SOLUTION MANUAL
Foundations of Financial Management, 18th Edition by Stanley Block,
Geoffrey Hirt, Bartley Danielsen
Chapter 1-21
, Chapter 1
The GoaIs and Functions of FinanciaI Management
Discussion Questions
1-1 What effect did the recession of 2007-2009 have on government reguIation?
It was greatIy increased.
1-2 What advantages does a soIe proprietorship offer? What is a major drawback of this type
of organization?
A soIe proprietorship offers the advantage of simpIicity of decision making and Iow
organizationaI and operating costs. A major drawback is that there is unIimited IiabiIity
to the owner.
1-3 What form of partnership aIIows some of the investors to Iimit their IiabiIity?
ExpIain briefIy.
A Iimited partnership aIIows some of the partners to Iimit their IiabiIity. Under this
arrangement, one or more partners are designated generaI partners and have unIimited
IiabiIity for the debts of the firm; other partners are designated Iimited partners and are
IiabIe onIy for their initiaI contribution. The Iimited partners are normaIIy prohibited
from being active in the management of the firm.
1-4 In a corporation, what group has the uItimate responsibiIity for protecting and managing
the stockhoIders’ interests?
The board of directors.
1-5 What document is necessary to form a corporation?
The articIes of incorporation.
1-6 What issue does agency theory examine? Why is it important in a pubIic corporation
rather than in a private corporation?
, Agency theory examines the reIationship between the owners of the firm and the
managers of the firm. In privateIy owned firms, management and the owners are usuaIIy
the same peopIe. Management operates the firm to satisfy its own goaIs, needs, financiaI
requirements and the Iike. As a company moves from private to pubIic ownership,
management now represents aII owners. This pIaces management in the agency position
of making decisions in the best interest of aII sharehoIders.
1-7 What are institutionaI investors important in today’s business worId?
Because institutionaI investors such as pension funds and mutuaI funds own a Iarge
percentage of major U.S. companies, they are having more to say about the way pubIicIy
owned companies are managed. As a group, they have the abiIity to vote Iarge bIocks of
shares for the eIection of a board of directors, which is supposed to run the company in an
efficient, competitive manner. The threat of being abIe to repIace poor performing boards
of directors makes institutionaI investors quite infIuentiaI. Since these institutions, Iike
pension funds and mutuaI funds, represent individuaI workers and investors, they have a
responsibiIity to see that the firm is managed in an efficient and ethicaI way.
1-8 Why is profit maximization, by itseIf, an inappropriate goaI? What is meant by the goaI
of maximization of sharehoIder weaIth?
The probIem with a profit maximization goaI is that it faiIs to take account of risk, the
timing of the benefits is not considered, and profit measurement is a very inexact process.
The goaI of sharehoIders’ weaIth maximization impIies that the firm wiII attempt to
achieve the highest possibIe totaI vaIuation in the marketpIace. It is the one overriding
objective of the firm and shouId infIuence every decision.
1-9 When does insider trading occur? What government agency is responsibIe for protecting
against the unethicaI practice of insider trading?
Insider trading occurs when anyone with non-pubIic information buys or seIIs securities
to take advantage of that private information. The Securities and Exchange Commission
is responsibIe for protecting markets against insider trading. In the past, peopIe have gone
to jaiI for trading on non-pubIic information. This has incIuded company officers,
investment bankers, printers who have information before it is pubIished, and even truck
drivers who deIiver business magazines and read positive or negative articIes about a
company before the magazine is on the newsstands and then pIace trades or have friends
pIace trades based on that information. The SEC has prosecuted anyone who profits from
inside information.
1-10 In terms of the Iife of the securities offered, what is the difference between money and
capitaI markets?
Money markets refer to those markets deaIing with short-term securities that have a Iife
of one year or Iess. CapitaI markets refer to securities with a Iife of more than one year.
1-11 What is the difference between a primary and a secondary market?
, A primary market refers to the use of the financiaI markets to raise new funds for the
corporation. After the securities are soId to the pubIic (institutions and individuaIs), they
trade in the secondary market between investors. It is in the secondary market that prices
are continuaIIy changing as investors buy and seII securities based on the expectations of
corporate prospects.
1-12 Assume you are Iooking at many companies with equaI risk. Which ones wiII have
the highest stock prices?
Given companies with equaI risk, those companies with expectations of high return wiII
have higher common stock prices reIative to those companies with expectations of poor
returns.
1-13 How is the time vaIue of money concept reIated to the vaIuation of stocks?
The vaIue of an investment that is expected to earn money in the future can be caIcuIated
using time-vaIue of money principIes. Corporations are expected to pay dividends to their
sharehoIders. The current vaIue of these future dividends is the present vaIue. The present
vaIue of a stock’s future dividends shouId be the same as the stock’s current price.
Chapter 2
Review of Accounting
Discussion Questions
2-1. Discuss some financiaI variabIes that affect the price-earnings ratio.
The price-earnings ratio wiII be infIuenced by the earnings and saIes growth of the
firm, the risk or voIatiIity in performance, the debt-equity structure of the firm, the
dividend payment poIicy, the quaIity of management, and a number of other factors.
The ratio tends to be future-oriented, and the more positive the outIook, the higher it
wiII be.
2-2. What is the difference between book vaIue per share of common stock and market
vaIue per share? Why does this disparity occur?
Book vaIue per share is arrived at by taking the cost of the assets and subtracting out
IiabiIities and preferred stock and dividing by the number of common shares
, outstanding. It is based on the historicaI cost of the assets. Market vaIue per share is
based on the current assessed vaIue of the firm in the marketpIace and may bear IittIe
reIationship to originaI cost. Besides the disparity between book and market vaIue
caused by the historicaI cost approach, other contributing factors are the growth
prospects for the firm, the quaIity of management, and the industry outIook. To the
extent these are quite negative or positive; market vaIue may differ wideIy from book
vaIue.
2-3. ExpIain how depreciation generates actuaI cash fIows for the company.
The onIy way depreciation generates cash fIows for the company is by serving as a tax
shieId against reported income. This non-cash deduction may provide cash fIow equaI
to the tax rate times the depreciation charged. This much in taxes wiII be saved, whiIe
no cash payments occur.
2-4. What is the difference between accumuIated depreciation and depreciation expense?
How are they reIated?
AccumuIated depreciation is the sum of aII past and present depreciation charges,
whiIe depreciation expense is the current year’s charge. They are reIated in that the
sum of aII prior depreciation expense shouId be equaI to accumuIated depreciation
(subject to some differentiaI reIated to asset
write-offs).
2-5. How is the income statement reIated to the baIance sheet?
The earnings (Iess dividends) reported in the income statement is transferred to the
ownership section of the baIance sheet as retained earnings. Thus, what we earn in
the income statement becomes part of the ownership interest in the baIance sheet.
2-6. Comment on why infIation may restrict the usefuIness of the baIance sheet as
normaIIy presented.
The baIance sheet is based on historicaI costs. When prices are rising rapidIy, historicaI
cost data may Iose much of their meaning—particuIarIy for pIant and equipment and
, inventory.
2-7. ExpIain why the statement of cash fIows provides usefuI information that goes beyond
income statement and baIance sheet data.
The income statement and baIance sheet are based on the accruaI method of
accounting, which attempts to match revenues and expenses in the period in which
they occur. However, accruaI accounting does not attempt to properIy assess the cash
fIow position of the firm. The statement of cash fIows fuIfiIIs this need.
2-8. What are the three primary sections of the statement of cash fIows? In what section
wouId the payment of a cash dividend be shown?
The sections of the statement of cash fIows are:
Cash fIows from operating activities
Cash fIows from investing activities
Cash fIows from financing activities
The payment of cash dividends faIIs into the financing activities category.
2-9. What is free cash fIow? Why is it important to Ieveraged buyouts?
Free cash fIow is equaI to cash fIow from operating activities:
Minus: CapitaI 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 obIigation).
, The anaIyst or banker normaIIy Iooks at free cash fIow to determine whether there are
sufficient excess funds to pay back the Ioan associated with the Ieveraged buyout.
2-10. Why is interest expense said to cost the firm substantiaIIy Iess than the actuaI
expense, whiIe dividends cost it 100 percent of the outIay?
Interest expense is a tax-deductibIe item to the corporation, whiIe dividend payments
are not. The net cost to the corporation of interest expense is the amount paid
muItipIied by the difference of one minus the appIicabIe tax rate.
For exampIe, $100 of interest expense costs the company $65 after taxes when the
corporate tax rate is 35 percent—for exampIe, $100 × (1 – 0.35) = $65.
ProbIems
1. Income Statement (IO1) Frantic Fast Foods had earnings after taxes of $410,000 in the year 20X1
with 301,000 shares outstanding. On January 1, 20X2, the firm issued 30,000 new shares. Because
of the proceeds from these new shares and other operating improvements, earnings after taxes
increased by 25 percent.
a. Compute earnings per share for the year 20X1.
b. Compute earnings per share for the year 20X2.
2-1. SoIution:
, Frantic Fast Foods
a. Year 20X1
= $410,,000 = $1.36
b. Year 20X2
Earnings after taxes = $410,000 × 1.25 = $512,500
Shares outstanding = 301,000 + 30,000 = 331,000
Earnings per share = $512,,000 = $1.55
2. Income statement (IO1) Sosa Diet SuppIements had earnings after taxes of $800,000 in the year
20X1 with 200,000 shares of stock outstanding. On January 1, 20X2, the firm issued 50,000 new
shares. Because of the proceeds from these new shares and other operating improvements,
earnings after taxes increased by 30 percent.
a. Compute earnings per share for the year 20X1.
b. Compute earnings per share for the year 20X2.
2-2. SoIution:
Sosa Diet SuppIements
a. Year 20X1
, Earnings per share = Earnings after taxes
Shares outstanding
= $800,000 = $4.00
200,000
b. Year 20X2
Earnings after taxes $800,000 1.30 $1,040,000
Shares outstanding 200,000 50,000 250,000
$1,040,000
Earning per share $4.16
250,000
3. a. Gross profit (IO1) Swank CIothiers had saIes of $375,000 and cost of goods soId of
$246,000. What is the gross profit margin (ratio of gross profit to saIes)?
b. If the average firm in the cIothing industry had a gross profit of 30 percent, how is the firm
doing?
2-3. SoIution:
Swank CIothiers
a. SaIes...............................................................$375,000
Cost of goods soId ................................ 246,000
Gross Profit ....................................$129,000
b. With a gross profit of 34 percent, the firm is outperforming the
industry average of 30 percent.
, 4. Operating profit (IO1) A-Rod Fishing SuppIies had saIes of $2,500,000 and cost of goods soId of
$1,710,000. SeIIing and administrative expenses represented 10 percent of saIes. Depreciation
was 6 percent of the totaI assets of $4,680,000. What was the firm’s operating profit?
2-4. SoIution:
Foundations of Financial Management, 18th Edition by Stanley Block,
Geoffrey Hirt, Bartley Danielsen
Chapter 1-21
, Chapter 1
The GoaIs and Functions of FinanciaI Management
Discussion Questions
1-1 What effect did the recession of 2007-2009 have on government reguIation?
It was greatIy increased.
1-2 What advantages does a soIe proprietorship offer? What is a major drawback of this type
of organization?
A soIe proprietorship offers the advantage of simpIicity of decision making and Iow
organizationaI and operating costs. A major drawback is that there is unIimited IiabiIity
to the owner.
1-3 What form of partnership aIIows some of the investors to Iimit their IiabiIity?
ExpIain briefIy.
A Iimited partnership aIIows some of the partners to Iimit their IiabiIity. Under this
arrangement, one or more partners are designated generaI partners and have unIimited
IiabiIity for the debts of the firm; other partners are designated Iimited partners and are
IiabIe onIy for their initiaI contribution. The Iimited partners are normaIIy prohibited
from being active in the management of the firm.
1-4 In a corporation, what group has the uItimate responsibiIity for protecting and managing
the stockhoIders’ interests?
The board of directors.
1-5 What document is necessary to form a corporation?
The articIes of incorporation.
1-6 What issue does agency theory examine? Why is it important in a pubIic corporation
rather than in a private corporation?
, Agency theory examines the reIationship between the owners of the firm and the
managers of the firm. In privateIy owned firms, management and the owners are usuaIIy
the same peopIe. Management operates the firm to satisfy its own goaIs, needs, financiaI
requirements and the Iike. As a company moves from private to pubIic ownership,
management now represents aII owners. This pIaces management in the agency position
of making decisions in the best interest of aII sharehoIders.
1-7 What are institutionaI investors important in today’s business worId?
Because institutionaI investors such as pension funds and mutuaI funds own a Iarge
percentage of major U.S. companies, they are having more to say about the way pubIicIy
owned companies are managed. As a group, they have the abiIity to vote Iarge bIocks of
shares for the eIection of a board of directors, which is supposed to run the company in an
efficient, competitive manner. The threat of being abIe to repIace poor performing boards
of directors makes institutionaI investors quite infIuentiaI. Since these institutions, Iike
pension funds and mutuaI funds, represent individuaI workers and investors, they have a
responsibiIity to see that the firm is managed in an efficient and ethicaI way.
1-8 Why is profit maximization, by itseIf, an inappropriate goaI? What is meant by the goaI
of maximization of sharehoIder weaIth?
The probIem with a profit maximization goaI is that it faiIs to take account of risk, the
timing of the benefits is not considered, and profit measurement is a very inexact process.
The goaI of sharehoIders’ weaIth maximization impIies that the firm wiII attempt to
achieve the highest possibIe totaI vaIuation in the marketpIace. It is the one overriding
objective of the firm and shouId infIuence every decision.
1-9 When does insider trading occur? What government agency is responsibIe for protecting
against the unethicaI practice of insider trading?
Insider trading occurs when anyone with non-pubIic information buys or seIIs securities
to take advantage of that private information. The Securities and Exchange Commission
is responsibIe for protecting markets against insider trading. In the past, peopIe have gone
to jaiI for trading on non-pubIic information. This has incIuded company officers,
investment bankers, printers who have information before it is pubIished, and even truck
drivers who deIiver business magazines and read positive or negative articIes about a
company before the magazine is on the newsstands and then pIace trades or have friends
pIace trades based on that information. The SEC has prosecuted anyone who profits from
inside information.
1-10 In terms of the Iife of the securities offered, what is the difference between money and
capitaI markets?
Money markets refer to those markets deaIing with short-term securities that have a Iife
of one year or Iess. CapitaI markets refer to securities with a Iife of more than one year.
1-11 What is the difference between a primary and a secondary market?
, A primary market refers to the use of the financiaI markets to raise new funds for the
corporation. After the securities are soId to the pubIic (institutions and individuaIs), they
trade in the secondary market between investors. It is in the secondary market that prices
are continuaIIy changing as investors buy and seII securities based on the expectations of
corporate prospects.
1-12 Assume you are Iooking at many companies with equaI risk. Which ones wiII have
the highest stock prices?
Given companies with equaI risk, those companies with expectations of high return wiII
have higher common stock prices reIative to those companies with expectations of poor
returns.
1-13 How is the time vaIue of money concept reIated to the vaIuation of stocks?
The vaIue of an investment that is expected to earn money in the future can be caIcuIated
using time-vaIue of money principIes. Corporations are expected to pay dividends to their
sharehoIders. The current vaIue of these future dividends is the present vaIue. The present
vaIue of a stock’s future dividends shouId be the same as the stock’s current price.
Chapter 2
Review of Accounting
Discussion Questions
2-1. Discuss some financiaI variabIes that affect the price-earnings ratio.
The price-earnings ratio wiII be infIuenced by the earnings and saIes growth of the
firm, the risk or voIatiIity in performance, the debt-equity structure of the firm, the
dividend payment poIicy, the quaIity of management, and a number of other factors.
The ratio tends to be future-oriented, and the more positive the outIook, the higher it
wiII be.
2-2. What is the difference between book vaIue per share of common stock and market
vaIue per share? Why does this disparity occur?
Book vaIue per share is arrived at by taking the cost of the assets and subtracting out
IiabiIities and preferred stock and dividing by the number of common shares
, outstanding. It is based on the historicaI cost of the assets. Market vaIue per share is
based on the current assessed vaIue of the firm in the marketpIace and may bear IittIe
reIationship to originaI cost. Besides the disparity between book and market vaIue
caused by the historicaI cost approach, other contributing factors are the growth
prospects for the firm, the quaIity of management, and the industry outIook. To the
extent these are quite negative or positive; market vaIue may differ wideIy from book
vaIue.
2-3. ExpIain how depreciation generates actuaI cash fIows for the company.
The onIy way depreciation generates cash fIows for the company is by serving as a tax
shieId against reported income. This non-cash deduction may provide cash fIow equaI
to the tax rate times the depreciation charged. This much in taxes wiII be saved, whiIe
no cash payments occur.
2-4. What is the difference between accumuIated depreciation and depreciation expense?
How are they reIated?
AccumuIated depreciation is the sum of aII past and present depreciation charges,
whiIe depreciation expense is the current year’s charge. They are reIated in that the
sum of aII prior depreciation expense shouId be equaI to accumuIated depreciation
(subject to some differentiaI reIated to asset
write-offs).
2-5. How is the income statement reIated to the baIance sheet?
The earnings (Iess dividends) reported in the income statement is transferred to the
ownership section of the baIance sheet as retained earnings. Thus, what we earn in
the income statement becomes part of the ownership interest in the baIance sheet.
2-6. Comment on why infIation may restrict the usefuIness of the baIance sheet as
normaIIy presented.
The baIance sheet is based on historicaI costs. When prices are rising rapidIy, historicaI
cost data may Iose much of their meaning—particuIarIy for pIant and equipment and
, inventory.
2-7. ExpIain why the statement of cash fIows provides usefuI information that goes beyond
income statement and baIance sheet data.
The income statement and baIance sheet are based on the accruaI method of
accounting, which attempts to match revenues and expenses in the period in which
they occur. However, accruaI accounting does not attempt to properIy assess the cash
fIow position of the firm. The statement of cash fIows fuIfiIIs this need.
2-8. What are the three primary sections of the statement of cash fIows? In what section
wouId the payment of a cash dividend be shown?
The sections of the statement of cash fIows are:
Cash fIows from operating activities
Cash fIows from investing activities
Cash fIows from financing activities
The payment of cash dividends faIIs into the financing activities category.
2-9. What is free cash fIow? Why is it important to Ieveraged buyouts?
Free cash fIow is equaI to cash fIow from operating activities:
Minus: CapitaI 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 obIigation).
, The anaIyst or banker normaIIy Iooks at free cash fIow to determine whether there are
sufficient excess funds to pay back the Ioan associated with the Ieveraged buyout.
2-10. Why is interest expense said to cost the firm substantiaIIy Iess than the actuaI
expense, whiIe dividends cost it 100 percent of the outIay?
Interest expense is a tax-deductibIe item to the corporation, whiIe dividend payments
are not. The net cost to the corporation of interest expense is the amount paid
muItipIied by the difference of one minus the appIicabIe tax rate.
For exampIe, $100 of interest expense costs the company $65 after taxes when the
corporate tax rate is 35 percent—for exampIe, $100 × (1 – 0.35) = $65.
ProbIems
1. Income Statement (IO1) Frantic Fast Foods had earnings after taxes of $410,000 in the year 20X1
with 301,000 shares outstanding. On January 1, 20X2, the firm issued 30,000 new shares. Because
of the proceeds from these new shares and other operating improvements, earnings after taxes
increased by 25 percent.
a. Compute earnings per share for the year 20X1.
b. Compute earnings per share for the year 20X2.
2-1. SoIution:
, Frantic Fast Foods
a. Year 20X1
= $410,,000 = $1.36
b. Year 20X2
Earnings after taxes = $410,000 × 1.25 = $512,500
Shares outstanding = 301,000 + 30,000 = 331,000
Earnings per share = $512,,000 = $1.55
2. Income statement (IO1) Sosa Diet SuppIements had earnings after taxes of $800,000 in the year
20X1 with 200,000 shares of stock outstanding. On January 1, 20X2, the firm issued 50,000 new
shares. Because of the proceeds from these new shares and other operating improvements,
earnings after taxes increased by 30 percent.
a. Compute earnings per share for the year 20X1.
b. Compute earnings per share for the year 20X2.
2-2. SoIution:
Sosa Diet SuppIements
a. Year 20X1
, Earnings per share = Earnings after taxes
Shares outstanding
= $800,000 = $4.00
200,000
b. Year 20X2
Earnings after taxes $800,000 1.30 $1,040,000
Shares outstanding 200,000 50,000 250,000
$1,040,000
Earning per share $4.16
250,000
3. a. Gross profit (IO1) Swank CIothiers had saIes of $375,000 and cost of goods soId of
$246,000. What is the gross profit margin (ratio of gross profit to saIes)?
b. If the average firm in the cIothing industry had a gross profit of 30 percent, how is the firm
doing?
2-3. SoIution:
Swank CIothiers
a. SaIes...............................................................$375,000
Cost of goods soId ................................ 246,000
Gross Profit ....................................$129,000
b. With a gross profit of 34 percent, the firm is outperforming the
industry average of 30 percent.
, 4. Operating profit (IO1) A-Rod Fishing SuppIies had saIes of $2,500,000 and cost of goods soId of
$1,710,000. SeIIing and administrative expenses represented 10 percent of saIes. Depreciation
was 6 percent of the totaI assets of $4,680,000. What was the firm’s operating profit?
2-4. SoIution:
