P2–1



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|P2–1 |Reviewing basic financial statements |

| | |

| |The income statement for the year ended December 31, 2006, the balance sheets for December 31, 2006 and 2005, and the statement of |

| |retained earnings for the year ended December 31, 2006, for Technica, Inc., are given on pages 82 and 83 . Briefly discuss the form |

| |and informational content of each of these statements. |

| |Technica, Inc.  |

| |Income Statement  |

| |for the Year Ended December 31, 2006 |

| | |

| |Sales revenue |

| |Â |

| |$600,000 |

| | |

| |Less: Cost of goods sold |

| |Â |

| |460,000 |

| | |

| |Gross profits |

| |Â |

| |$140,000 |

| | |

| |Less: Operating expenses |

| | |

| | |

| |General and administrative expenses |

| |$30,000 |

| |Â |

| | |

| | |

| |Depreciation expense |

| |30,000 |

| |Â |

| | |

| | |

| |Total operating expense |

| |Â |

| |60,000 |

| | |

| |Operating profits |

| |Â |

| |$ 80,000 |

| | |

| |Less: Interest expense |

| |Â |

| |10,000 |

| | |

| |Net profits before taxes |

| |Â |

| |$ 70,000 |

| | |

| |Less: Taxes |

| |Â |

| |27,100 |

| | |

| |Earnings available for common stockholders |

| |Â |

| |$ 42,900 |

| | |

| |Earnings per share (EPS) |

| |Â |

| |$2.15 |

| | |

| |Technica, Inc.  |

| |Balance Sheets |

| | |

| |Â |

| |December 31 |

| | |

| |Assets |

| |2006 |

| |2005 |

| | |

| |Cash |

| |$ 15,000 |

| |$ 16,000 |

| | |

| |Marketable securities |

| |7,200 |

| |8,000 |

| | |

| |Accounts receivable |

| |34,100 |

| |42,200 |

| | |

| |Inventories |

| |82,000 |

| |50,000 |

| | |

| |Total current assets |

| |$138,300 |

| |$116,200 |

| | |

| |Land and buildings |

| |$150,000 |

| |$150,000 |

| | |

| |Machinery and equipment |

| |200,000 |

| |190,000 |

| | |

| |Furniture and fixtures |

| |54,000 |

| |50,000 |

| | |

| |Other |

| |11,000 |

| |10,000 |

| | |

| |Total gross fixed assets |

| |$415,000 |

| |$400,000 |

| | |

| |Less: Accumulated depreciation |

| |145,000 |

| |115,000 |

| | |

| |Net fixed assets |

| |$270,000 |

| |$285,000 |

| | |

| |Total assets |

| |$408,300 |

| |$401,200 |

| | |

| |Liabilities and Stockholders’ Equity |

| | |

| |Accounts payable |

| |$ 57,000 |

| |$ 49,000 |

| | |

| |Notes payable |

| |13,000 |

| |16,000 |

| | |

| |Accruals |

| |5,000 |

| |6,000 |

| | |

| | |

| |Total current liabilities |

| |$ 75,000 |

| |$ 71,000 |

| | |

| |Long-term debt |

| |$150,000 |

| |$160,000 |

| | |

| |Stockholders’ equity |

| |Â |

| |Â |

| | |

| | |

| |Common stock equity (shares outstanding: 19,500 in 2006 and 20,000 in 2005) |

| |$110,200 |

| |$120,000 |

| | |

| | |

| |Retained earnings |

| |73,100 |

| |50,200 |

| | |

| | |

| |Total stockholders’ equity |

| |$183,300 |

| |$170,200 |

| | |

| |Total liabilities and stockholders’ equity |

| |$408,300 |

| |$401,200 |

| | |

| | |

| | |

| | |

| | |

| | |

| |Technica, Inc.  |

| |Statement of Retained Earnings  |

| |for the Year Ended December 31, 2006 |

| | |

| |Retained earnings balance (January 1, 2006) |

| |$50,200 |

| | |

| |Plus: Net profits after taxes (for 2006) |

| |42,900 |

| | |

| |Less: Cash dividends (paid during 2006) |

| |20,000 |

| | |

| |Retained earnings balance (December 31, 2006) |

| |$73,100 |

| | |

| | |

| | |

| | |

| |Income statement: In this one-year summary of the firm’s operations, Technica, Inc. showed a net profit for 2006 and the ability to |

| |pay cash dividends to its stockholders. |

| |Balance sheet: The financial condition of Technica, Inc. at December 31, 2005 and 2006 is shown as a summary of assets and |

| |liabilities. Technica, Inc. has an excess of current assets over current liabilities, demonstrating liquidity. The firm’s fixed |

| |assets represent over one-half of total assets ($270,000 of $408,300). The firm is financed by short-term debt, long-term debt, |

| |common stock, and retained earnings. It appears that it repurchased 500 shares of common stock in 2006. |

| |Statement of retained earnings: Technica, Inc. earned a net profit of $42,900 in 2006 and paid out $20,000 in cash dividends. The |

| |reconciliation of the retained earnings account from $50,200 to $73,100 shows the net amount ($22,900) retained by the firm. |

| | |

| | |

|P2–2 |Financial statement account identification |

| | |

| |Mark each of the accounts listed in the following table as follows: |

| | |

| |In column (1), indicate in which statement—income statement (IS) or balance sheet (BS)—the account belongs. |

| |In column (2), indicate whether the account is a current asset (CA), current liability (CL), expense (E), fixed asset (FA), |

| |long-term debt (LTD), revenue (R), or stockholders’ equity (SE). |

| |Account name |

| |(1)  |

| |Statement |

| |(2)  |

| |Type of account |

| | |

| |Accounts payable |

| |_______ |

| |_______ |

| | |

| |Accounts receivable |

| |_______ |

| |_______ |

| | |

| |Accruals |

| |_______ |

| |_______ |

| | |

| |Accumulated depreciation |

| |_______ |

| |_______ |

| | |

| |Administrative expense |

| |_______ |

| |_______ |

| | |

| |Buildings |

| |_______ |

| |_______ |

| | |

| |Cash |

| |_______ |

| |_______ |

| | |

| |Common stock (at par) |

| |_______ |

| |_______ |

| | |

| |Cost of goods sold |

| |_______ |

| |_______ |

| | |

| |Depreciation |

| |_______ |

| |_______ |

| | |

| |Equipment |

| |_______ |

| |_______ |

| | |

| |General expense |

| |_______ |

| |_______ |

| | |

| |Interest expense |

| |_______ |

| |_______ |

| | |

| |Inventories |

| |_______ |

| |_______ |

| | |

| |Land |

| |_______ |

| |_______ |

| | |

| |Long-term debts |

| |_______ |

| |_______ |

| | |

| |Machinery |

| |_______ |

| |_______ |

| | |

| |Marketable securities |

| |_______ |

| |_______ |

| | |

| |Notes payable |

| |_______ |

| |_______ |

| | |

| |Operating expense |

| |_______ |

| |_______ |

| | |

| |Paid-in capital in excess of par |

| |_______ |

| |_______ |

| | |

| |Preferred stock |

| |_______ |

| |_______ |

| | |

| |Preferred stock dividends |

| |_______ |

| |_______ |

| | |

| |Retained earnings |

| |_______ |

| |_______ |

| | |

| |Sales revenue |

| |_______ |

| |_______ |

| | |

| |Selling expense |

| |_______ |

| |_______ |

| | |

| |Taxes |

| |_______ |

| |_______ |

| | |

| |Vehicles |

| |_______ |

| |_______ |

| | |

| |(a) |(b) |

|Account Name |Statement |Type of Account |

|Accounts payable |BS |CL |

|Accounts receivable |BS |CA |

|Accruals |BS |CL |

|Accumulated depreciation |BS |FA* |

|Administrative expense |IS |E |

|Buildings |BS |FA |

|Cash |BS |CA |

|Common stock (at par) |BS |SE |

|Cost of goods sold |IS |E |

|Depreciation |IS |E |

|Equipment |BS |FA |

|General expense |IS |E |

|Interest expense |IS |E |

|Inventories |BS |CA |

|Land |BS |FA |

|Long-term debt |BS |LTD |

|Machinery |BS |FA |

|Marketable securities |BS |CA |

|Notes payable |BS |CL |

|Operating expense |IS |E |

|Paid-in capital in excess of par |BS |SE |

|Preferred stock |BS |SE |

|Preferred stock dividends |IS |E |

|Retained earnings |BS |SE |

|Sales revenue |IS |R |

|Selling expense |IS |E |

|Taxes |IS |E |

|Vehicles |BS |FA |

* Here we have to remember that Accumulated Depreciation is actually a “Contra Asset Account”

|P4–23 |Funding your retirement |

| | |

| |You plan to retire in exactly 20 years. Your goal is to create a fund that will allow you to receive $20,000 at the end of each |

| |year for the 30 years between retirement and death (a psychic told you would die exactly 30 years after you retire). You know that |

| |you will be able to earn 11% per year during the 30-year retirement period. |

| | |

| |1. How large a fund will you need when you retire in 20 years to provide the 30-year, $20,000 retirement annuity? |

| |2. How much will you need today as a single amount to provide the fund calculated in part a if you earn only 9% per year during the|

| |20 years preceding retirement? |

| |3. What effect would an increase in the rate you can earn both during and prior to retirement have on the values found in |

| |parts a and b? Explain. |

(a) PVA ’ PMT × (PVIFA11%,30) (b) PV ’ FV × (PVIF9%,20)

PVA ’ $20,000 × (8.694) PV ’ $173,880 × (0.178)

PVA ’ $173,880.00 PV ’ $30,950.64

Calculator solution: $173,875.85 Calculator solution: $31,024.82

(c) Both values would be lower. In other words, a smaller sum would be needed in 20 years for the annuity and a smaller amount would have to be put away today to accumulate the needed future sum.

|P4–32 |Funding budget shortfalls |

| | |

| |As part of your personal budgeting process, you have determined that in each of the next 5 years you will have budget shortfalls. |

| |In other words, you will need the amounts shown in the following table at the end of the given year to balance your budget—that is,|

| |to make inflows equal outflows. You expect to be able to earn 8% on your investments during the next 5 years and wish to fund the |

| |budget shortfalls over the next 5 years with a single amount. |

| | |

| |End of year |

| |Budget shortfall |

| | |

| |1 |

| |$ 5,000 |

| | |

| |2 |

| |4,000 |

| | |

| |3 |

| |6,000 |

| | |

| |4 |

| |10,000 |

| | |

| |5 |

| |3,000 |

| | |

| | |

| |How large must the single deposit today into an account paying 8% annual interest be to provide for full coverage of the |

| |anticipated budget shortfalls? |

| | |

| |What effect would an increase in your earnings rate have on the amount calculated in part a? Explain. |

(a)

| |Budget | | | | |

|Year |Shortfall |× |PVIF8%,n |’ |Present Value |

|1 |$5,000 |× |0.926 |’ |$4,630 |

|2 |4,000 |× |0.857 |’ |3,428 |

|3 |6,000 |× |0.794 |’ |4,764 |

|4 |10,000 |× |0.735 |’ |7,350 |

|5 |3,000 |× |0.681 |’ |2,043 |

| | | | | |$22,215 |

| | | |Calculator solution: |$22,214.03 |

A deposit of $22,215 would be needed to fund the shortfall for the pattern shown in the table.

(b) An increase in the earnings rate would reduce the amount calculated in part (a). The higher rate would lead to a larger interest being earned each year on the investment. The larger interest amounts will permit a decrease in the initial investment to obtain the same future value available for covering the shortfall.

|P4–46 |Loan amortization schedule |

| | |

| |Joan Messineo borrowed $15,000 at a 14% annual rate of interest to be repaid over 3 years. The loan is amortized into three equal,|

| |annual, end-of-year payments. |

| | |

| |1. Calculate the annual, end-of-year loan payment. |

| |2. Prepare a loan amortization schedule showing the interest and principal breakdown of each of the three loan payments. |

| |3. Explain why the interest portion of each payment declines with the passage of time. |

(a) PMT ’ $15,000 ( (PVIFA14%,3)

PMT ’ $15,000 ( 2.322

PMT ’ $6,459.95

Calculator solution: $6,460.97

(b)

|End of |Loan |Beginning of |Payments |End of Year |

|Year |Payment |Year Principal | |Principal |

| | | |Interest |Principal | |

|1 |$6,459.95 |$15,000.00 |$2,100.00 |$4,359.95 |$10,640.05 |

|2 |$6,459.95 |10,640.05 |1,489.61 |4,970.34 |5,669.71 |

|3 |$6,459.95 |5,669.71 |793.76 |5,666.19 |0 |

(The difference in the last year’s beginning and ending principal is due to rounding.)

(c) Through annual end-of-the-year payments, the principal balance of the loan is declining, causing less interest to be accrued on the balance.

|P4–48 |Monthly loan payments |

| | |

| |Tim Smith is shopping for a used car. He has found one priced at $4,500. The dealer has told Tim that if he can come up with a down|

| |payment of $500, the dealer will finance the balance of the price at a 12% annual rate over 2 years (24 months). |

| | |

| |Assuming that Tim accepts the dealer’s offer, what will his monthly (end-of-month) payment amount be? |

| |Use a financial calculator or Equation 4.15a (found in footnote 9) to help you figure out what Tim’s monthly payment would be if |

| |the dealer were willing to finance the balance of the car price at a 9% annual rate. |

(a) PMT ’ $4,000 ( (PVIFA1%,24)

PMT ’ $4,000 ( (21.243)

PMT ’ $188.28

Calculator solution: $188.29

(b) PMT ’ $4,000 ( (PVIFA0.75%,24)

PMT ’ $4,000 ( (21.889)

PMT ’ $182.74

Calculator solution: $182.74

|P6–15 |Basic bond valuation |

| | |

| |Complex Systems has an outstanding issue of $1,000-par-value bonds with a 12% coupon interest rate. The issue pays |

| |interest annually and has 16 years remaining to its maturity date. |

| | |

| |A. If bonds of similar risk are currently earning a 10% rate of return, how much should the Complex Systems bond sell for today? |

| |B. Describe the two possible reasons why similar-risk bonds are currently earning a return below the coupon interest rate on the |

| |Complex Systems bond. |

| |C. If the required return were at 12% instead of 10%, what would the current value of Complex Systems’ bond be? Contrast this |

| |finding with your findings in part a and discuss. |

(a) Bo ’ I ( (PVIFAkd%,n) + M ( (PVIFkd%,n)

Bo ’ 120 ( (PVIFA10%,16) + M ( (PVIF10%,16)

Bo ’ $120 ( (7.824) + $1,000 ( (0.218)

Bo ’ $938.88 + $218

Bo ’ $1,156.88

Calculator solution: $1,156.47

(b) Since Complex Systems’ bonds were issued, there may have been a shift in the supply-demand relationship for money or a change in the risk of the firm.

(c) Bo ’ I ( (PVIFAkd%,n) + M ( (PVIFkd%,n)

Bo ’ 120 ( (PVIFA12%,16) + M ( (PVIF12%,16)

Bo ’ $120 ( (6.974) + $1,000 ( (0.163)

Bo ’ $836.88 + $163

Bo ’ $999.88

Calculator solution: $1,000

When the required return is equal to the coupon rate, the bond value is equal to the par value. In contrast to (a) above, if the required return is less than the coupon rate, the bond will sell at a premium (its value will be greater than par).

|P7–6 |Common stock valuation—Zero growth |

| | |

| |Scotto Manufacturing is a mature firm in the machine tool component industry. The firm’s most recent common stock dividend was $2.40|

| |per share. Because of its maturity as well as its stable sales and earnings, the firm’s management feels that dividends will remain |

| |at the current level for the foreseeable future. |

| | |

| |a. If the required return is 12%, what will be the value of Scotto’s common stock? |

| |b. If the firm’s risk as perceived by market participants suddenly increases, causing the required return to rise to 20%, what will |

| |be the common stock value? |

| |c. Judging on the basis of your findings in parts a and b, what impact does risk have on value? Explain. |

(a) Po ’ $2.40 ( 0.12

Po ’ $20

(b) Po ’ $2.40 ( 0.20

Po ’ $12

(c) As perceived risk increases, the required rate of return also increases, causing the stock price to fall.

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