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Financial Analysis, Master's Level, Damodaran Investment Valuation and Eugene F. Brigham and Joel F.
Houston, Fundamentals of Financial Management, Current Edition => ch2. Analysis of Financial
Statements, Ratio Analysis, and Du Pont system => Topic started by: danny on July 03, 2009, 01:35:02 pm

Title: Homework 2

Post by: danny on July 03, 2009, 01:35:02 pm

Homework 2: Chapter 3 & 4

1. All else being equal, which of the following will increase a company’s current ratio?

a. An increase in accounts receivable.

b. An increase in accounts payable.

c. An increase in net fixed assets.

d. Statements a and b are correct.

e. All of the statements above are correct.

Answer a. is the correct one.

The current ratio is defined as Current assets/ current liabilities!

So if you want to increase the current ratio you have to increase current assets, and your current
liabilities must decrease. Therefore accounts receiveable are current assets!

Accounts payable are current liabilities, so if they would increase, the current ratio would decline. The
net- fixed assets are long term assets, so they have no effect on the current ratio!

3. Which of the following alternatives could potentially result in a net increase in a company’s cash flow
for the current year?

a. Reduce the days sales outstanding ratio.

b. Increase the number of years over which fixed assets are depreciated.
c. Decrease the accounts payable balance.

d. Statements a and b are correct.

e. All of the statements above are correct.

Statement a. is correct.

If you increase the depreciation period you get smaller amounts depreciated each year. In addition
to that depreciation is a non-cash expense, which is used to reduce taxable income. This will result in less
depreciation expense and higher taxes for the period. Because taxes are paid with cash, the companies
cash flow will decrease! Decreasing assounts payable will need cash to pay off the accounts payable
balance.

5. Amazon Electric wants to increase its debt ratio, which will also increase its interest expense. Assume
that the higher debt ratio will have no effect on the company’s operating income, total assets, or tax
rate. Also, assume that the basic earning power ratio exceeds the before-tax cost of debt financing.
Which of the following will occur if the company increases its debt ratio?

a. Its ROA will fall.

b. Its ROE will increase.

c. Its basic earning power (BEP) will stay unchanged.

d. Statements a and c are correct.

e. All of the statements above are correct.

The correct answer is e.

If the dept is higher, the interest expense will increase and the net income decline.

This results in a lower ROA.

Net income and equity decline! BUT net income declines more less than equity, because the earning
power exceeds the cost of dept. So the ROE is going up.

Ebit and total assets will stay the same.

12. Company A and Company B have the same total assets, return on assets (ROA), and profit margin.
However, Company A has a higher debt ratio and interest expense than Company B. Which of the
following statements is most correct?

a. Company A has a higher ROE (return on equity) than Company B.

b. Company A has a higher total assets turnover than Company B.

c. Company A has a higher operating income (EBIT) than Company B.

d. Statements a and b are correct.

e. Statements a and c are correct.

The correct answer is e.

A and B , both have the same net income, the same sales and the same assets.

When a has more dept than b it must have less equity. Therefore the ROE of a is higher, than b’s!

[ROE= net income/ equity]

Because they both have the same total assets and sales, the total assets ratios have to be the same!

(In case that) a, has more interest expense than b, but they have the same net income, this results I an
higher operating income of a.

16. Russell Securities has $100 million in total assets and its corporate tax rate is 40 percent. The
company recently reported that its basic earning power (BEP) ratio was 15 percent and its return on
assets (ROA) was 9 percent. What was the company’s interest expense?

a. $ 0

b. $ 2,000,000

c. $ 6,000,000

d. $15,000,000

e. $18,000,000
The correct answer is a.

BEP is defined as: EBIT/ total assets

= 0,15= EBIT/ 100000000 => solved to EBIT => 15000000

ROA is defined as : Net Income / Total Assets

= 0,09= NI / 100000000 => solved to NI => 9000000

EBT is defined as: NI / (1-T) (T = Tax rate)

= EBT = 9000000 / 0,6 => EBT = 15000000

After calculating we come to the result that the interest expense is 0!

18. Given the following information, calculate the market price per share of WAM Inc.:

Net income $200,000.00

Earnings per share $2.00

Stockholders’ equity $2,000,000.00

Market/Book ratio 0.20

a. $20.00

b. $ 8.00

c. $ 4.00

d. $ 2.00

e. $ 1.00
The correct answer is c.

First we need to know the number of shares: Net income/ earnings per share

= 200000/ 2 = 100000

Then we have to calculate the book value per share: Stockholders equity / number of shares

= 2000000 / 100000 = 20

At last we have to calculate the market value: Book value * book value p. s.

= 0,2*20= 4

19. Meyersdale Office Supplies has common equity of $40 million. The company’s stock price is $80 per
share and its market/book ratio is 4.0. How many shares of stock does the company have outstanding?

a. 500,000

b. 125,000

c. 2,000,000

d. 800,000,000

e. Insufficient information.

The correct answer is c.

We have to calculate the market/ Book ratio: (M/B) = ((price per share* shares) / book Value)

=> 4= ((80*shares)/ 40000000) , solved to shares => shares = 2000000

21. A firm has a profit margin of 15 percent on sales of $20,000,000. If the firm has debt of $7,500,000,
total assets of $22,500,000, and an after-tax interest cost on total debt of 5 percent, what is the firm’s
ROA?

a. 8.4%

b. 10.9%

c. 12.0%
d. 13.3%

e. 15.1%

The correct answer is d.

First we have to calculate the net income: profit margin * sales

= 0,15* 20000000 = 3000000

Then we have to calculate the ROA: net income / total assets

= 3000000/ 22500000 = 13,3 => 13,3 %

23. Tapley Dental Supply Company has the following data:

Net income $240

Sales $10,000

Total assets $6,000

Debt ratio 75%

TIE ratio 2.0

Current ratio 1.2

BEP ratio 13.33%

If Tapley could streamline operations, cut operating costs, and raise net income to $300 without affecting
sales or the balance sheet (the additional profits will be paid out as dividends), by how much would its
ROE increase?

a. 3.00%

b. 3.50%

c. 4.00%
d. 4.25%

e. 5.50%

The correct answer is c.

First calculate the equity: 0,25 ( because 75 % dept ratio) *total assets

= 0,25 *6000 = 1500

Then calculate the Current ROE: Net income / Equity

= 240 / 1500 = 16 => 16 %

After that calculate new ROE: new net income / equity

= 300/ 1500 = 20 => 20 %

The delta of the current and the new ROE gives us the answer to the question:

Delta ROE = 20 % - 16 % = 4 %

27. Cleveland Corporation has 100,000 shares of common stock outstanding, its net income is
$750,000, and its P/E is 8. What is the company’s stock price?

a. $20.00

b. $30.00

c. $40.00

d. $50.00

e. $60.00

The correct answer is e.

To calculate the stock price you first have to calculate EPS: net income/ shares of common stock

= 750000 / 100000 = 7,5

After that, calculate the P / E ratio : price / EPS

= you have to solve it after the price:

Price/ EPS = 8 => Price = 8 * 7,5 = 60

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