Part B: Present ValueECN 134: Solution Key to Problem Set Financial Economics Prof. Farshid MojaverPart AProblem 1: Cash Flows at WARF Computers, Inc. Angus has asked you to prepare the financial statement of each flows and the accounting statement of cash flows. He has also asked you to answer the following questions:1. How would you describe Wart Computer’s cash flows?2. Which cash flow statement more accurately describes the cash flows at the company?3. In light of your previous answers, comment on Nick’s expansion plans.Answer)The operating cash flow for the company is: (NOTE: All numbers are in thousands of dollars)OCF = EBIT + Depreciation – Current taxesOCF = $1,332 + 159 – 386 = $1,105To calculate the cash flow from assets, we need to find the capital spending and change in networking capital. The capital spending for the year was:Capital spending Ending net fixed assets $2,280 – Beginning net fixed assets 1,792 + Depreciation 159 Net capital spending $ 647And the change in net working capital was: Change in net working capital Ending NWC $728 – Beginning NWC 586 Change in NWC $142So, the cash flow from assets was: Cash flow from assets Operating cash flow $1,105 – Net capital spending 647 – Change in NWC 142 Cash flow from assets $316The cash flow to creditors was: Cash flow to creditors Interest paid $95 – Net New Borrowing 20 Cash flow to Creditors $75The cash flow to stockholders was: Cash flow to stockholders 1Dividends paid $212 – Net new equity raised –29 Cash flow to Stockholders $241The accounting cash flow statement of cash flows for the year was: Statement of Cash Flows Operations Net income $742 Depreciation 159 Deferred taxes 109 Changes in assets and liabilities Accounts receivable (31) Inventories 14 Accounts payable 17 Accrued expenses (99) Other (9) Total cash flow from operations $902 Investing activities Acquisition of fixed assets $(786) Sale of fixed assets 139 Total cash flow from investing activities $(547) Financing activities Retirement of debt $(98) Proceeds of long-term debt 118 Notes payable 5 Dividends (212) Repurchase of stock (40) Proceeds from new stock issues 11 Total cash flow from financing activities $(216) Change in cash (on balance sheet) $39Answers to questions1. The firm had positive earnings in an accounting sense (NI > 0) and had positive cash flow fromoperations and a positive cash flow from assets. The firm invested $142 in new net working capitaland $647 in new fixed assets. The firm was able to return $241 to its stockholders and $75 tocreditors.2. The financial cash flows present a more accurate picture of the company since it accurately reflectsinterest cash flows as a financing decision rather than an operating decision.3. The expansion plans look like they are probably a good idea. The company was able to return asignificant amount of cash to its shareholders during the year, but a better use of these cash flows2may have been to retain them for the expansion. This decision will be discussed in more detail laterin the book.Problem 2: Financial Ratio Analysis A financial ratio by itself tells us little about a company because financial ratios vary great deal across industries. There are two basic methods for analyzing financial ratios for a company: Time trend analysis and per group analysis. In time trend analysis, you find the ratios for the company over some period, say five years, and examine how each ratio has changed over this period. In peer group analysis, you compare a company’s financial ratios to those of its peers. Why might each of these analysis methods be useful? What does each tell you about the company’s financial health? Answer)Time trend analysis gives a picture of changes in the company’s financial situation over time. Comparinga firm to itself over time allows the financial manager to evaluate whether some aspects of the firm’soperations, finances, or investment activities have changed. Peer group analysis involves comparing thefinancial ratios and operating performance of a particular firm to a set of peer group firms in the sameindustry or line of business. Comparing a firm to its peers allows the financial manager to evaluatewhether some aspects of the firm’s operations, finances, or investment activities are out of line with thenorm, thereby providing some guidance on appropriate actions to take to adjust these ratios ifappropriate. Both allow an investigation into what is different about a company from a financialperspective, but neither method gives an indication of whether the difference is positive or negative. Forexample, suppose a company’s current ratio is increasing over time. It could mean that the company hadbeen facing liquidity problems in the past and is rectifying those problems, or it could mean thecompany has become less efficient in managing its current accounts. Similar arguments could be madefor a peer group comparison. A company with a current ratio lower than its peers could be more efficientat managing its current accounts, or it could be facing liquidity problems. Neither analysis method tellsus whether a ratio is good or bad, both simply show that something is different, and tells us where tolook. Problem 3: Du Pont Identity If Roten Inc., has an equity multiplier of 1.35, total asset turn-over of 2.15, and profit margin of 5.8 percent, what is its ROE?Answer) ROE = (PM)(TAT)(EM) ROE = (.058)(2.15)(1.35) = .1683 or 16.83%Problem 4: Using Du Pont Identity Y3K, Inc., has sales of $3,100, total assets of $1,580, and a debt-equity ratio of 1.20. If its return on equity is 16 percent, what is its net income?Answer) 3This is a multi-step problem involving several ratios. The ratios given are all part of the Du Pont Identity.The only Du Pont Identity ratio not given is the profit margin. If we know the profit margin, we can findthe net income since sales are given. So, we begin with the Du Pont Identity: ROE = 0.16 = (PM)(TAT)(EM) = (PM)(S / TA)(1 + D/E)Solving the Du Pont Identity for profit margin, we get:PM = [(ROE)(TA)] / [(1 + D/E)(S)] PM = [(0.16)($1,1580)] / [(1 + 1.20)( $3,100)] = .0371Now that we have the profit margin, we can use this number and the given sales figure to solve for