 percent. With Plan D, the cost of increased debt rises to 12 percent, and the
firm incurs negative leverage reducing EPS and also increasing the financial risk to Dream Company.

b. Return on assets = 5% EBIT = ₱600,000

Current Plan D Plan E

EBIT ₱600,000 ₱600,000 ₱600,000
Less: Interest 600,000 960,000 300,000
EBT 0 (360,000) 300,000
Less: Taxes (45%) 0 (162,000) 135,000
EAT 0 (198,000) 165,000
Common shares 750,000 375,000 1,125,000
EPS 0 (₱.53) ₱.15

Return on assets = 15% EBIT = ₱1,800,000

Current Plan D Plan E

EBIT ₱1,800,000 ₱1,800,000 ₱1,800,000
Less: Interest 600,000 960,000 300,000
EBT 1,200,000 840,000 1,500,000
Less: Taxes (45%) 540,000 378,000 675,000
EAT 660,000 462,000 825,000
Common shares 750,000 375,000 1,125,000
EPS ₱.88 ₱1.23 ₱.73

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If the return on assets decreases to 5%, Plan E provides the best EPS, and at 15% return, Plan D provides the best
EPS. Plan D is still risky, having an interest coverage ratio of less than 2.0.

c. Return on assets = 10% EBIT = ₱1,200,000

Current Plan D Plan E

EBIT ₱1,200,000 ₱1,200,000 ₱1,200,000
EAT 330,000 132,000 495,000
Common shares 750,000 500,0001 1,000,0002
EPS ₱.44 ₱.26 ₱.50

(1) 750,000 – (₱3,000,000/₱12 per share)

= 750,000 – 250,000 = 500,000

(2) 750,000 + (₱3,000,000/₱12 per share)

= 750,000 + 250,000 = 1,000,000

As the price of the common stock increases, Plan E becomes more attractive because fewer shares can be retired
under Plan D and, by the same logic, fewer shares need to be sold under Plan E.

CHAPTER 15

FINANCIAL FORECASTING
FOR STRATEGIC GROWTH

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The reason is that, ultimately, sales are the driving force behind a business. A firm’s assets, employees, and, in
fact, just about every aspect of its operations and financing exist to directly or indirectly support sales. Put
differently, a firm’s future need for things like capital assets, employees, inventory, and financing are determined
by its future sales level.

2. Accounts payable, accrued wages and accrued taxes increase spontaneously and proportionately with sales.
Retained earnings increase, but not proportionately.

3. False. At low growth rates, internal financing will take care of the firm’s needs.

4. The internal growth rate is greater than 15%, because at a 15% growth rate the negative EFN indicates that there
is excess internal financing. If the internal growth rate is greater than 15%, then the sustainable growth rate is
certainly greater than 15%, because there is additional debt financing used in that case (assuming the firm is not
100% equity-financed). As the retention ratio is increased, the firm has more internal sources of funding, so the
EFN will decline. Conversely, as the retention ratio is decreased, the EFN will rise. If the firm pays out all its
earnings in the form of dividends, then the firm has no internal sources of funding (ignoring the effects of
accounts payable); the internal growth rate is zero in this case and the EFN will rise to the change in total assets.

II. Problems

Problem 1 (Pro Forma Statements)

It is important to remember that equity will not increase by the same percentage as the other assets. If every other item
on the income statement and balance sheet increases by 15 percent, the pro forma income statement and balance sheet
will look like this:

Pro forma Pro forma

Income Statement Balance Sheet

Sales ₱26,450 Assets ₱18,170 Debt ₱ 5,980

Costs 19,205 _______ Equity 12,190
Net income ₱ 7,245 Total ₱18,170 Total ₱18,170

In order for the balance sheet to balance, equity must be:

Equity = Total liabilities and equity – Debt

Equity = ₱18,170 – 5,980 = ₱12,190

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Equity increased by:

Equity increase = ₱12,190 – 10,600 = ₱1,590

Net income is ₱7,245 but equity only increased by ₱1,590; therefore, a dividend of ₱5,655 must have been paid.
Dividends paid is the additional financing needed.

Dividend = ₱7,245 – 1,590 = ₱5,655

Problem 2 (Calculating EFN)

An increase of sales to ₱7,424 is an increase of:

Sales increase = (₱7,424 – 6,300) / ₱6,300 = .18 or 18%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:

Pro forma Pro forma

Income Statement Balance Sheet

Sales ₱7,434 Assets ₱21,594 Debt ₱12,400

Costs 4,590 _______ Equity 8,744
Net income ₱2,844 Total ₱21,594 Total ₱21,144

If no dividends are paid, the equity account will increase by the net income, so:
Equity = ₱5,900 + 2,844 = ₱8,744

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = ₱21,594 – 21,144 = ₱450

Problem 3 (Calculating EFN)

An increase of sales to ₱21,840 is an increase of:

Sales increase = (₱21,840 – 19,500) / ₱19,500 = .12 or 12%

Assuming costs and assets increase proportionally, the pro forma financial statements will look like this:

Pro forma Pro forma

Income Statement Balance Sheet

Sales ₱21,840 Assets ₱109,760 Debt ₱52,500

Costs 16,800 ______ _ Equity 79,208
EBIT 5,040 Total ₱109,760 Total ₱99,456
Taxes (40%) 2,016
Net income ₱ 3,024

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or:

Dividends = (₱1,400 / ₱2,700) (₱3,024) = ₱1,568

The addition to retained earnings is:

Addition to retained earnings = ₱3,024 – 1,568 = ₱1,456

And the new equity balance is:

Equity = ₱45,500 + 1,456 = ₱46,956

So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = ₱109,760 – 99,456 = ₱10,304

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Problem 4 (Sales and Growth)

The maximum percentage sales increase is the sustainable growth rate. To calculate the sustainable growth rate, first
we need to calculate the ROE, which is:

ROE = NI / TE
ROE = ₱8,910 / ₱56,000 = .1591 or 15.91%

The plowback ratio, b, is one minus the payout ratio, so:

b = 1 – .30 = .70

Now we can use the sustainable growth rate equation to get:

Sustainable growth rate = (ROE × b) / [1 – (ROE × b)]

Sustainable growth rate = [.1591(.70)] / [1 – .1591(.70)] = .1253 or 12.53%

So, the maximum peso increase in sales is:

Maximum increase in sales = ₱42,000 (.1253) = ₱5,264.03

Problem 5 (Calculating Retained Earnings from Pro Forma Income)

Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income statement will look like this:

Jordan Corporation
Pro Forma Income Statement

Sales ₱45,600.00
Costs 22,080.00
Taxable income ₱23,520.00
Taxes (34%) 7,996.80
Net income ₱ 15,523.20

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year times net income, or:

Dividends = (₱5,200/₱12,936) (₱15,523.20) = ₱6,240.00

And the addition to retained earnings will be:

Addition to retained earnings = ₱15,523.20 – 6,240 = ₱9,283.20

Problem 6 (Applying Percentage of Sales)

Below is the balance sheet with the percentage of sales for each account on the balance sheet. Notes payable, total
current liabilities, long-term debt, and all equity accounts do not vary directly with sales.

Jordan Corporation
Balance Sheet

Assets (₱) (%)

Current assets
Cash ₱ 3,050 8.03
Accounts receivable 6,900 18.16
Inventory 7,600 20.00
Total ₱17,550 46.18
Fixed assets
Net plant and equipment ₱34,500 90.79
Total assets ₱52,050 136.97

Liabilities and Owners’ equity

Current liabilities
Accounts payable ₱ 1,300 3.42
Notes payable 6,800 n/a
Total ₱ 8,100 n/a
Long-term debt ₱25,000 n/a

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 Financial Management 1
Owners’ equity
Common stock and paid-in surplus ₱15,000 n/a
Retained earnings 3,950 n/a
Total ₱18,950 n/a
Total liabilities and Owners’ equity ₱52,050 n/a

Problem 7 (External Financing Requirements)

a., b., & c.
Lewis Company
Pro Forma Income Statement
December 31, 2012
(Millions of Pesos)

1st Pass AFN 2nd Pass

2011 (1 + g) 2012 Effects 2012
Sales ₱8,000 (1.2) ₱9,600 ₱9,600
Operating costs 7,450 (1.2) 8,940 8,940
EBIT ₱ 550 ₱ 660 ₱ 660
Interest 150 150 +30* 180
EBT ₱ 400 ₱ 510 ₱ 480
Taxes (40%) 160 204 192
Net income ₱ 240 ₱ 306 ₱ 288

Dividends: ₱1.04 x ₱1.10 x

150 = ₱ 156 150 ₱ 165 +24** ₱ 189
Addition to RE: ₱ 84 ₱ 141 ₱ 99

*∆ in interest expense = (₱51 + ₱248) x 0.10 = ₱30.

**∆ in 2012 Dividends = ₱368/₱16.96 x ₱1.10 = ₱24.
∆ in addition to retained earnings = ₱99 − ₱141 = −₱42.

Lewis Company
Pro Forma Balance Sheet
December 31, 2012
(Millions of Pesos)

1st 2nd
Pass AFN Pass
2011 (1 + g) Additions 2012 Effects 2012
Cash ₱ 80 (1.2) ₱ 96 ₱ 96
Accounts
receivable 240 (1.2) 288 288
Inventory 720 (1.2) 864 864
Total current
assets ₱1,040 ₱1,248 ₱1,248
Fixed assets 3,200 (1.2) 3,840 3,840
Total assets ₱4,240 ₱5,088 ₱5,088
Accounts
payable ₱ 160 (1.2) ₱ 192 ₱ 192
Accruals 40 (1.2) 48 48
Notes payable 252 252 +51** 303
Total current
liabilities ₱ 452 ₱ 492 ₱543
Long-term debt 1,244 1,244 +248** 1,492
Total debt ₱1,696 ₱1,736 ₱2,035
Common stock 1,605 1,605 +368** 1,973
Retained
earnings 939 141* 1,080 −42*** 1,038
Total liabilities
and equity ₱4,240 ₱4,421 ₱5,046

AFN = ₱ 667 ₱ 42

*See Income Statement, 1st pass.

** CA/CL = 2.3; D/A = 40%.
Maximum total debt = 0.4 x ₱5,088 = ₱2,035.

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 Financial Management 1
Maximum increase in debt = ₱2,035 − ₱1,736 = ₱299.
Maximum current liabilities = ₱1,248/2.3 = ₱543.
Increase in notes payable = ₱543 − ₱492 = ₱51.
Increase in long-term debt = ₱299 − ₱51 = ₱248.
Increase in common stock = ₱667 − ₱299 = ₱368.
***∆ in RE = ₱99 − ₱141 = −₱42.

Problem 8 (Long-term financing needed)

a. Total liabilities and equity = Accounts payable + Long-term debt +

Common stock + Retained earnings
₱1,200,000 = ₱375,000 + LTD + ₱425,000 + ₱295,000
Long-term debt (LTD) = ₱105,000

Total debt = Accounts payable + Long-term debt

Total debt = ₱375,000 + ₱105,000 = ₱480,000

Alternatively;

Total debt = Total liabilities and equity − Common stock − Retained earnings
Total debt = ₱1,200,000 − ₱425,000 − ₱295,000 = ₱480,000

b. Assets/Sales (A*/S) = ₱1,200,000/₱2,500,000 = 48%

Liabilities/Sales (L*/S) = ₱375,000/₱2,500,000 = 15%

2012 Sales = (1.25) (₱2,500,000) = ₱3,125,000

AFN = (A*/S) (∆S) − (L*/S) (∆S) − PS2 (1 − D)

= (0.48) (₱625,000) – (0.15) (₱625,000) – (0.06) (₱3,125,000) (0.6)

− ₱75,000

AFN = ₱300,000 − ₱93,750 − ₱112,500 − ₱75,000 = ₱18,750

Problem 9 (Additional Funds Needed)

Cash ₱ 100 x 2 = ₱ 200

Accounts receivable 200 x 2 = 400
Inventory 200 x 2 = 400
Net fixed assets 500 + 0.0 = 500
Total assets ₱1,000 ₱1,500

Accounts payable ₱ 50 x 2 = ₱ 100

Notes payable 150 150*
Accruals 50 x 2 = 100
Long-term debt 400 400
Common stock 100 100
Retained earnings 250 + 40 = 290
Total liabilities and equity ₱1,000 ₱1,140

AFN = ₱360

*₱150 + ₱360 = ₱510

Capacity sales = Current sales/0.5 = ₱1,000/0.5 = ₱2,000

Target FA/S ratio = ₱500/₱2,000 = 0.25

Target FA = 0.25 (₱2,000) = ₱500 = Required FA. Since the firm currently has ₱500 of FA, no new FA will be
required.

Addition to RE = P (S2) (1 – Payout ratio) = 0.05 (₱2,000) (0.4) =

Problem 10 (Additional Funds Needed)

Percent of Sales Table

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 Financial Management 1
Cash 5% Accounts payable 30.0%
Accounts receivable 30 Accrued expenses 2.5
Inventory 20
Current assets 55% Current liabilities 32.5%
(spontaneous) (spontaneous)

Sales = 20% (₱3,000,000) = ₱600,000

New Sales level = ₱3,000,000 + ₱600,000 = ₱3,600,000

New Funds Required (NFR) = A (∆S) – L (∆S) – PS2 (1 – D)

NFR = 55% (₱600,000) – 32.5% (₱600,000) – 8% (₱3,600,000) (1 – 7)

NFR = ₱330,000 – ₱195,000 – ₱86,400 = ₱48,600

Problem 11 (Percent-of-sales method)

Sales = (10%) (₱100,000,000) = ₱10,000,000

New Sales level = ₱100,000,000 + ₱10,000,000 = ₱110,000,000

New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS2 (1 – D)

= (₱85,000,000/100) (₱10,000,000) – (₱25,000,000/100) (₱10,000,000) − .07 (₱110,000,000) (.60)

NFR = ₱8,500,000 − ₱2,500,000 − ₱4,620,000 = ₱1,380,000

Problem 12 (Percent-of-sales method)

a. Sales = (15%) (₱300,000,000) = ₱45,000,000

New Sales level = ₱300,000,000 + ₱45,000,000 = ₱345,000,000

New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS2 (1 – D)

= (₱240,000,000/₱300,000,000) (₱45,000,000) – (₱120,000,000/₱300,000,000) (₱45,000,000) − .08

(₱345,000,000) (1 − .25)

NFR = ₱36,000,000 − ₱18,000,000 − ₱20,700,000 = (₱2,700,000)

A negative figure for new funds required indicated that an excess of funds (₱2,700,000) is available for new
investment. No external funds are needed.

b. New Funds Required (NFR) = (A/S) (∆S) – (L/S) (∆S) – PS2 (1 – D)

= ₱36,000,000 − ₱18,000,000 − .095 (₱345,000,000) (1 − .5)

= ₱36,000,000 − ₱18,000,000 − ₱16,387,500

NFR = ₱1,612,500 external funds required

The net profit margin increased slightly, from 8% to 9.5%, which decreases the need for external funding. The
dividend payout ratio increased tremendously, however, from 25% to 50%, necessitating more external financing.
The effect of the dividend policy change overpowered the effect of the net profit margin change.

Problem 13 (External Funds Requirement)

a. Sales = (15%) (₱100,000,000) = ₱15,000,000

Spontaneous Assets = 5% + 15% + 20% + 40% = 80%

Spontaneous Liabilities = 15% + 10% = 25%

New Sales level = ₱100,000,000 + ₱15,000,000 = ₱115,000,000

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New Funds Required (NFR) = A (∆S) – L (∆S) – PS2 (1 – D)

NFR = 80% (₱600,000) – 25% (₱600,000) – 10% (₱115,000,000) (1 – .5)

NFR = ₱12,000,000 – ₱3,750,000 – ₱5,750,000 = ₱2,500,000

b. If Mercury reduces the payout ratio, the company will retain more earnings and need less external funds. A slower
growth rate means that less assets will have to be financed and in this case, less external funds would be needed.
A declining profit margin will lower retained earnings and forced Mercury to seek more external funds.

Problem 14 (Leverage and Sensitivity Analysis)

a. Return on assets = 12%

Current Plan A Plan B

EBIT ₱1,500,000 ₱2,250,000 ₱2,250,000
Less: Interest 1,200,0001 1,920,0003 1,200,0005
EBT 300,000 330,000 1,050,000
Less: Taxes (40%) 120,000 132,000 420,000
EAT 180,000 198,000 630,000
Common shares 200,0002 300,0004 700,0006
EPS ₱.90 ₱.66 ₱.90

(1) (80% x ₱10,000,000) x 15% = ₱8,000,000 x 15% = ₱1,200,000

(2) (20% x ₱10,000,000)/ ₱10 = ₱2,000,000/₱10 = 200,000 shares

(3) ₱1,200,000 (current) + (80% x ₱5,000,000) x 18%

= ₱1,200,000 + ₱720,000 = ₱1,920,000

(4) 200,000 shares (current) + (20% x ₱5,000,000)/ ₱10

= 200,000 + 100,000 = 300,000 shares

(5) Unchanged

(6) 200,000 shares (current) + ₱5,000,000/₱10

= 200,000 + 500,000 = 700,000 shares

EBIT
b. DFL =
EBIT − I

₱1,500,000
DFL (Current) = = 5x
₱1,500,000 − ₱1,200,000

₱2,250,000
DFL (Plan A) = = 6.82x
₱2,250,000 − ₱1,920,000

₱2,250,000
DFL (Plan B) = = 2.14x
₱2,250,000 − ₱1,200,000

c.
Plan A Plan B
EAT ₱198,000 ₱630,000
Common shares 250,0001 450,0002
EPS ₱.79 ₱1.40

(1) 200,000 shares (current) + (20% x ₱5,000,000)/ ₱20

= 200,000 + 50,000 = 250,000 shares

(2) 2000,000 shares (current) + ₱5,000,000/₱20

= 200,000 + 250,000 = 450,000 shares

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Plan B would continue to provide the higher earnings per shares. The difference between Plans A and B is even
greater than that indicated in part (a).

d. Not only does the price of the common stock create wealth to the shareholder, which is the major objective of the
financial manager, but it greatly influences the ability to finance projects at a high or low cost of capital.

CHAPTER 16

FORECASTING SHORT-TERM
(OPERATING) FINANCIAL REQUIREMENTS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The pro forma financial statements and cash budget enable the firm to determine its future level of asset needs
and the associated financing that will be required. Furthermore, one can track actual events against the
projections. Bankers and other lenders also use these financial statements as a guide in credit decisions.

2. The collections and purchase schedules measure the speed at which receivables are collected and purchases are
paid. To the extent collections do not cover purchasing costs and other financial requirements, the firm must look
to borrowing to cover the deficit.

3. The more rapid the turnover inventory, the greater the need for purchase and replacement. Rapidly turning
inventory makes for somewhat greater ease in foreseeing future requirements and reduces the cost of carrying
inventory.

4. Rapid growth in sales and profits is often associated with rapid growth in asset commitment. A ₱100,000 increase
in sales may occasion a ₱50,000 increase in assets, with perhaps only ₱10,000 of the new financing coming from
profits. It is very seldom that incremental profits from sales expansion can meet new financing needs.

5. Level production in a cyclical industry has the advantage of allowing for the maintenance of a stable work force
and reducing inefficiencies caused by shutting down production during slow periods and accelerating work during
crash production periods. A major disadvantage is that a large stock of inventory may be accumulated during the
slow sales period. This inventory may be expensive to finance, with an associated danger of obsolescence.

6. The percent-of-sales forecast is only as good as the functional relationship of assets and liabilities to sales. To the
extent that past relationships accurately depict the future, the percent-of-sales method will give values that
reasonably represent the values derived through the pro forma statements and the cash budget.

7.
a. Sales forecast – a forecast of a firm’s unit and peso sales for some future period; generally based on recent
sales trends plus forecasts of the economic prospects for the nation, region, industry and so forth.
b. Projected financial statement method – a method of forecasting financial requirements based on forecasted
financial statements.
c. Spontaneously generated funds – funds that are obtained automatically from routine business transactions.
d. Dividend payout ratio – the percentage of earnings paid out in dividends.
e. Pro forma financial statement – same as letter (b)
f. Additional funds needed (AFN) – funds that a firm must raise externally through borrowing or by selling new
common or preferred stock.
AFN formula = Required increase in assets – Spontaneous increase in liabilities – Increase in retained
earnings
g. Capital intensity ratio – the amount of assets required per peso of sales (A/S).

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h. Lumpy assets – assets that cannot be acquired in small increments but must be obtained in large, discrete
units.
i. Financing feedback – the effects on the income statement and balance sheet of actions taken to finance
increases in assets.

8. A budget is a detailed quantitative plan for the acquisition and use of financial and other resources over a given
time period. Budgetary control involves using budgets to increase the likelihood that all parts of an organization
are working together to achieve the goals set down in the planning stage.

9. a. Budgets communicate management’s plans throughout the organization.

b. Budgets force managers to think about and plan for the future. In the absence of the necessity to prepare a
budget, many managers would spend all of their time dealing with day-to-day emergencies.

c. The budgeting process provides a means of allocating resources to those parts of the organization where they
can be used most effectively.

d. The budgeting process can uncover potential bottlenecks before they occur.

e. Budgets coordinate the activities of the entire organization by integrating the plans of its various parts.
Budgeting helps to ensure that everyone in the organization is pulling in the same direction.

f. Budgets define goals and objectives that can serve as benchmarks for evaluating subsequent performance.

10. A master budget represents a summary of all of management’s plans and goals for the future, and outlines the way
in which these plans are to be accomplished. The master budget is composed of a number of smaller, specific
budgets encompassing sales, production, raw materials, direct labor, manufacturing overhead, selling and
administrative expenses, and inventories. The master budget usually also contains a budgeted income statement,
budgeted balance sheet, and cash budget.

11. The level of sales impacts virtually every other aspect of the firm’s activities. It determines the production budget,
cash collections, cash disbursements, and selling and administrative budget that in turn determine the cash budget
and budgeted income statement and balance sheet.

12. No. Planning and control are different, although related concepts. Planning involves developing goals and
developing budgets to achieve those goals. Control, by contrast, involves the means by which management
attempts to ensure that the goals set down at the planning stage are attained.

13. The flow of budgeting information moves in two directions—upward and downward. The initial flow should be
from the bottom of the organization upward. Each person having responsibility over revenues or costs should
prepare the budget data against which his or her subsequent performance will be measured. As the budget data are
communicated upward, higher-level managers should review the budgets for consistency with the overall goals of
the organization and the plans of other units in the organization. Any issues should be resolved in discussions
between the individuals who prepared the budgets and their managers. All levels of an organization should
participate in the budgeting process—not just top management or the accounting department. Generally, the lower
levels will be more familiar with detailed, day-to-day operating data, and for this reason will have primary
responsibility for developing the specifics in the budget. Top levels of management should have a better
perspective concerning the company’s strategy.

14. The direct labor budget and other budgets can be used to forecast workforce staffing needs. Careful planning can
help a company avoid erratic hiring and laying off of employees.

15. The principal purpose of the cash budget is NOT to see how much cash the company will have in the bank at the
end of the year. Although this is one of the purposes of the cash budget, the principal purpose is to provide
information on probable cash needs during the budget period, so that bank loans and other sources of financing
can be anticipated and arranged well in advance.

II. Multiple Choice Questions

1. B 6. D 11. A 16. C 21. C

2. B 7. C 12. C 17. B 22. A
3. E 8. C 13. C 18. C 23. B
4. C 9. C 14. C 19. B 24. C
5. C 10. D 15. D 20. C 25. A

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III. Problems

Problem 1

a. February March April May June

Sales ₱60,000 ₱70,000 ₱75,000 ₱95,000 ₱110,000
Credit sales 54,000 63,000 67,500 85,500 99,000
Collections:
Cash
(10% of Sales) 6,000 7,000 7,500 9,500 11,000
60% first month
after sale 37,800 40,500 51,300
40% second
month after sale 21,600 25,200 27,000
Total Receipts ₱66,900 ₱75,200 ₱89,300

b. Receivables at End of June:

90% of June Sales ₱ 99,000
40% of May Credit Sales 34,200
₱133,200

Problem 2

January February March April May

Cash ₱4,200 ₱6,000 ₱7,800 ₱6,600 ₱5,400
Credit 9,800 11,400 18,200 15,400 12,600
Collections:
Cash 7,800 6,600 5,400
40% on the following month 5,600 7,280 6,160
60% on the second month 5,880 8,400 10,920
Total Collections ₱19,280 ₱22,280 ₱22,480

Cash Budget
Collections ₱19,280 ₱22,280 ₱22,480
− Payments 21,300 19,100 22,400
Cash Flow (2,020) 3,180 80
+ Beginning Cash Balance 2,000 2,000 2,000
Cumulative Cash Balance (20) 5,180 2,080
Loan (Repayment) 2,020 (3,180) (80)
Cumulative Loan Balance 4,020 840 760
Ending Cash Balance ₱2,000 ₱2,000 ₱2,000
Problem 3

a. February March April May June

Sales ₱60,000 ₱80,000 ₱100,000 ₱120,000 ₱110,000
Credit sales 54,000 72,000 90,000 108,000 99,000
Collections:
Cash
(10% of Sales) 10,000 12,000 11,000
70% 1 month
following sale 50,400 63,000 75,600
30% 2 months
following sale 16,200 21,600 27,000
Monthly Cash
Receipts ₱76,600 ₱96,600 ₱113,600

b. Accounts receivables at the End of June:

90% of June Credit Sales ₱ 99,000
30% of May Credit Sales 32,400
Total Receivables Balance ₱131,400

Problem 4

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a. April May June Total

February sales:
₱230,000 × 10% ₱ 23,000 ₱ 23,000
March sales:
₱260,000 × 70%, 10% 182,000 ₱ 26,000 208,000
April sales: ₱300,000 ×
20%, 70%, 10% 60,000 210,000 ₱ 30,000 300,000
May sales:
₱500,000 × 20%, 70% 100,000 350,000 450,000
June sales:
₱200,000 × 20% 40,000 40,000
Total cash collections ₱265,000 ₱336,000 ₱420,000 ₱1,021,000

Observe that even though sales peak in May, cash collections peak in June. This occurs because the bulk of the
company’s customers pay in the month following sale. The lag in collections that this creates is even more
pronounced in some companies. Indeed, it is not unusual for a company to have the least cash available in the months
when sales are greatest.

b. Accounts receivable at June 30:

From May sales: ₱500,000 × 10% ₱ 50,000

From June sales: ₱200,000 × (70% + 10%) 160,000
Total accounts receivable at June 30 ₱210,000

Problem 5

Unit volume (3,000 x 1.20) 3,600

Price (₱200 x 1.10) ₱ 220
Total sales ₱792,000
Returns (5%) 39,600
Net sales ₱752,400

Problem 6

Projected sales 40,000 units

Desired ending inventory 6,000 (15% x 40,000)
Beginning inventory 8,500
Units to be produced 37,500

Problem 7

Projected sales 12,000 units (8,000 x 1.50)

Desired ending inventory 600 (5% x 12,000)
Beginning inventory 400
Units to be produced 12,200

Problem 8

Projected sales 50,000 units

Desired ending inventory 5,600 (40% x 14,000)
Beginning inventory 14,000
Units to be produced 41,600

Problem 9

September October November December

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Credit sales ₱50,000 ₱40,000 ₱35,000 ₱60,000
20% Collected in
month of sales 8,000 7,000 12,000
70% Collected in
month after sales 35,000 28,000 24,500
Total cash receipts ₱43,000 ₱35,000 ₱36,500

Problem 10

April May June Quarter

Budgeted sales in units 50,000 75,000 90,000 215,000
Add: Desired ending inventory* 7,500 9,000 8,000 8,000
Total needs 57,500 84,000 98,000 223,000
Less: Beginning inventory 5,000 7,500 9,000 5,000
Required production 52,500 76,500 89,000 218,000

*10% of the following month’s sales in units.

CHAPTER 17

ADDRESSING WORKING CAPITAL

POLICIES AND MANAGEMENT OF
SHORT-TERM ASSETS AND LIABILITIES

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. These are firms with relatively long inventory periods and/or relatively long receivables periods. Thus, such firms
tend to keep inventory on hand, and they allow customers to purchase on credit and take a relatively long time to
pay.

2. These are firms that have a relatively long time between the time purchased inventory is paid for and the time that
inventory is sold and payment received. Thus, these are firms that have relatively short payables periods and/or
relatively long receivable cycles.

3. Carrying costs will decrease because they are not holding goods in inventory. Shortage costs will probably
increase depending on how close the suppliers are and how well they can estimate need. The operating cycle will
decrease because the inventory period is decreased.

4. Since the cash cycle equals the operating cycle minus the accounts payable period, it is not possible for the cash
cycle to be longer than the operating cycle if the accounts payable period is positive. Moreover, it is unlikely that
the accounts payable period would ever be negative since that implies the firm pays its bills before they are
incurred.

II. Multiple Choice Questions

1. C 6. A 11. C
2. C 7. B 12. B
3. B 8. D 13. D
4. C 9. C 14. B
5. D 10. B

III. Problems

Problem 1 (Cash Equation)

The total liabilities and equity of the company are the net book worth, or market value of equity, plus
current liabilities and long-term debt, so:

Total liabilities and equity = ₱10,380 + 1,450 + 7,500 = ₱19,330

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This is also equal to the total assets of the company. Since total assets are the sum of all assets, and cash is an asset,
the cash account must be equal to total assets minus all other assets, so:

Cash = ₱19,330 – 15,190 – 2,105 = ₱2,035

We have NWC other than cash, so the total NWC is:

NWC = ₱2,105 + 2,035 = ₱4,140

We can find total current assets by using the NWC equation. NWC is equal to:

NWC = CA – CL
₱4,140 = CA – ₱1,450
CA = ₱5,590

Problem 2 (Changes in the Operating Cycle)

a. Increase. If receivables go up, the time to collect the receivables would increase, which increases the operating
cycle.

b. Increase. If credit repayment times are increased, customers will take longer to pay their bills, which will lead to
an increase in the operating cycle.

c. Decrease. If the inventory turnover increases, the inventory period decreases.

d. No change. The accounts payable period is part of the cash cycle, not the operating cycle.

e. Decrease. If the receivables turnover increases, the receivables period decreases.

f. No change. Payments to suppliers affects the accounts payable period, which is part of the cash cycle, not the
operating cycle.

Problem 3 (Changes in Cycles)

a. Increase; Increase. If the terms of the cash discount are made less favorable to customers, the accounts
receivable period will lengthen. This will increase both the cash cycle and the operating cycle.

b. Increase; No change. This will shorten the accounts payable period, which will increase the cash cycle. It will
have no effect on the operating cycle since the accounts payable period is not part of the operating cycle.

c. Decrease; Decrease. If more customers pay in cash, the accounts receivable period will decrease. This will
decrease both the cash cycle and the operating cycle.

d. Decrease; Decrease. Assume the accounts payable period does not change. Fewer raw materials purchased will
reduce the inventory period, which will decrease both the cash cycle and the operating cycle.

e. Decrease; No change. If more raw materials are purchased on credit, the accounts payable period will tend to
increase, which would decrease the cash cycle. We should say that this may not be the case. The accounts
payable period is a decision made by the company’s management. The company could increase the accounts
payable account and still make the payments in the same number of days. This would leave the accounts
payable period unchanged, which would leave the cash cycle unchanged. The change in credit purchases made
on credit will not affect the inventory period or the accounts payable period, so the operating cycle will not
change.

f. Increase; Increase. If more goods are produced for inventory, the inventory period will increase. This will
increase both the cash cycle and operating cycle.

Problem 4 (The Operating and Cash Cycles)

We first need the turnover ratios. Note that we use the average values for all balance sheet items and that we base the
inventory and payables turnover measures on cost of goods sold:

Inventory turnover = ₱11,375/ [(₱1,273 + ₱1,401)/2] = 8.51 times

Receivables turnover = ₱14,750/ [(₱3,782 + ₱3,368)/2] = 4.13 times
Payables turnover = ₱11,375/ [(₱1,795 + ₱2,025)/2] = 5.96 times

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We can now calculate the various periods:

Inventory period = 365 days/8.51 times = 42.89 days

Receivables period = 365 days/4.13 times = 88.38 days
Payables period = 365 days/5.96 times = 61.24 days

So the time it takes to acquire inventory and sell it is about 43 days. Collection takes another 88 days, and the
operating cycle is thus 43 + 88 = 131 days. The cash cycle is thus 131 days less the payables period: 131 – 61 = 70
days.

Problem 5 (Working Capital)

a. Working Capital = ₱400,000

Net Working Capital = ₱400,000 − ₱200,000 = ₱200,000
Current Ratio = ₱400,000/₱200,000 = 2 times

b. Five Star’s return on equity is 12.5 percent (₱62,700/₱500,000).

Five Star Manufacturing Company

Income Statement
For the Year Ended December 31, 2011

Net sales ₱800,000

EBIT (20% of sales) 160,000
Less: Interest expense
Short-term debt (10%) 20,000
Long-term debt (15%) 45,000
Earnings before taxes 95,000
Less: Income taxes (34%) 32,300
Net income ₱62,700
c. The net working capital and current ratios for each strategy are shown below:

Strategies
Current Assets as a Percent of Sales
30% 50% 70%
Current assets (CA) ₱300,000 ₱ 500,000 ₱ 700,000
Fixed assets 600,000 600,000 600,000
Total assets ₱900,000 ₱1,100,000 ₱1,300,000

Current liabilities (CL)* ₱180,000 ₱ 200,000 ₱ 260,000

Long-term liabilities 270,000 330,000 390,000
Total liabilities ₱450,000 ₱ 550,000 ₱ 650,000
Stockholders’ equity (SE) 450,000 550,000 650,000
Total liabilities and equity ₱900,000 ₱1,100,000 ₱1,300,000

Net working capital (CA – CL) ₱120,000 ₱ 300,000 ₱ 440,000

Current ratio (CA/CL) 1.7 times 2.5 times 2.7 times

*Assume that all current liabilities are in the form of short-term debt.

d. The firm’s liquidity position, as measured by the amount of net working capital and current ratio, improves when
current assets are a higher percentage of sales.

e. The rate of return on equity for each strategy is shown below:

Strategies
Current Assets as a Percent of Sales
30% 50% 70%
Net sales ₱1,000,000 ₱1,000,000 ₱1,000,000
EBIT (18% of sales) 180,000 180,000 180,000
Interest expense
Short-term debt (10%) 18,000 20,000 26,000
Long-term debt (15%) 40,500 49,500 58,500
Earnings before taxes (EBT) 121,500 110,500 95,500
Income taxes (34%) 41,310 37,570 32,470
Net income ₱ 80,190 ₱ 72,930 ₱ 63,030

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Return on equity (NI/SE) 17.8% 13.0% 9.7%

f. Five Star’s profitability decreases as liquidity increases. For example, the firm’s liquidity (current ratio = 2.7
times) is the highest but profitability (ROE = 9.7 percent) is the lowest when current assets are 70 percent of sales.

g. The return on equity, net working capital and current ratio for each strategy are shown below:

Financing- Mix Strategies

Restricted Compromise Flexible
EBIT ₱180,000 ₱180,000 ₱180,000
Interest expenses
Short-term (10%) 10,000 30,000 45,000
Long-term (15%) 52,500 22,500 0
Earnings before taxes (EBT) 117,500 127,500 135,000
Income taxes (34%) 39,950 43,350 45,900
Net income ₱77,550 ₱84,150 ₱89,100

Return on equity (NI/SE) 17.2% 18.7% 19.8%

Net working capital (CA – CL) ₱200,000 0 (₱150,000)
Current ratio (CA/CL) 3.0 times 1.0 times 0.7 times

CHAPTER 18

APPLICATION OF QUANTITATIVE TECHNIQUES IN PLANNING, CONTROL AND

DECISION MAKING - II

I. Questions
1. PERT is superior to Gantt Charts in complex projects because:
a. PERT charts are flexible and can reflect slippage or changes in plans, but Gantt charts simply plot a bar chart
against a calendar scale.
b. PERT charts reflect interdependencies among activities; Gantt charts do not.
c. PERT charts reflect uncertainties or tolerances in the time estimates for various activities; Gantt charts do not.
2. The use of PERT provides a structured foundation for planning complex projects in sufficient detail to facilitate
effective control.
A workable sequence of events that comprise the project are first identified. Each key event should represent a
task; then the interdependent relationships between the events are structured.
After the network of events is constructed, cost and time parameters are established for each package. Staffing
plans are reviewed and analyzed.
The “critical path” computation identifies sequence of key events with total time equal to the time allotted for the
project’s completion. Jobs which are not on the critical path can be slowed down and the slack resources
available on these activities reallocated to activities on the critical path.
Use of PERT permits sufficient scheduling of effort by functional areas and by geographic location. It also allows
for restructuring scheduling efforts and redeployment of workers as necessary to compensate for delays or
bottlenecks. The probability of completing this complex project on time and within the allotted budget is
increased.
3. Time slippage in noncritical activities may not warrant extensive managerial analysis because of available slack,
but activity cost usually increases with time and should be monitored.
4. The critical path is the network path with the longest cumulative expected activity time. It is critical because a
slowdown along this path delays the entire project.
5. Crashing the network means finding the minimum cost for completing the project in minimum time in order to
achieve an optimum tradeoff between cost and time. The differential crash cost of an activity is the additional
cost of that activity for each period of time saved.
6. Slack is the amount of time an event can be delayed without affecting the project’s completion date. Slack can be
utilized by management as a buffer against bottlenecks that may occur on the critical path.
7. Unit gross margin are typically computed with an allocation of fixed costs. Total fixed costs generally will not
change with a change in volume within the relevant range. Unitizing the fixed costs results in treating them as
though they are variable costs when, in fact, they are not. Moreover, when multiple products are manufactured,

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the relative contribution becomes the criterion for selecting the optimal product mix. Fixed costs allocations can
distort the relative contributions and result in a suboptimal decision.
8. This approach will maximize profits only if there are no constraints on production or sales, or if both products use
all scarce resources at an equal rate. Otherwise management would want to maximize the contribution per unit of
scarce resource.
9. The opportunity cost of a constraint is the cost of not having additional availability of the constrained resources.
This is also called a shadow price.
10. The feasible production region is the area which contains all possible combinations of production outputs. It is
bounded by the constraints imposed on production possibilities. The production schedule which management
chooses must come from the feasible production region.
11. The accountant usually supplies the contribution margin data that is used in formulating a profit-maximizing
objective function. In addition, the accountant participates in the analysis of linear programming outputs by
assessing the costs of additional capacity or of changes in product mix.
12. a. Hourly fee for inventory audit (C)
b. Salary of purchasing supervisor (N)
c. Costs to audit purchase orders and invoices (P)
d. Taxes on inventory (C)
e. Stockout costs (P)
f. Storage costs charged per unit in inventory (C)
g. Fire insurance on inventory (C)
h. Fire insurance on warehouse (N)
i. Obsolescence costs on inventory (C)
j. Shipping costs per shipment (P)
13. Although the inventory models are developed by operations researchers, statisticians and computer specialists,
their areas of expertise do not extend to the evaluation of the differential costs for the inventory models.
Generally, discussions of inventory models take the costs as given. It is the role of the accountant to determine
which costs are appropriate for inclusion in an inventory model.
14. Cost of capital represents the interest expense on funds if they were borrowed or opportunity cost if funds were
provided internally or by owners. It is included as carrying cost of inventory because funds are tied up in
inventory.
15. Costs that vary with the average number of units in inventory:
Inventory insurance P 2.80
Inventory tax 2.05 (P102.25 x 2%)
Total P 4.85
Costs that vary with the number of units purchased:
Purchase price P102.25
Insurance on shipment 1.50
Total P103.75
Total carrying cost = (25% x P103.75) cost of capital + P4.85 = P25.94 + P4.85 = P30.79
Order costs:
Shipping permit P201.65
Costs to arrange for the shipment 21.45
Unloading 80.20
Stockout costs 122.00
Total P425.30

II. Problems

Problem 1 (Solution is found on the next page.)

Problem 2

Requirement (a)

The critical path through each of the three alternative paths calculated as the longest is 0 - 1 - 6- 7- 8.

0-1-2-5-8 2 + 8 + 10 + 14 = 34
0-1-3-4-7-8 2+8+7+5+3 = 25
0-1-6-7-8 2 + 26 + 9 + 3 = 40*
63
 Financial Management 1
________
* critical

Requirement (b)

40 - 3 - 5 = 32

Requirement (c)

If path 4 - 7 has an unfavorable time variance of 10, this means it takes a total time of 15 to finish this activity rather
than 5. This gives the path 0 - 1 - 3 - 4 - 7 - 8 a total time of 35, but since this is less than the critical path of 40, it has
no effect.

Requirement (d)

The earliest time for reaching event 5 via 0 - 1 - 2 - 5 is 20, the sum of the expected times.

Problem 3

No, they didn’t make a right decision, since they included fixed costs which do not differ in the short run. If they had
used contribution margin instead of gross margin, they would have had P5 for G1 and P6.50 for G2, therefore they
would have decided to produce G2 exclusively.

64
 Application of Quantitative Techniques in Planning, Control and Decision Making – II Chapter 18

Problem 1

Requirement (a)

TASKS 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

HOrder 1 Order 3 Order 4 Order 2

o
b
b
i
n
g

X MX X X Order 1 X X Order 3 X X X Order 4 Order 2

a
c
h
i
n
i
n
g

___________
X Dead Time
18-65
 Financial Management 1

Requirement (b)

28 days are required for the four orders.

66
 Solutions Manual
Problem 4

Order costs Insurance + Other

= order costs
P P860 + P18
= = P878
Carrying costs Out-of-pocket Cost of capital
+
= costs on inventory
S P65 + 20% x
= P222 = P119.40

a. Carrying costs:
QS 250 x P109.40
= = P13,675.00
2 2

Order costs:
AP 1,500 x P878
= = P 5,268.00
Q 250

Total P18,943.00

b. Economic order quantity:


2 x 1,500 x P878
Q* = =  24,077 =
P109.40
155 units

Carrying costs:
QS 155 x P109.40
= = P 8,478.50
2 2

Order costs:
AP 1,500 x P878
= = P 8,496.77
Q 155

Total P16,975.27

Problem 5

67-67
68
It is necessary to evaluate the annual carrying costs and expected stockout costs at each safety-stock level. The
carrying cost will be P24.40 for each unit in safety stock. With the given order size, there are 15 orders placed a year
(i.e., 39,000/2,600 = 15). Based on these computations, we prepare the following schedule:

Safety Carrying Costs Expected Stockout Total

Stock of Safety Stock Costs Costs
0 0 0.50 x 15a x P1,650 = P12,375 P12,375
150 150 x P24.40 = P3,660 0.20 x 15a x P1,650 = P 4,950 8,610
175 175 x P24.40 = P4,270 0.05 x 15a x P1,650 = P 1,273.5 5,507.5 (optional)
250 250 x P24.40 = P6,100b 0.01 x 15a x P1,650 = P 247.5 6,347.5

Additional computations:
a
15 is the number of orders per year.
b
It should be evident that at this level the carrying costs alone exceed the total costs at a safety stock of 175
units. Therefore, it is not possible for this or any safety-stock level larger than 250 to be less costly than
175 units. Indeed, given a total cost at 175 units of P5,507.5, stockout costs would have to occur with
probability zero for any safety stock greater than 225.72 units (i.e., P5,507.5 / P24.40 = P225.72).

III. Multiple Choice Questions

1. C 11. D 21. D 31. C

2. B 12. C 22. C 32. D
3. D 13. A 23. C 33. A
4. B 14. A 24. D 34. C
5. D 15. A 25. D 35. D
6. C 16. C 26. B 36. C
7. A 17. C 27. D 37. D
8. A 18. D 28. E 38. D
9. A 19. C 29. B
10. C 20. D 30. A

CHAPTER 19

ACCOUNTS RECEIVABLE
AND INVENTORY MANAGEMENT

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

68
 69

1. Cash and marketable securities are generally used to meet the transaction needs of the firm and for contingency
purposes. Because the funds must be available when needed, the primary concern should be with safety and
liquidity rather than the maximum profits.

2. Float exists because of the delay time in check processing. Electronic funds transfer, or the electronic movement
of funds between computer terminals, would eliminate the need for checks and thus eliminate float.

3. A firm could operate with a negative balance on the corporate books knowing float will carry them through at the
bank. Checks written on the corporate books may not clear until many days later at the bank. For this reason, a
negative account balance on the corporate books of ₱100,000 may still represent a positive balance at the bank.

4. By slowing down disbursements or the processing of checks against the corporate account, the firm is able to
increase float and also to provide a source of short-term financing.

5. The average collection period, the ratio of bad debts to credit sales and the aging of accounts receivable.

6. Trade credit is usually granted on open account. The invoice is the credit instrument.

7. Credit costs: cost of debt, probability of default, and the cash discount. No-credit costs: lost sales. The sum of
these is the carrying costs.

8. 1. Character: determines if a customer is willing to pay his or her debts.

2. Capacity: determines if a customer is able to pay debts out of operating cash flow.
3. Capital: determines the customer’s financial reserves in case problems occur with operating cash flow.
4. Collateral: assets that can be liquidated to pay off the loan in case of default.
5. Conditions: customer’s ability to weather an economic downturn and whether such a downturn is likely.

9. 1. Perishability and collateral value

2. Consumer demand
3. Cost, profitability, and standardization
4. Credit risk
5. The size of the account
6. Competition
7. Customer type

If the credit period exceeds a customer’s operating cycle, then the firm is financing the receivables and other
aspects of the customer’s business that go beyond the purchase of the selling firm’s merchandise.

69
70
10. a. B: A is likely to sell for cash only, unless the product really works. If it does, then they might grant
longer credit periods to entice buyers.
b. A: Landlords have significantly greater collateral, and that collateral is not mobile.
c. A: Since A’s customers turn over inventory less frequently, they have a longer inventory period, and thus,
will most likely have a longer credit period as well.
d. B: Since A’s merchandise is perishable and B’s is not, B will probably have a longer credit period.
e. A: Rugs are fairly standardized and they are transportable, while carpets are custom fit and are not
particularly transportable.

11. The three main categories of inventory are: raw material (initial inputs to the firm’s production process), work-in-
progress (partially completed products), and finished goods (products ready for sale). From the firm’s perspective,
the demand for finished goods is independent from the demand for the other types of inventory. The demand for
raw material and work-in-progress is derived from, or dependent on, the firm’s needs for these inventory types in
order to achieve the desired levels of finished goods.
12. JIT systems reduce inventory amounts. Assuming no adverse effects on sales, inventory turnover will increase.
Since assets will decrease, total asset turnover will also increase. Recalling the DuPont equation, an increase in
total asset turnover, all else being equal, has a positive effect on ROE.

13. Carrying costs should be equal to order costs. Since the carrying costs are low relative to the order costs, the firm
should increase the inventory level.

14. Since the price of components can decline quickly, Apple does not have inventory which is purchased and then
declines quickly in value before it is sold. If this happens, the inventory may be sold at a loss. While this approach
is valuable, it is difficult to implement. For example, Apple manufacturing plants will often have areas set aside
that are for the suppliers. When parts are needed, it is a matter of going across the floor to get new parts. In fact,
m0st computer manufacturers are trying to implement similar inventory systems.

II. Multiple Choice Questions

1. D 4. A 7. D 10. D 13. D
2. B 5. D 8. C 11. D
3. D 6. C 9. B 12. D

III. Problems

Problem 1

The firm’s average daily sales are its annual (credit) sales divided by 365 days.

Average daily sales = ₱912,500/365 days = ₱2,500

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 71
The average collection period is the credit period plus the average days past the due date.

Average collection period = 45 + 15 = 60 days

The average investment in accounts receivable is determined by multiplying the average daily sales by the average
collection period.

Investment in accounts receivable = ₱2,500 x 60 = ₱150,000

Problem 2

a. The accounts receivable turnover is calculated by dividing 365 days by the average collection period of 25 days.

Accounts receivable turnover = 365/25 = 15 times

b. The average investment in accounts receivable is calculated by dividing credit sales by the accounts receivable
turnover.

Average investment in accounts receivable = ₱600,000/15 = ₱40,000

This method uses the total sales value of the accounts receivable. The cost (variable or total) is sometimes used as
the relevant measure of the amount of funds tied up in accounts receivable. Using only variable cost as the
relevant measure, the investment in accounts receivable would be ₱32,000 (₱40,000 x 0.80).

Problem 3

a. The marginal pretax profits for each risk class are shown below:

Risk Class
A B C
1. Marginal profits on additional sales
= Additional sales x CM
= Additional sales x 0.15 ₱7,500 ₱6,000 ₱3,000

2. Marginal increase in bad debt losses

= Additional sales x Bad debt loss
ratio 2,500 3,200 2,400

3. Marginal investment in A/R

= (Additional sales/365) x 90
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72
A = ₱12,330, B = ₱9,900, C = ₱4,950

Opportunity cost of marginal

investment in AR
= Marginal investment in A/R x
Opportunity cost 2,466 2,376 6,485

4. Net change in pretax profits

= Marginal profits – Marginal costs ₱2,534 ₱424 (₱885)

* The contribution margin of 0.15 is calculated by subtracting the variable cost percentage from 1.00 or (1.00 – 0.85 =
0.15)

Problem 4

Jazz Auto Supply should not adopt the change in the discount rate because the change results in a net disadvantage of
₱211.

1. Marginal profits on additional sales

= Additional sales x Contribution margin
= ₱0 x 0.25 ₱ 0

2. Current bad debt losses

= Current sales x Current bad debt loss ratio
= ₱400,000 x 0.03 = ₱12,000

New bad debt losses

= New sales x New bad debt loss ratio
= ₱400,000 x 0.025 = ₱10,000

Reduction in bad debt losses

= Current bad debt losses – New bad debt losses
= ₱12,000 − ₱10,000 2,000

3. Current average A/R balance

= Current average daily sales x Current average collection period
= (₱400,000/365) x 42 = ₱46,032

New average A/R balance

= New average daily sales x New average collection period
= (₱400,000/365) x 38 = ₱41,648

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 73

Reduction in A/R investment

= Current average A/R balance – New average A/R balance
= ₱46,032 - ₱41,648 = ₱4,384

Earnings on funds released by reduction in A/R investment

= Reduction in A/R x Required pretax rate of return
= ₱4,384 x 0.18 789

4. Cost of current cash discount

= Current sales x Current percentage taking discount
x Current percentage discount
= ₱400,000 x 0.45 x 0.01 = ₱1,800

Cost of new discount

= New sales x New percentage taking discount
x New percentage discount
= ₱400,000 x 0.60 x 0.02 = ₱4,800

Cost of increase in cash discount

= Cost of new cash discount – Cost of current cash discount
= ₱4,800 − ₱1,800 3,000

5. Net advantage/disadvantage of changing credit terms

= Marginal returns – Marginal costs
= (₱0 + ₱2,000 + ₱789) − ₱3,000 (₱211)

Problem 5

a. S = 12,000; O = ₱50; C = ₱0.10

Q* = (2) (12,000) (₱50) = 3,464 gallons

₱0.10

b. The average inventory is determined by dividing the economic order

quantity, Q* by 2, as follows:

Average inventory = 3,464/2 = 1,732 gallons

73
74

c. C = ₱0.10; Q* = 3,464; S = 12,000 ; O = ₱50

Total inventory costs = CQ/2 + SO/Q

TIC = [(0.10) (3,464) / 2] + [(12,000) (₱50) / 3,464) = ₱346 per month

d. Q* = 3,464; Average daily demand = 12,000/30days

T* = Q*/Average daily demand

T* = 3,464 / (12,000/30 days) = 9 days

e. S = 12,000; Q* = 3,464

N* = S/Q*
N* = 12,000 / 3,464 = 3 orders per month or

Time period = 30; T = 9

N* = Time period/T*
N* = 30 / 9 = 3 orders per month

Problem 6

a. S = 36,000; O = ₱100; C = ₱5

Q* = (2) (36,000) (₱100) = 1,200 fruit cakes

₱5

b. Q* = 1,200 ; SS = 3,000

Average inventory (Qa) = [(Q*/2) + SS]

Qa = [(1,200 / 2) + 3,000] = 3,600 fruit cakes

c. S = 36,000; Q* = 1,200

N* = S/Q*
N* = 36,000 / 1,200 = 30 orders per year

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 75

d. Fruitcake Specialists’ total inventory cost is found by multiplying the

average inventory, 3,600 fruit cakes, by the carrying cost per unit, ₱5,
and then adding the product of the orders per year, 30, multiplied by the
ordering costs per order, ₱100.

Total inventory costs = (3,600) (₱5) + (30) (₱100) = ₱21,000

e. SS = 3,000; S = 36,000; Time period = 365 ; n = 5

Qr = SS + (S/Time period) (n)

Qr = 3,000 + (36,000 / 365) (5) = 3,495 fruitcakes

Problem 7

The costs per period are the same whether or not credit is offered; so we can ignore the production costs. The firm
currently has sales of, and collects ₱110 x 2,000 = ₱220,000 per period. If credit is offered, sales will rise to ₱120 x
2,000 = ₱240,000.

Defaults will be 4 percent of sales, so the cash inflow under the new policy will be .96 x ₱240,000 = ₱230,400. This
amounts to an extra ₱10,400 every period. At 2 percent per period, the PV is ₱10,400/.02 = ₱520,000. If the switch is
made, Dama de Noche will give up this month’s revenues of ₱220,000; so the NPV of the switch is ₱300,000. If only
half of the customers take the credit, then the NPV is half as large: ₱150,000. So, regardless of what percentage of
customers takes the credit, the NPV is positive. Thus, the change is a good idea.

Problem 8

The cash flow from the old policy is the quantity sold times the price, so:

Cash flow from old policy = 40,000(₱510) = ₱20,400,000

The cash flow from the new policy is the quantity sold times the new price, all times one minus the default rate, so:

Cash flow from new policy = 40,000(₱537) (1 – .03) = ₱20,835,600

The incremental cash flow is the difference in the two cash flows, so:

Incremental cash flow = ₱20,835,600 – 20,400,000 = ₱435,600

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76
The cash flows from the new policy are a perpetuity. The cost is the old cash flow, so the NPV of the decision to
switch is:

NPV = –₱20,400,000 + ₱435,600/.025 = –₱2,976,000

Problem 9

a. The old price as a percentage of the new price is: ₱90/₱91.84 = .98

So the discount is: Discount = 1 – .98 = .02 or 2%

The credit terms will be: Credit terms: 2/15, net 30

b. We are unable to determine for certain since no information is given concerning the percentage of customers
who will take the discount. However, the maximum receivables would occur if all customers took the credit, so:

Receivables = 3,300(₱90) = ₱297,000 (at a maximum)

c. Since the quantity sold does not change, variable cost is the same under either plan.

d. No, because: d –  = .02 – .11 = –.09 or –9%

Therefore the NPV will be negative. The NPV is:

NPV = –3,300(₱90) + (3,300) (₱91.84) (.02 – .11)/(.01) = –₱3,023,592

The breakeven credit price is:

P (1 + r) / (1 –) = ₱90 (1.01)/ (.89) = ₱102.13

This implies that the breakeven discount is:

Breakeven discount = 1 – (₱90/₱102.13) = .1188 or 11.88%

The NPV at this discount rate is:

NPV = –3,300(₱90) + (3,300) (₱102.13) (.1188 – .11)/(.01)

NPV  0

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Problem 10

a. The cost of the credit policy switch is the quantity sold times the variable cost. The cash inflow is the price
times the quantity sold, times one minus the default rate. This is a one-time, lump sum, so we need to discount
this value one period. Doing so, we find the NPV is:

NPV = –15(₱760) + (1 – .2) (15) (₱1,140)/1.02 = ₱2,011.76

The order should be taken since the NPV is positive.

b. To find the breakeven default rate, , we just need to set the NPV equal to zero and solve for the breakeven
default rate. Doing so, we get:

NPV = 0 = –15(₱760) + (1 –) (12) (₱1,140)/1.02

 = .3200 or 32.00%

c. Effectively, the cash discount is:

Cash discount = (₱1,140 – 1,090) / ₱1,140 = .0439 or 4.39%

Since the discount rate is less than the default rate, credit should not be granted. The firm would be better off
taking the ₱1,090 up-front than taking an 80% chance of making ₱1,140.

Problem 11

a. The cash discount is:

Cash discount = (₱75 – 71) / ₱75 = .0533 or 5.33%

The default probability is one minus the probability of payment, or:

Default probability = 1 – .90 = .10

Since the default probability is greater than the cash discount, credit should not be granted; the NPV of doing so
is negative.

b. Due to the increase in both quantity sold and credit price when credit is granted, an additional incremental cost
is incurred of:

Additional cost = (6,200) (₱33 – 32) + (6,900 – 6,200) (₱33)

Additional cost = ₱29,300
77
78

The breakeven price under these assumptions is:

NPV = 0 = –₱29,300 – (6,200) (₱71) + {6,900 [(1 – .10) P – ₱33] – 6,200(₱71 – 32)} / (1.00753 – 1)

NPV = –₱34,100 – 440,200 + 273,940.31P – 10,044,478.08 – 10,666,468.16

₱21,185,246.24 = ₱273,940.31P
P = ₱77.34

c. The credit report is an additional cost, so we have to include it in our analysis. The NPV when using the credit
reports is:

NPV = 6,200 (32) – .90 (6,900) 33 – 6,200 (71) – 6,900 (₱1.50) + {6,900 [0.90 (75 – 33) – 1.50] – 6,200 (71 –
32)} / (1.00753 – 1)

NPV = ₱198,400 – 204,930 – 440,200 – 10,350 + 384,457.73

NPV = –₱72,622.27

The reports should not be purchased and credit should not be granted.

CHAPTER 20

SHORT-TERM SOURCES
FOR FINANCING CURRENT ASSETS

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. It is advisable to borrow in order to take a cash discount when the cost of borrowing is less than the cost of
foregoing the discount. If it cost us 36 percent to miss a discount, we would be much better off finding an
alternate source of funds for 8 to 10 percent.
78
 79

2. The prime rate is the rate that a bank charges its most creditworthy customers. The average customer can expect
to pay one or two percent (or more) above prime.

3. The stated interest rate is the percentage rate unadjusted for time or method of repayment. The effective interest
rate is the true rate and considers all these variables. A 5 percent stated rate for 90 days provides a 20 percent
effective rate. The financial manager should recognize the effective rate as the true cost of borrowing. The
effective rate is also referred to as the APR (Annual Percentage Rate).

4. Commercial paper can be either purchased or issued by a corporation. To the extent one corporation purchases
another corporation’s commercial paper as a short-term investment, it is a current asset. Conversely, if a
corporation issues its own commercial paper, it is a current liability.

5. Pledging accounts receivable means receivables are used as collateral for a loan; factoring account receivables
means they are sold outright to a finance company.

6. Three types of lender control used in inventory financing are

a. Blanket inventory lien-general claim against inventory or collateral. No specific items are marked or
designated.

b. Trust receipt-borrower holds the inventory in trust for the lender. Each item is marked and has a serial
number. When the inventory is sold, the trust receipt is canceled and the funds go into the lender’s account.

c. Warehousing the inventory is physically identified, segregated, and stored under the direction of an
independent warehouse company that controls the movement of the goods. If done on the premises of the
warehousing firm, it is termed public warehousing. An alternate arrangement is field warehousing whereby
the same procedures are conducted on the borrower’s property.

II. Multiple Choice Questions

1. A 16. B 31. D 46. D

2. B 17. A 32. A 47. A
3. D 18. C 33. A 48. B
4. B 19. D 34. A 49. B
5. D 20. D 35. C 50. C

6. C 21. D 36. D 51. A

7. A 22. C 37. C 52. C
8. D 23. D 38. D 53. C
9. B 24. C 39. B 54. A

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80
10. D 25. D 40. C 55. C

11. A 26. D 41. D 56. D

12. A 27. A 42. D 57. D
13. B 28. B 43. C
14. C 29. B 44. C
15. B 30. D 45. D

P10 million + P125,000 1

P200 million  P125,000  P10 million 180 / 360

III. Problems

Problem 1

The discounted interest cost of the commercial paper issue is calculated as follows:
Loan proceeds
Interest expense = .10(for P500,000
x P200 loan)
million x 180 / 360 = P10 million

P11,667
The effective cost of credit can now be calculated as follows: 12
P388,333 2
RATE = x

RATE = 46%

Problem 2

a. Interest for two months = .14 x  x P500,000

= P11,667

= P500,000  (.2 x P500,000 + P11,667)

= P383,333

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 81
RATE = x

= .030043 x 6 = .18026, or 18.026%

Note that Jan would actually have to borrow more than the needed P500,000 in order to cover the compensating
balance requirement. However, as we demonstrated earlier, the effective cost of credit will not be affected by
adjusting the loan amount for interest expense changes accordingly.

b. The estimation of the cost of forgoing trade discounts is generally quite straightforward; however, in this case the
firm actually stretches its trade credit for purchases made during July beyond the due date by an additional 30
days. If it is able to do this without penalty, then the firm effectively forgoes a 3 percent discount for not paying
Interest for two 2
within 15 days and does not pay for an additional 45 days (60 days less the discount period of 15 days). Thus, for
months
the July trade credit, Jan’s cost is calculated as follows: 12

RATE = (.03 / .97) x (360 / 45) = 24.74%

However, for the August trade credit the firm actually pays at the end of the credit period (the 30th day), so that
the cost of trade credit becomes
P10,000 + P3,750 12
RATE = (.03 / .97) x (360 / 15) = 74.22%
P500,000 2
c.
= .12 x x P500,000

= P10,000
.18 x P200,000 1
Pledging fee = .005 x P750,000
P200,000 1
= P3,750

RATE = x

= .0275 x 6 = .165, or 16.5%

Problem 3

a. RATE = x

= .18, or 18%

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82

b. RATE = x

= .20, or 20%

c. RATE = x

= .21212, or 21.212%
2%
Alternative (a) offers the lower-cost service360
of financing, although it carries the highest stated rate of interest. The
reason for this, of course,98% is nocompensating
its that there (55 10) balance requirement nor is interest discounted for this
alternative.

Problem 4
Cost of not taking Discount % 360 =
x
a cash discount 100%  Disc.% Final due date-
Discount period

= x = 2.04% x 8 = 16.32%

Effective rate of interest with a 20% compensating balance requirement:

= Interest rate / (1  C)
= 14% / (1  .2)
= 14% / (.8) = 17.5%

The effective cost of the loan, 17.5%, is more than the cost of passing up the discount, 16.32%. Kiwi Corporation
should continue to pay in 55 days and pass up the discount.
.16 x P200,000 1
Problem 5
P200,000  .20 x P200,000 1
P5,500 360
a. Effective rate of interest = P300,000 x .14
60 x P200,000 1
P200,000  .14 x P200,000  .2 x P200,000 1
= 1.83% x 6 = 10.98%
2% 360
b. Cost of lost discount = x
98% (70  10)
= 2.04% x 6 = 12.24%
82
 P6,850 360 83
P375,000
c. Yes, because the cost of borrowing is less than the cost  the
of losing P75,000
discount.
60
P6,850
d. P300,000 P300,000 P300,000
P300,000 = =
(1  C) (1  .20) .80

= P375,000 amount needed to be borrowed

e. Effective interest rate = x

= x 6 = 2.28% x 6

= 13.68%

No, do not borrow with a compensating balance2ofx 20

4 percent
x P9,000since the effective rate is greater than the savings
from taking the cash discount. (P100,000  P20,000  P9,000) x (4 + 1)

Problem 6

a. Trust Bank

Effective interest rate

2 x 12 x P9,000
=
(P100,000  P10,000) x (12 + 1)
= P72,000 / P355,000 = 20.28%

Northeast Bank

Effective interest rate

= P216,000 / P1,170,000 = 18.46%

Choose Northeast Bank since it has the lowest effective interest rate.

b. The numerators stay the same as in part (a) but the denominator increases to reflect the use of more money
because compensating balances are already maintained at both banks.

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Trust Bank

Effective interest rate = P72,000 / (P100,000  P9,000) x 5

= P72,000 / P455,000 = 15.82%

Northeast Bank

Effective interest rate = P216,000 / (P100,000 x 13)

= P216,000 / P1,300,000 = 16.62%

c. Yes. If compensating balances are maintained at both banks in the normal course of business, then Trust Bank
should be chosen over Northeast Bank. The effective cost of its loan will be less.

Problem 7

a. 11.73% Costs incurred by using commercial paper

b. 12.09% Net funds available from commercial paper
c. 18%

Problem 8

a. Cost of commercial paper =

Cost of commercial paper in the first quarter

Cost of issuing commercial paper:

Interest (P4,000,000 x .0775 x ¼) P 77,500

Placement fee (P4,000,000 x .00125) 5,000
First quarter cost P 82,500 =

Funds available for use:

Funds raised P4,000,000
Less: Compensating balance P400,000
Less: Interest and placement 82,500 482,500
Net funds available in first quarter P3,517,500

Cost of commercial paper in the first quarter P 82,500

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P3,517,500

= 2.345%

Cost of issuing commercial paper per quarter:

Interest (P4,000,000 x .0775 x ¼) P 77,500

Funds available for use: =

Funds raised P4,000,000
Less: Compensating balance P400,000
77,500 477,500
Net funds available per quarter P3,522,500

Cost of commercial paper per quarter P 77,500

P3,522,500

= 2.20%

Total annual effective cost of commercial paper

Effective cost = 1st quarter cost + 3(cost of 2nd, 3rd, 4th qtrs.)
= .02345 + 3(.02200)
= .02345 + .06600
= .08945
= 8.95%

Familia Inc. should choose commercial paper because the cost of bank financing (10.4 percent) exceeds the cost
of commercial paper (8.95 percent) by greater than 1 percent.

b. The characteristics Familia Inc. should possess in order to deal regularly in the commercial paper market include:

1. Have a prestigious reputation, be financially strong, and have a high credit rating.
2. Have flexibility to arrange for large amounts of funds through regular banking channels.
3. Have a large and frequently recurring short-term or seasonal needs for funds.
4. Have the ability to deal in large denominations of funds for periods of one to nine months and be willing
to accept the fact that commercial paper cannot be paid prior to maturity.

Problem 9

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a. The expected monthly cost of bank financing is the sum of the interest cost, processing cost, bad debt expense,
and credit department cost. The calculations are as follows:

Interest .15 / 12 x P180,000 = P 2,250

Processing .02 x P180,000 / .75 = 4,800
Credit department = 2,500
Bad debt expense .0175 x .7 x P900,000 = 11,025
Expected monthly cost of bank financing P20,575

b. The expected monthly cost of factoring is the sum of the interest cost and the factor cost. The calculations are as
follows:

Interest .015 x P180,000 = P 2,700

Factor .025 x .7 x P900,000 = 15,750
Expected monthly cost of factoring P18,450

c. The following are possible advantages of factoring:

1. Using a factor eliminates the need to carry a credit department.

2. Factoring is a flexible source of financing because as sales increase, the amount of readily available
financing increases.
3. Factors specialize in evaluating and diversifying credit risks.

d. The following are possible disadvantages of factoring:

1. The administrative costs may be excessive when invoices are numerous and relatively small in peso
amount.
2. Factoring removes one of the most liquid of the firm’s assets and weakens the position of creditors. It
may mar their credit rating and increase the cost of other borrowing arrangements.
3. Customers could react unfavorably to a firm’s factoring their accounts receivable.

e. Based upon the calculations in Parts a and b, the factoring arrangement should be continued. The disadvantages
of factoring are relatively unimportant in this case, especially since Canada Company has been using the factor in
the past. Before arriving at a final decision, the other services offered by the factor and bank would have to be
evaluated, as well as the margin of error inherent in the estimation of the source data used in the calculations for

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Parts a and b. The additional borrowing capacity needed by Canada Company is irrelevant because the firm
only needs P180,000 and the bank will loan P472,500 (P900,000 x .70 x .75) and the factor will lend P567,000
(P900,000 x .70 x .90).

Problem 10

a. The annual percentage cost of each company’s credit terms is calculated as follows:
Discount 360 days
Cost = x
1.00 – Discount Credit period – Discount period

The cost of each supplier must be weighted by the proportion of the total provided by the supplier.

Annual Weighted
Percentage Cost Weight Average Cost
Supplier (1) (2) (1) x (2)
Fort Co. .367 .30 .110
Jester Co. .242 .25 .061
Jam Co. - .35 -
Smitt & Co. .172 .10 .017
Total 1.00 .188

Average effective annual interest rate is 18.8 percent.

b. No, the average effective annual interest rate does not indicate whether they should borrow funds to take
advantage of the terms on a specific account. The borrowing decision should be based on the effective annual
interest rate of each supplier’s credit terms. Money should be borrowed to pay within the discount period only
when the cost of borrowing is less than the effective annual interest rate of the credit terms. For instance, Fort Co.
has an effective annual interest rate of 36.7% and should be paid on day 10 only if the cost of borrowing is less
than 36.7%.
c. 1. A line of credit is a loan agreement in which the borrower has, with certain specified limitations, control over
the amount borrowed (up to some maximum) and when the funds are repaid.

2. Yes, a line of credit would be appropriate for Billy Madison if the company needs to borrow short-term
money to take advantage of the cash discounts.

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