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Exam (elaborations) TEST BANK FOR First Course In Probability 9th Edition By Sheldon M. Ross. John L. (Solution Manual)

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Exam (elaborations) TEST BANK FOR First Course In Probability 9th Edition By Sheldon M. Ross. John L. (Solution Manual) SOLUTIONS TO EXERCISE AND CASES For FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION Stephen H. Penman CHAPTER ONE Introduction to Investing and Valuation Exercises Drill Exercises E1.1. Calculating Enterprise Value Enterprise Value = $1,800 million E1.2. Calculating Value Per Share Equity Value = $1,800 E1.3 Buy or Sell? Value = $850 + $675 = $1,525 million Value per share = $1,525/25 = $61 Market price = $45 Therefore, BUY! Applications E1.4. Finding Information on the Internet: Dell Computer and General Motors This is an exercise in discovery. The links on the book’s web site will help with the search. Here is the link to yahoo finance: E1.5. Enterprise Market Value: General Mills and Hewlett-Packard (a) General Mills Market value of the equity = Book value of total (short-term and long-term) debt = Enterprise value Note three points: (i) Total market value of equity = Price per share × Shares outstanding. (ii) The book value of debt is typically assumed to equal its market value, but financial statement footnotes give market value of debt to confirm this. (iii) The book value of equity is not a good indicator of its market value. The price-tobook ratio for the equity can be calculated from the numbers given: $20,925/$6,215.8 = 3.37. (b) This question provokes the issue of whether debt held as assets is part of enterprise value (a part of operations) or effectively a reduction of the net debt claim on the firm. The issue arises in the financial statement analysis in Part II of the book: are debt assets part of operations or part of financing activities? Debt is part of financing activities if it is held to absorb excess cash rather than used as a business asset. The excess cash could be applied to buying back the firm’s debt rather than buying the debt of others, so the net debt claim on enterprise value is what is important. Put another way, HP is not in the business of trading debt, so the debt asset is not part of enterprise operations. The calculation of enterprise value is as follows: Market value of equity = $47 × 2,473 million shares = $116,231 million Book value of net debt claims: Short-term borrowing $ 711 million Long-term debt 7,688 Total debt $8,399 million Debt assets 11,513 (3,114) Enterprise value 113,117 million E1.6. Identifying Operating, Investing, and Financing Transactions (a) Financing (b) Operations (c) Operations; but advertising might be seen as investment in a brand-name asset (d) Financing (e) Financing (f) Operations (g) Investing. R& D is an expense in the income statement, so the student might be inclined to classify it as an operating activity; but it is an investment. (h) Operations. But an observant student might point out that interest – that is a part of financing activities – affects taxes. Chapter 9 shows how taxes are allocated between operating and financing activities in this case. (i) Investing (j) Operations CHAPTER TWO Introduction to the Financial Statements Exercises Drill Exercises E2.1. Applying Accounting Relations: Balance Sheet, Income Statement and Equity Statement a. Liabilities = $150 million b. Net Income = $205 million c. Ending equity = $32 million As net income (in the income statement) is $30 million, $2 million was reported as “other comprehensive income” in the equity statement. d. Net payout = Dividends + Share repurchases – Share issues As there were no share issues or repurchases, dividend = $12. E2.2. Applying Accounting Relations: Cash Flow Statement Change in cash = $195 million E2.3. The Financial Statements for a Savings Account a. ___________________________________________________________________________ BALANCE SHEET INCOME STATEMENT Assets (cash) $100 Owners’ equity $100 Revenue $5 Expenses 0 Earnings $5 STATEMENT OF CASH FLOWS STATEMENT OF OWNERS’ EQUITY Cash from operations $5 Balance, end of Year 0 $100 Cash investment 0 Earnings, Year 1 5 Cash in financing activities: Dividends (withdrawals), Year 1 (5) Dividends (5) Balance, end of Year 1 $100 Change in cash $ 0 b. As the $5 in cash is not withdrawn, cash in the account increases to $105, and owners’ equity increases to $105. Earnings are unchanged. ______________________________________________________________________ BALANCE SHEET INCOME STATEMENT Assets (cash) $105 Owners’ equity $105 Revenue $5 Expenses 0 Earnings $5 STATEMENT OF CASH FLOWS STATEMENT OF OWNERS’ EQUITY Cash from operations $5 Balance, end of Year 0 $100 Cash investment 0 Earnings, Year 1 5 Cash in financing activities: Dividends (withdrawals), Year 1 (0) Dividends (0) Balance, end of Year 1 $105 Change in cash $ 5 ______________________________________________________________________ c. With the investment of cash flow from operations in a mutual fund, the financial statements would be as follows: _______________________________________________________________________ BALANCE SHEET INCOME STATEMENT Assets (cash) $100 Revenue $5 Mutual Fund 5 Equity $105 Expenses 0 Total assets $105 Total $105 Earnings $5 STATEMENT OF CASH FLOWS STATEMENT OF OWNERS’ EQUITY Cash from operations $5 Balance, end of Year 0 $100 Cash investment (5) Earnings, Year 1 5 Cash in financing activities: Dividends (withdrawals), Year 1 (0) Dividends (0) Balance, end of Year 1 $100 Change in cash $ 0 E2.4. Preparing an Income Statement and Statement of Shareholders’ Equity Income statement: Sales $4,458 Cost of good sold 3,348 Gross margin 1,110 Selling expenses (1,230) Research and development (450) Operating income (570) Income taxes 200 Net loss (370) Note that research and developments expenses are expensed as incurred. Equity statement: Beginning equity, 2009 $3,270 Net loss $(370) Other comprehensive income 76 (294) ($76 is unrealized gain on securities) Share issues 680 Common dividends (140) Ending equity, 2009 $3,516 Comprehensive income (a loss of $294 million) is given in the equity statement. Unrealized gains and losses on securities on securities available for sale are treated as other comprehensive income under GAAP. Net payout = Dividends + share repurchases – share issues = 140 + 0 – 680 = - 540 That is, there was a net cash flow from shareholders into the firm of $540 million. Taxes are negative because income is negative (a loss). The firm has a tax loss that it can carry forward. E2.5. Classifying Accounting Items a. Current asset b. Net revenue in the income statement: a deduction from revenue c. Net accounts receivable, a current asset: a deduction from gross receivables d. An expense in the income statement. But R&D is usually not a loss to shareholders; it is an investment in an asset. e. An expense in the income statement, part of operating income (and rarely an extraordinary item). If the restructuring charge is estimated, a liability is also recorded, usually lumped with “other liabilities.” f. Part of property, plan and equipment. As the lease is for the entire life of the asset, it is a “capital lease.” Corresponding to the lease asset, a lease liability is recorded to indicate the obligations under the lease. g. In the income statement h. Part of dirty-surplus income in other comprehensive income. The accounting would be cleaner if these items were in the income statement. i. A liability j. Under GAAP, in the statement of owners equity. However from the shareholders’ point of view, preferred stock is a liability k. Under GAAP, an expense. However from the shareholders’ point of view, preferred dividends are an expense. Preferred dividends are deducted in calculating “net income available to common” and for earnings in earnings per share. l. As an expense in the income statement. E2.6. Violations of the Matching Principle a. Expenditures on R&D are investments to generate future revenues from drugs, so are assets whose historical costs ideally should be placed on the balance sheet and amortized over time against revenues from selling the drugs. Expensing the expenditures immediately results in mismatching: revenues from drugs developed in the past are charged with costs associated with future revenues. However, the benefits of R&D are uncertain. Accountants therefore apply the reliability criterion and do not recognize the asset. Effectively GAAP treats R&D expenditures as a loss. b. Advertising and promotion are costs incurred to generated future revenues. Thus, like R&D, matching requires they be booked as an asset and amortized against the future revenues they promote, but GAAP expenses them. c. Film production costs are made to generate revenues in theaters. So they should be matched against those revenues as the revenues are earned rather than expensed immediately. In this way, the firm reports its ability to add value by producing films. E2.7. Using Accounting Relations to Check Errors Ending shareholders’ equity can be derived in two ways: 1. Shareholders’ equity = assets – liabilities 2. Shareholders’ equity = Beginning equity + comprehensive income – net dividends So, if the two calculations do not agree, there is an error somewhere. First make the calculations for comprehensive income and net dividends: Comprehensive income = net income + other comprehensive income = revenues – expenses + other comprehensive income = 2,300 –1,750 – 90 = 460 Net dividend = dividends + share repurchases – share issues = 400 +150 –900 = - 350 Now back to the two calculations: 1. Shareholders’ equity = 4,340 – 1,380 = 2,960 2, Shareholders’ equity = 19,140 + 460 – (-350) = 19,950 The two numbers do not agree. There is an error somewhere. Applications E2.8. Finding Financial Statement Information on the Internet This is a self-guiding exercise. Students can take it further by downloading financial statements into a spreadsheet. Go to the links of the book’s web site. E2.9. Testing Accounting Relations: General Mills Inc. This exercise tests some basic accounting relations. (a) Total liabilities = Total assets – stockholders’ equity = 12,826 (b) Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders 6,216 = 5,319 +? – 782 ? = 1,679 Net payout to common = cash dividends + stock purchases – share issues = 782 E2.10. Testing Accounting Relations: Genetech Inc. (a) Revenue = $4,621.2 million (b) ebit = $1,136.8 million (c) ebitda =$1,490.0 million Depreciation and amortization is reported as an add-back to net income to get cash flow from operations in the cash flow statement. Long-term assets = $5,980.6 million Total Liabilities = $2,621.2 million Short-term Liabilities =$1,243.3 million (c) Change in cash and cash equivalents = Cash flow from operations – Cash used in investing activities + Cash from financing activities Change in cash and cash equivalents is given by the changes in the amount is the balance sheet = $270.1 – 372.2 = -$102.1 So, -$102.1 = $1,195.8 - $451.6 + ? So ? = -$846.3 million That is, there was a cash outflow of $846.3 million for financing activities. E2.11. Find the Missing Number in the Equity Statement: Cisco Systems Inc. Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders a. $32,304 = $31,931 + 6,526 -? ? = $6,153 b. Net payout to common = cash dividends + stock purchases – share issues 6,153 = 0 + ? – 2,869 = 9,022 E2.12. Find the Missing Numbers in Financial Statements: General Motors a. Total Equity (end) = Total Equity (beginning) + Comprehensive Income – Net Payout to Common Shareholders -56,990 = -37,094 + ? – 283 ? = -19,613 (a loss) b. Comprehensive income = Net income + Other comprehensive income -19,613 = -18,722 + ? ? = - 891 c. Net income = Revenue – expenses and losses -18,722 = ? – 60,895 ? = 42,173 d. June 30, 2008 December 31, 2007 Assets 136,046 148,883 Liabilities ? = 193,036 ? = 185,977 Equity -56,990 -37,094 E2.13. Mismatching at WorldCom Capitalizing costs takes them out of the income statement, increasing earnings. But the capitalized costs are then amortized against revenues in later periods, reducing earnings. The net effect on income in any period is the amount of costs for that period less the amortization of costs for previous periods. The following schedule calculates the net effect. The numbers in parentheses are the amortizations, equal to the cost in prior periods dividend by 20. 1Q, 2001 2Q, 2001 3Q, 2001 4Q, 2001 1Q, 2002 1Q, 2001 cost: $780 $780 $ (39) $ (39) $ (39) $ (39) 2Q, 2001 cost: 605 605 (30) (30) (30) 3Q, 2001 cost: 760 760 (38) (38) 4Q, 2001 cost: 920 920 (46) 1Q, 2002 cost: 790 790 Overstatement of earnings $780 $566 $691 $813 $637 The financial press at the time reported that earnings were overstated by the amount of the expenditures that were capitalized. That is not quite correct. E2.14. Calculating Stock Returns: Nike, Inc. The stock return is the change in price plus the dividend received. So, Nike’s stock return for fiscal year 2008 is 12.875/55 = 23.41%. CHAPTER THREE How Financial Statements are Used in Valuation Exercises Drill Exercises E3.1. Calculating a Price from Comparables Average of the two prices = $55 per share E3.2. Stock Prices and Share Repurchases Market price per share after repurchase = $1,800/90 = $20 E3.3 Unlevered (Enterprise) Multiples Market price of equity = 80 × $7 = $560 million Market value of debt 140 (assumes book value – market value) Market value of enterprise $700 million Book value of shareholders’ equity = $250 - 140 = $110million a. P/B = 560/110 = 5.09 b. Unlevered P/S = 700/560 = 1.25 c. Enterprise P/B = 700/250 = 2.8 E3.4. Identifying Firms with Similar Multiples This is a self-guided exercise. E3.5. Valuing Bonds For this question, first calculate discount factors for each of five years ahead. You can also get them from present value tables where the discount factor is given as 1/1.05t. At a 5% required return, the discount factors are: Year Ahead (t) Discount factor (1.05t) 1 1.05 2 1.1025 3 1.1576 4 1.2155 5 1.2763 a. The only cash flow is the $1,000 at maturity Present value (PV) of $1,000 five years hence = $1,000/1.2763 = $783.51 b. This is easy. If the coupon rate is the required rate of return, the bond is worth its face value, $1,000. You can show this by working the problem as in part b, but with an annual coupon of $50. c. The yearly cash flows and their present value are: Year Ahead (t) Discount factor (1.05t) Cash Flow PV 1 1.05 40 38.10 2 1..28 3 1..55 4 1..91 5 1.2763 1, 040 814.86 Total Present Value $956.70 (Your answers might differ by a couple of cents if you use discount factors to 5 or 6 decimal places.) E3.6. Applying Present Value Calculations to Value a Building This is a straight forward present value problem: the required return--the discount rate--is applied to forecasted net cash receipts to convert the forecast to a valuation: Present value of net cash receipts of 1.1 million for 5 years at 12% (annuity factor is 3.6048) $3.965 million Present value of $12 million “terminal payoff” at end of 5 years (present value factor is 0.5674) 6.809 Value of building $10.774 Applications E3.7 The Method of Comparables: Dell, Inc. First calculate the multiples for the comparable firms from the price and accounting numbers: Sales Earnings Book Value Market Value Hewlett-Packard Co. $45,226 $ 624 $13,953 $32,963 Gateway Inc. 6,080 (1,290) 1,565 1,944 HP: Price/Sales = 0.73 P/E = 52.8 P/B = 2.4 Gateway: Price/Sales = 0.32 P/E - (not applicable: negative earnings) P/B = 1.2 Now apply the multiples to Dell: Average Multiples Dell’s Dell’s for Comparable Number Valuation Sales 0.53 x 31,168 = $16,519 million Earnings 52.8* x 1,246 = 65,789 Book value 1.8 x 4,694 = 8,449 Average of valuations 30,252 * HP only With 2,602 million shares outstanding, the estimated value per share = $30,252/2,602 = $11.63 Difficulties: - P/E can’t be calculated for a loss firm - The “comparables” are not exactly like Dell - The calculation assumes the market prices for the “comps” are efficient - Not sure how to weight the three valuation based on sales, earnings and book values; the valuations differ considerably, depending on the multiple used E3.8. A Stab at Valuation Using Multiples: Biotech Firms Multiples of the various accounting numbers for the five firms can be calculated and the average multiple applied to Genentech’s corresponding accounting numbers. This yields prices for Genentech: Multiple Comparison Firm Mean Estimated Genentech Value (millions) P/B 4.16 $5,610.9 E/P .0245* 5,077.6 (P-B)/R&D 10.66 4,699.2 P/Revenue 6.05 4,809.0 Mean over all values 5,049.2 *Excludes firms with losses. E/P is used rather than P/E because a very high P/E due to very small earnings can affect the mean considerably. The mean E/P also excludes the loss firms since Genentech did not have losses. Research and development (R&D) expenditures are compared to price minus book value. As the R&D asset is not on balance sheets, its missing value is in this difference. The average ratio of 10.66 is applied to Genetech’s R&D expenditures to yield a valuation for its R&D asset of $3,350.4 million which, when added to the book value of the other net assets, gives a valuation of $4,699.2 million for Genentech. This is clearly very rough. The average of the values based on the mean multiples is $5,049.2 million. Genetech’s actual traded value in April 1995 was $5,637.6 million. E3.9. Pricing Multiples: General Mills, Inc. E3.10. Measuring Value Added (a) Buying a stock: Value of a share = 0.12 2 = $ 16.67 Price of a share 19.00 Value lost per share $ 2.33 (b) Value of the investments: Present value of net cash flow of $1M per year for five years (at 9%) $ 3.890 million Initial costs 2.000 Value added $ 1.890 million E3.11. Forecasting Prices in an Efficient Market: Weyerhaeuser Company This tests whether you can forecast future prices, ex-dividend, using the no-arbitrage relationship between prices at different points in time. The T-Bill rate at the end of 1995 was 5.5%. So the CAPM cost of capital = 5.5% + (1.0 × 6.0%) = 11.5% (using an 6% risk premium). (a) 1995 2 P1997 = r P = 1.1152 × 42 = 52.22 This is the cum-dividend price (b) 2 P1997 = r P − rd − d = (1.1152 x 42) - (1.115 × 1.60) - 1.60 = 48.83 16.84 0.095 1 / = × = 1.6× = E S S P P E E3.12. Valuation of Bonds and the Accounting for Bonds, Borrowing Costs, and Bond Revaluations The purpose of this exercise is to familiarize students with the accounting for bonds. The cash flows and discount rates for each bond are as follows: Coupon 1000 Redempt. 1.08 1.1664 1.2597 1.3605 1.4693 Discount rate (a) Present value of cash flows = value of bond = $840.31. (b) (1) Borrowing cost = $840.31 × 8% = $67.22 per bond (2) This is the way accountants calculate interest (the effective interest method): $67.22 per bond will be recorded as interest expense. This will be made up of the coupon plus an amortization of the bond discount. The amortization is $67.22 - $40.00 = $27.22. This accrual accounting records the effective interest of $67.22, not the cash flow. (c) (1) As the firm issued the bonds at 8%, it is still borrowing at 8%. Of course, if the firm issued new debt at the end of 2009, its borrowing cost would be 6%. (2) Interest expense for 2009 will be $69.40 per bond. This is the book value of the bond at the end of 2008 times 8%: $867.53 × 8% = $69.40. The book value of the bond at the end of 2008

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Institution
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, A Solution Manual for:
A First Course In Probability: Seventh Edition
by Sheldon M. Ross.

John L. Weatherwax∗


September 4, 2007




Introduction

Acknowledgements

Special thanks to Vincent Frost and Andrew Jones for helping find and correct various typos
in these solutions.



Miscellaneous Problems

The Crazy Passenger Problem

The following is known as the “crazy passenger problem” and is stated as follows. A line of
100 airline passengers is waiting to board the plane. They each hold a ticket to one of the 100
seats on that flight. (For convenience, let’s say that the k-th passenger in line has a ticket
for the seat number k.) Unfortunately, the first person in line is crazy, and will ignore the
seat number on their ticket, picking a random seat to occupy. All the other passengers are
quite normal, and will go to their proper seat unless it is already occupied. If it is occupied,
they will then find a free seat to sit in, at random. What is the probability that the last
(100th) person to board the plane will sit in their proper seat (#100)?

If one tries to solve this problem with conditional probability it becomes very difficult. We
begin by considering the following cases if the first passenger sits in seat number 1, then all



1

,the remaining passengers will be in their correct seats and certainly the #100’th will also.
If he sits in the last seat #100, then certainly the last passenger cannot sit there (in fact he
will end up in seat #1). If he sits in any of the 98 seats between seats #1 and #100, say seat
k, then all the passengers with seat numbers 2, 3, . . . , k − 1 will have empty seats and be able
to sit in their respective seats. When the passenger with seat number k enters he will have
as possible seating choices seat #1, one of the seats k + 1, k + 2, . . . , 99, or seat #100. Thus
the options available to this passenger are the same options available to the first passenger.
That is if he sits in seat #1 the remaining passengers with seat labels k +1, k +2, . . . , 100 can
sit in their assigned seats and passenger #100 can sit in his seat, or he can sit in seat #100
in which case the passenger #100 is blocked, or finally he can sit in one of the seats between
seat k and seat #99. The only difference is that this k-th passenger has fewer choices for
the “middle” seats. This k passenger effectively becomes a new “crazy” passenger.

From this argument we begin to see a recursive structure. To fully specify this recursive
structure lets generalize this problem a bit an assume that there are N total seats (rather
than just 100). Thus at each stage of placing a k-th crazy passenger we can choose from

• seat #1 and the last or N-th passenger will then be able to sit in their assigned seat,
since all intermediate passenger’s seats are unoccupied.
• seat # N and the last or N-th passenger will be unable to sit in their assigned seat.
• any seat before the N-th and after the k-th. Where the k-th passenger’s seat is taken
by a crazy passenger from the previous step. In this case there are N −1 −(k + 1) + 1 =
N − k − 1 “middle” seat choices.

If we let p(n, 1) be the probability that given one crazy passenger and n total seats to select
from that the last passenger sits in his seat. From the argument above we have a recursive
structure give by
N −1
1 1 1 X
p(N, 1) = (1) + (0) + p(N − k, 1)
N N N k=2
N −1
1 1 X
= + p(N − k, 1) .
N N k=2

where the first term is where the first passenger picks the first seat (where the N will sit
correctly with probability one), the second term is when the first passenger sits in the N-th
seat (where the N will sit correctly with probability zero), and the remaining terms represent
the first passenger sitting at position k, which will then require repeating this problem with
the k-th passenger choosing among N − k + 1 seats.

To solve this recursion relation we consider some special cases and then apply the principle
of mathematical induction to prove it. Lets take N = 2. Then there are only two possible
arraignments of passengers (1, 2) and (2, 1) of which one (the first) corresponds to the second
passenger sitting in his assigned seat. This gives
1
p(2, 1) = .
2

, If N = 3, then from the 3! = 6 possible choices for seating arraignments

(1, 2, 3) (1, 3, 2) (2, 3, 1) (2, 1, 3) (3, 1, 2) (3, 2, 1)

Only
(1, 2, 3) (2, 1, 3) (3, 2, 1)
correspond to admissible seating arraignments for this problem so we see that
3 1
p(3, 1) = = .
6 2
1
If we hypothesis that p(N, 1) = 2
for all N, placing this assumption into the recursive
formulation above gives
N −1
1 1 X1 1
p(N, 1) = + = .
N N k=2 2 2
Verifying that indeed this constant value satisfies our recursion relationship.

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