Solution to Chapter 7 Comprehensive Problems

Problem 7-1

Income Statements:	2020	Calculation	2019
Sales revenue			$200
Operating expenses			190
Operating income			10
Income tax expense (.20)			2
Net income			$8
Balance Sheets:	12/31/20		12/31/19
Cash			$5
Accounts receivable			20
Land			75
Total assets			$100
Accounts payable			$14
Common stock			80
Retained earnings			6
Total liabilities and s/equity			$100
Statements of Cash Flows:	2020		2019
Net income			$8
Change in accounts receivable			(20)
Change in accounts payable			14
Cash flows from operating activities			2
Purchase of land			(75)
Cash flows from investing activities			(75)
Sale of common stock			80
Payment of dividends			(2)
Cash flows from financing activities			78
Net change in cash			$5

Problem 7-2

1.

2.

3.

Free Cash Flow	Time Value Factor 5% WACC	Present Value (Rounded)
FCF2020: $200	.95238 (n= 1)
FCF2021: 230	.90703 (n= 2)
FCF2022: 280	.86384 (n= 3)
FCF2023: 300	.82270 (n = 4)
FCFTV:	.82270 (n = 4)
Firm Value

4.

5.

6.

Problem 7-3

1a.

1b.

2a.

2b.

Firm	Net Income	# of Shares	EPS	Share Price	P/E Ratio
Rancho	$44,000	16,500		$48.06
Temecula	$166,000	83,000		$28.00
Riverside	$112,000	168,000		$10.72

3.

guidelines to be used for problems 7-1 , 7-2, 7-3

7-1. Rancho Cucamonga Inc. reported its 2019 financial statements and created a template for its 2020 financial statements forecast as follows: 2020 2019 $200 Income Statements: Revenue Operating expenses Operating income Income tax expense (-20) Net income 190 10 2 $8 12/31/20 12/31/19 S5 20 75 $100 $14 80 6 $100 Balance Sheets: Cash Accounts receivable Land Total assets Accounts payable Common stock Retained earnings Total liabilities and s/equity Statements of Cash Flows: Net income Change in accounts receivable Change in accounts payable Cash flows from operating activities Purchase of land Cash flows from investing activities Sale of common stock Payment of dividends Cash flows from financing activities Net change in cash 2020 2019 $8 (20) 14 2 (75) (75) 80 (2 78 $5 You forecast the following items for Rancho in 2020: Revenues and accounts receivable will increase 10% from their 2019 amounts. Operating expenses will be $205 in 2020. The 2020 income tax rate will be the same as the 2019 income tax rate. The firm expects a 10% operating return on assets in 2020. Rancho will purchase land for $30 cash in 2020. The firm will issue $30 of common stock to pay for the land. Rancho will pay a $7 cash dividend in 2020. Required: Present Rancho's 2020 financial statement forecast by completing the cells in the template above. 190 Chapter 7 Financial Statement Analysis II 7-2. Assume that you forecast free cash flows (FCF) for Rancho Cucamonga Inc. for the next four years on December 31, 2019 as follows: Year 2020 2021 2022 2023 FCF $200 230 280 300 In addition, you determine that the firm's cost of capital is 5% and you forecast an annual growth rate of 3% beyond the forecast period. The present value factors for 5% are as follows: N Value 1 .95238 .90703 .86384 .82270 2 3 4 Required: 1. Forecast FCF for 2024. 2. Determine the terminal value (TV) of FCF at the end of 2023. 3. Complete the following table to determine firm value (FV) (Round to the nearest dollar.) Time Present Value of Year FCF Value FCF (Rounded 2020 $200 .95238 2021 230 .90703 2022 280 .86384 2023 300 .82270 TV .82270 FV 4. Assume that Rancho Cucamonga has $3,000 of debt at the end of 2019. Compute the intrinsic value of common equity at the end of 2019. 5. Assume the Rancho Cucamonga has 500 shares of common stock outstanding at the end of 2019. Compute the intrinsic share price of common stock at the end of 2019. 6. Rancho's stock was trading at $20.50 a share on December 31, 2019. Would you invest in Rancho Cucamonga Inc.? Introduction to Accounting and Finance 191 Introduction to Accounting and Finance 191 7-3. 1. Co. X has a price-to-earnings ratio of 12 times, and Co. Y trades at 11 times its earnings. Required: a. State which of the two firms the stock market values more highly. b. Assume that you consider Cos. X and Y to be equally profitable, liquid, and solvent and that equality will continue in the future. State which firm you would invest in. 2. You are considering investing in one of three firms within the same industry. Your financial analysis reveals that all three firms have been (and will continue to be equally profitable, liquid, and solvent. Required: a. Explain why you could not use either EPS or share price to determine which firm to invest in. b. Complete the following table (rounded to the nearest cent) and state the firm that you would invest in. Firm Net Income # of Shares EPS Share Price P/E Ratio Rancho $44,000 16,500 $48.06 Temecula $166,000 83,000 $28.00 Riverside $112,000 168,000 $10.72 3. You are the investment banker for Redlands Inc., a privately-held company that would like to be a publicly traded stock. Your financial analysis determined that Redlands' financial performance has mirrored that of its industry, and you expect that equal financial performance will continue in the future. Redlands reported $60,000 net income. You determine that the firms in Redlands industry trade at 17 times earnings. Assume that Redlands plans to issue 80,000 shares of common stock. Required: Determine the issue price for a share of Redlands' stock