tb chapter03

8/8/2019 TB Chapter03

1/68

(Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual

Easy:

Current ratio Answer: a Diff: E

1. All else being equal, which of the following will increase a company’scurrent 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.

Current ratio Answer: d Diff: E

. !epsi "orporation’s current ratio is #.$, while "o%e "ompany’s currentratio is 1.$. &oth firms want to 'window dress( their coming end)of)year

financial statements. As part of its window dressing strategy, each firmwill double its current liabilities by adding short)term debt and placing

the funds obtained in the cash account. *hich of the statements belowbest describes the actual results of these transactions?

a. +he transactions will have no effect on the current ratios.b. +he current ratios of both firms will be increased.

c. +he current ratios of both firms will be decreased.d. nly !epsi "orporation’s current ratio will be increased.

e. nly "o%e "ompany’s current ratio will be increased.

Cash flows Answer: a Diff: E

-. *hich of the following alternatives could potentially result in a net

increase in a company’s cash flow for the current year?

a. educe the days sales outstanding ratio.b. /ncrease the number of years over which fixed assets are depreciated.c. 0ecrease the accounts payable balance.

d. Statements a and b are correct.e. All of the statements above are correct.

Chapter 3 - Page 1

CHAPTE !A"A#$%&% ' &"A"C&A# %TATEME"T%


2/68

Leverage and financial ratios Answer: d Diff: E

. Stennett "orp.’s "2 has proposed that the company issue new debt and use

the proceeds to buy bac% common stoc%. *hich of the following are li%elyto occur if this proposal is adopted? 3Assume that the proposal would

have no effect on the company’s operating income.4

a. eturn on assets 3A4 will decline.b. +he times interest earned ratio 3+/54 will increase.c. +axes paid will decline.

d. Statements a and c are correct.e. 6one of the statements above is correct.

Leverage and profitability ratios Answer: e Diff: E

$. Ama7on 5lectric wants to increase its debt ratio, which will alsoincrease its interest expense. Assume that the higher debt ratio will

have no effect on the company’s operating income, total assets, or taxrate. Also, assume that the basic earning power ratio exceeds the before)

tax cost of debt financing. *hich of the following will occur if the

company increases its debt ratio?

a. /ts A will fall.b. /ts 5 will increase.

c. /ts basic earning power 3&5!4 will stay unchanged.d. Statements a and c are correct.


EVA Answer: b Diff: E N

8. *hich of the following statements is most correct?

a. A company that has positive net income must also have positive 59A.

b. /f a company’s 5 is greater than its cost of equity, its 59A ispositive.c. /f a company increases its 59A, its 5 must also increase.

d. Statements a and b are correct.e. All of the above statements are correct.

ROE and EVA Answer: e Diff: E

:. *hich of the following statements is most correct about 5conomic 9alueAdded 359A4?

a. /f a company has no debt, its 59A equals its net income.b. /f a company has positive 5, its 59A must also be positive.

c. A company’s 59A will be positive whenever the cost of equity exceedsthe 5.

d. All of the statements above are correct.e. 6one of the statements above is correct.

Chapter 3 - Page 2


3/68

ROE and EVA Answer: b Diff: E

;. 0evon /nc. has a higher 5 than &erwyn /nc. 31: percent compared to 1

percent4, but it has a lower 59A than &erwyn. *hich of the followingfactors could explain the relative performance of these two companies?

a. 0evon is much larger than &erwyn.

b. 0evon is ris%ier, has a higher *A"", and a higher cost of equity.c. 0evon has a higher operating income 35&/+4.d. Statements a and b are correct.


Ratio analysis Answer: b Diff: E

1## million in total

assets and a 1# percent return on assets 3A4. 5ach company has a #percent tax rate. &edford, however, has a higher debt ratio and higher

interest expense. *hich of the following statements is most correct?

a. +he two companies have the same basic earning power 3&5!4.

b. &edford has a higher return on equity 354.c. &edford has a lower level of operating income 35&/+4.


inancial state!ent analysis Answer: a Diff: E

1#. "ompany and "ompany @ each recently reported the same earnings pershare 35!S4. "ompany ’s stoc%, however, trades at a higher price. *hich

of the following statements is most correct?

a. "ompany must have a higher !5 ratio.b. "ompany must have a higher mar%et to boo% ratio.

c. "ompany must be ris%ier.d. "ompany must have fewer growth opportunities.e. All of the statements above are correct.

inancial state!ent analysis Answer: e Diff: E

11. "ompany A’s 5 is # percent, while "ompany &’s 5 is 1$ percent. *hichof the following statements is most correct?

a. "ompany A must have a higher A than "ompany &.

b. "ompany A must have a higher 59A than "ompany &.c. "ompany A must have a higher net income than "ompany &.


Chapter 3 - Page 3


4/68

inancial state!ent analysis Answer: e Diff: E

1. "ompany A and "ompany & have the same total assets, return on assets

3A4, and profit margin. =owever, "ompany A has a higher debt ratio andinterest expense than "ompany &. *hich of the following statements is

most correct?

a. "ompany A has a higher 5 3return on equity4 than "ompany &.b. "ompany A has a higher total assets turnover than "ompany &.c. "ompany A has a higher operating income 35&/+4 than "ompany &.

d. Statements a and b are correct.e. Statements a and c are correct.

inancial state!ent analysis Answer: d Diff: E N

1-. 6elson "ompany is thin%ing about issuing new common stoc%. +he proceedsfrom the stoc% issue will be used to reduce the company’s outstanding

debt and interest expense. +he stoc% issue will have no effect on thecompany’s total assets, 5&/+, or tax rate. *hich of the following is

li%ely to occur if the company goes ahead with the stoc% issue?

a. +he company’s net income will increase.

b. +he company’s times interest earned ratio will increase.c. +he company’s A will increase.

d. All of the above statements are correct.e. 6one of the above statements is correct.

"iscellaneous ratios Answer: a Diff: E

1. "ompanies A and & have the same profit margin and debt ratio. =owever,"ompany A has a higher return on assets and a higher return on equitythan "ompany &. *hich of the following can explain these observed ratios?

a. "ompany A must have a higher total assets turnover than "ompany &.b. "ompany A must have a higher equity multiplier than "ompany &.c. "ompany A must have a higher current ratio than "ompany &.

d. Statements b and c are correct.e. All of the statements above are correct.

"iscellaneous ratios Answer: e Diff: E R

1$. &ichette 2urniture "ompany recently issued new common stoc% and used theproceeds to reduce its short)term notes payable and accounts payable.+his action had no effect on the company’s total assets or operating

income. *hich of the following effects did occur as a result of thisaction?

a. +he company’s current ratio decreased.

b. +he company’s basic earning power ratio increased.c. +he company’s time interest earned ratio decreased.d. +he company’s debt ratio increased.

e. +he company’s equity multiplier decreased.

Chapter 3 - Page 4


5/68

Medium:

Current ratio Answer: d Diff: "

18. 9an &uren "ompany has a current ratio B 1.


6/68

e. 0rysdale has a lower price earnings ratio than "ommerce.Ratio analysis Answer: a Diff: "

#. Dou are an analyst following two companies, "ompany E and "ompany D. Douhave collected the following informationF

• +he two companies have the same total assets.

• "ompany E has a higher total assets turnover than "ompany D.• "ompany E has a higher profit margin than "ompany D.• "ompany D has a higher inventory turnover ratio than "ompany E.• "ompany D has a higher current ratio than "ompany E.

*hich of the following statements is most correct?

a. "ompany E must have a higher net income.b. "ompany E must have a higher 5.c. "ompany D must have a higher A.

d. Statements a and b are correct.e. Statements a and c are correct.

Effects of leverage Answer: a Diff: "

1. *hich of the following statements is most correct?

a. A firm with financial leverage has a larger equity multiplier than anotherwise identical firm with no debt in its capital structure.

b. +he use of debt in a company’s capital structure results in taxbenefits to the investors who purchase the company’s bonds.

c. All else equal, a firm with a higher debt ratio will have a lower

basic earning power ratio.d. All of the statements above are correct.

e. Statements a and c are correct.

inancial state!ent analysis Answer: a Diff: "

. *hich of the following statements is most correct?

a. An increase in a firm’s debt ratio, with no changes in its sales andoperating costs, could be expected to lower its profit margin on

sales.b. An increase in the 0S, other things held constant, would generally

lead to an increase in the total assets turnover ratio.c. An increase in the 0S, other things held constant, would generally

lead to an increase in the 5.d. /n a competitive economy, where all firms earn similar returns on

equity, one would expect to find lower profit margins for airlines,

which require a lot of fixed assets relative to sales, than for freshfish mar%ets.

e. /t is more important to adGust the debt ratio than the inventoryturnover ratio to account for seasonal fluctuations.

Chapter 3 - Page 6


7/68

inancial state!ent analysis Answer: d Diff: " N

-. =arte Hotors and Hills Automotive each have the same total assets, the

same level of sales, and the same return on equity 354. =arte Hotors,however, has less equity and a higher debt ratio than does Hills

Automotive. *hich of the following statements is most correct?

a. Hills Automotive has a higher net income than =arte Hotors.b. Hills Automotive has a higher profit margin than =arte Hotors.

c. Hills Automotive has a higher return on assets 3A4 than =arteHotors.


Leverage and financial ratios Answer: e Diff: "

. "ompany A and "ompany & have the same total assets, tax rate, and netincome. "ompany A, however, has a lower profit margin than "ompany &."ompany A also has a higher debt ratio and, therefore, higher interest

expense than "ompany &. *hich of the following statements is most correct?

a. "ompany A has a higher total assets turnover.b. "ompany A has a higher return on equity.

c. "ompany A has a higher basic earning power ratio.d. Statements a and b are correct.e. All of the statements above are correct.

Leverage and financial ratios Answer: d Diff: " N

$. "ompany A and "ompany & have the same tax rate, total assets, and basic

earning power. &oth companies have positive net incomes. "ompany A has ahigher debt ratio, and therefore, higher interest expense than "ompany &.*hich of the following statements is true?

a. "ompany A has a higher A than "ompany &.b. "ompany A has a higher times interest earned 3+/54 ratio than "ompany &.c. "ompany A has a higher net income than "ompany &.

d. "ompany A pays less in taxes than "ompany &.e. "ompany A has a lower equity multiplier than "ompany &.

Du #ont e$uation Answer: b Diff: " R

8. Dou observe that a firm’s profit margin is below the industry average,while its return on equity and debt ratio exceed the industry average.

*hat can you conclude?

a. eturn on assets must be above the industry average.

b. +otal assets turnover must be above the industry average.c. +otal assets turnover must be below the industry average.d. Statements a and b are correct.e. 6one of the statements above is correct.

Chapter 3 - Page 7


8/68

ROE and EVA Answer: d Diff: "

:. =uxtable Hedical’s "2 recently estimated that the company’s 59A for the

past year was 7ero. +he company’s cost of equity capital is 1 percent,its cost of debt is ; percent, and its debt ratio is # percent. *hich

of the following statements is most correct?

a. +he company’s net income was 7ero.b. +he company’s net income was negative.c. +he company’s A was 1 percent.

d. +he company’s 5 was 1 percent.e. +he company’s after)tax operating income was less than the total

dollar cost of capital.

ROE and EVA Answer: b Diff: "

;. *hich of the following statements is most correct?

a. /f two firms have the same 5 and the same level of ris%, they must

also have the same 59A.

b. /f a firm has positive 59A, this implies that its 5 exceeds its costof equity.

c. /f a firm has positive 5, this implies that its 59A is alsopositive.


"iscellaneous ratios Answer: b Diff: "


9/68

"iscellaneous ratios Answer: e Diff: "

-#. eeves "orporation forecasts that its operating income 35&/+4 and total

assets will remain the same as last year, but that the company’s debtratio will increase this year. *hat can you conclude about the company’s

financial ratios? 3Assume that there will be no change in the company’stax rate.4

a. +he company’s basic earning power 3&5!4 will fall.b. +he company’s return on assets 3A4 will fall.

c. +he company’s equity multiplier 35H4 will increase.d. All of the statements above are correct.

e. Statements b and c are correct.

"iscellaneous ratios Answer: d Diff: "

-1. "ompany E has a higher 5 than "ompany D, but "ompany D has a higher A

than "ompany E. "ompany E also has a higher total assets turnover ratiothan "ompany DI however, the two companies have the same total assets.

*hich of the following statements is most correct?

a. "ompany E has a lower debt ratio than "ompany D.

b. "ompany E has a lower profit margin than "ompany D.c. "ompany E has a lower net income than "ompany D.


Tough:

ROE and EVA Answer: a Diff: %

-. 0ivision A has a higher 5 than 0ivision &, yet 0ivision & creates more

value for shareholders and has a higher 59A than 0ivision A. &oth

divisions, however, have positive 5s and 59As. *hat could explain theseperformance measures?

a. 0ivision A is ris%ier than 0ivision &.b. 0ivision A is much larger 3in terms of equity capital employed4 than

0ivision &.

c. 0ivision A has less debt than 0ivision &.d. Statements a and b are correct.


Chapter 3 - Page 9


10/68

Ratio analysis Answer: d Diff: %

--. Dou have collected the following information regarding "ompanies " and 0F

• +he two companies have the same total assets.• +he two companies have the same operating income 35&/+4.• +he two companies have the same tax rate.

• "ompany " has a higher debt ratio and interest expense than "ompany 0.• "ompany " has a lower profit margin than "ompany 0.

n the basis of this information, which of the following statements ismost correct?

a. "ompany " must have a higher level of sales.

b. "ompany " must have a lower 5.c. "ompany " must have a higher times interest earned 3+/54 ratio.d. "ompany " must have a lower A.

e. "ompany " must have a higher basic earning power 3&5!4 ratio.

Ratio analysis Answer: d Diff: %

-. An analyst has obtained the following information regarding two

companies, "ompany E and "ompany DF

• "ompany E and "ompany D have the same total assets.• "ompany E has a higher interest expense than "ompany D.• "ompany E has a lower operating income 35&/+4 than "ompany D.• "ompany E and "ompany D have the same return on equity 354.• "ompany E and "ompany D have the same total assets turnover 3+A+4.• "ompany E and "ompany D have the same tax rate.

n the basis of this information, which of the following statements is

most correct?

a. "ompany E has a higher times interest earned 3+/54 ratio.b. "ompany E and "ompany D have the same debt ratio.

c. "ompany E has a higher return on assets 3A4.d. "ompany E has a lower profit margin.

e. "ompany E has a higher basic earning power 3&5!4 ratio.

Ratio analysis and Du #ont e$uation Answer: d Diff: %

-$. Jancaster "o. and Dor% "o. both have the same return on assets 3A4.=owever, Jancaster has a higher total assets turnover and a higher equity

multiplier than Dor%. *hich of the following statements is most correct?

a. Jancaster has a lower profit margin than Dor%.b. Jancaster has a lower debt ratio than Dor%.c. Jancaster has a higher return on equity 354 than Dor%.d. Statements a and c are correct.


Chapter 3 - Page 10


11/68

Leverage and financial ratios Answer: d Diff: %

-8. &lair "ompany has >$ million in total assets. +he company’s assets are

financed with >1 million of debt and > million of common equity. +hecompany’s income statement is summari7ed belowF

perating income 35&/+4 >1,###,###

/nterest 1##,###5arnings before taxes 35&+4 > $#,###

+he company wants to increase its assets by >1 million, and it plans tofinance this increase by issuing >1 million in new debt. +his action

will double the company’s interest expense but its operating income willremain at # percent of its total assets, and its average tax rate willremain at # percent. /f the company ta%es this action, which of the

following will occurF

a. +he company’s net income will increase.b. +he company’s return on assets will fall.

c. +he company’s return on equity will remain the same.d. Statements a and b are correct.e. All of the statements above are correct.

"iscellaneous ratios Answer: c Diff: %

-:. Some %ey financial data and ratios are reported in the table below for=emmingway =otels and for its competitor, 2it7gerald =otelsF

atio =emmingway =otels 2it7gerald =otels

!rofit margin K -KA .# billion >1.$ billion&5! #K #K5 1;K K

n the basis of the information above, which of the following statements

is most correct?

a. =emmingway has a higher total assets turnover than 2it7gerald.b. =emmingway has a higher debt ratio than 2it7gerald.c. =emmingway has higher net income than 2it7gerald.


Chapter 3 - Page 11


12/68

Multiple Choice: Po*lems

Easy:

inancial state!ent analysis Answer: a Diff: E

-;. ussell Securities has >1## million in total assets and its corporate tax

rate is # percent. +he company recently reported that its basic earningpower 3&5!4 ratio was 1$ percent and its return on assets 3A4 was <percent. *hat was the company’s interest expense?

a. > #

b. > ,###,###c. > 8,###,###

d. >1$,###,###e. >1;,###,###

"ar&et price per share Answer: b Diff: E

-1,$#I

priceearnings ratio B $I shares outstanding B $I and mar%etboo% ratioB 1.$. "alculate the mar%et price of a share of the company’s stoc%.

a. > --.--b. > :$.##

c. > 1#.##d. >188.8:

e. >1--.-

"ar&et price per share Answer: c Diff: E

#. Liven the following information, calculate the mar%et price per share of*AH /nc.F

6et income >##,###.##5arnings per share >.##Stoc%holders’ equity >,###,###.##Har%et&oo% ratio #.#

a. >#.##b. > ;.##

c. > .##d. > .##

e. > 1.##

"ar&et'boo& ratio Answer: c Diff: E

1

. Heyersdale ffice Supplies has common equity of ># million. +hecompany’s stoc% price is >;# per share and its mar%etboo% ratio is .#.=ow many shares of stoc% does the company have outstanding?

a. $##,###

b. 1$,###c. ,###,###

Chapter 3 - Page 12


13/68

d. ;##,###,###e. /nsufficient information.

"ar&et'boo& ratio Answer: e Diff: E N

. Strac% =ouseware Supplies /nc. has > billion in total assets. +he other

side of its balance sheet consists of >#. billion in current liabilities,>#.8 billion in long)term debt, and >1. billion in common equity. +he

company has -## million shares of common stoc% outstanding, and its stoc%price is ># per share. *hat is Strac%’s mar%etboo% ratio?

a. 1.$b. .8$

c. -.1$d. .#

e. $.##

ROA Answer: d Diff: E

-. A firm has a profit margin of 1$ percent on sales of >#,###,###. /f the

firm has debt of >:,$##,###, total assets of >,$##,###, and an after)

tax interest cost on total debt of $ percent, what is the firm’s A?

a. ;.K

b. 1#..;8b. >$#.##c. >#.##

d. >8#.##e. >$:.


14/68

ROE Answer: c Diff: E

$. +apley 0ental Supply "ompany has the following dataF

6et income >#Sales >1#,###+otal assets >8,###

0ebt ratio :$K+/5 ratio .#"urrent ratio 1.&5! ratio 1-.--K

/f +apley could streamline operations, cut operating costs, and raise net

income to >-## without affecting sales or the balance sheet 3theadditional profits will be paid out as dividends4, by how much would its

5 increase?

a. -.##Kb. -.$#K

c. .##Kd. .$K

e. $.$#K

#rofit !argin Answer: c Diff: E

8. Dour company had the following balance sheet and income statementinformation for ##F

&alance SheetF"ash > #A 1,###/nventories $,###+otal current assets >8,## 0ebt >,###6et fixed assets ,1#,###"ost of goods sold ;##/nterest 31#K4 ##5&+ > ##+axes 3#K4 18#6et income > #

+he industry average inventory turnover is $. Dou thin% you can change

your inventory control system so as to cause your turnover to equal theindustry average, and this change is expected to have no effect on either

sales or cost of goods sold. +he cash generated from reducing inventories

will be used to buy tax)exempt securities that have a : percent rate ofreturn. *hat will your profit margin be after the change in inventoriesis reflected in the income statement?

a. .1K

b. .Kc. .$K

Chapter 3 - Page 14


15/68

d. $.-Ke. 8.:K

Du #ont e$uation Answer: a Diff: E

:. +he *ilson "orporation has the following relationshipsF

Sales+otal assets .#×

eturn on assets 3A4 .#Keturn on equity 354 8.#K

*hat is *ilson’s profit margin and debt ratio?

a. KI #.--b. KI #.--

c. KI #.8:d. KI #.8:e. KI #.$#

#'E ratio and stoc& price Answer: b Diff: E

;. +he "harleston "ompany is a relatively small, privately owned firm. Jastyear the company had net income of >1$,### and 1#,### shares were

outstanding. +he owners were trying to determine the equilibrium mar%etvalue for the stoc% prior to ta%ing the company public. A similar firm

that is publicly traded had a priceearnings ratio of $.#. Csing onlythe information given, estimate the mar%et value of one share of

"harleston’s stoc%.

a. >1#.##

b. > :.$#c. > $.##

d. > .$#e. > 1.$#

#'E ratio and stoc& price Answer: e Diff: E

:$#,###, and its !5 is ;. *hat is the company’s stoc%price?

a. >#.##

b. >-#.##c. >#.##

d. >$#.##e. >8#.##

Chapter 3 - Page 15


16/68

Current ratio and inventory Answer: b Diff: E N

$#. /%en &erry 2arms has >$ million in current assets, >- million in current

liabilities, and its initial inventory level is >1 million. +he companyplans to increase its inventory, and it will raise additional short)term

debt 3that will show up as notes payable on the balance sheet4 topurchase the inventory. Assume that the value of the remaining current

assets will not change. +he company’s bond covenants require it tomaintain a current ratio that is greater than or equal to 1.$. *hat isthe maximum amount that the company can increase its inventory before it

is restricted by these covenants?

a. >#.$# million

b. >1.## millionc. >1.-- milliond. >1.88 million

e. >.-- million

Medium:

Accounts receivable increase Answer: b Diff: " R

$1. "annon "ompany has enGoyed a rapid increase in sales in recent years,following a decision to sell on credit. =owever, the firm has noticed a

recent increase in its collection period. Jast year, total sales were >1million, and >$#,### of these sales were on credit. 0uring the year, the

accounts receivable account averaged >1,#$:8,###b. >8--,---

c. >:$#,###

Chapter 3 - Page 16


17/68

d. ># million. +he company’s

times interest earned 3+/54 ratio is ;.#, its tax rate is # percent, andits basic earning power 3&5!4 ratio is 1# percent. *hat is the company’s

return on assets 3A4?

a. 8.$Kb. $.$##,### in total assets. +he company’s basic earning

power 3&5!4 is 1# percent, its times interest earned 3+/54 ratio is $,and the company’s tax rate is # percent. *hat is the company’s returnon assets 3A4?

a. -.Kb. .#Kc. .;K

d. 8.#Ke. :.K

ROE Answer: c Diff: " R

$8. Sel7er /nc. sells all its merchandise on credit. /t has a profit marginof percent, days sales outstanding equal to 8# days, receivables of

>1$#,###, total assets of >- million, and a debt ratio of #.8. *hat isthe firm’s return on equity 354? Assume a -8$)day year.

a. :.1K

b. --.Kc. -.Kd. :1.#K

Chapter 3 - Page 17


18/68

e. ;.1K

Chapter 3 - Page 18


19/68

ROE Answer: b Diff: "

$:. A firm has a debtequity ratio of $# percent. "urrently, it has interest

expense of >$##,### on >$,###,### of total debt outstanding. /ts tax rateis # percent. /f the firm’s A is 8 percent, by how many percentage

points is the firm’s 5 greater than its A?

a. #.#Kb. -.#Kc. $.K

d. :.Ke.


20/68

E$uity !ultiplier Answer: d Diff: "

8#. A firm that has an equity multiplier of .# will have a debt ratio of

a. .##b. -.##c. 1.##

d. #.:$e. #.$

%(E ratio Answer: e Diff: "

81. Alumbat "orporation has >;##,### of debt outstanding, and it pays aninterest rate of 1# percent annually on its ban% loan. Alumbat’s annual

sales are >-,##,###, its average tax rate is # percent, and its netprofit margin on sales is 8 percent. /f the company does not maintain a

+/5 ratio of at least times, its ban% will refuse to renew its loan,and ban%ruptcy will result. *hat is Alumbat’s current +/5 ratio?

a. .

b. -.c. -.8d. .#

e. $.#

%(E ratio Answer: b Diff: " N

8. Hoss Hotors has >; billion in assets, and its tax rate is # percent. +he

company’s basic earning power 3&5!4 ratio is 1 percent, and its returnon assets 3A4 is - percent. *hat is Hoss’ times interest earned 3+/54

ratio?

a. .$

b. 1.:1c. 1.##

d. 1.--e. .$#

%(E ratio Answer: b Diff: "

8-. Jancaster Hotors has total assets of ># million. /ts basic earning poweris $ percent, its return on assets 3A4 is 1# percent, and the

company’s tax rate is # percent. *hat is Jancaster’s +/5 ratio?

a. .$

b. -.#c. 1.$

d. 1.e. #.8

Chapter 3 - Page 20


21/68

%(E ratio Answer: d Diff: " N

8. oll’s &outique currently has total assets of >- million in operation.

ver this year, its performance yielded a basic earning power 3&5!4 of $percent and a return on assets 3A4 of 1 percent. +he firm’s earnings

are subGect to a -$ percent tax rate. n the basis of this information,what is the firm’s times interest earned 3+/54 ratio?

a. 1.;

b. 1.< billion in total assets. +he company’sbasic earning power 3&5!4 ratio is < percent, and its times interestearned ratio is -.#. !eterson’s depreciation and amorti7ation expense

totals >1 billion. /t has >#.8 billion in lease payments and >#.-

billion must go towards principal payments on outstanding loans and long)term debt. *hat is !eterson’s 5&/+0A coverage ratio?

a. .#8b. 1.$c. .$

d. 1.1#e. .::

Debt ratio Answer: c Diff: "

88. @ansas ffice Supply had >,###,### in sales last year. +he company’snet income was >##,###, its total assets turnover was 8.#, and the

company’s 5 was 1$ percent. +he company is financed entirely with debtand common equity. *hat is the company’s debt ratio?

a. #.#

b. #.-#c. #.--

d. #.8#e. #.88

#rofit !argin Answer: a Diff: "

8:. +he Herriam "ompany has determined that its return on equity is 1$percent. Hanagement is interested in the various components that went into

this calculation. Dou are given the following informationF total

debttotal assets B #.-$ and total assets turnover B .;. *hat is theprofit margin?

a. -.;Kb. $.Kc. 8.


22/68

e. 1.;Kinancial state!ent analysis Answer: e Diff: " R

8;. "ollins "ompany had the following partial balance sheet and completeincome statement information for ##F

!artial &alance SheetF

"ash > #A 1,###

/nventories ,###+otal current assets > -,##

6et fixed assets , 8,###

/ncome StatementF

Sales >1#,###"ost of goods sold ;##/nterest 31#K4 ##

5&+ > ##

+axes 3#K4 18#6et income > #

+he industry average 0S is -# 3assuming a -8$)day year4. "ollins plansto change its credit policy so as to cause its 0S to equal the industry

average, and this change is expected to have no effect on either sales orcost of goods sold. /f the cash generated from reducing receivables is

used to retire debt 3which was outstanding all last year and has a 1#percent interest rate4, what will "ollins’ debt ratio 3+otal debt+otalassets4 be after the change in 0S is reflected in the balance sheet?

a. --.--Kb. $.;K

c. $.:$Kd. 8#.##Ke. 8$.8$K

inancial state!ent analysis Answer: b Diff: " R

81,##,###.##"urrent liabilities > -:$,###.##0ays sales outstanding 30S4 3-8$)day year4 #.##/nventory turnover ratio .;#"urrent ratio 1.#

+he company’s current assets consist of cash, inventories, and accountsreceivable. =ow much cash does +aft have on its balance sheet?

a. )> ;,---

b. > 8;,1$,###

d. >##,###

Chapter 3 - Page 22


23/68

e. >-18,88:

)asic earning power Answer: d Diff: "

:#. Aaron Aviation recently reported the following informationF

6et income >$##,###

A 1#K/nterest expense >##,###

+he company’s average tax rate is # percent. *hat is the company’sbasic earning power 3&5!4?

a. 1.1K

b. 18.8:Kc. 1:.--Kd. #.8:K

e. .$#K

#'E ratio and stoc& price Answer: e Diff: "

:1

. 0ean &rothers /nc. recently reported net income of >1,$##,###. +hecompany has -##,### shares of common stoc%, and it currently trades at >8#a share. +he company continues to expand and anticipates that one year

from now its net income will be >,$##,###. ver the next year thecompany also anticipates issuing an additional 1##,### shares of stoc%, so

that one year from now the company will have ##,### shares of commonstoc%. Assuming the company’s priceearnings ratio remains at its current

level, what will be the company’s stoc% price one year from now?

a. >$$

b. >8#c. >8$

d. >:#e. >:$

Current ratio and D*O Answer: a Diff: "

:. !arcells ets has the following balance sheet 3in millions4F

"ash > 1## 6otes payable > 1##/nventories -## Accounts payable ##Accounts receivable ## Accruals 1##+otal current assets > ;## +otal current liabilities > ##6et fixed assets 1,## Jong)term bonds 8##

+otal debt >1,###MMMMMM +otal common equity 1,###

+otal assets >,### +otal liabilities and equity >,###

!arcells’ 0S 3on a -8$)day basis4 is #, which is above the industryaverage of -#. Assume that !arcells is able to reduce its 0S to theindustry average without reducing sales, and the company ta%es the freed)up cash and uses it to reduce its outstanding long)term bonds. /f this

occurs, what will be the new current ratio?

a. 1.:$b. 1.--

Chapter 3 - Page 23


24/68

c. .--d. 1.$

e. 1.8:Current ratio Answer: c Diff: " N

:-. "artwright &rothers has the following balance sheet 3all numbers areexpressed in millions of dollars4F

"ash > $# Accounts payable > -##Accounts receivable $# 6otes payable -##

/nventories $# Jong)term debt 8##6et fixed assets 1,$# "ommon stoc% ;##

+otal assets >,### +otal claims >,###

"artwright’s average daily sales are >1# million. "urrently,"artwright’s days sales outstanding 30S4 is well above the industryaverage of 1$. "artwright is implementing a plan that is designed to

reduce its 0S to 1$ without reducing its sales. /f successful the planwill free up cash, half of which will be used to reduce notes payable and

the other half will be used to reduce accounts payable. *hat will be thecurrent ratio if "artwright fully succeeds in implementing this plan?

a. 1.##b. #.8-

c. 1.-#d. 1.$

e. 1.$#

Current ratio Answer: b Diff: " N

:. efferson "o. has > million in total assets and >- million in sales. +he

company has the following balance sheetF

"ash > 1##,### Accounts payable > ##,###Accounts receivable ##,### Accruals 1##,###/nventories $##,### 6otes payable ##,###

6et fixed assets 1,##,### Jong)term debt :##,###"ommon equity ;##,###

+otal liabilities+otal assets >,###,### and equity >,###,###

efferson wants to improve its inventory turnover ratio so that it equalsthe industry average of 1#.#×. +he company would li%e to accomplish this

goal without reducing sales. /f successful, the company would ta%e thefreed)up cash from the reduction in inventories and use half of it to

reduce notes payable and the other half to reduce common equity. *hatwill be efferson’s current ratio, if it is able to accomplish its goal

of improving its inventory management?

a. 1.-b. 1.$#c. .$#

d. .##

Chapter 3 - Page 24


25/68

e. 1.#

Chapter 3 - Page 25


26/68

Credit policy and ROE Answer: c Diff: " R

:$. 0aggy "orporation has the following simplified balance sheetF

"ash > $,### "urrent liabilities >##,###/nventories 1;## million. *hat are the company’s sales? 3Assume that the

company has no preferred stoc%.4

a. >1,#,###,###b. >,##,###,###

c. > 1#,###,###d. > -8#,###,###e. >


27/68

Net inco!e and Du #ont e$uation Answer: c Diff: " N

:;. Samuels 5quipment has >1# million in sales. /ts 5 is 1$ percent andits total assets turnover is -.$×. +he company is 1## percent equity

financed. *hat is the company’s net income?

a. >1,$##,###b. >,;$:,1-

c. > ;,$:1d. >,---,---

e. > $,$##

Tough:

ROE Answer: c Diff: %

:


28/68

ROE Answer: d Diff: %

;#. Leorgia 5lectric reported the following income statement and balance

sheet for the previous yearF

&alance SheetF"ash > 1##,###

/nventories 1,###,###Accounts receivable $##,###

"urrent assets >1,8##,###+otal debt >,###,###

6et fixed assets ,##,### +otal equity ,###,###+otal assets >8,###,### +otal claims >8,###,###

/ncome StatementF

Sales >-,###,###perating costs 1,8##,###perating income 35&/+4 >1,##,###

/nterest ##,###+axable income 35&+4 >1,###,###

+axes 3#K4 ##,###6et income > 8##,###

+he company’s interest cost is 1# percent, so the company’s interest

expense each year is 1# percent of its total debt.

*hile the company’s financial performance is quite strong, its "2 3"hief2inancial fficer4 is always loo%ing for ways to improve. +he "2 has

noticed that the company’s inventory turnover ratio is considerablywea%er than the industry average, which is 8.#. As an exercise, the "2

as%s what would the company’s 5 have been last year if the followinghad occurredF

• +he company maintained the same sales, but was able to reduce

inventories enough to achieve the industry average inventory turnoverratio.

• +he cash that was generated from the reduction in inventories wasused to reduce part of the company’s outstanding debt. So, thecompany’s total debt would have been > million less the freed)up

cash from the improvement in inventory policy. +he company’sinterest expense would have been 1# percent of new total debt.

• Assume equity does not change. 3+he company pays all net income asdividends.4

Cnder this scenario, what would have been the company’s 5 last year?

a. :.#Kb.


29/68

ROE and financing Answer: a Diff: %

;1. Savelots Stores’ current financial statements are shown belowF

&alance SheetF

/nventories > $## Accounts payable > 1##ther current assets ## Short)term notes payable -:#

2ixed assets -:# "ommon equity ;##+otal assets >1,:# +otal liab. and equity >1,:#

/ncome StatementFSales >,###

perating costs 1,;-5&/+ > 1$:

/nterest -:5&+ > 1#+axes 3#K4 ;6et income > :

A recently released report indicates that Savelots’ current ratio of 1.


30/68

ROE and refinancing Answer: d Diff: %

;. Aurillo 5quipment "ompany 3A5"4 proGected that its 5 for next year

would be Gust 8 percent. =owever, the financial staff has determinedthat the firm can increase its 5 by refinancing some high interest

bonds currently outstanding. +he firm’s total debt will remain at>##,### and the debt ratio will hold constant at ;# percent, but the

interest rate on the refinanced debt will be 1# percent. +he rate on theold debt is 1 percent. efinancing will not affect sales, which areproGected to be >-##,###. 5&/+ will be 11 percent of sales and the

firm’s tax rate is # percent. /f A5" refinances its high interestbonds, what will be its proGected new 5?

a. -.#K

b. ;.Kc. 1#.#Kd. 1$.8K

e. 1;.:K

%(E ratio Answer: d Diff: %

;-. Jombardi +ruc%ing "ompany has the following dataF

Assets >1#,###

!rofit margin -.#K+ax rate #K

0ebt ratio 8#.#K/nterest rate 1#.#K+otal assets turnover .#

*hat is Jombardi’s +/5 ratio?

a. #.1.8 million of accounts receivable on itsbalance sheet. +he company’s 0S is # 3based on a -8$)day year4, itscurrent assets are >.$ million, and its current ratio is 1.$. +he

company plans to reduce its 0S from # to the industry average of -#without causing a decline in sales. +he resulting decrease in accounts

receivable will free up cash that will be used to reduce current

liabilities. /f the company succeeds in its plan, what will 9ictoria’snew current ratio be?

a. 1.$#b. 1.


31/68

e. 1.88#'E ratio and stoc& price Answer: b Diff: %

;$. EDO’s balance sheet and income statement are given belowF

&alance SheetF"ash > $# Accounts payable > 1##

A 1$# 6otes payable #/nventories -## Jong)term debt 31#K4 :##2ixed assets $## "ommon equity 3# shares4 ##+otal assets >1,### +otal liabilities and equity >1,###

/ncome StatementFSales >1,###

"ost of goods sold ;$$5&/+ > 1$/nterest :#

5&+ > :$+axes 3--.---K4 $6et income > $#

+he industry average inventory turnover is $, the interest rate on thefirm’s long)term debt is 1# percent, # shares are outstanding, and thestoc% sells at a !5 of ;.#. /f EDO changed its inventory methods so as

to operate at the industry average inventory turnover, if it used thefunds generated by this change to buy bac% common stoc% at the current

mar%et price and thus to reduce common equity, and if sales, the cost ofgoods sold, and the !5 ratio remained constant, by what dollar amount

would its stoc% price increase?

a. > -.--

b. > 8.8:

c. > ;.:$d. >1#.##e. >1.$#

Du #ont e$uation and debt ratio Answer: e Diff: %

;8. "ompany A has sales of >1,###, assets of >$##, a debt ratio of -#percent, and an 5 of 1$ percent. "ompany & has the same sales, assets,

and net income as "ompany A, but its 5 is -# percent. *hat is &’s debtratio? 3=intF &egin by loo%ing at the 0u !ont equation.4

a. $.#Kb. -$.#K

c. $#.#Kd. $.$K

e. 8$.#K

Chapter 3 - Page 31


32/68

inancial state!ent analysis Answer: a Diff: %

;:. A company has Gust been ta%en over by new management that believes it can

raise earnings before taxes 35&+4 from >8## to >1,###, merely by cuttingovertime pay and reducing cost of goods sold. !rior to the change, the

following data appliedF

+otal assets >;,###0ebt ratio $K+ax rate -$K

&5! ratio 1-.-1$K5&+ >8##

Sales >1$,###

+hese data have been constant for several years, and all income is paidout as dividends. Sales, the tax rate, and the balance sheet will remainconstant. *hat is the company’s cost of debt? 3=intF *or% only with

old data.4

a. 1.1##,###!rofit margin 8.#K+ax rate #K

0ebt ratio #.#K

/nterest rate ;.#K+otal assets turnover -.#

*hat is Jone Star’s 5&/+?

a. > -,##

b. >1,###c. >1;,###d. >-#,###

e. >--,##

Chapter 3 - Page 32


33/68

*ales increase needed Answer: b Diff: % N

;1,###,###

"ost of goods sold :,$##,###5&/+ > ,$##,###

/nterest 1,$##,###5&+ > -,###,###+axes 3#K4 1,##,###

6et income > 1,;##,###

+he company’s "2, 2red Hert7, wants to see a $ percent increase in netincome over the next year. /n other words, his target for next year’s

net income is >,$#,###. Hert7 has made the following observationsF

• icardo’s operating margin 35&/+Sales4 was -:.$ percent this pastyear. Hert7 expects that next year this margin will increase to# percent.

•

icardo’s interest expense is expected to remain constant.• icardo’s tax rate is expected to remain at # percent.

n the basis of these numbers, what is the percentage increase in sales

that icardo needs in order to meet Hert7’s target for net income?

a. :.


34/68

#rofit !argin and Du #ont analysis Answer: a Diff: E N

-,## +otal liabilities and equity >-,##

Hiller also reported sales revenues of >.$ billion and a # percent 5 for

this same year.

ROA Answer: d Diff: " N


35/68

(The following information applies to the next three problems.)

0o%ic, /nc. reported the following balance sheets for year)end ##1 and ##3dollars in millions4F

## ##1

"ash > 8$# > $##Accounts receivable $# :##

/nventories ;$# 8##+otal current assets >1,1,;##

6et fixed assets ,$# ,##+otal assets >,## >,###

Accounts payable > 8;# > -##6otes payable ## 8##

*ages payable # ##+otal current liabilities >1,1## >1,1##

Jong)term bonds 1,### 1,###"ommon stoc% 1,$## 1,##

etained earnings ;## :##+otal common equity >,-## >1,,## >,###

"iscellaneous concepts Answer: e Diff: E N

$# millionb. >1$# million

c. >$# milliond. >-$# million

e. >$# million

Chapter 3 - Page 35


36/68

*ales, D*O, and inventory turnover Answer: b Diff: " N

1##,### > ;$,###Accounts receivable -,### -$#,###

/nventories 1,###,### :##,###+otal current assets >1,$-,### >1,1-$,###6et fixed assets -,###,### ,;##,###

+otal assets >,$-,### >-, :##,### > $$,###6otes payable ;##,### 1,$##,### >1,$,###Jong)term debt 1,##,### 1,##,###"ommon stoc% 1,$##,### 1,###,###

etained earnings --,### 1,;-,### >1,,$-,### >-,1,##,### of long)term debt in 1


37/68

inancial state!ent analysis Answer: a Diff: E N


38/68

Chapter 3 - Page 38

CHAPTE !A"%+E% A"D %'#T&'"%


39/68

1- Current ratio Answer: a Diff: E

emember, the current ratio is "A"J. /n order to increase the current ratio,either current assets must increase, or current liabilities must decrease.Accounts receivable are a current asset, and if they increase the current

ratio will increase. So, statement a is true. Accounts payable are a currentliability, so if they increase the current ratio declines. So, statement b is

false. 6et fixed assets are long)term assets, not current assets, so theywill not affect the current ratio. So, statement c is false.

- Current ratio Answer: d Diff: E

!epsi "orporationF&eforeF "urrent ratio B >$#>1## B #.$#.

AfterF "urrent ratio B >1$#>## B #.:$.

"o%e "ompanyF&eforeF "urrent ratio B >1$#>1## B 1.$#.

AfterF "urrent ratio B >$#>## B 1.$.

-- Cash flows Answer: a Diff: E

Statement a is correct. +he other statements are false. /ncreasing the years

over which fixed assets are depreciated results in smaller amounts beingdepreciated each year. Liven that depreciation is a non)cash expense and isused to reduce taxable income, the change would result in less depreciation

expense and higher taxes for the year. Since taxes are paid with cash, thecompanyQs cash flow would decrease. /n addition, decreasing accounts payable

results in using cash to pay off the accounts payable balance.

- Leverage and financial ratios Answer: d Diff: E

Statements a and c are correct. +he increase in debt payments will reduce net

income and hence reduce A. Also, higher debt payments will result in lowertaxable income and less tax. +herefore, statement d is the best choice.

$- Leverage and profitability ratios Answer: e Diff: E

Statement a is trueI higher debt will increase interest expense and net incomewill decline, resulting in a lower A than before. Statement b is trueI both

net income and equity are going to decline, but net income will decline lessbecause the basic earning power exceeds the cost of debt, so 5 will actually

rise. Statement c is trueI both 5&/+ and total assets remain the same.+herefore, statement e is the best choice.

8- EVA Answer: b Diff: E N

+he correct answer is statement b. A company can have positive 6/ and stillhave negative 59A. Joo% at the following formulaF

59A B 6/ ) 3"ost of 5quity43Amount of 5quity "apital4.

/f the cost of equity times the amount of equity is greater than 6/, 59A couldbe negative. ust because a company has a positive 6/ does not mean that it

is earning enough to adequately compensate its shareholders. +herefore,statement a is not correct.

2or statement b, loo% at the following formulaF


40/68

59A B 35 ) %435quity4.

As long as 5 is greater than the cost of equity, 59A will be positive.

+herefore, statement b is correct.

2rom the formula above, you can see that a company can increase its 59A byincreasing its 5, decreasing its cost of equity, or by increasing its equity

investment. Any of these three changes would increase 59A, not Gust theincrease in 5. +herefore, statement c is incorrect.

:- ROE and EVA Answer: e Diff: E

59A is the value added after both shareholders and debtholders have been paid.6et income only ta%es payments to debtholders into account, not shareholders.

+herefore, statement a is false. 59A B 35 ) %4 × +otal equity. So, if % islarger than 5, 59A would be negative even if 5 is positive. +he

shareholders are getting a return but not as much as they require. +herefore,statement b is false. Statement c is exactly the opposite of what is true, soit is false. 59A will be negative whenever the cost of equity exceeds the

5. Since statements a, b, and c are false, the correct choice is statement

e.

;- ROE and EVA Answer: b Diff: E

50 R 5&I 59A0 P 59A&.

59A can be calculated with - different equationsF

314 59A B 5&/+31 ) +4 )

×

"apital,peratingSupplied)/nvestor+otal

*A"" .

34 59A B 6/ 3%S × 5quity4.

3-4 59A B 35 ) %S4 × 5quity.

Since 0evon has a higher 5, but its 59A is lower, the only things that couldexplain this is if 314 its %s were higher or 34 its equity 3or si7e4 were

lower.

Since statement a would have the opposite effect 3increasing 0evon’s 59A4,statement a is false. /f the %S were higher, then 35 ) %S4 would be lower,

and 59A would be lower. +herefore, statement b is true. A higher 5&/+ wouldlead to a higher 59A, so statement c is false.

< - Ratio analysis

Answer: b Diff: E

&edford B 0I &ree7ewood B O.

+A0 B +AOI A0 B AOI +0 B +OI 0A0 R 0AOI /6+0 R /6+OI A B 6/+A./f both companies have the same A and total assets, then they must both havethe same net incomes. +herefore, 6/0 B 6/O.

2irst, compare &5!s. &5! B 5&/++A. *or% bac%ward up the income statement.

/f both companies have the same 6/ and tax rate, then they must both have thesame 5&+. =owever, &edford has higher interest payments, so its 5&/+ must behigher than &ree7ewood’s. 3ememberF 5&+ T / B 5&/+.4 +herefore, statement

c is false. /n addition, &edford’s &5! is higher than &ree7ewood’s, sostatements a, d, and e are all false. Statement b must be true for the

following reason. "ompare 5s. 5 B


41/68

A × 5H and 5H BA01

1

−.

&edford has a higher 0A ratio than &ree7ewoodI therefore, it has a higher 5H

than &ree7ewood. /f its 5H is higher and its A is the same, then &edford’s5 must be higher than &ree7ewood’s.

1#- inancial state!ent analysis Answer: a Diff: E

11- inancial state!ent analysis Answer: e Diff: E

5 B 6/5quityI A B 6/+AI 59A B 6/ ) %s × 5quity.

*e %now nothing about the debt ratio or equity multiplier of either company.

emember, A B 55H 35H B equity multiplier4. Since we don’t have 5H, wedon’t have enough information to say anything about A. +herefore, statement

a is false. *e don’t %now anything about the %s or the amount of equity ofeither company. +herefore, we don’t %now enough to determine which company’s

59A is higher. +herefore, statement b is false. *e %now that A’s 5 ishigher than &’s. =owever, we don’t %now how much equity either one has, so we

cannot say which one has a higher net income. +herefore, statement c isfalse. Since statements a, b, and c are false, the correct choice must bestatement e.

1- inancial state!ent analysis Answer: e Diff: E

2rom the first sentence, both firms have the same net income, sales, andassets. Since A has more debt, it must have less equity. +hus, its 5

3calculated as 6et income5quity4 is higher than &’s. So statement a iscorrect. Since the two firms have the same total assets and sales, their

total assets turnover ratios must be the same. So statement b is false. /f Ahas higher interest expense than & but the same net income, this means that A

must have higher operating income 35&/+4 than &. +herefore statement c is

correct. Since statements a and c are correct, the correct choice isstatement e.

1-- inancial state!ent analysis Answer: d Diff: E N

+he correct answer is statement d. Although 5&/+ is unchanged, interestexpense will go down, so 6/ will increase. +herefore, statement a is correct./f 5&/+ is unchanged, but interest expense goes down, the +/5 ratio 35&/+/6+4

will increase. +herefore, statement b is correct. /f the stoc% issue has noeffect on the company’s total assets, but 6/ has increased 3see statement a4,

then A 36/+A4 will increase. +herefore, statement c is also correct.

1- "iscellaneous ratios Answer: a Diff: E

+he 0u !ont equation statesF 5 B !H × +A+ × 5H.

+he firms have the same profit margin and equity multiplier. +he equity

multiplier is the same because both companies have the same debt ratio. /f"ompany A has a higher 5 than &, then from the 0u !ont equation "ompany A

also has a higher total assets turnover ratio than &. +he current ratio doesnot explain the ratios discussed. +herefore, only statement a explains the

observed ratios.


42/68

1$- "iscellaneous ratios Answer: e Diff: E R

"urrent ratio B "urrent assets"urrent liabilities. +his transaction will

reduce current liabilities, which results in a higher current ratio. Sostatement a is false. +he basic earning power ratio B 5&/++A. Since neither

the firm’s operating income 35&/+4 or total assets have changed, its &5! ratioremains unchanged. So statement b is false. +/5 B 5&/+/nterest. 5&/+ will

be unaffected, but we may see interest costs fall due to the firm having lessdebt. +his will result in an increase in the +/5 ratio. So statement c isfalse. Statement d is also false for the same reasons as statements a and b.

+otal debt is reduced but total assets remain the same. +he firm now has moreequity, so the equity multiplier 3Assets5quity4 will decrease, so statement e

is correct.

18- Current ratio Answer: d Diff: "

Statement d is the correct answer. 2or statements a and b a reduction in the

numerator and denominator by the same amount will increase the current ratiobecause the current ratio is greater than 1. /n statement c only the

denominator goes down 3long)term bonds are not in the current ratio4, so thecurrent ratio will increase.

1:- Current ratio Answer: e Diff: "

1;- Ratio analysis Answer: c Diff: "

1


43/68

#- Ratio analysis Answer: a Diff: %

Statement a is correctI the others are false. /f "ompany E has a higher totalassets turnover 3Sales+A4 but the same total assets, it must have higher salesthan D. /f E has higher sales and also a higher profit margin 36/Sales4 than

D, it must follow that E has a higher net income than D. Statement b is false.5 B 6/5U or 5 B A × 5quity multiplier. /n either case we need to %now

the amount of equity that both firms have. +his is impossible to determinegiven the information in the question. +herefore, we cannot say that E must

have a higher 5 than D. Statement c is false. emember from the 0u !ontequation that A B !rofit margin × +otal assets turnover B 6/S × S+A. Since"ompany E has both a higher profit margin and total assets turnover than

"ompany D, E’s A must also be higher than D’s.

1- Effects of leverage Answer: a Diff: "

Statement a is correct. +he other statements are false. +he use of debtprovides tax benefits to the corporations that issue debt, not to theinvestors who purchase debt 3in the form of bonds4. +he basic earning power

ratio would be the same if the only thing that differed between the firms were

their debt ratios.

- inancial state!ent analysis Answer: a Diff: "

Statement a is true because, if a firm ta%es on more debt, its interestexpense will rise, and this will lower its profit margin. f course, there

will be less equity than there would have been, hence the 5 might rise eventhough the profit margin declined.

- - inancial state!ent analysis

Answer: d Diff: " N

+he correct answer is statement d. Start with the 0u !ont equationF

6/S × S+A × +A5 B 5. *e %now S+A and 5 are the same for both. Sincethe equity of Hills is higher than =arte, its 6/ must also be higher to %eep

5 the same. So, statement a is correct. +he other statements are then alsotrue. Liven Hills’ higher net income, both the profit margin and the A for

Hills are also higher than =arte’s.

- Leverage and financial ratios Answer: e Diff: "

+A+ B Sales+A. &oth companies have the same total assets. =owever, since A

has a lower profit margin than & and its net income is the same as &’s, itmust have higher salesI thus, A has a higher total assets turnover ratio than

&. +herefore, statement a is true. 5 B 6/5quity. &oth companies have thesame total assets and net income, but A has more debt and thus less equitythan &. +herefore, A has a higher 5 than &. +herefore, statement b is true.

&5! B 5&/++A. *e %now that A has higher interest payments than & but thesame net income as &. +herefore, A must have a higher 5&/+ than & to cover

this extra interest. +hus, A must have a higher basic earning power ratiothan &. +herefore, statement c is true. Since statements a, b, and c are

true, the correct choice is statement e.


44/68

$- Leverage and financial ratios Answer: d Diff: " N

/f &5! and total assets are equal, we %now that 5&/+ is equal. "ompany A has

a higher debt ratio and higher interest expense than "ompany &.Since "ompany A has lower net income, it must have a lower A 3since total

assets are the same4. /f 5&/+ is the same for both A and & and "ompany A hashigher interest expense, "ompany A must have a lower +/5 ratio than "ompany &.

"ompany A has a lower 5&+ and lower net income than "ompany &. /f A has lower5&+, then "ompany A pays less in taxes than "ompany &. +here is a positiverelationship between the debt ratio and the equity multiplier, which means

that "ompany A has a higher equity multiplier than & because A’s debt ratio ishigher than &’s. +herefore, the correct choice is statement d.

8- Du #ont e$uation Answer: b Diff: " R

+he 0u !ont equationF 5 B 3!H43+A+435H4. 5 is above average. !H isbelow average. 5H is above average because a high debt ratio implies a high5H. +herefore, +A+ must be higher for the equation to hold. 6ote that the

firm’s A does not have to be higher than the industry A for this equation

to hold.:- ROE and EVA Answer: d Diff: "

59A B 6/ 3%s × 5quity4. %s × 5quity cannot be 7ero, therefore, net income

must be positive if 59A is 7ero. So statements a and b are false. A B 6/+A.+his equation really does not have anything to do with the 59A calculation.

Statement c is only correct if the firm has 7ero debt, which we %now not to becorrect. 3*e are given information in the question stating that the firm’sdebt ratio is # percent.4 +herefore, statement c is also false. 5 B

6/5quity. ewrite the 59A equation by substituting into it 59A B #, and yougetF 6/ B %s × 5quity. 0ivide both sides by 5quity and you obtain the

following equationF 6/5quity B %s. +hus 5 B 1K. Statement e would give anegative 59A and the problem states that the firm’s 59A is 7ero, so it is

false.

;- ROE and EVA Answer: b Diff: "

Statement a is falseI 59A depends upon the amount of equity invested, which

could be different for the two firms. Statement b is correctI for positive59A, the 5 must exceed the cost of equity. Statement c is falseI it is very

plausible to have a firm with positive 5 and a higher cost of equity,resulting in negative 59A.


45/68

-1- "iscellaneous ratios Answer: d Diff: "

Since E has a lower A 36/+A4 than D and both firms have the same assets, E

must have a lower net income than D. So statement c is correct. E has ahigher 5 36/5U4 than D, even though its net income is lower. "onsequently,

E must have less equity than D, and therefore, more debt than D. So statementa is false. Since E has a higher total assets turnover ratio 3Sales+A4 than

D and both firms have the same assets, E’s sales must be higher than D’s.+his fact, combined with E’s lower net income, means that E must have a lowerprofit margin 36/Sales4 than D, so statement b is correct. +hus, statements

b and c are both correct. So, the correct choice is statement d.

-- ROE and EVA Answer: a Diff: %

+he following formula will ma%e this question much easierF 59A B 35 ) %s4 ×

+otal equity. /f 0ivision A is ris%ier than 0ivision &, then A’s cost of

equity capital will be higher than &’s. /f %s is higher, 59A will be lower.So, statement a is true. /f A is larger than & in terms of equity, then the

term 35 ) %s4 will be multiplied by a much larger number for 0ivision A.Since A’s 5 is also higher than &’s, then its 59A would be higher than &’s.

+herefore, statement b is false. /f A has less debt, then its interestpayments will be lower than &’s, so its 5&/+ will be higher. Another way towrite the 59A formula is 59A B 5&/+ 31 +4 V"ost of capital × /nvestor)

supplied capital employedW. So, a higher 5&/+ will lead to a higher 59A. /naddition, a lower level of debt will ma%e A less ris%y than &, so A’s cost of

equity will be lower than &’s. 2rom the other 59A formula, we can see thatthis would cause a higher 59A, not a lower one. So, statement c is false.

--- Ratio analysis Answer: d Diff: %

Statement d is correctI the others are false. A B 6/+A. "ompany " hashigher interest expense than "ompany 0I therefore, it must have lower netincome. Since the two firms have the same total assets, A" P A0. Statement

a is falseI we cannot tell what sales are. 2rom the facts as stated above,they could be the same or different. Statement b is falseI "ompany " must

have lower equity than "ompany 0, which could lead it to have a higher 5because its equity multiplier would be greater than company 0Qs. Statement c

is false as +/5 B 5&/+/nterest, and " has higher interest than 0 but the same5&/+I therefore, +/5" P +/50. Statement e is falseI they have the same &5! B5&/++A from the facts as given in this problem.

-- Ratio analysis Answer: d Diff: %

*e can conclude that E has a lower 6/, because it has a lower 5&/+ and higherinterest than D, but the same tax rate as D. Sales for each company are the

same because they have the same total assets and the same total assetsturnover ratio 3+A+ B Sales+A4. +herefore, since E has a lower 6/ and same

sales as D, it must follow that it has a lower profit margin 36/Sales4.


46/68

-$ - Ratio analysis and Du #ont e$uation

Answer: d Diff: %

AJ B ADI S+AJ R S+ADI 5HJ R 5HD, or A5J R A5D.

2rom the 0u !ont equation we %now that A B !rofit margin × +otal assets

turnover. /f the firms’ As are equal, but Jancaster’s total assetsturnover is greater than Dor%’s then Jancaster’s profit margin must be lowerthan Dor%’s. +herefore, statement a is true. +he debt ratio is calculated as

1 ) 15quity multiplier. So, if Jancaster has a higher equity multiplier thanDor%, its debt ratio must be higher too. So, statement b is false. 2rom the

extended 0u !ont equation we %now that 5 B !rofit margin × +otal assetsturnover × 5quity multiplier. *e also %now that A B !rofit margin × +otal

assets turnover. Since we %now the firms’ As are equal and Jancaster has a higher equity multiplier it musthave a higher 5 too. +herefore, statement c is true. Since statements a and

c are true, the correct choice is statement d.

-8- Leverage and financial ratios Answer: d Diff: %

+he new income statement will be as followsF

perating income 35&/+4 >1,##,### #. × >8,###,###/nterest expense ##,###5arnings before taxes 35&+4 >1,###,###+axes 3#K4 ##,###6et income > 8##,###

Ald B 1#.;KB>$,###,###

>$#,###

Assets

6/= I 6ew5 B 1#K.B>8,###,###

>8##,###

+herefore, A falls.

5ld B 1-.$K>,###,###

>$#,###

5quity

6/== I 56ew B 1$.#K.

>,###,###

>8##,###=

Since net income increases, A falls and 5 increases, statement d is thecorrect choice.


47/68

-:- "iscellaneous ratios Answer: c Diff: %

Step 1F Cse the ratios and data to arrive at alternative relationships toanswer the questionF

+A+ B Sales+A

B 6/+A × S6/ B A × 1!H.

0A B +0+A

B 3+A ) 5U4+A B 3+A+A4 ) 35U+A4

B 1 ) 35U6/4 × 36/+A4 B 1 ) 3A54.

A B 6/+A

6/ B +A × A.

Step F Substitute the data given with the alternative relationships obtainedin Step 1F

=emmingway 2it7gerald +A+ B A!H B #.##.1 billion.

2rom the calculations above, statement c is the correct choice.

-;- inancial state!ent analysis Answer: a Diff: E

&5! B 5&/++A#.1$ B 5&/+>1##,###,###

5&/+ B >1$,###,###.

A B 6/+A#.#< B 6/>1##,###,###

6/ B >1$,###,###.

+herefore interest expense B >#.


48/68

-##,###>.## B 1##,###.

&oo% value per share B >,###,###1##,### B >#.Har%et value B #.3&oo% value4 B #.3>#4 B >.## per share.

1- "ar&et'boo& ratio Answer: c Diff: E

shares.,###,###

shares;#>##>18#,###,#

#>#,###,##

shares;#>#.

&9

sharesshareper!rice

&

H

=

×=

×=

×=

- "ar&et'boo& ratio Answer: e Diff: E N

+A B >,###,###,###I "J B >##,###,###I J+ debt B >8##,###,###I "5 B

>1,##,###,###I Shares outstanding B -##,###,###I !# B >#I H& B ?

&oo% value B

###,###,-##

###,###,##,1> B >.##.

H& B##.>

##.#> B $.#.

-- ROA Answer: d Diff: E

6et income B #.1$3>#,###,###4 B >-,###,###. A B >-,###,###>,$##,### B 1-.-K.

- %(E ratio Answer: b Diff: E

+/5 B 5&/+/6+

: B 3>-## T /6+4/6+ :/6+ B >-## T /6+ 8/6+ B >-##

/6+ B >$#.

$- ROE Answer: c Diff: E

5quity B #.$3>8,###4 B >1,$##.


49/68

"urrent 5 B5

6/ B

>1,$##

># B 18K.

6ew 5 B>1,$##

>-## B #.# B #K.

∆5 B #K ) 18K B K.

8- #rofit !argin Answer: c Diff: E

"urrent inventory turnover B/nv

S B

>$,###

>1#,### B .

6ew inventory turnover B/nv

S B $I /nv B

$

S B

$

>1#,### B >,###.

2reed cash B >$,### ) >,### B >-,###./ncrease in 6/ B #.#:3>-,###4 B >1#.

6ew !rofit margin BSales

6/ B

>1#,###

>1#T># B #.#$# B .$K.

:- Du #ont e$uation Answer: a Diff: E

2irst, calculate the profit margin, which equals 6/SalesFA B 6/+A B #.#.Sales+otal assets B S+A B .

!H B 36/+A43+AS4 B #.#3#.$4 B #.#. V+AS B 1 B #.$.W

6ext, find the debt ratio by finding the equity ratioF

5+A B 356/436/+A4. V5 B 6/5 and A B 6/+A.W5+A B 31543A4 B 31#.#843#.#4 B #.88:, or 88.:K equity.+herefore, 0+A must be #.--- B --.-K.

;- #'E ratio and stoc& price Answer: b Diff: E

5!S B >1$,###1#,### B >1.$#.

!5 B $.# B !>1.$#. ! B >:.$#.


50/68

.###,###,1>E

E###,###,1>

E$.####,$##>

E$.1###,$##,>E###,###,$>

$.1E###,###,->

E###,###,$>

$.1E"J

E"A

≤

≥

≥

+≥+

≥+

+

≥

+

+

$1- Accounts receivable increase Answer: b Diff: " R

0S B >1,#$#,###-8$4 B 8# days.

6ew A B V3>$#,###431.$43-8$4W38#431.$4 B >1,#$1,-:#.

$- Accounts receivable Answer: a Diff: " R

2irst solve for current annual sales using the 0S equation as followsF $# B

>1,###,###3Sales-8$4 to find annual sales equal to >:,-##,###./f sales fall by 1#K, the new sales level will be >:,-##,###3#.8,$:#,###. Again, using the 0S equation, solve for the new accountsreceivable figure as followsF - B A3>8,$:#,###-8$4 or A B >$:8,###.

$-- ROA Answer: a Diff: "

5quity multiplier B 131 ) 0A4 B 131 ) #.4 B 1.8:.5 B A × 5quity multiplier

1;K B 3A431.8:4A B 1#.;K.

$- ROA Answer: e Diff: "

Step 1F *e must find +A. *e are given &5! and 5&/+.

&5! B+A

5&/+ and +A B

&5!

5&/+.

+herefore, +A B >#,###,####.1, or >## million.

Step F 6/+A B A, so now we need to find net income. 6et income is foundby wor%ing through the income statement 3in millions4F

5&/+ >#/nterest $ 3from +/5 ratioF ; B 5&/+/nt4


51/68

5&+ >-$+axes 3#K4 16/ >1

Step -F A B >1>## B #.#$$ B $.$K.

$$ - ROA

Answer: c Diff: " N

&5! B 5&/++A B #.1#, so 5&/+ B #.1# × >$##,### B >$#,###.+/5 B 5&/+/6+ B $, so /6+ B >$#,###$ B >1#,###.

5&/+ >$#,###/nt )1#,###5&+ >#,###+axes 3#K4 )18,###6/ >,###

A B 6/+A B >,###>$##,### B #.#;, or .;K.

$8- ROE Answer: c Diff: " R

3Sales per day430S4 B A 3Sales-8$438#4 B >1$#,###

Sales B >-8,$##.

0ebt ratio B #.8 B +otal debt>-,###,###.+otal debt B >1,-,###,### ) >1,1,#;#,###.

5 B >-8,$##>1,#;#,### B -.-;K ≈ -.K.

$:- ROE Answer: b Diff: "

+otal equity B 3>$,###,###434 B >1#,###,###.+otal assets B >$,###,### T >1#,###,### B >1$,###,###.6et income B 3#.#843>1$,###,###4 B >1#,###,### B


52/68

5&/+ B +A × &5! B >1,###3#.#4 B >##.

"alculate net income and 5F

6et income B 35&/+ ) /431 ) +4 B V>## ) #.#$:3>-$#4W3#.84 B >11#..5 B >11#.>8$# B 18.;##,### × #.1 B >;#,###.6et income B >-,##,### × #.#8 B >111-#,###.5&/+ B >-#,### T >;#,### B >##,###.+/5 B >##,###>;#,### B $.#×.

8- %(E ratio Answer: b Diff: " N

+A B >;,###,###,###I + B #KI 5&/++A B 1KI A B -KI +/5 ?

.###,###,5&/+

1.#,###>;,###,###

5&/+

=

=

.###,###,#>6/

#-.#,###>;,###,###

6/

=

=

6ow use the income statement format to determine interest so you can calculate

the firm’s +/5 ratio.


53/68

5&/+ >##,###,### 5&+ B >#,###,####.8

+axes 3#K4 18#,###,###

6/ >#,###,### See above.

/6+ B 5&/+ 5&+ B >##,###,###

+/5 B 5&/+/6+

B >$8#,###,### B 1.:1- ≈ 1.:1.

8-- %(E ratio Answer: b Diff: "

emember, +/5 B 5&/+/nterest. *e need to find 5&/+ and /nterest.

+A B >#,###,###I &5! B $KI A B 1#KI + B #K.

&5! B 5&/++A$K B 5&/+>#,###,###

>$,###,### B 5&/+.

A B 6/+A

1#K B 6/>#,###,###>,###,### B 6/.

6/ B 35&/+ ) /431 ) +4>,###,### B 3>$,###,### ) /431 ) #.4

>,###,### B 3>$,###,### ) /43#.84>-,---,--- B >$,###,### ) /

>1,888,88: B /.

+herefore, +/5 B 5&/+/B >$,###,###>1,888,88:

B -.#×.

8- %(E ratio Answer: d Diff: " N

+he times interest earned 3+/54 ratio is calculated as the ratio of 5&/+ andinterest expense. *e can find 5&/+ from the &5! ratio and total assets givenin the problem.

&5! B+A

5&/+

$K B>-,###,###

5&/+

5&/+ B >:$#,###.

/nterest expense can be obtained from the income statement by simply wor%ingyour way up the income statement. +o do this, however, we must first

calculate net income from the data given for A.

A B+A

6/


54/68

1K B>-,###,###

6/

6/ B >-8#,###.

Solving for 5&+ and then interest, we findF

5&+ B+4)31

6/

5&+ B4-$.#13

###,-8#>

−

5&+ B >$$-,;8.

5&/+ /6+ B 5&+>:$#,### /6+ B >$$-,;8 /6+ B >1

+/5 B -.;×.

8$- E)(%DA coverage ratio Answer: a Diff: " N

+A B >8##,###,###I !rincipal payments B >-##,###,###I 5&/+0A coverage

B ?

5&/+>;1#,###,###.

- B 5&/+/6+

- B >;1#,###,###/6+

/6+ B >:#,###,###.

5&/+0A B 5&/+ T 0A

B >;1#,###,### T >1,###,###,### B >1,;1#,###,###.

5&/+0A coverage ratio BpmtsJeasepmts!rinc./6+

paymentsJease5&/+0A

+++

B###,###,8##>###,###,-##>###,###,:#>

###,###,8##>###,###,;1#,1>

++

+


55/68

B###,###,1:#,1>

###,###,1#,> B .#$1#,###-8

>1,### B -8.$ days. /ndustry average 0S B -# days.

educe receivables by 3-8.$ -#4

-8$

>1#,### B >1:;.#;.

0ebt B >###.1# B >,###.

+A

+0 B

>1:;.#;)>8,###

>1:;.#;)>,### B 8$.8$K.

8


56/68

/nventory B Sales/nventory turnover

B >1,##,###.; B >$#,###.

2inally, find the amount of cashF"ash B "urrent assets ) A ) /nventory

B >$#,### ) >1-1,$#8.;$ ) >$#,### B >8;,8;,


57/68

+he current 5!S is >1,$##,###-##,### shares or >$. +he current !5 ratio is

then >8#>$ B 1. +he new number of shares outstanding will be ##,###. +hus,the new 5!S B >,$##,#####,### B >8.$. /f the shares are selling for 1times 5!S, then they must be selling for >8.$314 B >:$.

: - Current ratio and D*O

Answer: a Diff: "

Step 1F 0etermine average daily sales using the old 0S.

0S BSales0ailyAverage

seceivable.

/f 0S changes while sales remain the same, then receivables mustchange.

# BSales0ailyAverage

##>

>1# B Average 0aily Sales.

Step F 0etermine the new level of receivables required for !arcells to

achieve the industry average 0S.

-# B>1#

seceivable

>-## B eceivables.

Step -F "alculate the new current ratio.eceivables decline by >1##, so current assets declined by >1##.

+herefore, the new level of current assets is >;## ) >1## B >:##. Sincethe >1## cash freed up is used to reduce long)term bonds, cur)rentliabilities remain at >##. "urrent ratio B >:##>## B 1.:$.

:-- Current ratio Answer: c Diff: " N

"urrentlyF0S B AAverage 0aily Sales


58/68

B >$#>1#

B $ days.

6ow, "artwright wants to reduce 0S to 1$. +he firm needs to reduce accountsreceivable because it doesn’t want to reduce average daily sales. So, we cancalculate the new A balance as followsF

0S B AAverage 0aily Sales 1$ B A>1#

>1$# million B A.

/f the firm reduces its 0S to the industry average, its A will be >1$#million, reduced by >1## million. +herefore, there must be an equal reduction

on the right side of the balance sheet. =alf of this >1## million of freed)upcash will be used to reduce notes payable, and the other half will be used toreduce accounts payable. +herefore, notes payable will fall by >$# million to

>$# million, and accounts payable will fall by >$# million to >$# million.

+herefore, we can now calculate the firm’s new current ratioF"urrent atio B "A"J

B 3"ash T A T /nv.436otes !ayable T Accounts !ayable4 B 3>$# T >1$# T >$#43>$# T >$#4

B >8$#>$## B 1.-#×.

:- Current ratio Answer: b Diff: " N

Step 1F "alculate the firm’s current inventory turnover./nv. turnover B Sales/nv.

B >-,###,###>$##,### B 8.#×.

6ew /nv. turnover B 1#.#× 3but sales stay the same4.

Step F "alculate what the firm’s inventory balance should be if the firm

maintains the industry average inventory turnover.

/nv. turnover B Sales/nv. 1#× B >- million/nv. >-##,### B /nv.

+he new inventory level will be >-##,###, so inventories will be reduced by

>##,### from the old level. +his means that current assets will decrease by>##,###.

Step -F "alculate the firm’s new current assets level.

"A B "ash T /nv. T A B >1##,### T >-##,### T >##,###

B >8##,###.

=alf of the >##,### that is freed up will be used to reduce notes payable, andthe other half will be used to reduce common equity. +herefore, notes payable

will be reduced by >1##,### to a new level of >1##,###.

Step F "alculate the firm’s new liabilities level."J B A! T Accruals T 6otes payable

B >##,### T >1##,### T >1##,### B >##,###.

Step $F "alculate the firm’s new current ratio with the improved inventory


59/68

management.

" B "A"J B >8##,###>##,### B 1.$×.

:$- Credit policy and ROE Answer: c Diff: " R

Cse the 0S formula to calculate accounts receivable under the new policy as

-8 B A3>:-#,###-8$4 or A B >:,###. +hus, >1$,### ) >:,### B >$-,### isthe cash freed up by reducing 0S to -8 days. etiring >$-,### of long)termdebt leaves >:,### in long)term debt. Liven a 1#K interest rate, interest

expense is now >:,###3#.14 B >,:##. +hus, 5&+ B 5&/+ ) /nterest B >:#,###) >,:## B >$,-##. 6et income is >$,-##31 ) #.-4 B >-1,:1#. +hus, 5 B

>-1,:1#>##,### B 1$.;8K.

:8- Du #ont e$uation Answer: d Diff: "

&eforeF 5quity multiplier B 131 ) 0A4 B 131 ) #.$4 B .#. 5 B 3!H43Assets turnover435H4 B 31#K43#.$43.#4 B $K.

AfterF V5 B 3$K4 B 1#KWF

1#K B 31K43#.$435H4 5H B -.-- B A5.

5A B 1-.-- B #.-.

0A B 1 #.- B #.: B :#K.

::- *ales and e+tended Du #ont e$uation Answer: a Diff: "

6/5 B 1$KI 0A B #KI 5A B 8#KI A5 B 1#.8 B 1.888:I 6/S B $K.

Step 1F 0etermine total assets turnover from the extended 0u !ont equationF6/S × S+A × A5 B 5

3$K43S+A431.888:4 B 1$K#.#;-- S+A B 1$K

S+A B 1.;.

Step F 0etermine sales from the total assets turnover ratioFS+A B 1.;

S>;## B 1.;S B >1,# million.

:;- Net inco!e and Du #ont e$uation Answer: c Diff: " N

Step 1F "alculate total assets from information given.Sales B >1# million.

-.$× B Sales+A

-.$× BAssets

###,###,1#>

Assets B >,;$:,1.;$:1.

Step F "alculate net income.


60/68

+here is no debt, so Assets B 5quity B >,;$:,1.;$:1.

5 B 6/S × S+A × +A5

#.1$ B 6/>1#,###,### × -.$ × 1

#.1$ B###,###,1#>

6/$.-

>1,$##,### B -.$6/

>;,$:1.;8 B 6/.

::,### 5&/+ B >$,### +ax rate B #K

Sales B >:#,### +A+ B -.#

ecall the 0u !ont equationF 5 B 3!H43+A+435H4.

5 B 3A435H4.5 B 6/5quity.

5&/+ >$,###/nterest :,### 3Liven45&+ >1;,###

+axes 3#K4 :,## 3>1;,### × #K46/ >1#,;##

+A+ B Sales+otal assets

+otal assets B Sales+A+ B >:#,###- B >#,$##.

5 B 6/5quity B >1#,;##>#,$## B 8.8:K.

;#- ROE Answer: d Diff: %

/ndustry average inventory turnover B 8 B Sales/nventories.+o match this levelF /nventories B Sales8

>-,###,###8 B >$##,###.

"urrent inventories B >1,###,###. eduction in inventories B >1,###,### )

>$##,### B >$##,###. +his >$##,### is to be used to reduce debt.

6ew debt level B >,###,### ) >$##,### B >-,$##,###./nterest on this level of debt B >-,$##,### × #.1 B >-$#,###.

Joo% at the income statement to determine net incomeF5&/+ >1,##,###/nterest -$#,###5&+ >1,#$#,###+axes 3#K4 #,###6/ > 8-#,###

5 B 6et income5quity B >8-#,###>,###,### B #.-1$# or -1.$#K.


61/68

;1- ROE and financing Answer: a Diff: %

+he firm is not using its 'free( trade credit 3that is, accounts payable3A!44 to the same extent as other companies. Since it is financing part of

its assets with 1#K notes payable, its interest expense is higher thannecessary.

"alculate the increase in payablesF"urrent 3A!4/nventories ratio B >1##>$## B #.#.+arget A! B #.8#3/nventories4 B #.8#3>$##4 B >-##.

/ncrease in A! B >-## ) >1## B >##.

Since the current ratio and total assets remain constant, total liabilitiesand equity must be unchanged. +he increase in accounts payable must be

matched by an equal decrease in interest)bearing notes payable. 6otes payabledecline by >##. /nterest expense decreases by >## × #.1# B >#.

"onstruct comparative /ncome StatementsF ld 6ewSales >,### >,###perating costs 1,;- 1,;-5&/+ > 1$: > 1$:/nterest -: 1:5&+ > 1# > 1#

+axes 3#K4 ; $86et income 36/4 > : > ;

5 B 6/5quity B >:>;## B ;>;## B 1#.$K.6ew 5 B 1#.$K.

;- ROE and refinancing Answer: d Diff: %

elevant informationF ld 5 B 6/5quity B #.#8 B 8K.

Sales B >-##,###I 5&/+ B #.113Sales4 B #.113>-##,###4 B >--,###.0ebt B >##,###I 0A B #.;# B ;#K.

+ax rate B #K./nterest rate changeF ld bonds 1KI new bonds 1#K.

"alculate total assets and equity amountsF

Since debt B >##,###, total assets B >##,####.;# B >$#,###.5quity B 1 ) 0A B 1 ) #.;# B #.#.

5quity B 5+A × +A B #.# × >$#,### B >$#,###.

"onstruct comparative /ncome Statements from 5&/+, and calculate new 5F ld 6ew5&/+ >--,### >--,###/nterest ;,### #,###5&+ > $,### >1-,###


62/68

+axes 3#K4 ,### $,##6et income > -,### > :,;##

6ew 5 B 6/5quity B >:,;##>$#,### B #.1$8# B 1$.8K.

;-- %(E ratio Answer: d Diff: %

+/5 B/

5&/+ B ?

+A +urnover B SA B

S>1#,### B S B >#,###.

+A

+0B #.8I

+0 B #.83>1#,###40ebt B >8,###.

/ B >8,###3#.14 B >8##.

!H BS

6/ B -K

!H B>#,###

6/ B #.#-

6/ B >8##.

5&+ B#.4)31

>8## B >1,###.

5&/+ >1,8##/nterest 8##5&+ >1,###+axes 3#K4 ##6/ > 8##

+/5 B >1,8##>8## B .8:.


63/68

;- Current ratio Answer: e Diff: %

ld 0S B #I "A B >,$##,###I "A"J B 1.$I A B >1,8##,###.

Step 1F "alculate average daily salesF 0S B AAverage daily sales

# B >1,8##,###Average daily sales>#,### B Average daily sales.

Step F "alculate the new level of accounts receivable when 0S B -#F

-# B A>#,###>1,##,### B A.So, the change in receivables will be >1,8##,### >1,##,### B

>##,###.

Step -F "alculate the old level of current liabilitiesF

"urrent ratio B "A"J1.$ B >,$##,###"J>1,888,88: B "J.

Step F "alculate the new current ratioF+he change in receivables will cause a reduction in current assets of>##,### and a reduction in current liabilities of >##,###.

"A new B >,$##,### ) >##,### B >,1##,###."J new B >1,888,88: ) >##,### B >1,88,88:.

" new B >,1##,###>1,88,88: B 1.88.

;$- #'E ratio and stoc& price Answer: b Diff: %

=ere are some data on the initial situationF

5!S B >$## B >.$#.Stoc% price B >.$#3;4 B >#.

/f EDO had the industry average inventory turnover, its inventory balancewould beF

+urnover B $ B/nv

Sales B

/nv

>1,###

/nv B >1,###$ B >##.

+herefore, inventories would decline by >1##.

+he income statement would remain at the initial level. =owever, the company

could now repurchase and retire $ shares of stoc%F

e!riceshar

available2unds B

>#

>1## B $ shares.

+hus, the new 5!S would beF

6ew 5!S BgoutstandinShares

income6et B

$)#

>$# B >-.--.

+he new stoc% price would beF

6ew price B 6e

tb chapter03

Documents