Investment Analysis (FIN 383) Fall Homework 9

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1 Investment Analysis (FIN 383) Fall 2009 Homework 9 Instructions: please read carefully You should show your work how to get the answer for each calculation question to get full credit The due date is Tue Dec 15, Late homework will not be graded. Name(s): Student ID

2 1. A firm its ROE by using more debt in its capital structure. a. can increase b. can decrease c. cannot change d. More information is required. 1. d (since ROE depends on ROA, tax, and capital structure which is debt/equity) 2. A company in a 30% tax bracket will have a margin of if its ROA is 16% and asset turnover is 2. a. 8% b. 10% c. 16% d. 30% 2.a ROA EBIT/total asset 0.16 Asset turnover sale/total asset 2 We need to calculate margin EBIT/sale If we divide ROA by asset turnover, the total asset will cancel out, EBIT EBIT total _ asset So m arg in ROA sale total _ asset sale asset _ turnover 2 3. What is a company's debt to equity ratio if its asset to equity ratio is 2? a. 0.5 b. 1 c. 2 d. 2.5 Asset Debt Debt + equity Asset Debt National Furniture Company has an ROE of 11.9%, a debt/equity ratio of 2/3, a tax rate of 30%, and an interest rate on its debt of 12%. Its ROA is a. 12% b. 15% c. 20% d. 24% 4.b ROE (1 TaxRate) ROA + ( ROA InterestRate) (1 0.3) ROA + ( ROA 12) 3 Debt Solve for ROA 15%

3 5. The Asset Turnover of a company can be improved by. a. cutting operating expenses b. investing more efficiently with its assets c. borrowing more debt d. cutting operating and interest expenses 5.b The asset turnover ratio tells how efficient a company is using its asset to generate sale 6. What is the most correct relationship between a company's ROE and ROA when the company does not borrow any debt? a. ROE > ROA b. ROE ROA c. ROE < ROA d. ROE (1 + T)ROA ROE (1 TaxRate) ROA + ( ROA InterestRate) When there is no debt, we have ROE (1 TaxRate) ROA Since1- Tax rate < 1, therefore ROA has to be higher than ROE Debt 7. The capital structure of a company can be determined by using information from. a. the income statement b. the cash flow statement c. the balance sheet d. None of the above. 7. c (capital structure is how much debt and equity the company is using) 8. Which of the following balance sheet items is not considered an asset? A) inventory B) accounts receivable C) accrued taxes D) All of the above are assets 8. c 9. A firm has a ROE of 20% and a market-to-book ratio of Its P/E ratio is.

4 ROE P/E ratio A) 8.40 B) C) D) If we divide both numerator and denominator by the number of shares outstanding, we have Net income (or earning)/number of shares outstanding ROE total equity/number of shares outstanding market - to - book ratio Net income (or earning) 0.2 total equity market - to - book ratio price per share EPS price per share book value per share price per share book value per share 1 ROE 2.38 book value per share EPS earning per share (EPS) book value per share 0.2

5 Use the following to answer questions 11-14: The financial statements of Shuswap Lake Manufacturing Company are given below. Note: The common shares are trading in the stock market for $160 each. 10. The firm's current ratio for 2005 is. A) 0.90 B) 1.44 C) 1.89 D) ,150,000 CR ,000

6 11. The firm's leverage ratio for 2004 is. A) 0.90 B) 1.56 C) 1.89 D) ,500,000 L , , The firm's fixed asset turnover ratio for 2005 is. Please keep in mind that when a ratio involves both income statement and balance sheet numbers, the balance sheet numbers for the beginning and end of the year must be averaged. A) 3.39 B) 3.60 C) 6.00 D) ,000,000 FAT ,400, ,550, The firm's asset turnover ratio for 2005 is. Please keep in mind that when a ratio involves both income statement and balance sheet numbers, the balance sheet numbers for the beginning and end of the year must be averaged. A) 0.90 B) 1.56 C) 1.92 D) ,000,000 AT ,500, ,700, The net income of the company is $970. Taxes payable decrease by $120, depreciation is $85, and fixed assets are sold for $90. If the firm's inventories also decline by $65, what is the total change in cash for the firm for all activities? A) Increase of $970 B) Increase of $1090 C) Decrease of $970 D) Decrease of $1090 cash flow

7 15. Yesterday, Bicksler Corporation purchased (and received) raw materials on credit from its supplier. All else equal, if Bicksler s current ratio was 2.0 before the purchase, what effect did this transaction have on Bicksler s current ratio? a. increased b. decreased c. stayed the same d. There is not enough information to answer this question. e. None of the above is a correct answer. 15. b The company purchased on credit, so this will increase account payable or current liabilities, so the current ratio would decrease 16. The Crusty Pie Co., which specializes in apple turnovers, has a return on sales higher than the industry average, yet its ROA is the same as the industry average. How can you explain this? ROA (EBIT/Sales) (Sales/Total Assets) ROS ATO The only way that Crusty Pie can have an ROS higher than the industry average and an ROA equal to the industry average is for its ATO to be lower than the industry average. 17. The ABC Corporation has a profit margin on sales below the industry average, yet its ROA is above the industry average. What does this imply about its asset turnover? ABC s asset turnover must be above the industry average. 18. Jones Group has been generating stable after-tax return on equity (ROE) despite declining operating income. Explain how it might be able to maintain its stable after-tax ROE. Since ROE is a function of net profit and equity, it is possible to maintain a stable ROE, while net profits decline so long as equity also declines proportionally. 19. A company s current ratio is 2.0. If the company uses cash to retire notes payable due within one year, would this transaction increase or decrease the current ratio? What about the asset turnover ratio? This transaction would increase the current ratio. The transaction reduces both current assets and current liabilities by the same amount, but the reduction has a larger proportionate impact on current liabilities than on current assets. Therefore, the current ratio would increase. This transaction would increase the asset turnover ratio. Sales should remain unaffected, but assets are reduced.

8 20. The financial statements for Chicago Refrigerator Inc. are to be used to compute the ratios a through h for 2005.

9 a. Quick ratio. Quick Ratio (Current asset - Inventories)/ current liabilities $ 6360 $ $3945 b. Return on assets. EBIT Net income before tax + interest expense ROA Assets Average assets $ $ ($ $4792) % c. Return on common shareholders equity. Net income a. ROE Average common equity ROE Net income Average common equity $ ($550 + $829) d. Earnings per share of common stock. $1265 Earnings per share $ ( ) / 2

10 e. Profit margin. EBIT Profit margin Sales $ $ % $12065 f. Times interest earned. Times interest earned EBIT Interest expense $ $ $78 g. Inventory turnover. Inventory turnover Cost of goods sold $ Average inventory 0.5 ($ $2423) h. Leverage ratio. Leverage ratio Average assets Average common equity 0.5 ($ $8058) ($ $3353)

Computing Liquidity Ratios Current Ratio = CA / CL 708 / 540 = 1.31 times Quick Ratio = (CA Inventory) / CL (708 422) / 540 =.53 times Cash Ratio =

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