Chapter 4:

22. Since the company did not release any new equity, the shareholders’ equity grew solely due
to retained earnings. Specifically, the retained earnings for the year amounted to:

Retained earnings = NI – Dividends

Retained earnings = $29,000 – 6,400
Retained earnings = $22,600

As a result, the equity at the end of the year was:

Ending equity = $153,000 + 22,600

Ending equity = $175,600

The ROE based on the end of period equity was:

ROE = $29,000/$175,600
ROE = .1651, or 16.51%

The plowback ratio was:

Plowback ratio = Addition to retained earnings/NI

Plowback ratio = $22,600/$29,000
Plowback ratio = .7793, or 77.93%

Using the equation presented in the text for the sustainable growth rate, we get:

Sustainable growth rate = (ROE × b)/[1 – (ROE × b)]

Sustainable growth rate = [.1651(.7793)]/[1 – .1651(.7793)]
Sustainable growth rate = .1477, or 14.77%

The ROE based on the beginning of period equity is

ROE = $29,000/$153,000
ROE = .1895, or 18.95%

Using the shortened equation for the sustainable growth rate and the beginning of period ROE,
we get:

Sustainable growth rate = ROE × b

Sustainable growth rate = .1895 × .7793
Sustainable growth rate = .1477, or 14.77%

Using the shortened equation for the sustainable growth rate and the end of period ROE, we get:

Sustainable growth rate = ROE × b

Sustainable growth rate = .1651 × .7793
Sustainable growth rate = .1287, or 12.87%
 When applying the end-of-period Return on Equity (ROE) in the condensed sustainable growth
rate equation, the resulting growth rate tends to be underestimated. This phenomenon consistently
arises whenever there is an increase in equity. Specifically, if equity grows, the ROE calculated
based on the end-of-period equity is lower than the ROE derived from the beginning-of-period
equity. The abbreviated equation’s ROE (and consequently the sustainable growth rate) relies on
equity that was not present at the time when net income was earned

23. The ROA using end of period assets is:

ROA = $29,000/$215,000
ROA = .1349, or 13.49%

The beginning of period assets had to have been the ending assets minus the addition to retained
earnings, so:

Beginning assets = Ending assets – Addition to retained earnings

Beginning assets = $215,000 – 22,600
Beginning assets = $192,400

And the ROA using beginning of period assets is:

ROA = $29,000/$192,400
ROA = .1507, or 15.07%

Using the internal growth rate equation presented in the text, we get:

Internal growth rate = (ROA × b)/[1 – (ROA × b)]

Internal growth rate = [.1349(.7793)]/[1 – .1349(.7793)]
Internal growth rate = .1175, or 11.75%

Using the formula ROA × b, and beginning of period assets:

Internal growth rate = .1507 × .7793

Internal growth rate = .1175, or 11.75%

Using the formula ROA × b, and end of period assets:

Internal growth rate = .1349 × .7793

Internal growth rate = .1051, or 10.51%

When applying the end-of-period Return on Assets (ROA) in the condensed internal growth rate
equation, the resulting growth rate tends to be underestimated. This phenomenon consistently
arises whenever there is an increase in assets. Specifically, if assets grow, the ROA calculated
based on the end-of-period assets is lower than the ROA derived from the beginning-of-period
assets. The abbreviated equation’s ROA (and consequently the internal growth rate) relies on
assets that were not present at the time when net income was earned
24. Assuming costs vary with sales and a 20 percent increase in sales, the pro forma income
statement will look like this:

Pro Forma Income Statement

Sales $ 823,836
Costs 665,304
Other expenses 16,824
EBIT $ 141,708
Interest 12,090
Taxable income $ 129,618
Taxes (21%) 27,220
Net income $ 102,398

The payout ratio is constant, so the dividends paid this year is the payout ratio from last year
times net income, or:

Dividends = ($27,475/$83,740)($102,398)
Dividends = $33,597

And the addition to retained earnings will be:

Addition to retained earnings = $102,398 – 33,597

Addition to retained earnings = $68,801

The new retained earnings on the pro forma balance sheet will be:

New retained earnings = $166,705 + 68,801

New retained earnings = $235,506

The pro forma balance sheet will look like this:

Pro Forma Balance Sheet

Assets Liabilities and Owners’ Equity

Current assets Current liabilities

Cash $ 25,128 Accounts payable $ 64,548
Accounts receivable 38,364 Notes payable 13,215
Inventory 85,584 Total $ 77,763
Total $ 149,076 Long-term debt $ 127,500
Fixed assets
Net plant and Owners’ equity
equipment $ 410,376 Common stock and
paid-in surplus $ 105,000
Retained earnings 235,506
Total $ 340,506
Total liabilities and owners’
Total assets $ 559,452 equity $ 545,769
 So the EFN is:

EFN = Total assets – Total liabilities and equity

EFN = $559,452– 545,769
EFN = $13,683

25. First, we need to calculate full capacity sales, which is:

Full capacity sales = $686,530/.80

Full capacity sales = $858,163

The full capacity ratio at full capacity sales is:

Full capacity ratio = Fixed assets/Full capacity sales

Full capacity ratio = $341,980/$858,163
Full capacity ratio = .39850

The fixed assets required at the projected sales figure is the full capacity ratio times the projected
sales level:

Total fixed assets = .39850($823,836) = $328,301

So, EFN is:

EFN = ($149,076 + 328,301) – $545,769 = –$68,393

Note that this solution assumes that fixed assets are decreased (sold) so the company has a 100
percent fixed asset utilization. If we assume fixed assets are not sold, the answer becomes:

EFN = ($149,076 + 341,980) – $545,769 = –$54,713

Chapter 27

7. The cost savings before taxes do not impact the decision between leasing and buying, as the
company will undoubtedly utilize the equipment and achieve the savings, regardless of the financing
option chosen. The depreciation tax shield is also a factor to consider:

Depreciation tax shield = ($8,780,000/5)(.21)

Depreciation tax shield = $368,760

And the aftertax lease payment is:

Aftertax lease payment = $1,950,000(1 – .21)

Aftertax lease payment = $1,540,500

The aftertax cost of debt is:

Aftertax cost of debt = .07(1 – .21)

Aftertax cost of debt = .0553, or 5.53%

With these cash flows, the NAL is:

NAL = $8,780,000 – 1,540,500 – $1,540,500(PVIFA5.53%,4) – $368,760(PVIFA5.53%,5)

NAL = $270,134.62
 The equipment should be leased.

To find the maximum payment, we find where the NAL is equal to zero and solve for the
payment. Using X to represent the maximum payment:

NAL = 0 = $8,780,000 – X(1.0553)(PVIFA5.53%,5) – $368,760(PVIFA5.53%,5)

X = $1,600,493.57

So, the maximum pretax lease payment is:

Pretax lease payment = $1,600,493.57/(1 – .21)

Pretax lease payment = $2,025,941.23

8. The after-tax residual value of the asset represents an opportunity cost in the context of the
leasing decision. This value occurs at the end of the system’s life (Year 5). It’s important to note that
the residual value is not akin to a debt-like cash flow, as there is inherent uncertainty associated with it
at Year 0. Despite this uncertainty, in practical terms, we often use the after-tax cost of debt to
discount the residual value. This approach is commonly followed, and we aim to set the Net
Advantage to Leasing (NAL) equal to zero:

NAL = 0 = $8,780,000 – X(1.0553)(PVIFA5.53%,5) – 368,760(PVIFA5.53%,5) +

900,000/1.05535
X = $1,753,210.53

So, the maximum pretax lease payment is:

Pretax lease payment = $1,753,210.53/(1 – .21)

Pretax lease payment = $2,219,253.83

9. The security deposit is a cash outflow at the beginning of the lease and a cash inflow at the
end of the lease when it is returned. The NAL with these assumptions is:

NAL = $8,780,000 – 600,000 – 1,540,500 – $1,540,500(PVIFA5.53%,4) –

$368,760(PVIFA5.53%,5)
+ $600,000/1.05535
NAL = $128,563.07

With the security deposit, the firm should still lease the equipment rather than buy it, because
the NAL is greater than zero. We could also solve this problem another way. From Problem 7, we
know that the NAL without the security deposit is $270,134.62, so, if we find the present value of the
security deposit, we can add this to $270,134.62. The present value of the security deposit is:

PV of security deposit = –$600,000 + $600,000/1.05535

PV of security deposit = –$141,571.55

So, the NAL with the security deposit is:

NAL = $270,134.62 – 141,571.55

NAL = $128,563.07