Solutions to Chapter 4. Measuring Corporate Performance


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1 Solutions to Chapter 4 Measuring Corporate Performance 1. a. 7,018 Longterm debt ratio ,018 9,724 b. 4,794 7,018 6,178 Total debt ratio ,714 c. 2,566 Times interest earned d. 2,566 2,518 Cash coverage ratio e. 3,525 Current ratio ,794 f. 89 2,382 Quick ratio ,794 g. 1, Operating profit margin % 13,193 h. 4,060 Inventory turnover ( ) / 2 i. ( ) / 2 Days sales in inventory days 4,060/365 j. (2,382 2,490) / 2 Average collection period days 13,193/ 365 k. 1,223 Return on equity % (9,724 9,121) / 2 41
2 1, l. Return on assets % (27,714 27,503) / 2 m. Return on capital 1, % [(7,108 9,724) (6,833 9,121)]/ n. Payout ratio ,223 Est time: Market capitalization = ($84 205,000,000) = $17.22 billion Market value added = $17.22 billion $9.724 billion = $7.496 billion Markettobook ratio = $17.22 billion/$9.724 billion = 1.77 Est time: All values in millions. EVA = aftertax interest + net income (cost of capital total capitalization) = [$685*(1 0.35)] + $1,223 [8.3% ($7,108 + $9,724)] = $ All values in millions. a. EVA = aftertax interest + net income (cost of capital total capitalization) = [676 (1 0.35)] + $2,661 [.08 (9, ,777)] = $ EVA fell, since the cost of equity is higher. b. Accounting profits are unaffected by changes in the cost of equity. c. Economic value added is a better measure of company performance because accounting profits do not include all costs; specifically, the cost of equity capital. 5. a. MVA = market value of shares book value of equity = $46,192 19,393 = $26,799 MVA fell as the market value of the shares dropped 5% b. No, the expected return on all shares has risen. 42
3 c. Yes, the cost of equity capital has increased for Pepsi. 6. a. Sustainable growth rate = plowback ratio ROE = = 0.117, or 11.7% Home Depot s sustainable growth rate will rise with the higher plowback ratio. b. Sustainable growth = = , or 6% The sustainable growth rate will fall. Est time: , Return on assets % (27,714 27,503) / 2 sales 13,193 Asset turnover % average total assets 27,608.5 net income interest 1, Operating profit margin % sales 13,193 Asset turnover operating profit margin = = = ROA 1, Return on equity % (9,724 9,121) / 2 Assets Equity sales assets net income interest sales net income net income interest 27, ,193 1, , % 9, , ,193 1, (Notice that we have used average assets and average equity in this solution.) 43
4 9. a. The consulting firm has relatively few assets. The major asset is the knowhow of its employees. The consulting firm has the higher asset turnover ratio. b. The Catalog Shopping Network generates far more sales relative to assets since it does not have to sell goods from stores with high expenses and probably can maintain relatively lower inventories. The Catalog Shopping Network has the higher asset turnover ratio. b. The supermarket has a far higher ratio of sales to assets. The supermarket itself is a simple building and the store sells a high volume of goods with relatively low markups (profit margins). Standard Supermarkets has the higher asset turnover. Est time: ROC = aftertax operating income/equity, or Aftertax operating income = ROC equity EVA = aftertax operating income (cost of equity equity), substituting EVA = (ROC equity) (cost of equity equity), or EVA = equity (ROC cost of equity) Thus, EVA is positive if ROC exceeds the cost of equity. 11. a. Debtequity ratio longterm debt equity b. Return on equity net income average equity c. Operating profit margin net income interest sales cost of goodssold d. Inventory turnover average inventory current assets e. Current ratio current liabilities 44
5 average receivables f. Average collection period average daily sales cash marketable securities receivables g. Quick ratio current liabilities 12. If HD borrows $300 million and invests the funds in marketable securities, both current assets and current liabilities will increase. a. Liquidity ratios: 13, Current ratio , , Quick ratio , , Cash ratio , The transaction would result in a slight decrease in the current ratio and an increase in the quick ratio and the cash ratio, so the company might appear to be more liquid. However, a financial analyst would be very unlikely to conclude that the company is actually more liquid after engaging in such a transaction. b. Leverage ratios: The longterm debt ratio and the debtequity ratio would be unaffected since current liabilities are not included in these ratios. The total debt ratio will increase slightly, however: Total liabilities Total assets 21, , The very slight increase in the total debt ratio indicates that the company would appear to be very slightly more leveraged. However, a financial analyst would conclude that the company is actually no more leveraged than prior to the transaction. 45
6 13. a. Current ratio will be unaffected. Inventories are replaced with either cash or accounts receivable, but total current assets are unchanged. b. Current ratio will be unaffected. Accounts due are replaced with the bank loan, but total current liabilities are unchanged. c. Current ratio will be unaffected. Receivables are replaced with cash, but total current assets are unchanged. d. Current ratio will be unaffected. Inventories replace cash, but total current assets are unchanged. 14. The current ratio will be unaffected. Inventories replace cash, but total current assets are unchanged. The quick ratio falls, however, since inventories are not included in the most liquid assets. 15. Average collection period equals average receivables divided by average daily sales: Average collection period 6,333 9,800/ days Days sales in inventories 2 days 73,000/ Annual cost of goods sold = $10, /30 = $121, ,667 Inventory turnover times per year 10,
7 18. a. Interest expense = 0.08 $10 million = $800,000 Times interest earned = $1,000,000/$800,000 = 1.25 b. 1,000, ,000 Cash coverage ratio ,000 c. 1,000, ,000 Fixed payment coverage , , a. ROA = asset turnover operating profit margin = = 0.15 = 15% b. If debt/equity = 1, then debt = equity, so total assets are twice equity. assets 2 20,000 8,000 8,000 ROE ROA debt burden % equity 1 20,000 8, Total sales = $3, /20 = $54,750 Asset turnover ratio = $54,750/$75,000 = 0.73 ROA = asset turnover operating profit margin = = = 3.65% 21. Debtequity ratio longterm debt equity longterm debt 0.4 longterm debt = 0.4 $1,000,000 = $400,000 $1,000,000 Current assets Current liabilities 2.0 and current assets = $200,000 Therefore, current liabilities = $200,000/2 = $100,000 = notes payable Total liabilities = $500,
8 Total assets = total liabilities + equity = $500,000 + $1,000,000 = $1,500,000 Total debt ratio = $500,000/$1,500,000 = 0.33 Book debt Book equity Market equity 2 Book equity Book debt Market equity EBIT = revenues COGS depreciation = $3,000,000 $2,500,000 $200,000 = $300,000 Interest = 8% of face value = $80,000 Times interest earned = $300,000/$80,000 = 3.75 Est time: The firm has less debt relative to equity than the industry average, but its ratio of EBIT plus depreciation to interest expense is lower. Perhaps the firm has a lower ROA than its competitors and is therefore generating less EBIT per dollar of assets. Perhaps the firm pays a higher interest rate on its debt. Or perhaps its depreciation charges are lower because it uses less capital or older capital. 25. A decline in market interest rates will increase the value of the fixedrate debt and thus increase the marketvalue debtequity ratio. By this measure, leverage will increase. The decline in interest rates will also reduce the firm s interest payments on the floatingrate debt, which will increase the times interest earned ratio. By this measure, leverage will decrease. The impact of the lower rates on leverage is thus ambiguous. The firm has higher indebtedness relative to assets but greater ability to cover its cashflow obligations. 48
9 26. a. The shipping company, which has more tangible assets, will tend to have the higher debtequity ratio. (See Chapter 15, Sections 15.3 and 15.4, for a discussion of the reasons that firms holding tangible assets with active secondary markets tend to maintain higher debtequity ratios.) b. United Foods is in a more mature industry and probably has fewer favorable opportunities for reinvesting income. We would expect United Foods to have the higher payout ratio. c. The paper mill will have higher sales per dollar of assets. It is less capitalintensive (that is, has less capital per dollar of sales) than the integrated firm. d. The discount outlet sells many of its goods for cash. The power company bills monthly and usually gives customers a month to pay bills and therefore will have the longer collection period. e. Fledging Electronics will have the higher priceearnings multiple, reflecting its greater growth prospects. 27. Leverage ratios are of interest to banks or other investors lending money to the firm. They want to be assured that the firm is not borrowing more than it can reasonably be expected to repay. Liquidity ratios are also of interest to creditors who prefer that a firm s current assets are well in excess of its current liabilities. Liquidity ratios are especially important to those who lend to the firm for short periods, for example, by extending trade credit. If a firm buys goods on credit, the seller wants to know that, when the bill comes due, the firm will have enough cash on hand to pay it. Efficiency ratios might be of interest to stock market analysts who want to know how well the firm is being run. These ratios are also of great concern to the firm s own management, which needs to know if it is running as tight a ship as its competitors. 49
10 28. Income statement: Millions of Dollars Net sales $ Cost of goods sold Selling, general, & administrative expenses Depreciation EBIT Interest expense 1.25 Income before tax 8.75 Tax Net income $ Balance sheet: Millions of Dollars This Year Last Year Assets Cash and marketable securities $ 11 $ 20 Receivables Inventories Total current assets Net property, plant, equipment Total assets $115 $105 Liabilities & Shareholders Equity Accounts payable $ 25 $ 20 Notes payable Total current liabilities Longterm debt Shareholders equity Total liabilities & shareholders equity $115 $105 Solution procedure: 1. Total current liabilities = = Total current assets = = Cash = = Accounts receivable + cash = = Accounts receivable = 55 cash = = Inventories = = Total assets = total liabilities and shareholders equity = Net property, plant, equipment = = Sales = (365/avg. collection period) beginning receivables = (365/73) 34 =
11 10. Cost of goods sold = inventory turnover beginning inventory = = EBIT = = Interest = EBIT/times interest earned = 10/8 = Tax = (EBIT interest) 0.35 = ( ) 0.35 = Net income = EBIT interest tax = = LT debt = LT debt ratio (total assets current liabilities = 0.4 (115 55) = = Shareholders equity = = 36 Est time: a. See table and graph below. Profit Margin (%) Asset Turnover All manufacturing Food products Clothing Beverage & tobacco Chemicals Drugs Machinery Electrical Motor vehicles (0.42) 0.98 Computer and electronic Paper
12 Asset turnover declines as operating profit margin rises. This relationship makes sense as firms with low profit margins need to generate more volume. That is, if margins are low, each dollar of total assets must work harder to produce the same amount of total profit. b. See table and graph below Current Ratio Quick Ratio All Manufacturing Food Products Clothing Beverage & Tobacco Chemicals Drugs Machinery Electrical Motor Vehicles Computer and Electronics Paper
13 Quick Ratio Current Ratio These two measures of liquidity appear to move together. Higher quick ratios are associated with higher current ratios. You may conclude that once you know one of these ratios there is little to be gained by calculating the other. However, analysts should use caution as some firms may have a high current ratios but the result may be due to a high level of illiquid assets, such as old inventory. Est time: If company X does not raise any new finance during the year but generates a lot of earnings during the year that are immediately reinvested, it makes more sense to use starting capital when calculating X s return on capital. Return on capital is understated if average capital is used. The answer would change if X made a large issue of debt early in the year. In this case it would be better to use an average of starting and ending capital. For example, suppose company X has aftertax operating income of $3 million for the year. The starting capital was $30 million, composed of $10 million in longterm debt and $20 million in equity. Using starting capital, the X gives return on capital of 10%. If equity at yearend is $23 million, average capital is $31.5 million and return on capital is understated at only 9.5%. 413
14 The answer changes if X made a large issue of debt early in the year because the new debt increases aftertax income from the debt shield. When a company s additional financing during the year contributes a significant part of the year s operating income, it s better to divide by the average of the total capitalization at the beginning and end of the year. Solution to Minicase for Chapter 4 You will find an Excel spreadsheet solution for this minicase at the Online Learning Center (http://www.mhhe.com/bmm7e). Problems for HH are apparent in the areas of debt and assets. Leverage ratios improved between 2003 and 2007, but debt (both longterm and shortterm) has increased significantly in Liquidity ratios began to deteriorate in 2007, at the same time that the number of employees increased substantially. Further deterioration in liquidity ratios occurred in 2008, when inventories more than doubled and current liabilities increased by more than 85%. At the same time, sales remained virtually unchanged from
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