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Instructor’s Resource Manual for Principles of Managerial Finance Sixteenth Edition

Chad J. Zutter University of Pittsburgh

Scott B. Smart Indiana University

ISBN-13: 978-0-13-694561-1 ISBN-10: 0-13-694561-9

Chapter 1

The Role and Environment of Managerial Finance

iii

Table of Contents PART 1 Introduction to Managerial Finance

1 The Role of Managerial Finance

2 The Financial Market Environment

PART 2 Financial Tools

3 Financial Statements and Ratio Analysis

4 Long- and Short-Term Financial Planning

5 Time Value of Money

PART 3 Valuation of Securities

119

6 Interest Rates and Bond Valuation

121

7 Stock Valuation

149

PART 4 Risk and the Required Rate of Return

167

8 Risk and Return

169

9 The Cost of Capital

205

PART 5 Long-Term Investment Decisions

231

10 Capital Budgeting Techniques

233

11 Capital Budgeting Cash Flows

261

12 Risk Refinements in Capital Budgeting

293

PART 6 Long-Term Financial Decisions

327

13 Leverage and Capital Structure

329

14 Payout Policy

349

PART 7 Short-Term Financial Decisions

367

15 Working Capital and Current Assets Management

369

16 Current Liabilities Management

383

PART 8 Special Topics in Managerial Finance

399

17 Hybrid and Derivative Securities

401

18 Mergers, LBOs, Divestitures, and Business Failure

421

19 International Managerial Finance

437

Gitman • Principles of Managerial Finance, Twelfth Edition

Part One Introduction to Managerial Finance Chapters in This Part

Chapter 1

The Role of Managerial Finance

Chapter 2

The Financial Market Environment

Integrative Case 1: Merit Enterprise Corp.

Chapter 1 The Role of Managerial Finance  Instructor’s Resources Chapter Overview This chapter introduces the field of finance through building-block terms and concepts. The chapter starts by explaining what a firm is and discussing the goals that managers of a firm might pursue. The chapter provides a justification for focusing on shareholders rather than stakeholders broadly, but it also discusses other goals that firms might pursue. The opening section concludes with material on the importance of ethical behavior in business. The next section discusses the managerial finance function, the key decisions that financial managers make, and the principles that guide their decisions. The discussion draws out distinctions among the overlapping disciplines of finance, economics, and accounting. The third section describes pros and cons of different legal forms for a business. This section places particular emphasis on differences in taxation of proprietorships, partnerships, and corporations, and it highlights the importance of the marginal tax rate rather than the average tax rate. Next, this section describes the classical principal-agent problem and describes both internal and external corporate governance mechanisms that help manage that problem. This chapter and the ones to follow stress the important role finance vocabulary, concepts, and tools will play in the professional and personal lives of students—even those choosing other majors, such as accounting, economics information systems, management, marketing, or operations. Whenever possible, personal-finance applications are provided to motivate and illustrate topics. This pedagogical approach should inspire students to master chapter content quickly and easily.

 Suggested Answer to Opener-in-Review Students learned the stock price of Brookdale Senior Living lost 80% of its value from 2015 to 2019, prompting Land and Buildings (a prominent stockholder) to urge the firm sell its real-estate holdings, distribute the anticipated net sales proceeds ($21 cash) to shareholders, and then focus on managing its senior living facilities. Students were asked whether the proposal would make Brookdale’s shareholders better off if the expected cash proceeds were realized, but stock price dipped to $5 per share. Before restructuring, an investor with one Brookdale share had $21.35 in total wealth. Afterward, that same investor might have a share worth $5 and $21 in cash—total wealth of $26. The hypothetical shareholder reaped a gain of $4.65 per share or 21.8%. Before the asset sale, with 185.45 million shares outstanding and a share price of $21.35, total shareholder wealth was $3.96 billion. After the sale, with same shares outstanding and wealth per share now $26, shareholder wealth rose to $4.82 billion—a net gain of $0.86 billion.

Zutter/Smart • Principles of Managerial Finance, Sixteenth Edition

1-13 Agency problems arise when managers place personal goals ahead of their duty to shareholders to maximize stock price. The attendant costs are called agency costs. Agency costs can be implicit or explicit; either way they reduce shareholder wealth. An example of an ―implicit‖ agency cost is the dividends or capital gains shareholders miss out on because the firm’s management team pursued a personal interest (like maximizing sales to boost future compensation) rather than maximizing shareholder wealth. Of course, if shareholders sense stock price is not what it should be, they will start monitoring management more closely (as in the chapter opener with Brookdale Senior Living). The expenses associated with greater monitoring are an example of an ―explicit‖ agency cost. Agency problems in a firm can be reduced with a properly constructed and followed corporate-governance structure. Such a structure will feature checks and balances that reduce management’s interest in and ability to deviate from shareholder-wealth maximization. Like all corporate decisions, reducing agency costs is subject to marginal benefit–marginal cost analysis. In other words, the firm should invest in policies to align the incentives of management and shareholders as long as the marginal benefits exceed the marginal costs. 1-14 Firms most commonly try to mitigate agency problems by linking pay to metrics connected with shareholder wealth. Incentive plans tie compensation to share price. For example, the CEO might receive options offering the right to purchase stock at a set price (say current price) any time in the next few years. If the CEO takes actions that subsequently boost share price, she can profit personally by exercising the option—purchasing stock at the set price—and reselling at the higher market price. The higher the firm’s stock price, the more money the CEO can make, so options create a powerful incentive to focus laser-like on shareholder wealth. There is a downside, however. Sometimes general market trends swamp all the good done by management, so even though the CEO obsessed over shareholder wealth, her options proved worthless because a bear market hammered the firm’s stock price. This problem has made performance plans more popular. These plans link compensation with performance measures related to stock price that management can more closely control—such as earnings per share (EPS) and EPS growth. When targets for the performance metrics are attained, managers receive rewards like performance shares and/or cash bonuses. 1-15 If the board of directors fails to keep management focused on shareholder wealth, market forces can apply the necessary pressure. Two such forces are activism by institutional investors (such as Land and Buildings in the chapter opener) and the threat of hostile takeovers. Institutions typically hold large quantities of shares in many corporations. Because of their large stakes, these investors actively monitor management and vote their shares for the benefit of all shareholders. Large institutional investors reduce agency problems by using their voting clout to elect new directors that will make the changes in policies and personnel necessary to get underperforming stock to its highest possible price. The threat of hostile takeover can also keep management focused on shareholders. Say a firm has a stock price of $15, but that price could be $20 with bold action management is reluctant to take. The lure of a $5 capital gain per share could tempt an outside individual, group of investors or firm not supported by existing management to purchase controlling interest and force the necessary changes. Incumbent management knows ―necessary changes‖ means unemployment, so the threat of takeover could be enough to align their interests with those of the owners.

Chapter 1

The Role of Managerial Finance

 Suggested Answer to Focus on Ethics Box: Do Corporate Executives Have a Social Responsibility? How would Friedman view a sole proprietor’s use of firm resources to pursue social goals? In a sole proprietorship, the owner and manager are one in the same. So a manager using firm resources to support social goals would be doing exactly what the owner wanted. Put another way, Friedman would not see a conflict. He did not oppose pursuit of social goals by a firm or individual; he opposed doing so with someone else’s money.

 Suggested Answer to Focus on Practice Box: Must Search Engines Screen Out Fake News? Is the goal of maximizing shareholder wealth necessarily ethical or unethical? The ―end‖ of maximizing shareholder wealth is neither ethical nor unethical; it is neutral. But the means employed to pursue the end can be ethical or unethical. For example, taking actions to raise share price in clear violation of U.S. law is unethical—that is to say, wrong even if the violations are not uncovered. What responsibility, if any, does Google have to help users assess the veracity of online content? Management’s overriding concern should be shareholder wealth. Knowingly posting content a reasonable person could see is fake harms shareholders by damaging the Google brand, so some due diligence is warranted. How much Google should invest in validating online content depends on the marginal benefits and costs. Specifically, Google should verify as long as the marginal benefit to shareholders exceeds the marginal cost—that is, only as long as the net effect on stock price is positive.

 Suggested Answer to Focus on People/Planet/Profits Box: The Business Roundtable Revisits the Goal of a Corporation What kind of actions could CEOs who are members of the Business Roundtable take that would clearly indicate that their 2019 statement truly represented a break from the shareholder primacy doctrine? A break from shareholder primacy means not doing things that are good for shareholders or doing things that are not beneficial for shareholders. Doing something that benefits a stakeholder group does not necessarily represent a break from shareholder primacy because sometimes an action that benefits a stakeholder also benefits shareholders. For example, if customers and shareholders place a value on fighting climate change, then a company that makes green investments make may its own shareholders better off while also becoming more green. On the other hand, firms could spend so much on green investments that shareholder value might suffer. That would represent a true break from the shareholder primacy doctrine. Evidence of this might take the form of markets pushing down a firm’s stock price when it announces a major new green investment initiative.

Zutter/Smart • Principles of Managerial Finance, Sixteenth Edition

 Answers to Warm-Up Exercises E1-1

Advantages and disadvantages of partnership versus incorporation (LG 5)

Answer: Each form of business organization has advantages and disadvantages. One advantage of a simple partnership is that each partner’s income is taxed only once as personal income (i.e., subject to the personal income tax). Corporate income, in contrast, is taxed twice—corporate profits will be subject to the corporate income tax, and the dividends and capital gains from each partner’s stock will be taxed as personal income. Taxation is a key factor in choosing the form of business organization, but two other factors are also important. In a partnership, each partner has unlimited liability and may have to cover debts of other partners, while corporate owners have limited liability that guarantees they cannot lose more than they have invested in the corporation. The third major consideration is ease of transfer of the business. Partnerships are harder to transfer and technically dissolved when a partner dies, while a corporation has an infinite life (absent bankruptcy, merger, or acquisition) with ownership readily transferable through sale of existing shares. If a third party were asked to decide which legal form of business A&J Tax Preparation should take, it would be useful to have the following information:  Relevant specifics of current personal and corporate income tax codes (such as marginal rates, deductions, etc.)  Expected future changes in tax law  Expected longevity of firm  Age of current owners  Current succession plan  Risk tolerance of owners  Capital needs of firm  Growth prospects of firm  Reasons for each partner’s view on preferred form of ownership

Chapter 3 Financial Statements and Ratio Analysis

E1-2

Timing of cash flows (LG 4)

Answer: Based on the information provided, the choice is not obvious. Even though the second project is expected to provide a larger overall increase in earnings, the goal of the firm is maximizing shareholder value (not earnings per se), so the timing and risk of cash flows must be considered to determine which project is superior. For example, even if the second project’s cash flows are higher, they tend to arrive later, so it is not clear whether the second project is preferable to the first. E1-3

Cash flow vs. profits (LG 4)

Answer: It is not unusual for profitable firms to suffer a cash crunch. This typically happens when expenses must be paid before revenue can be collected. In such cases, the firm must arrange financing to plug the gap between cash inflows and outflows. If cash crunches are regular, management should consider going ahead with the party, particularly if it is important for employee morale (i.e., cancelling might significantly reduce productivity)— provided adequate short-term funding is available. If the crunch is new, larger problems could lie ahead, and funding a party before the cash-flow outlook became clear might expose the firm to financial risk. E1-4

Sunk costs (LG 5)

Answer: Marginal benefit-marginal cost analysis ignores sunk costs, so the $2.5 million dollars spent over the past 15 years is irrelevant to the current decision. At this point, what matters is whether expected revenues from additional investment exceed expected costs, after adjusting for the risk and timing of cash flows. If so, and funding is available, the investment is sound (irrespective of the specific capital expenditure required). The key to the decision may well lie in the satellite-division manager’s candid assessment that the project has little chance of viability. That assessment suggests additional expenditure is likely to throw good money after bad. E1-5

Agency costs (LG 6)

Answer: Agency costs arise when one party (principal) designates another party (agent) to act on her behalf and the second party (agent) has latitude to pursue her own interest at the expense of the principal. In a corporation, shareholders are principals and managers agents. If shareholders fail to monitor adequately, managers could focus on personal goals rather than shareholder value. The resulting negative impact on stock price is an example of an agency cost. Another example is the cost of stock options, which focus manager attention on share price but also raise managerial compensation. In the Donut Shop, Inc. example, the principal is store management, and the agents are employees. As normal humans, employees might prefer talking with other each or taking long breaks to focusing laser-like on customers. Banning tips led to poorer service, which could ultimately drive customers elsewhere and cost store managers their jobs. Tipping, like options, aligns the interests of principals and agents. The prospect of a tip kept employees (agents) focused on customer satisfaction, just as store management (principals) wished. One potential solution for Donut Shop, Inc., is a profit-sharing plan that includes employees whose behavior reduced customer satisfaction. For the new benefit to be effective, Donut Shop must sell the plan as a replacement for tipping and structure it to provide generous bonuses when profits rise (because profit sharing lacks the immediacy of tips for good service). Perhaps a simpler solution is recognizing the ban on tipping led to customerservice problems in the first place and reversing the policy. E1-6