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CHAPTER 4: ANALYSIS OF FINANCIAL STATEMENT

1. HD Corp and LD Corp have identical assets, sales, interest rates paid on their debt, tax
rates, and EBIT. Both firms finance using only debt and common equity and total assets equal
total invested capital. However, HD uses more debt than LD. Which of the following statements
is CORRECT?

a. Without more information, we cannot tell if HD or LD would have a higher or lower net
income.

b. HD would have the lower equity multiplier for use in the DuPont equation.

c. HD would have to pay more in income taxes.

d. HD would have the lower net income as shown on the income statement.

e. HD would have the higher operating margin.

ANSWER: d

RATIONALE: More debt would mean more interest, hence a lower NI, given a constant EBIT,
so d is correct. Also, we can rule out a and e, and HD would also have the higher multiplier,
which rules out b. And with more interest, HD would have to pay less taxes, not more.

2. Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets,
and basic earning power. Both firms finance using only debt and common equity and total assets
equal total invested capital. Both companies have positive net incomes. Company HD has a
higher total debt to total capital ratio and, therefore, a higher interest expense. Which of the
following statements is CORRECT?

a. Company HD pays less in taxes.

b. Company HD has a lower equity multiplier.

c. Company HD has a higher ROA.

d. Company HD has a higher times-interest-earned (TIE) ratio.

e. Company HD has more net income.

ANSWER: a
RATIONALE: Under the stated conditions, HD would have more interest charges, thus lower
taxable income and taxes. Thus, a is correct. All of the other statements are incorrect.

3. Companies HD and LD have the same tax rate, sales, total assets, and basic earning power.
Both companies have positive net incomes. Both firms finance using only debt and common
equity and total assets equal total invested capital. Company HD has a higher total debt to total
invested capital ratio and, therefore, a higher interest expense. Which of the following statements
is CORRECT?

a. Company HD has a lower equity multiplier.

b. Company HD has more net income.

c. Company HD pays more in taxes.

d. Company HD has a lower ROE.

e. Company HD has a lower times-interest-earned (TIE) ratio.

ANSWER: e

RATIONALE: HD has higher interest charges. Basic earning power equals EBIT/Assets, and
since assets and BEP are equal, EBIT must also be equal. TIE = EBIT/Interest. Therefore, HDs
higher interest charges means that its TIE must be lower. Thus, e is correct. All of the other
statements are incorrect.

4. Which of the following statements is CORRECT?

a. If a firm has high current and quick ratios, this always indicate that the firm is managing its
liquidity position well.

b. If a firm sold some inventory for cash and left the funds in its bank account, its current ratio
would probably not change much, but its quick ratio would decline.

c. If a firm sold some inventory on credit, its current ratio would probably not change much, but
its quick ratio would decline.
d. If a firm sold some inventory on credit as opposed to cash, there is no reason to think that
either its current or quick ratio would change.

e. The inventory turnover ratio and days sales outstanding (DSO) are two ratios that are used to
assess how effectively a firm is managing its current assets.

ANSWER: e

5. Which of the following statements is CORRECT?

a. A decline in a firms inventory turnover ratio suggests that it is improving both its inventory
management and its liquidity position, i.e., that it is becoming more liquid.

b. In general, its better to have a low inventory turnover ratio than a high one, as a low one
indicates that the firm has an adequate stock of inventory relative to sales and thus will not lose
sales as a result of running out of stock.

c. If a firms fixed assets turnover ratio is significantly lower than its industry average, this
could indicate that it uses its fixed assets very efficiently or is operating at over capacity and
should probably add fixed assets.

d. The more conservative a firms management is, the higher its total debt to total capital ratio is
likely to be.

e. The days sales outstanding ratio tells us how long it takes, on average, to collect after a sale is
made. The DSO can be compared with the firms credit terms to get an idea of whether
customers are paying on time.

ANSWER: e

6. Which of the following statements is CORRECT?

a. Other things held constant, the more debt a firm uses, the higher its operating margin will be.

b. Debt management ratios show the extent to which a firms managers are attempting to
magnify returns on owners capital through the use of financial leverage.

c. Other things held constant, the more debt a firm uses, the higher its profit margin will be.
d. Other things held constant, the higher a firms total debt to total capital ratio, the higher its
TIE ratio will be.

e. Debt management ratios show the extent to which a firms managers are attempting to reduce
risk through the use of financial leverage. The higher the total debt to total capital ratio, the
lower the risk.

ANSWER: b

7. Which of the following statements is CORRECT?

a. Other things held constant, the less debt a firm uses, the lower its return on total assets will be.

b. The advantage of the basic earning power ratio (BEP) over the return on total assets for
judging a companys operating efficiency is that the BEP does not reflect the effects of debt and
taxes.

c. The return on common equity (ROE) is generally regarded as being less significant, from a
stockholders viewpoint, than the return on total assets (ROA).

d. The price/earnings (P/E) ratio tells us how much investors are willing to pay for a dollar of
current earnings. In general, investors regard companies with higher P/E ratios as being more
risky and/or less likely to enjoy higher future growth.

e. Suppose you are analyzing two firms in the same industry. Firm A has a profit margin of 10%
versus a margin of 8% for Firm B. Firm As total debt to total capital ratio is 70% versus 20%
for Firm B. Based only on these two facts, you cannot reach a conclusion as to which firm is
better managed, because the difference in debt, not better management, could be the cause of
Firm As higher profit margin.

ANSWER: b

8. Which of the following statements is CORRECT?


a. In general, if investors regard a company as being relatively risky and/or having relatively
poor growth prospects, then it will have relatively high P/E and M/B ratios.

b. The basic earning power ratio (BEP) reflects the earning power of a firms assets after giving
consideration to financial leverage and tax effects.

c. The apparent, but not necessarily the true, financial position of a company whose sales
are seasonal can change dramatically during a given year, depending on the time of year when
the financial statements are constructed.

d. The market/book (M/B) ratio tells us how much investors are willing to pay for a dollar of
accounting book value. In general, investors regard companies with higher M/B ratios as being
more risky and/or less likely to enjoy higher future growth.

e. It is appropriate to use the fixed assets turnover ratio to appraise firms effectiveness in
managing their fixed assets if and only if all the firms being compared have the same proportion
of fixed assets to total assets.

ANSWER: c

9. Walter Industries current ratio is 0.5. Considered alone, which of the following actions
would increase the companys current ratio?

a. Borrow using short-term notes payable and use the cash to increase inventories.

b. Use cash to reduce accruals.

c. Use cash to reduce accounts payable.

d. Use cash to reduce short-term notes payable.

e. Use cash to reduce long-term bonds outstanding.

ANSWER: a

RATIONALE: The following equation can be used. If you add equal amounts to the numerator
and denominator, then if Orig CR = or > 1.0, CR will decline, but if Orig CR < 1.0, CR will
increase. Obviously, if you add to one but not the other, CR will increase or decrease in a
predictable manner. We see that a is correct.

Example:

Original Plus New Old New

CA/CL $1 CA/CL CR CR

1 0.50 0.67 CR rises if initial CR is less than 1.0

10. Safecos current assets total to $20 million versus $10 million of current liabilities, while
Riscos current assets are $10 million versus $20 million of current liabilities. Both firms would
like to window dress their end-of-year financial statements, and to do so they tentatively plan
to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash
accounts. Which of the statements below best describes the results of these transactions?

a. The transactions would improve Safecos financial strength as measured by its current ratio
but lower Riscos current ratio.

b. The transactions would lower Safecos financial strength as measured by its current ratio but
raise Riscos current ratio.

c. The transactions would have no effect on the firm financial strength as measured by their
current ratios.

d. The transactions would lower both firm financial strength as measured by their current ratios.
e. The transactions would improve both firms financial strength as measured by their current
ratios.

ANSWER: b

RATIONALE: The key here is to recognize that if the CR is less than 1.0, then a given increase
to both current assets and current liabilities will increase the CR, while the reverse will hold if
the initial CR is greater than 1.0. Thus, the transactions would make Risco look stronger but
Safeco look weaker. Heres an illustration:

Safeco:

Original Plus New Old New CA/CL $10 CA/CL CR CR

2.00 1.50 CR falls because initial CR is greater than 1.0

Risco:

Original Plus New Old New


CA/CL $10 CA/CL CR CR

0.50 0.67 CR rises because initial CR is less than 1.0

All of the statements except b are incorrect.

11. Companies HD and LD have the same total assets, sales, operating costs, and tax rates, and
they pay the same interest rate on their debt. Both firms finance using only debt and common
equity and total assets equal total invested capital. However, company HD has a higher total debt
to total capital ratio. Which of the following statements is CORRECT?

a. Given this information, LD must have the higher ROE.

b. Company LD has a higher basic earning power ratio (BEP).

c. Company HD has a higher basic earning power ratio (BEP).

d. If the interest rate the companies pay on their debt is more than their basic earning power
(BEP), then Company HD will have the higher ROE.

e. If the interest rate the companies pay on their debt is less than their basic earning power
(BEP), then Company HD will have the higher ROE.

ANSWER: e

RATIONALE: The companies have the same EBIT and assets, hence the same BEP ratio. If the
interest rate is less than the BEP, then using more debt will raise the ROE. Therefore, statement e
is correct. The others are all incorrect.

12. Which of the following statements is CORRECT?

a. Even though Firm As current ratio exceeds that of Firm B, Firm Bs quick ratio might exceed
that of A. However, if As quick ratio exceeds Bs, then we can be certain that As current ratio
is also larger than Bs.

b. Suppose a firm wants to maintain a specific TIE ratio. It knows the amount of its debt, the
interest rate on that debt, the applicable tax rate, and its operating costs. With this information,
the firm can calculate the amount of sales required to achieve its target TIE ratio.

c. Since the ROA measures the firms effective utilization of assets without considering how
these assets are financed, two firms with the same EBIT must have the same ROA.

d. Suppose all firms follow similar financing policies, face similar risks, have equal access to
capital, and operate in competitive product and capital markets. However, firms face different
operating conditions because, for example, the grocery store industry is different from the airline
industry. Under these conditions, firms with high profit margins will tend to have high asset
turnover ratios, and firms with low profit margins will tend to have low turnover ratios.

e. Klein Cosmetics has a profit margin of 5.0%, a total assets turnover ratio of 1.5 times, no debt
and therefore an equity multiplier of 1.0, and an ROE of 7.5%. The CFO recommends that the
firm borrow funds using long-term debt, use the funds to buy back stock, and raise the equity
multiplier to 2.0. The size of the firm (assets) would not change. She thinks that operations
would not be affected, but interest on the new debt would lower the profit margin to 4.5%. This
would probably not be a good move, as it would decrease the ROE from 7.5% to 6.5%.

ANSWER: b

Multiple Choice: Problems

A good bit of relatively simple algebra is involved in these problems, and although the
calculations are simple, it will take students some time to set up the problems and do the
arithmetic. We allow for this when assigning problems for a timed test. Also, note that students
must know the definitions of a number of ratios to answer the questions. We provide our students
with a formula sheet on exams, using the relevant sections of Appendix C at the then of the
text. Otherwise, they spend too much time trying to memorize thing rather than trying to
understand the issues.

The difficulty of the problems depends on (1) whether or not students are provided with a
formula sheet and (2) the amount of time they have to work the problems. Out difficulty
assessments assume that they have a formula sheet and areasonable amount of time for the test.
Note that a few of the problems are trivially easy if students have formula sheets.

To work some of the problems, students must transpose equations and solve for items that are
normally inputs. For example, the equation for the profit margin is given as Profit margin = Net
income/Sales. We might have a problem where sales and the profit margin are given and then
require students to find the firms net income. We explain to our students in class before the
exam that they will have to transpose terms in the formulas to work some problems.

Problems 84 through 114 are all stand-along problems with individualized data. Problems 115
through 133 are all based on a common set of financial statements, and they require students to
calculate ratios and find items like EPS, TIE, and the like using this data set. The financial
statements can be changed algorithmically, and this changes the calculated ratios and other
items.
13. Ryngard Corps sales last year were $38,000, and its total assets were $16,000. What was its
total assets turnover ratio (TATO)?

a. 2.04

b. 2.14

c. 2.26

d. 2.38

e. 2.49

ANSWER: d

RATIONALE: Sales $38,000

Total assets $16,000

TATO = Sales/Total assets = 2.38

14. Beranek Corp has $720,000 of assets (which equal total invested capital), and it uses no
debtit is financed only with common equity. The new CFO wants to employ enough debt to
raise the total debt to total capital ratio to 40%, using the proceeds from borrowing to buy back
common stock at its book value. How much must the firm borrow to achieve the target debt
ratio?

a. $273,600

b. $288,000

c. $302,400

d. $317,520

e. $333,396

ANSWER: b

RATIONALE: Total assets = Total invested capital $720,000


Target debt to total capital ratio 40%

Debt to achieve target ratio = Amount borrowed = Target % Invested


capital = $288,000

15. Ajax Corps sales last year were $435,000, its operating costs were $362,500, and its interest
charges were

$12,500. What was the firms times-interest-earned (TIE) ratio?

a. 4.72

b. 4.97

c. 5.23

d. 5.51

e. 5.80

ANSWER: e

RATIONALE: Sales $435,000

Operating costs $362,500

Operating income (EBIT) $ 72,500

Interest charges $ 12,500

TIE ratio = EBIT/Interest = 5.80

16. Royce Corps sales last year were $280,000, and its net income was $23,000. What was its
profit margin?

a. 7.41%

b. 7.80%

c. 8.21%

d. 8.63%
e. 9.06%

ANSWER: c

RATIONALE: Sales $280,000

Net income $23,000

Profit margin = NI/Sales 8.21%

17. River Corps total assets at the end of last year were $415,000 and its net income was
$32,750. What was its return on total assets?

a. 7.89%

b. 8.29%

c. 8.70%

d. 9.14%

e. 9.59%

ANSWER: a

RATIONALE: Total assets $415,000

Net income $32,750

ROA = NI/Assets = 7.89%

18. X-1 Corps total assets at the end of last year were $405,000 and its EBIT was 52,500. What
was its basic earning power (BEP) ratio?

a. 11.70%

b. 12.31%
c. 12.96%

d. 13.61%

e. 14.29%

ANSWER: c

RATIONALE: Total assets $405,000

EBIT $52,500

BEP = EBIT/Assets = 12.96%

19. Zero Corps total common equity at the end of last year was $405,000 and its net income
was $70,000. What was its ROE?

a. 14.82%

b. 15.60%

c. 16.42%

d. 17.28%

e. 18.15%

ANSWER: d

RATIONALE: Common equity $405,000

Net income $70,000

ROE = NI/Equity = 17.28%

20. Your sister is thinking about starting a new business. The company would require $375,000
of assets, and it would be financed entirely with common stock. She will go forward only if she
thinks the firm can provide a 13.5% return on the invested capital, which means that the firm
must have an ROE of 13.5%. How much net income must be expected to warrant starting the
business?

a. $41,234

b. $43,405

c. $45,689

d. $48,094

e. $50,625

ANSWER: e

RATIONALE: Assets = Equity $375,000

Target ROE 13.5%

Required net income = Target ROE Equity = $50,625

21. Herring Corporation has operating income of $225,000 and a 40% tax rate. The firm has
short-term debt of $120,000, long-term debt of $330,000, and common equity of $450,000. What
is its return on invested capital?

a. 13.75%

b. 14.33%

c. 15.00%

d. 16.25%

e. 17.10%
EBIT $225,000

Tax rate 40%

Short-term debt $120,000

Long-term debt $330,000

Common equity $450,000

ROIC = [EBIT(1 T)]/(STD + LTD + E) 15%

ANSWER: c

RATIONALE:

22. Song Corps stock price at the end of last year was $23.50 and its earnings per share for the
year were $1.30. What was its P/E ratio?

a. 17.17

b. 18.08

c. 18.98
d. 19.93

e. 20.93

ANSWER: b

RATIONALE: Stock price $23.50

EPS $1.30

P/E = Stock price/EPS 18.08

23. Hoagland Corps stock price at the end of last year was $33.50, and its book value per share
was $25.00. What was its market/book ratio?

a. 1.34

b. 1.41

c. 1.48

d. 1.55

e. 1.63

ANSWER: a

RATIONALE: Stock price $33.50

Book value per share $25.00

M/B ratio = Stock price/Book value per share = 1.34

24. Precision Aviation had a profit margin of 6.25%, a total assets turnover of 1.5, and an equity
multiplier of 1.8. What was the firms ROE?

a. 15.23%
b. 16.03%

c. 16.88%

d. 17.72%

e. 18.60%

Profit margin 6.25%

TATO 1.50

Equity multiplier 1.80

ROE = PM TATO Eq. multiplier = 16.88%

ANSWER: c

RATIONALE:

25. Meyer Incs total invested capital is $625,000, and its total debt outstanding is $185,000.
The new CFO wants to establish a total debt to total capital ratio of 55%. The size of the firm
will not change. How much debt must the company add or subtract to achieve the target debt to
capital ratio?

a. $158,750

b. $166,688

c. $175,022

d. $183,773
e. $192,962

ANSWER: a

RATIONALE: Total invested capital $625,000

Old debt $185,000

Target debt to capital ratio 55%

Target amount of debt = Target debt % Total invested capital


= $343,750

Change in amount of debt outstanding = Target debt Old debt


= $158,750

26. Helmuth Incs latest net income was $1,250,000, and it had 225,000 shares outstanding. The
company wants to pay out 45% of its income. What dividend per share should it declare?

a. $2.14

b. $2.26

c. $2.38

d. $2.50

e. $2.63

ANSWER: d

RATIONALE: Net income $1,250,000

Shares outstanding 225,000

Payout ratio 45%

EPS = NI/shares outstanding = $5.56

DPS = EPS Payout % = $2.50


27. Garcia Industries has sales of $200,000 and accounts receivable of $18,500, and it gives its
customers 25 days to pay. The industry average DSO is 27 days, based on a 365-day year. If the
company changes its credit and collection policy sufficiently to cause its DSO to fall to the
industry average, and if it earns 8.0% on any cash freed- up by this change, how would that
affect its net income, assuming other things are held constant?

a. $241.45

b. $254.16

c. $267.54

d. $281.62

e. $296.44

Rate of return on cash generated

8.0%

Sales $200,000

A/R $18,500

Days in Year 365

Sales/day = Sales/365 = $547.95

Company DSO = Receivables/Sales per day = 33.8

Industry DSO 27.0

Difference = Company DSO Industry DSO = 6.8

Cash flow from reducing the DSO = Difference Sales/day = $3,705.48

Additional Net Income = Return on cash Added cash flow = $296.44

Alternative Calculation: A/R at industry DSO


$14,794.52

Change in A/R $3,705.48

Additional Net Income $296.44

ANSWER: RATIONALE:
28. Faldo Corp sells on terms that allow customers 45 days to pay for merchandise. Its sales last
year were $325,000, and its year-end receivables were $60,000. If its DSO is less than the 45-day
credit period, then customers are paying on time. Otherwise, they are paying late. By how much
are customers paying early or late? Base your answer on this equation: DSO Credit Period =
Days early or late, and use a 365-day year when calculating the DSO. A positive answer
indicates late payments, while a negative answer indicates early payments.

a. 21.27

b. 22.38

c. 23.50

d. 24.68

e. 25.91

ANSWER: b

RATIONALE:Credit period 45

Sales $325,000

Sales/day = Sales/365 = $890.41

Receivables $60,000

Company DSO = Receivables/Sales per day = 67.38

Company DSO Credit Period = Days early () or late (+) = 22.38

29. Han Corps sales last year were $425,000, and its year-end receivables were $52,500. The
firm sells on terms that call for customers to pay 30 days after the purchase, but some delay
payment beyond Day 30. On average, how many days late do customers pay? Base your answer
on this equation: DSO Allowed credit period = Average days late, and use a 365-day year
when calculating the DSO.

a. 12.94

b. 13.62
c. 14.33

d. 15.09

e. 15.84

ANSWER: d

RATIONALE: Sales $425,000

Sales/day = Sales/365 = $1,164.38

Receivables $52,500

Company DSO = Receivables/Sales per day = 45.09

Credit period 30

DSO Credit period = Days late 15.09

30. Wie Corps sales last year were $315,000, and its year-end total assets were $355,000. The
average firm in the industry has a total assets turnover ratio (TATO) of 2.4. The firms new CFO
believes the firm has excess assets that can be sold so as to bring the TATO down to the industry
average without affecting sales. By how much must the assets be reduced to bring the TATO to
the industry average, holding sales constant?

a. $201,934

b. $212,563

c. $223,750

d. $234,938

e. $246,684

ANSWER: c

RATIONALE: Sales $315,000

Actual total assets $355,000


Target TATO = Sales/Total assets = 2.40

Target assets = Sales/Target TATO = $131,250

Asset reduction = Actual assets Target assets = $223,750

31. A new firm is developing its business plan. It will require $615,000 of assets (which
equals total invested capital), and it projects $450,000 of sales and $355,000 of operating costs
for the first year. Management is reasonably sure of these numbers because of contracts with its
customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires it to have a TIE of
at least 4.0, and if the TIE falls below this level the bank will call in the loan and the firm will go
bankrupt. The firm will use only debt and common equity for financing. What is
the maximum debt to capital ratio (measured as debt/total invested capital) the firm can use?
(Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then
the related debt to capital ratio.)

a. 41.94%

b. 44.15%

c. 46.47%

d. 48.92%

e. 51.49%

Assets = Total invested capital

$615,000

Sales $450,000

Operating costs $355,000

Operating income (EBIT) $ 95,000

Target TIE 4.00

Maximum interest expense = EBIT/Target TIE $23,750


Interest rate 7.50%

Max. debt = Max interest expense/Interest rate $316,667

Maximum debt to capital ratio = Debt/Total invested capital 51.49%

ANSWER: RATIONALE:

32. Duffert Industries has total assets of $1,000,000 and total current liabilities (consisting
only of accounts payable and accruals) of $125,000. Duffert finances using only long-term debt
and common equity. The interest rate on its debt is 8% and its tax rate is 40%. The firms basic
earning power ratio is 15% and its debt-to capital rate is 40%. What are Dufferts ROE and
ROIC?

a. 12.00%; 10.29%

b. 12.57%; 10.29%

c. 13.94%; 9.86%

d. 13.94%; 10.29%

e. 13.94%; 11.50%

ANSWER: d

Total assets $1,000,000

RATIONALE:

Balance sheet:
Current liabilities $ 125,000

Debt 350,000

Common equity 525,000

Total liabilities $1,000,000

D/(D + E) = 0.4

D/($1,000,000 $125,000,000) = 0.4

D = $350,000

Now calculate EBIT:

BEP = 0.15 = EBIT/TA = EBIT/$1,000,000

EBIT = $150,000

Calculate ROIC: ROIC = [EBIT(1 T)]/(D + E) = [$150,000(0.6)]/$875,000 = 10.29%

Now determine net income from income statement:

EBIT $150,000

Interest 28,000 (0.08 $350,000)

EBT $122,000

Taxes (40%) 48,800

NI $ 73,200

ROE = NI/E = $73,200/$525,000 = 13.94%


33. Chang Corp. has $375,000 of assets, and it uses only common equity capital (zero debt).
Its sales for the last year were $595,000, and its net income was $25,000. Stockholders recently
voted in a new management team that has promised to lower costs and get the return on equity
up to 15.0%. What profit margin would the firm need in order to achieve the 15% ROE, holding
everything else constant?

a. 9.45%

b. 9.93%

c. 10.42%

d. 10.94%

e. 11.49%

ANSWER: a

RATIONALE: Total assets = Equity because zero debt $375,000

Sales $595,000

Net income $25,000

Target ROE 15.00%

Net income reqd to achieve target ROE = Target ROE Equity


= $56,250

Profit margin needed to achieve target ROE = NI/Sales = 9.45%

34. Last year Ann Arbor Corp had $155,000 of assets (which equals total invested capital),
$305,000 of sales, $20,000 of net income, and a debt-to-total-capital ratio of 37.5%. The new
CFO believes a new computer program will enable it to reduce costs and thus raise net income to
$33,000. The firm finances using only debt and common equity. Assets, total invested capital,
sales, and the debt to capital ratio would not be affected. By how much would the cost reduction
improve the ROE?

a. 11.51%

b. 12.11%

c. 12.75%
d. 13.42%

e. 14.09%

Assets = Total invested capital

$155,000

Debt to total capital ratio 37.5%

Debt = Capital Debt % = $58,125

Equity = Assets Debt = $96,875

Sales $305,000

Old net income $20,000

New net income $33,000

New ROE = New NI/Equity = 34.065%

Old ROE = Old NI/Equity = 20.645%

Increase in ROE = New ROE Old ROE = 13.42%

ANSWER:RATIONALE:

35. Brookman Incs latest EPS was $2.75, its book value per share was $22.75, it had 315,000
shares outstanding, and its debt/total invested capital ratio was 44%. The firm finances using
only debt and common equity and its total assets equal total invested capital. How much debt
was outstanding?
a. $4,586,179

b. $4,827,557

c. $5,081,639

d. $5,349,094

e. $5,630,625

ANSWER: e

RATIONALE: EPS $2.75

BVPS $22.75

Shares outstanding 315,000

Debt to total capital ratio 44.0%

Total equity = Shares outstanding BVPS = $7,166,250

Total assets = Total equity/(1 Debt to total capital ratio)


= $12,796,875

Total debt = Total assets Equity = $5,630,625

36. Last year Harrington Inc. had sales of $325,000 and a net income of $19,000, and its year-
end assets were

$250,000. The firms total-debt-to-total-capital ratio was 45.0%. The firm finances using only
debt and common equity and its total assets equal total invested capital. Based on the DuPont
equation, what was the ROE?

a. 13.82%

b. 14.51%

c. 15.23%

d. 16.00%

e. 16.80%
a Sales

$325,000

Assets = Total invested capital $250,000

Net income $19,000

Debt to total capital ratio 45.0%

Debt = Debt % Capital = $112,500

Equity = Assets Debt = $137,500

Profit margin = NI/Sales = 5.85%

TATO = Sales/Assets = 1.30

Equity multiplier = Assets/Equity = 1.82

ROE 13.82%

ANSWER: RATIONALE:

37. Last year Rennie Industries had sales of $305,000, assets of $175,000 (which equals total
invested capital), a profit margin of 5.3%, and an equity multiplier of 1.2. The CFO believes that
the company could reduce its assets by $51,000 without affecting either sales or costs. The firm
finances using only debt and common equity. Had it reduced its assets by this amount, and had
the debt/total invested capital ratio, sales, and costs remained constant, how much would the
ROE have changed?

a. 4.10%

b. 4.56%
c. 5.01%

d. 5.52%

e. 6.07%

Old New

Sales $305,000 $305,000

Original assets = Original capital $175,000

Reduction in assets = Reduction in capital $ 51,000

New assets = Old assets Reduction = $124,000

TATO = Sales/Assets = 1.74 2.46

Profit margin 5.30% 5.30%

Equity multiplier 1.20 1.20

ROE = PM TATO Eq. multiplier = 11.08% 15.64%

Change in ROE 4.56%

ANSWER: RATIONALE:
38. Last year Blease Inc had a total assets turnover of 1.33 and an equity multiplier of 1.75. Its
sales were $295,000 and its net income was $10,600. The firm finances using only debt and
common equity and its total assets equal total invested capital. The CFO believes that the
company could have operated more efficiently, lowered its costs, and increased its net income by
$10,250 without changing its sales, assets, or capital structure. Had it cut costs and increased its
net income by this amount, how much would the ROE have changed?

a. 6.55%

b. 7.28%

c. 8.09%

d. 8.90%

e. 9.79%
c

Old New

Sales $295,000 $295,000

Original net income $ 10,600 $ 10,600

Increase in net income $ 0 $ 10,250

New net income $ 10,600 $ 20,850

Profit margin = NI/Sales = 3.59% 7.07%

TATO 1.33 1.33

Equity multiplier 1.75 1.75

ROE = PM TATO Eq. multiplier = 8.36% 16.45%

Change in ROE 8.09%

ANSWER: RATIONALE:

39. Last year Jandik Corp. had $295,000 of assets (which is equal to its total invested capital),
$18,750 of net income, and a debt-to-total-capital ratio of 37%. Now suppose the new CFO
convinces the president to increase the debt- to-total-capital ratio to 48%. Sales, total assets, and
total invested capital will not be affected, but interest expenses would increase. However, the
CFO believes that better cost controls would be sufficient to offset the higher interest expense
and thus keep net income unchanged. By how much would the change in the capital structure
improve the ROE?

a. 2.13%
b. 2.35%

c. 2.58%

d. 2.84%

e. 3.12%

Assets = Total invested capital

$295,000

Old debt to capital ratio 37%

Old debt = Capital Old debt % = $109,150

Old equity = Assets Debt $185,850

New debt to capital ratio 48%

New debt = Capital New debt % = $141,600

New Equity = Assets New debt = $153,400

Net income $18,750

New ROE = New income/New Equity 12.22%

Old ROE = Old income/Old Equity 10.09%

Increase in ROE 2.13%

ANSWER: RATIONALE:
40. Last year Kruse Corp had $305,000 of assets (which is equal to its total invested capital),
$403,000 of sales,

$28,250 of net income, and a debt-to-total-capital ratio of 39%. The new CFO believes the firm
has excessive fixed assets and inventory that could be sold, enabling it to reduce its total assets
and total invested capital to $252,500.

The firm finances using only debt and common equity. Sales, costs, and net income would not be
affected, and the firm would maintain the same capital structure (but with less total debt). By
how much would the reduction in assets improve the ROE?

a. 2.85%

b. 3.00%

c. 3.16%

d. 3.31%

e. 3.48%

ANSWER: c
RATIONALE: Original New

Assets = Total invested capital $305,000 $252,500

Sales $403,000 $403,000

Net income $28,250 $28,250

Debt to capital ratio 39.00% 39.00%

Debt = Capital debt % = $118,950 $98,475

Equity = Assets Debt = $186,050 $154,025

ROE = NI/Equity = 15.184% 18.341%

Increase in ROE 3.16%

41. Jordan Inc has the following balance sheet and income statement data:

Cash $ 14,000 Accounts payable $ 42,000

Receivables 70,000 Other current liab. 28,000

Inventories 280,000 Total CL $ 70,000

Total CA $364,000 Long-term debt 140,000

Net fixed assets 126,000 Common equity 280,000

Total assets $490,000 Total liab. and equity $490,000

Sales $280,000

Net income $ 21,000

The new CFO thinks that inventories are excessive and could be lowered sufficiently to cause the
current ratio to equal the industry average, 2.75, without affecting either sales or net income.
Assuming that inventories are sold off and not replaced to get the current ratio to the target level,
and that the funds generated are used to buy back common stock at book value, by how much
would the ROE change?

a. 11.26%

b. 11.85%

c. 12.45%

d. 13.07%

e. 13.72%

ANSWER: b
RATIONALE:
Original balance sheet and income statement data:

Cash $ 14,000 Accounts payable $ 42,000

Receivables 70,000 Other current 28,000


liabilities

Inventories 280,000 Total CL $ 70,000

Total CA $364,000 Long-term debt 140,000

Net fixed assets 126,000 Common equity 280,000

Total assets $490,000 Total liab. and $490,000


equity

Sales $280,000

Net income $ 21,000

Actual current ratio 5.20

Target current ratio 2.75


Old current assets = $364,000

Current assets to have CR = Target: Target current ratio Cur. Liab.


= $192,500

Reduction in current assets = Old CA New CA = Inventory reduction


= $171,500

Reduction in common equity = Reduction in inventory = $171,500

New common equity = Old equity Reduction = $108,500

Orig ROE = NI/Old Equity: 7.50%

New ROE = NI/New Equity: 19.35%

ROE = 11.85%

42. Last year Hamdi Corp. had sales of $500,000, operating costs of $450,000, and year-end
assets (which is equal to its total invested capital) of $395,000. The debt-to-total-capital ratio was
17%, the interest rate on the debt was 7.5%, and the firms tax rate was 35%. The new CFO
wants to see how the ROE would have been affected if the firm had used a 50% debt-to-total-
capital ratio. Assume that sales, operating costs, total assets, total invested capital, and the tax
rate would not be affected, but the interest rate would rise to 8.0%. By how much would the
ROE change in response to the change in the capital structure?

a. 1.71%

b. 1.90%

c. 2.11%

d. 2.34%

e. 2.58%
d

Old New

Interest rate 7.5% 8.0%

Tax rate 35% 35%

Assets = Total capital $395,000 $395,000

Debt-to-capital ratio 17% 50%

Debt = Capital Debt ratio = $ 67,150 $197,500

Equity = Assets Debt = $327,850 $197,500

Sales $500,000 $500,000

Operating costs 450,000 450,000

EBIT = Sales Operating costs = $ 50,000 $ 50,000

Interest paid = Interest rate Debt = 5,036 15,800

Taxable income $ 44,964 $ 34,200

Taxes 15,737 11,970

Net income $ 29,226 $ 22,230

ROE 8.91% 11.26%

Change in ROE 2.34%

ANSWER: RATIONALE:
43. Quigley Inc. is considering two financial plans for the coming year. Management expects
sales to be $300,000, operating costs to be $265,000, assets (which is equal to its total invested
capital) to be $200,000, and its tax rate to be 35%. Under Plan A it would finance the firm using
25% debt and 75% common equity. The interest rate on the debt would be 8.8%, but under a
contract with existing bondholders the TIE ratio would have to be maintained at or above 4.0.
Under Plan B, the maximum debt that met the TIE constraint would be employed. Assuming that
sales, operating costs, assets, total invested capital, the interest rate, and the tax rate would all
remain constant, by how much would the ROE change in response to the change in the capital
structure?

a. 3.71%

b. 4.08%

c. 4.48%

d. 4.93%

e. 5.18%

ANSWER: a

RATIONALE: Work down the Plan A column, find the Max Debt, then use it to complete Plan
B and the ROEs.

Plan A Plan B

Interest rate 8.80% 8.80%

Tax rate 35% 35%

Assets = Total capital $200,000 $200,000

Debt ratio: Plan A given, Plan B calculated 25% 49.7%

Debt $ 50,000 $ 99,432

Equity $150,000 $100,568

Sales Constant $300,000 $300,000


Operating costs Constant 265,000 265,000

EBIT Constant $ 35,000 $ 35,000

Interest 4,400 8,750

Taxable income $ 30,600 $ 26,250

Taxes 10,710 9,188

Net income $ 19,890 $ 17,063

ROE = NI/Equity = 13.26% 16.97%

TIE = EBIT/Interest = Minimum TIE 7.95

$ of Interest consistent with minimum TIE 4.00

= EBIT/Min. TIE =

$8,750

Max debt = Interest/interest rate = $99,432

Change in ROE 3.71%

Exhibit 4.1

The balance sheet and income statement shown below are for Koski Inc. Note that the firm has
no amortization charges, it does not lease any assets, none of its debt must be retired during the
next 5 years, and the notes payable will be rolled over.

Balance Sheet (Millions of $)

Assets 2014
Cash and securities $ 2,500

Accounts receivable 11,500

Inventories 16,000

Total current assets $30,000

Net plant and equipment $20,000

Total assets $50,000

Liabilities and Equity Accounts payable

$ 9,500

Accruals 5,500

Notes payable 7,000

Total current liabilities $22,000

Long-term bonds $15,000

Total liabilities $37,000

Common stock $ 2,000

Retained earnings 11,000

Total common equity $13,000

Total liabilities and equity $50,000

Income Statement (Millions of $) 2014

Net sales $87,500

Operating costs except depreciation 81,813


Depreciation 1,531

Earnings bef interest and taxes (EBIT) $ 4,156

Less interest 1,375

Earnings before taxes (EBT) $ 2,781

Taxes 973

Net income $ 1,808

Other data:

Shares outstanding (millions)

500.00

Common dividends $632.73

Int rate on notes payable & L-T bonds 6.25%

Federal plus state income tax rate 35%

Year-end stock price $43.39

44. Refer to Exhibit 4.1. What is the firms current ratio?

a. 0.99

b. 1.10

c. 1.23

d. 1.36

e. 1.50
ANSWER: d

RATIONALE: Current ratio = Current assets/Current liabilities = 1.36

45. Refer to Exhibit 4.1. What is the firms quick ratio? a. 0.51

b. 0.64

c. 0.76

d. 0.92

e. 1.10

ANSWER: b

RATIONALE: Quick ratio = (CA Inventory)/CL = 0.64

46. Refer to Exhibit 4.1. What is the firms days sales outstanding? Assume a 365-day year for
this calculation.

a. 39.07

b. 41.13

c. 43.29

d. 45.57

e. 47.97

ANSWER: e

RATIONALE: DSO = Accounts receivable/(Sales/365) = 47.97

47. Refer to Exhibit 4.1. What is the firms total assets turnover? a. 1.12

b. 1.40
c. 1.75

d. 2.10

e. 2.52

ANSWER: c

RATIONALE: Total assets turnover ratio = TATO = Sales/Total assets = 1.75

48. Refer to Exhibit 4.1. What is the firms inventory turnover ratio? a. 5.47

b. 5.74

c. 6.03

d. 6.33

e. 6.65

ANSWER: a

RATIONALE: Inventory turnover ratio = Sales/Inventory = 5.47

49. Refer to Exhibit 4.1. What is the firms TIE?

a. 2.20

b. 2.45

c. 2.72

d. 3.02

e. 3.33
ANSWER: d

RATIONALE: TIE = EBIT/Interest charges = 3.02

50. Refer to Exhibit 4.1. What is the firms total debt to total capital ratio?

a. 48.55%

b. 53.95%

c. 59.94%

d. 62.80%

e. 68.11%

ANSWER: d

RATIONALE: Debt to capital ratio = Total debt/Total invested capital = 62.86%

51. Refer to Exhibit 4.1. What is the firms ROA?

a. 3.62%

b. 3.98%

c. 4.37%

d. 4.81%

e. 5.29%

ANSWER: a

RATIONALE: ROA = Net income/Total assets = 3.62%


52. Refer to Exhibit 4.1. What is the firms ROE?

a. 13.21%

b. 13.91%

c. 14.60%

d. 15.33%

e. 16.10%

ANSWER: b

RATIONALE: ROE = Net income/Common equity = 13.91%

53. Refer to Exhibit 4.1. What is the firms BEP?

a. 7.50%

b. 7.90%

c. 8.31%

d. 8.73%

e. 9.16%

ANSWER: c

RATIONALE: BEP = EBIT/Total assets = 8.31%

54. Refer to Exhibit 4.1. What is the firms profit margin?

a. 1.51%

b. 1.67%

c. 1.86%

d. 2.07%
e. 2.27%

ANSWER: d

RATIONALE: Profit margin = Net income/Sales = 2.07%

55. Refer to Exhibit 4.1. What is the firms operating margin?

a. 3.12%

b. 3.46%

c. 3.85%

d. 4.28%

e. 4.75%

ANSWER: e

RATIONALE: Operating margin = EBIT/Sales = 4.75%

56. Refer to Exhibit 4.1. What is the firms return on invested capital?

a. 4.25%

b. 5.67%

c. 7.72%

d. 9.33%

e. 11.87%

ANSWER: c
RATIONALE: Return on invested capital = [EBIT(1 T)]/Total invested capital = 7.72%

57. Refer to Exhibit 4.1. What is the firms dividends per share?

a. $1.14

b. $1.27

c. $1.39 d.

$1.53

e. $1.68

ANSWER: b

RATIONALE: DPS = Common dividends paid/Shares outstanding = $1.27

58. Refer to Exhibit 4.1. What is the firms EPS?

a. $3.26

b. $3.43

c. $3.62

d. $3.80

e. $3.99

ANSWER: c

RATIONALE: EPS = Net income/Common shares outstanding = $3.62

59. Refer to Exhibit 4.1. What is the firms P/E ratio?

a. 12.0

b. 12.6

c. 13.2

d. 13.9
e. 14.6

ANSWER: a

RATIONALE: P/E ratio = Price per share/Earnings per share = 12.0 We actually fixed the P/E
ratio at 12 in order to get a stock price. Either the price or the P/E ratio must be fixed or the
model becomes very complicated and a stock pricing equation is required.

60. Refer to Exhibit 4.1. What is the firms book value per share?

a. $22.29

b. $23.47

c. $24.70

d. $26.00

e. $27.30

ANSWER: d

RATIONALE: BVPS = Common equity/Shares outstanding = $26.00

61. Refer to Exhibit 4.1. What is the firms market-to-book ratio?

a. 0.87

b. 1.02

c. 1.21

d. 1.42

e. 1.67

ANSWER: e
RATIONALE: Market/book ratio (M/B) = Price per share/BVPS = 1.67

62. Refer to Exhibit 4.1. What is the firms equity multiplier?

a. 3.85

b. 4.04

c. 4.24

d. 4.45

e. 4.68

ANSWER: a

RATIONALE: Equity multiplier = Total assets/Common equity = 3.85

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