Homework #1 - Solution

The solution is provided at the bottom.

i. Rao Construction recently reported $20.50 million of sales, $12.60 million of operating
costs other than depreciation, and $3.00 million of depreciation. It had $8.50 million of
bonds outstanding that carry a 7.0% interest rate, and its federal-plus-state income tax
rate was 40%. What was Rao's operating income, or EBIT, in millions?

a. $3.21
b. $3.57
c. $3.97
d. $4.41
e. $4.90

ii. Wu Systems has the following balance sheet. How much net operating working capital
does the firm have?

Cash $ 100 Accounts payable $ 200

Accounts receivable 650 Accruals 350
Inventory 550 Notes payable 350
Current assets $1,300 Current liabilities $ 900
Net fixed assets 1,000 Long-term debt 600
Common equity 300
Retained earnings 500
Total assets $2,300 Total liab. & equity $2,300

a. $675
b. $750
c. $825
d. $908
e. $998

iii. Brown Office Supplies recently reported $15,500 of sales, $8,250 of operating costs other
than depreciation, and $1,750 of depreciation. It had $9,000 of bonds outstanding that
carry a 7.0% interest rate, and its federal-plus-state income tax rate was 40%. How much
was the firm's earnings before taxes (EBT)?

a. $4,627
b. $4,870
c. $5,114
d. $5,369
e. $5,638

iv. Emery Mining Inc. recently reported $150,000 of sales, $75,500 of operating costs other
 than depreciation, and $10,200 of depreciation. The company had $16,500 of
outstanding bonds that carry a 7.25% interest rate, and its federal-plus-state income tax
rate was 35%. How much was the firm's net income? The firm uses the same
depreciation expense for tax and stockholder reporting purposes.

a. $35,167.33
b. $37,018.24
c. $38,966.57
d. $41,017.44
e. $43,068.31

v. Vasudevan Inc. recently reported operating income of $2.75 million, depreciation of

$1.20 million, and had a tax rate of 40%. The firm's expenditures on fixed assets and net
operating working capital totaled $0.6 million. How much was its free cash flow, in
millions?

a. $1.93
b. $2.03
c. $2.14
d. $2.25
e. $2.36

vi. C. F. Lee Inc. has the following income statement. How much after-tax operating income
does the firm have?

Sales $2,850.00
Costs 1,850.00
Depreciation 192.00
EBIT $ 808.00
Interest expense 285.00
EBT $ 523.00
Taxes (35%) 183.05
Net income $ 339.95

a. $427.78
b. $450.29
c. $473.99
d. $498.94
e. $525.20

vii. Hartzell Inc. had the following data for 2010, in millions: Net income = $600; after-tax
operating income [EBIT(1 - T)] = $700; and Total assets = $2,000. Information for 2011
is as follows: Net income = $825; after-tax operating income [EBIT(1 - T)] = $925; and
Total assets = $2,500. How much free cash flow did the firm generate during 2011?

a. $383
 b. $425
c. $468
d. $514
e. $566

viii. Ryngard Corp's 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

ix. Beranek Corp has $720,000 of assets, and it uses no debt--it is financed only with
common equity. The new CFO wants to employ enough debt to raise the debt/assets 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

x. Ajax Corp's sales last year were $435,000, its operating costs were $362,500, and its
interest charges were $12,500. What was the firm's times-interest-earned (TIE) ratio?

a. 4.72
b. 4.97
c. 5.23
d. 5.51
e. 5.80

xi. 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 firm's ROE?

a. 15.23%
b. 16.03%
c. 16.88%
d. 17.72%
e. 18.60%

xii. Meijer Inc's assets are $625,000, and its total debt outstanding is $185,000. The new
CFO wants to establish a debt/assets ratio of 55%. The size of the firm does not change.
How much debt must the company add or subtract to achieve the target debt ratio?
 a. $158,750
b. $166,688
c. $175,022
d. $183,773
e. $192,962

xiii. A new firm is developing its business plan. It will require $615,000 of assets, 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. What is the maximum debt ratio (measured as debt/assets) the firm can
use? (Hint: Find the maximum dollars of interest, then the debt that produces that
interest, and then the related debt ratio.)

a. 41.94%
b. 44.15%
c. 46.47%
d. 48.92%
e. 51.49%

xiv. Spartan 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%

xv. 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 firm's total-debt-to-total-assets ratio was 45.0%.
Based on the DuPont equation, what was the ROE?

a. 13.82%
b. 14.51%
c. 15.23%
d. 16.00%
e. 16.80%

SOLUTION
i. Answer: e

Sales $20.50
- Operating costs excluding depreciation -12.60
- Depreciation -3.00
Operating income (EBIT) $ 4.90

Note that operating income is before interest and taxes.

ii. Answer: b

Cash $ 100 Accounts payable $ 200

Accounts receivable 650 Accruals 350
Inventory 550 Notes payable 350
Current assets $1,300 Current liabilities $ 900
Net fixed assets 1,000 Long-term debt 600
Common equity 300
Retained earnings 500
Total assets $2,300 Total liab. & equity $2,300

Net operating working capital = Current assets – (Current liabilities – Notes payable)
NOWC = $1,300.00 – $550
NOWC = $750

iii. Answer: b

Bonds $9,000.00
Interest rate 7.00%

Sales $15,500.00
- Operating costs excluding depreciation -8,250.00
- Depreciation -1,750.00
Operating income (EBIT) $ 5,500.00
- Interest charges -630.00
EBT = Taxable income $ 4,870

iv. Answer: d

Bonds $16,500
Interest rate 7.25%
Tax rate 35%

Sales $150,000
- Operating costs excluding depreciation -75,500
- Depreciation -10,200
Operating income (EBIT) $64,300.00
- Interest charges -1,196.25
Taxable income $63,103.75
- Taxes -22,086.31
Net income $41,017.44

v. Answer: d

FCF = EBIT(1 – T) + Deprec. – (Capex + NOWC)

 EBIT $2.75
Tax rate 40%
Depreciation $1.20
Capex + NOWC $0.60
FCF = $2.25

vi. Answer: e

Sales $2,850.00
- Costs -1,850.00
- Depreciation -192.00
EBIT $ 808.00
- Interest expense -285.00
EBT $ 523.00
- Taxes: rate = 35% -183.05
Net income $ 339.95

EBIT $808.00
Tax rate 35%
EBIT(1 − T) = $525.20

vii. Answer: b

Note that FCF = EBIT(1-tax) + Depreciation – Capex – ΔNOWC

Where Capex = (NFA2011 + Depreciation – NFA2010)
And ΔNOWC = NOWC2011 – NOWC 201 = {[CA2011 – (CL2011 – Notes2011)] - [CA2010 – (CL2010 –
Notes2010)]}
Therefore,
FCF = EBIT(1-tax) + Depreciation – (NFA2011 + Depreciation – NFA2010) – {[CA2011 – (CL2011 – Notes2011)]
- [CA2010 – (CL2010 – Notes2010)]}
= EBIT(1 - tax) – (NFA2011 – NFA2010) – [(CA2011 – CA 2010) – (CL2011 – Notes 2011) + (CL2010 –
Notes2010)]
If we assume that: -(CL2011-Notes2011) + (CL2010 – Notes2010) = 0, then we have:
FCF = EBIT(1-tax) – (NFA2011 – NFA2010) – (CA2011 – CA 2010), or
FCF = EBIT(1-tax) – [(NFA2011 + CA 2011) – (NFA2010 + CA2010)], but NFA + CA = TA
 FCF = EBIT(1-tax) – (TA2011 – TA2010)

2010 2011
Total assets (TA) $2,000 $2,500

2011 FCF = EBIT(1 − T) – Change in TA

2011 FCF = $925 – ($2500 - $2000)
2011 FCF = $425

viii. Answer: d

Sales $38,000
Total assets $16,000
TATO = Sales/Total assets = 2.38

ix. Answer: b
 Total assets $720,000
Target debt ratio 40%
Debt to achieve target ratio = Amount borrowed = Target % × Assets = $288,000

x. Answer: e

Sales $435,000
- Operating costs $362,500
Operating income (EBIT) $72,500
Interest charges $12,500
TIE ratio = EBIT/Interest = 5.80

xi. Answer: c

Profit margin 6.25%

TATO 1.50
Equity multiplier 1.80
ROE = PM × TATO × Eq. multiplier = 16.88%

xii. Answer: a

Total assets $625,000

Old debt $185,000
Target debt ratio 55%
Target amount of debt = Target debt % × Total assets = $343,750
Change in amount of debt outstanding = Target debt – Old debt = $158,750

xiii. Answer: e

Assets $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 ratio = Debt/Assets 51.49%

xiv. Answer: a

Total assets = Equity because zero debt $375,000

Sales $595,000
Net income $25,000
Target ROE 15.00%
Net income req'd to achieve target ROE = Target ROE × Equity = $56,250
Profit margin needed to achieve target ROE = NI/Sales = 9.45%

xv. Answer: a

Sales $325,000
Assets $250,000
Net income $19,000
Debt ratio 45.0%
Debt = Debt % × Assets = $112,500
Equity = Assets − Debt = $137,500
Profit margin = NI/Sales = 5.85%
TATO 1.30
Equity multiplier = Assets/Equity = 1.82
ROE 13.82%