BUS530 Chapter 4 notes
Which of the following represent questions the financial manager would ask to evaluate investment
decisions?
- How profitable are investments relative to the cost of capital?
- How should profitability be measured?
Market Capitalization is defined as – the total value of the firms equity.
The Market-to-Book Ratio is equal to the market value of equity divided by the book value of equity.
Market-to-book ratio= market value of equity / book value of equity
Which of the following are considered drawbacks associated with performance measures?
-Market values fluctuate
-Market values of privately owned companies are not available for observation
-The market value of a company’s shares reflects investors’ expectations
Which part of the return on equity equation depends on the firm’s production and marketing skills, not
the firm’s financing mix?
-Return on assets.
Economic value added is defined as the
-Profit after deducting all costs, including the cost of capital.
Liquid assets include which of the following?
-Inventories of finished goods
-Accounts receivable.
Which of the following are helpful for measuring the firm’s profits per dollar of assets?
-Return of equity
-Return of capital
-Return on assets
When determining if a ratio is good or bad, managers look at industry norms in order to
-Compare their measures with the measures of companies in the same line of business.
Which of the following ratios measure the firm’s efficiency with which it uses its assets?
-Asset turnover
-Inventory turnover
Which of the following refers to using borrowed funds, or debt, so as to attempt to increase the returns
to equity?
-Financial leverage
Which parts of the return on equity equation depend on the firm’s financing mix (its debt-equity mix)?
-Leverage ratio
-Debt burden
Which of the following ratios shows the extent to which interest obligations are covered by earnings?
-Times interest earned ratio
The cash coverage ratio is equal to
-EBIT plus depreciation divided by interest payments
A highly leveraged company will have a long-term debt-equity ratio that is higher than a less leveraged
company.
A times interest earned ratio of 5 states that
-Income before interest and taxes covers the interest obligations 5 times.
Which of the following statements are possible explanations for a high receivables turnover number?
-Unpaid bills are a small proportion of sales
-The firm has an efficient credit department that is quick to follow up on late payers
-The firm has a restrictive credit policy
Which of the following are considered advantages of using EVA and Accounting rates of return over
market-value based measures?
-Can be calculated for a particular division
-Not affected by economic factors that move the stock market prices
-Show current performance
Most firms would prefer both high profit margin and high turnover; however, this strategy typically leads
to lower sales per dollar of assets. The Du Pont formula can help companies
-Determine if they should pursue a high profit margin/ low turnover strategy
-Identify the constraints firms face
-Determine if they should pursue a high turnover/ low profit margin strategy.
Liquid assets are those that can be quickly converted to cash.
Asset turnover, inventory turnover, and receivables turnover are all rations used to measure a firm’s
efficiency.
Return on capital and return on assets are used instead of economic value added to compare managers
whose assets differ in size.
Economic value added is a better measure of a company’s performance than is accounting income
because EVA
-Considers the firm’s opportunity costs.
The cost of capital is made visible to operating managers through
-Economic value added
Which of the following ratios measures after-tax operating income as a fraction of the firm’s total assets?
-Return on assets
Here is a simplified balance sheet for Locust Farming:
Locust Farming
Balance Sheet
($ in millions)
Current assets $42,544 Current
liabilities $29,735
Long-term assets 46,872 Long-term debt 27,772
Other
liabilities 14,357
Equity 17,552
Total $89,416 Total $89,416
Locust has 665 million shares outstanding with a market price of $103 a
share.
Market value added is the difference between the market value and the book value of the firm
a. Calculate the company’s market value added.
Market value = 665 million shares x 103 = 68,495 million
Market value added = 68,495,000 – (equity 17,552) = 50,943
b. Market / Book = 68,495 / 17,552 = 3.90
c. How much value has the company created for its shareholders as a percent of the investment of
the equity holders?
390%
Correct answer 290%
Explanation
a.
Market value = 665 million × $103 = $68,495 million
Market value added = $68,495 – $17,552 = $50,943 million
b. Market value / Book value = $68,495 / $17,552 = 3.90
c. Value added as a multiple of the equity investment is 50,943/17,552 = 2.90, or equivalently,
290% of the book value of equity.
Suppose the broad stock market falls 20% in a year and Home Depot’s stock
price falls by 15%.
a. Will the company’s market value added rise or fall? Fall
b. Should this change affect our assessment of the performance of Home Depot’s managers? Yes
c. Would you feel differently about Home Depot’s managers if the stock market were unchanged
and Home Depot’s stock fell by 15%? No
Explanation
Market value = 1,335 million × $128.75 = $171,881 million
The market value added for Home Depot = $171,881 − $9,336 = $162,545 million
Assuming the stock price drops 15%, the market value is now $171,881 × 0.85 = $146,099
Market value added = $146,099 – $9,336 = $136,763
Here are simplified financial statements for Watervan Corporation:
INCOME STATEMENT
(Figures in $ millions)
Net sales $891.00
Cost of goods sold 751.00
Depreciation 41.00
Earnings before interest and taxes
(EBIT)
$99.00
Interest expense 22.00
Income before tax $ 77.00
Taxes 26.95
Net income $ 50.05
BALANCE SHEET
(Figures in $ millions)
End of
Year Start of
Year
Assets
Current assets $ 379 $ 332
Long-term assets 278 232
Total assets $ 657 $ 564
Liabilities and shareholders’ equity
Current liabilities $ 204 $ 167
Long-term debt 118 131
Shareholders’ equity 335 266
Total liabilities and shareholders’
equity $ 657 $ 564
The company’s cost of capital is 8%
a. Calculate Watervan’s economic value added (EVA).
b.
c. What is the company’s return on capital? (Use start-of-year rather than
average capital.)
d. What is its return on equity? (Use start-of-year rather than average
equity.)
e. Is the company creating value for its shareholders?
Explanation
a.
Economic value added = After-tax interest + Net income – (Cost of capital × Total capitalization)
Economic value added = (1 – 0.35) × $22 + 50.05 – (8% × [$266 + 131]) = $32.59
b.
Return on capital = (1 – 0.35) × $22.00 + 50.05 = 0.1621 , or 16.21 %
$ 266 + 131
c.
Return on equity = $50 = 0.1882 , or 18.82 %
$ 266
d.
Yes. The EVA indicates the firm is producing value in excess of the cost of capital. Thus, it is
producing value. The ROC and ROE are also consistent with this conclusion.
Home Depot entered fiscal 2016 with a total capitalization of $27,234 million.
In 2016, debt investors received interest income of $837 million. Net income
to shareholders was $6,366 million. (Assume a tax rate of 35%.)
Calculate the economic value added assuming its cost of capital is 10%
After-tax operating income – (.10 x 27,234)
After-tax interest + net income ? 837 + 6366 = 7203 – 2723.40 = 4479.60
Explanation
Economic value added = After-tax interest + Net income – (Cost of capital × Total capitalization)
Economic value added = (1 – .35) × $837 + 6,366 − (.10 × $27,234) = $4,186.65
Here are simplified financial statements for Phone Corporation in a recent
year:
INCOME STATEMENT
(Figures in $ millions)
Net sales $13,500
Cost of goods sold 4,260
Other expenses 4,147
Depreciation 2,638
Earnings before interest and taxes
(EBIT)
$2,455
Interest expense 705
Income before tax $ 1,750
Taxes (at 30%) 525
Net income $ 1,225
Dividends $ 896
BALANCE SHEET
(Figures in $ millions)
End of
Year Start of
Year
Assets
Cash and marketable securities $ 93 $ 162
Receivables 2,582 2,570
Inventories 207 258
Other current assets 887 952
Total current assets $ 3,769 $ 3,942
Net property, plant, and equipment 20,013 19,955
Other long-term assets 4,256 3,810
Total assets $ 28,038 $ 27,707
Liabilities and shareholders’ equity
Payables $ 2,604 $ 3,080
Short-term debt 1,439 1,593
Other current liabilities 831 807
Total current liabilities $ 4,874 $ 5,480
Long-term debt and leases 6,022 6,117
Other long-term liabilities 6,218 6,189
Shareholders’ equity 10,924 9,921
Total liabilities and shareholders’
equity $ 28,038 $ 27,707
Calculate the following financial ratios for Phone Corporation
Explanation
a.
Return on equity
=
$1,225 = 0.1175, or
11.75%
($10,924 + 9,921) /
2
b.
Return on assets
=
$1,225 + 705 × (1 –
0.30) = 0.0617, or
6.17%
($28,038 + 27,707) / 2
c.
Return on
capital =
$1,225 + 705 × (1 – 0.30) = 13,500.0000, or
10.42%
[($6,022 + 10,924) + ($6,117 +
9,921)] / 2
d.
Days in inventory = $258 = 22.11 days
$4,260 / 365
e.
Inventory turnover = $4,260 = 16.51
258
f.
Average collection period
=
$2,570 = 69.49
days
$13,500 /
365
g.
Operating profit
margin =
$1,225 + 705 × (1 –
0.30) = 0.1273, or
12.73%
$13,500
h.
Long-term debt ratio = $6,022 = 0.36
$6,022 + 10,924
i.
Total debt ratio = $4,874 + 6,022 + 6,218 = 0.61
$28,038
j.
Times interest earned = $2,455 = 3.48
$705
k.
Cash coverage ratio = $2,455 + 2,638 = 7.22
$705
l.
Current ratio = $3,769 = 0.77
$4,874
m.
Quick ratio = $93 + 2,582 = 0.55
$4,874
Consider this simplified balance sheet for Geomorph Trading:
Current assets $230 Current liabilities$150
Long-term assets 620 Long-term debt 220
Other liabilities 150
Equity 330
$850 $850
A. What is the company’s debt-equity ratio?
Total debt (current liabilities + long-term debt + other liabilities) = 520 / equity 330 = 1.58
b. what is the ratio of total long-term debt to total long term capital?
Total long term debt / total long term capital = 220 / 220+330 = .40
d. What is its net working capital?
Difference between current assets and current liability 230-150 = 80
d. Current assets divided by current liabilities 230/150 = 1.53
Lever Age pays an 10% rate of interest on $9.00 million of outstanding debt
with face value $9 million. The firm’s EBIT was $3 million.
a. What is its times interest earned?
Interest expense = .10 x 9 billion = .90
Times interest earned = $3/.90=3.33
b. if depreciation is $100,000, what is its cash coverage ratio?
3 million + 100,000 / .90 = 34.44 3.44
Long-term debt ratio 0.1
Times interest earned 10.0
Current ratio 1.2
Quick ratio 1.0
Cash ratio 0.4
Inventory turnover 3.0
Average collection period 73 days
Use the above information from the tables to work out the following missing
entries, and then calculate the company’s return on equity. Note: Turnover and
the average collection period are calculated using start-of-year, not average,
values.
Explanation
Total current liabilities = $20.00 + 30.00 = $50.00
Total current assets = $50.00 × 1.2 = $60.00
Cash = $50.00 × .4 = $20.00
Accounts receivable + Cash = $50.00 × 1.0 = $50.00
Accounts receivable = $50.00 – Cash = $50.00 – 20.00 = $30.00
Inventories = $60.00 – 20.00 – 30.00 = $10.00
Total assets = Total liabilities and shareholders’ equity = $280.00
Net property, plant, equipment = $280.00 – 60.00 = $220.00
Sales = (365 / Average collection period) × Beginning receivables = (365 / 73) × $48 = $240.00
Cost of goods sold = Inventory turnover × Beginning inventory = 3.0 × $40 = $120.00
EBIT = $240.00 – 120.00 – 24.00 – 34.00 = $62.00
Interest = EBIT / Times interest earned = $62.00 / $10.0 = $6.20
Income before tax = EBIT – Interest expense = $62.00 – 6.20 = $55.80
Tax = Income before tax × .35 = $55.80 × .35 = $19.53
Net income = Income before tax – Tax = $55.80 – 19.53 = $36.27
Long-term debt + Equity = Total liabilities and equity – Total current liablities = $280 – 50 =
$230
Long-term debt ratio = .10 = Long-term debt / (Long-term debt + Equity) = Long-term debt /
$230; LTD = $23
Shareholders' equity = Total liabilities and equity – Total current liabilities – Long-term debt =
$280 – 50 – 23 = $207
Torrid Romance Publishers has total receivables of $3,140, which represents
20 days’ sales. Total assets are $114,610. The firm’s operating profit margin is
5.6%. Find the firm's ROA and asset turnover ratio.
Asset turn over ratio
Total sales = 3,140 x 365 days / 20 = 57305
Asset turnover ratio = 57305 / 114,610 = .50
ROA
Asset turnover x operating profit margin
.50 x 0.056 = 0.028 = 2.8%
