CHAPTER 10

Answers to Problems

1(a).
Net Income 400,000
Return on Total Equity    34.5% or using the 3 components :
Equity 1,160,000

Net Income Sales Total Assets

ROE  x x
Sales Total Assets Equity
400,000 6,000,000 4,000,000
 x x  34.5%
6,000,000 4,000,000 1,160,000
 0.067 x 1.5 x .3.448
 34.65% (slight difference is due to rounding)

1(b). Growth Rate = (retention rate) x (return on equity)

= [1 – (160,000/400,000)] x .345
= (1 - .40) x .345
= .60 x .345
= 20.7%

1(c). 0.04 x $6,000,000 = $240,000 (profit margin x sales)

240,000
ROE   20.7%
1,160,000
ROE  0.04 x 1.5 x 3.45  20.7%

1(d). Using the ROE of 20.7 in part c) and a net income of $240,000, we have

Growth Rate = .60 x .207 = 12.42%

If dividends were $40,000, then RR = 1 – ($40,000/240,000)

= 1 - .167 = .833

Then growth rate = .833 x .207 = 17.25%

2(a). ROE = Net profit margin x Total asset turnover x Total assets/equity
Company K: ROE = 0.04 x 2.2 x 2.4 = .2112
Company L: ROE = 0.06 x 2.0 x 2.2 = .2640
Company M: ROE = 0.10 x 1.4 x 1.5 = .2100

2(b). Growth Rate = Retention Rate x ROE

 = (1 - Payout Rate) x ROE
Company K: Growth Rate = 1 – (1.25/2.75) x .2112
= .545 x .2112 = .1151

Company L: Growth Rate = 1 – (1.00/3.00) x .2640

= .67 x .2640 = .1769

Company M: Growth Rate = 1 – (1.00/4.50) x .2100

= .778 x .21 = .1634
3. Current ratio = 650/350 = 1.857
Quick ratio = 320/350 = 0.914
Receivables turnover = 3500/195 = 17.95x
Average collection period = 365/17.95 = 20.33 days
Total asset turnover = 3500/2182.5 = 1.60x
Inventory turnover = 2135/280 = 7.625x
Fixed asset turnover = 3500/1462.5 = 2.39x
Equity turnover = 3500/1035 = 3.382x
Gross profit margin = (3500 - 2135)/3500 = .39
Operating profit margin = 258/3500 = .074
Return on capital (129 + 62)/1922.5 = .099 (invested capital: 2050 for 2013, 1795 for
2012)
Return on equity = 129/1185 = .109
Return on common equity = 114/1035 = .110
Debt/equity ratio = 625/1225 = .51
Debt/total capital ratio = 625/1850 = .338
Interest coverage = 258/62 = 4.16x
Fixed charge coverage = 258/[62 + (15/.66)] = 3.045x (preferred stock dividends are
computed on a before-tax basis)

Cash flow/long-term debt = (129 + 105 - 110)/625 = .198

= Net Income + non-cash charges (change in depreciation) - change in net working
capital (excl. cash)

Cash flow/total debt = (129 + 105 - 110)/975 = .127

Retention rate = 1 - (40/114) = .65

 Sophie’s current performance appears in line with its historical performance and the
industry average except in the areas of profitability (measured by return on capital and
return on common equity) and leverage (cash flow to long-term debt and cash flow to total
debt ratios). Its retention rate has increased markedly and its inventory turnover has fallen.

4.
2010 2014
4(a). To clarify a point of possible confusion: operating income in the problem set-up excludes
depreciation; we need to subtract it from operating income to obtain the appropriate ROE
(NI/Equity = 19/159 = 11.93% for 2010, 30/220 = 13.6% for 2014).

Operating Margin = (Operating Income – Depreciation)/Sales

= (38 - 3)/542 = 6.46% = (76 - 9)/979 = 6.84%

Asset Turnover = Sales/Total Assets

= 542/245 = 2.21x = 979/291 = 3.36x

Interest Burden = Interest Expense/Total Assets

= 3/245 = 1.22% = 0/291 = 0%

Financial Leverage = Total Assets/Common Shareholders Equity

= 245/159 = 1.54x = 291/220 = 1.32x

Tax Rate = Income Taxes/Pre-tax Income

= 13/32 = 40.63% = 37/67 = 55.22%

The recommended formula is:

Return on (ROE) = [(Op. Margin x Asset Turnover) - Int. Burden] x Equity Financial
Leverage x (100% - Income Tax Rate)

2010 = [(6.46% x 2.21x) - 1.22%] x 1.54 x (100% - 40.63%)

= 13.05 x 1.54 x .5937 = 11.93%

2014 = [(6.84% x 3.36x) - 0%] x 1.32 x (100% - 55.22%)

= 22.98 x 1.32 x .4478 = 13.58%

Two alternative approaches are also correct.

ROE = [(Op. Margin - (Int. Burden/Asset Turnover)] x Financial Leverage x Asset

Turnover x (100% - Income Tax Rate)

ROE = [(Financial Leverage x Asset Turnover x Operating Margin) - (Financial Leverage

x Interest Burden)] x (100% - Income Tax Rate)

4(b). Asset turnover measures the ability of a company to minimize the level of assets (current
 and fixed) to support its level of sales. The asset turnover increased substantially over the
period thus contributing to an increase in the ROE.

Financial leverage measures the amount of financing outside of equity including short and
long-term debt. Financial leverage declined over the period thus adversely affected the
ROE. Since asset turnover rose substantially more than financial leverage declined, the net
effect was an increase in ROE.

5. a). i. Adjusted Interest Coverage = EBITDA / Interest Expense =

$4,490,000 / $1,596,400 = 2.81
This is a reduction of 1.91 from the pre-adjustment ratio of 4.72.

Off-Balance EBITDA Interest Expense Interest Coverage

Sheet Item Impact Impact Impact
Pre-adjustment $4,450,000 $942,000 4.72

- Guarantee of debt (n/a) $0 $0

- Sale of receivables (1) +$40,000 +$40,000
- Operating lease (2) $0 +$614,400
Net Adjustment +$40,000 +$654,400
v
Post-adjustment $4,490,000 $1,596,400 2.81
(1) Sale of receivables = Interest income (EBITDA) & interest expense: $500,000 @
8% = $40,000.
(2) Operating lease = Interest expense: $6,144,000 @ 10% = $614,400.

In adjusting for the sold accounts receivable and treating it as a secured loan, operating income
(EBITDA) should be increased by the interest income ($40,000). This treatment assumes that the
“loan proceeds” from the financed receivables would be invested to generate interest income (for
simplicity's sake, the same rate of interest is assumed, but an alternative rate could be justified). The
financing costs of the loan ($40,000) would be added to interest expense and will not affect
EBITDA.

In adjusting for the operating lease and treating it as a capital lease, interest expense for the first
year of the lease ($614,400) should be added to adjusted interest expense.

ii. Adjusted Leverage = Long-term Debt / Equity =

= $16,753,400 / $33,460,000 = 0.50
This is an increase of 0.20 from the pre-adjustment ratio of 0.30.

Off-Balance Long-term Debt Equity Leverage

Sheet Item Impact Impact Impact
Pre-adjustment $10,000,000 $33,460,000 0.30

- Guarantee of debt (1) +$ 995,000 $0

 - Sale of receivables (n/a) $0 $0
- Operating lease (2) +$ 5,758,400 |0
Net Adjustment +$ 6,753,400 $0

Post-adjustment $16,753,400 $33,460,000 0.50

(1) Guarantee of debt = Long-term debt: $995,000.
(2) Operating lease = Long-term debt: $6,144,000 (PV of lease) - $385,600 (current portion)
= $5,758,400.

In adjusting for the guarantee of the affiliate's debt and treating it as internal long-term debt, long-
term debt should be increased by the amount of the guarantee ($995,000).
In adjusting for the operating lease and treating it as a capital lease, long-term debt should be
increased by the present value of the lease ($6,144,000) less the current or short-term portion—the
principal due in the next 12 months ($1,000,000 - $614,400 = $385,600).

iii. Adjusted Current Ratio = Current Assets / Current Liabilities =

= $5,235,000 / $5,385,600 = 0.97
This is a reduction of 0.08 from the pre-adjustment ratio of 1.05.

Off-Balance Current Assets Current Liabilities Current Ratio Impact

Sheet Item Impact Impact
Pre-adjustment $4,735,000 $4,500,000 1.05

- Guarantee of debt (n/a) 0 0

-Sale of receivables (1) +$500,000 +$500,000
- Operating lease (2) 0 +$385,600
Net Adjustment +$500,000 +$885,600

Post-adjustment $5,235,000 $5,385,600 0.97

(1) Sale of receivables = Accounts receivable (current assets) & notes payable (current
liabilities): $500,000.
(2) Operating lease = Current portion of lease obligation (current liabilities): $1 ,000,000
(annual payment) - $614,400 (interest expense) = $385,600 (principal payment).

In adjusting for the sold accounts receivable and treating it as a secured loan, accounts receivable
(current assets) and notes payable (current liabilities) should both be increased by the amount of the
sale ($500,000).

In adjusting for the operating lease and treating it as a capital lease, leases payable (current liabilities)
should be increased by the principal due in the next 12 months on the lease. This is equal to the
annual lease payment less the first year's interest expense ($1,000,000 - $614,400 = $385,600).