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Multiple Choice: Conceptual
Easy:
Current ratio Answer: a Diff: E
1
. All else being equal, which of the following will increase a company’s
current ratio?
a. An increase in accounts receivable.
b. An increase in accounts payable.
c. An increase in net fixed assets.
d. Statements a and b are correct.
e. All of the statements above are correct.
Current ratio Answer: d Diff: E
. !epsi "orporation’s current ratio is #.$, while "o%e "ompany’s current
ratio is 1.$. &oth firms want to 'window dress( their coming end)of)year
financial statements. As part of its window dressing strategy, each firm
will double its current liabilities by adding short)term debt and placing
the funds obtained in the cash account. *hich of the statements below
best 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%
Leverage and financial ratios Answer: d Diff: E
1
. 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%ely
to 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 3.,A4 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 also
increase its interest expense. Assume that the higher debt ratio will
have no effect on the company’s operating income, total assets, or tax
rate. Also, assume that the basic earning power ratio exceeds the before)
tax cost of debt financing. *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.
e. All of the statements above 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 is
positive.
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 9alue
Added 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 exceeds
the .,5.
d. All of the statements above are correct.
e. 6one of the statements above is correct.
Chapter 3  Page 2
ROE and EVA Answer: b Diff: E
;
. 0evon /nc. has a higher .,5 than &erwyn /nc. 31: percent compared to 11
percent4, but it has a lower 59A than &erwyn. *hich of the following
factors 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.
e. All of the statements above are correct.
Ratio analysis Answer: b Diff: E
<
. &edford =otels and &ree7ewood =otels both have >1## million in total
assets and a 1# percent return on assets 3.,A4. 5ach company has a 1#
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 3.,54.
c. &edford has a lower level of operating income 35&/+4.
d. Statements a and b are correct.
e. All of the statements above are correct.
inancial state!ent analysis Answer: a Diff: E
1#
. "ompany ? and "ompany @ each recently reported the same earnings per
share 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 !A5 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. *hich
of 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 &.
d. All of the statements above are correct.
e. 6one of the statements above is correct.
Chapter 3  Page 3
inancial state!ent analysis Answer: e Diff: E
1
. "ompany A and "ompany & have the same total assets, return on assets
3.,A4, and profit margin. =owever, "ompany A has a higher debt ratio and
interest 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 proceeds
from the stoc% issue will be used to reduce the company’s outstanding
debt and interest expense. +he stoc% issue will have no effect on the
company’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
11
. "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 equity
than "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 the
proceeds 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 this
action?
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
Medium:
Current ratio Answer: d Diff: "
18
. 9an &uren "ompany has a current ratio B 1.<. *hich of the following
actions will increase the company’s current ratio?
a. Cse cash to reduce short)term notes payable.
b. Cse cash to reduce accounts payable.
c. /ssue long)term bonds to repay short)term notes payable.
d. All of the statements above are correct.
e. Statements b and c are correct.
Current ratio Answer: e Diff: "
1:
. *hich of the following actions can a firm ta%e to increase its current
ratio?
a. /ssue short)term debt and use the proceeds to buy bac% long)term debt
with a maturity of more than one year.
b. .educe the company’s days sales outstanding to the industry average
and use the resulting cash savings to purchase plant and equipment.
c. Cse cash to purchase additional inventory.
d. Statements a and b are correct.
e. 6one of the statements above is correct.
Ratio analysis Answer: c Diff: "
1;
. As a short)term creditor concerned with a company’s ability to meet its
financial obligation to you, which one of the following combinations of
ratios would you most li%ely prefer?
"urrent 0ebt
ratio +/5 ratio
a. #.$ #.$ #.
b. 1.# 1.# #.$#
c. 1.$ 1.$ #.$#
d. .# 1.# #.8:
e. .$ #.$ #.:1
Ratio analysis Answer: c Diff: " N
1<
. 0rysdale 2inancial "ompany and "ommerce 2inancial "ompany have the same
total assets, the same total assets turnover, and the same return on
equity. =owever, 0rysdale has a higher return on assets than "ommerce.
*hich of the following can explain these ratios?
a. 0rysdale has a higher profit margin and a higher debt ratio than
"ommerce.
b. 0rysdale has a lower profit margin and a lower debt ratio than
"ommerce.
c. 0rysdale has a higher profit margin and a lower debt ratio than
"ommerce.
d. 0rysdale has lower net income but more common equity than "ommerce.
Chapter 3  Page 5
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. Dou
have 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 an
otherwise identical firm with no debt in its capital structure.
b. +he use of debt in a company’s capital structure results in tax
benefits 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 and
operating 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 fresh
fish mar%ets.
e. /t is more important to adGust the debt ratio than the inventory
turnover ratio to account for seasonal fluctuations.
Chapter 3  Page 6
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 3.,54. =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 3.,A4 than =arte
Hotors.
d. All of the statements above are correct.
e. 6one of the statements above is correct.
Leverage and financial ratios Answer: e Diff: "
1
. "ompany A and "ompany & have the same total assets, tax rate, and net
income. "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 a
higher 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
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 11 percent,
its cost of debt is ; percent, and its debt ratio is 1# 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 11 percent.
d. +he company’s .,5 was 11 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 cost
of equity.
c. /f a firm has positive .,5, this implies that its 59A is also
positive.
d. Statements b and c are correct.
e. All of the statements above are correct.
"iscellaneous ratios Answer: b Diff: "
<
. *hich of the following statements is most correct?
a. /f 2irms A and & have the same earnings per share and mar%et to boo%
ratio, they must have the same price earnings ratio.
b. 2irms A and & have the same net income, taxes paid, and total assets.
/f 2irm A has a higher interest expense, its basic earnings power
ratio 3&5!4 must be greater than that of 2irm &.
c. 2irms A and & have the same net income. /f 2irm A has a higher
interest expense, its return on equity 3.,54 must be greater than that
of 2irm &.
d. All of the statements above are correct.
e. 6one of the statements above is correct.
Chapter 3  Page 8
"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 debt
ratio will increase this year. *hat can you conclude about the company’s
financial ratios? 3Assume that there will be no change in the company’s
tax rate.4
a. +he company’s basic earning power 3&5!4 will fall.
b. +he company’s return on assets 3.,A4 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 ratio
than "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.
d. Statements b and c are correct.
e. All of the statements above are correct.
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 these
performance 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.
e. All of the statements above are correct.
Chapter 3  Page 9
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 is
most 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: %
1
. 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 3.,54.
• "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 3.,A4.
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 3.,A4.
=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 3.,54 than Dor%.
d. Statements a and c are correct.
e. All of the statements above are correct.
Chapter 3  Page 10
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 >1 million of common equity. +he
company’s income statement is summari7ed belowF
,perating income 35&/+4 >1,###,###
/nterest 1##,###
5arnings before taxes 35&+4 > <##,###
+axes 31#K4 8#,###
6et income > $1#,###
+he company wants to increase its assets by >1 million, and it plans to
finance this increase by issuing >1 million in new debt. +his action
will double the company’s interest expense but its operating income will
remain at # percent of its total assets, and its average tax rate will
remain at 1# percent. /f the company ta%es this action, which of the
following will occurF
a. +he company’s net income will increase.
b. +he company’s return on assets will fall.
c. +he company’s return on equity will remain the same.
d. Statements a and b are correct.
e. All of the statements above are correct.
"iscellaneous ratios Answer: c Diff: %
:
. Some %ey financial data and ratios are reported in the table below for
=emmingway =otels and for its competitor, 2it7gerald =otelsF
.atio =emmingway =otels 2it7gerald =otels
!rofit margin 1K K
.,A <K ;K
+otal assets >.# billion >1.$ billion
&5! #K #K
.,5 1;K 1K
,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.
d. Statements a and b are correct.
e. All of the statements above are correct.
Chapter 3  Page 11
Multiple Choice: P)o*lems
Easy:
inancial state!ent analysis Answer: a Diff: E
;
. .ussell Securities has >1## million in total assets and its corporate tax
rate is 1# percent. +he company recently reported that its basic earning
power 3&5!4 ratio was 1$ percent and its return on assets 3.,A4 was <
percent. *hat was the company’s interest expense?
a. > #
b. > ,###,###
c. > 8,###,###
d. >1$,###,###
e. >1;,###,###
"ar&et price per share Answer: b Diff: E
<
. Dou are given the following informationF Stoc%holders’ equity B >1,$#I
priceAearnings ratio B $I shares outstanding B $I and mar%etAboo% ratio
B 1.$. "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
1#
. Liven the following information, calculate the mar%et price per share of
*AH /nc.F
6et income >##,###.##
5arnings per share >.##
Stoc%holders’ equity >,###,###.##
Har%etA&oo% ratio #.#
a. >#.##
b. > ;.##
c. > 1.##
d. > .##
e. > 1.##
"ar&et'boo& ratio Answer: c Diff: E
11
. Heyersdale ,ffice Supplies has common equity of >1# million. +he
company’s stoc% price is >;# per share and its mar%etAboo% ratio is 1.#.
=ow many shares of stoc% does the company have outstanding?
a. $##,###
b. 1$,###
c. ,###,###
Chapter 3  Page 12
d. ;##,###,###
e. /nsufficient information.
"ar&et'boo& ratio Answer: e Diff: E N
1
. 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%etAboo% ratio?
a. 1.$
b. .8$
c. .1$
d. 1.1#
e. $.##
ROA Answer: d Diff: E
1
. A firm has a profit margin of 1$ 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. ;.1K
b. 1#.<K
c. 1.#K
d. 1.K
e. 1$.1K
%(E ratio Answer: b Diff: E
11
. "ulver /nc. has earnings after interest but before taxes of >##. +he
company’s times interest earned ratio is :.##. "alculate the company’s
interest charges.
a. >1.;8
b. >$#.##
c. >1#.##
d. >8#.##
e. >$:.<
Chapter 3  Page 13
ROE Answer: c Diff: E
1$
. +apley 0ental Supply "ompany has the following dataF
6et income >1#
Sales >1#,###
+otal assets >8,###
0ebt ratio :$K
+/5 ratio .#
"urrent ratio 1.
&5! ratio 1.K
/f +apley could streamline operations, cut operating costs, and raise net
income to >## without affecting sales or the balance sheet 3the
additional profits will be paid out as dividends4, by how much would its
.,5 increase?
a. .##K
b. .$#K
c. 1.##K
d. 1.$K
e. $.$#K
#rofit !argin Answer: c Diff: E
18
. Dour company had the following balance sheet and income statement
information for ##F
&alance SheetF
"ash > #
AA. 1,###
/nventories $,###
+otal current assets >8,## 0ebt >1,###
6et fixed assets ,<;# 5quity $,###
+otal assets ><,### +otal claims ><,###
/ncome StatementF
Sales >1#,###
"ost of goods sold <,##
5&/+ > ;##
/nterest 31#K4 1##
5&+ > 1##
+axes 31#K4 18#
6et income > 1#
+he industry average inventory turnover is $. Dou thin% you can change
your inventory control system so as to cause your turnover to equal the
industry average, and this change is expected to have no effect on either
sales or cost of goods sold. +he cash generated from reducing inventories
will be used to buy tax)exempt securities that have a : percent rate of
return. *hat will your profit margin be after the change in inventories
is reflected in the income statement?
a. .1K
b. .1K
c. 1.$K
Chapter 3  Page 14
d. $.K
e. 8.:K
Du #ont e$uation Answer: a Diff: E
1:
. +he *ilson "orporation has the following relationshipsF
SalesA+otal assets .#×
.eturn on assets 3.,A4 1.#K
.eturn on equity 3.,54 8.#K
*hat is *ilson’s profit margin and debt ratio?
a. KI #.
b. 1KI #.
c. 1KI #.8:
d. KI #.8:
e. 1KI #.$#
#'E ratio and stoc& price Answer: b Diff: E
1;
. +he "harleston "ompany is a relatively small, privately owned firm. Jast
year the company had net income of >1$,### and 1#,### shares were
outstanding. +he owners were trying to determine the equilibrium mar%et
value for the stoc% prior to ta%ing the company public. A similar firm
that is publicly traded had a priceAearnings ratio of $.#. Csing only
the information given, estimate the mar%et value of one share of
"harleston’s stoc%.
a. >1#.##
b. > :.$#
c. > $.##
d. > .$#
e. > 1.$#
#'E ratio and stoc& price Answer: e Diff: E
1<
. "leveland "orporation has 1##,### shares of common stoc% outstanding, its
net income is >:$#,###, and its !A5 is ;. *hat is the company’s stoc%
price?
a. >#.##
b. >#.##
c. >1#.##
d. >$#.##
e. >8#.##
Chapter 3  Page 15
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 company
plans to increase its inventory, and it will raise additional short)term
debt 3that will show up as notes payable on the balance sheet4 to
purchase the inventory. Assume that the value of the remaining current
assets will not change. +he company’s bond covenants require it to
maintain a current ratio that is greater than or equal to 1.$. *hat is
the maximum amount that the company can increase its inventory before it
is restricted by these covenants?
a. >#.$# million
b. >1.## million
c. >1. million
d. >1.88 million
e. >. million
Medium:
Accounts receivable increase Answer: b Diff: " R
$1
. "annon "ompany has enGoyed a rapid increase in sales in recent years,
following a decision to sell on credit. =owever, the firm has noticed a
recent increase in its collection period. Jast year, total sales were >1
million, and >$#,### of these sales were on credit. 0uring the year, the
accounts receivable account averaged >11,#<8. /t is expected that sales
will increase in the forthcoming year by $# percent, and, while credit
sales should continue to be the same proportion of total sales, it is
expected that the days sales outstanding will also increase by $# percent.
/f the resulting increase in accounts receivable must be financed
externally, how much external funding will "annon need? Assume a 8$)day
year.
a. > 11,#<8
b. > $1,:#
c. > 1:,$<
d. >1#8,1:1
e. > <,188
Accounts receivable Answer: a Diff: " R
$
. .uth "ompany currently has >1,###,### in accounts receivable. /ts days
sales outstanding 30S,4 is $# days. +he company wants to reduce its 0S,
to the industry average of  days by pressuring more of its customers to
pay their bills on time. +he company’s "2, estimates that if this policy
is adopted the company’s average sales will fall by 1# percent. Assuming
that the company adopts this change and succeeds in reducing its 0S, to 
days and does lose 1# percent of its sales, what will be the level of
accounts receivable following the change? Assume a 8$)day year.
a. >$:8,###
b. >8,
c. >:$#,###
Chapter 3  Page 16
d. ><##,###
e. ><88,88:
ROA Answer: a Diff: "
$
. A fire has destroyed a large percentage of the financial records of the
"arter "ompany. Dou have the tas% of piecing together information in
order to release a financial report. Dou have found the return on equity
to be 1; percent. /f sales were >1 million, the debt ratio was #.1#, and
total liabilities were > million, what would be the return on assets
3.,A4?
a. 1#.;#K
b. #.;#K
c. 1.$K
d. 1.8#K
e. /nsufficient information.
ROA Answer: e Diff: "
$1
. =umphrey =otels’ operating income 35&/+4 is >1# million. +he company’s
times interest earned 3+/54 ratio is ;.#, its tax rate is 1# percent, and
its basic earning power 3&5!4 ratio is 1# percent. *hat is the company’s
return on assets 3.,A4?
a. 8.1$K
b. $.<:K
c. 1.K
d. ;.$8K
e. $.$K
ROA Answer: c Diff: " N
$$
. 9iera "ompany has >$##,### 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 1# percent. *hat is the company’s return
on assets 3.,A4?
a. .K
b. 1.#K
c. 1.;K
d. 8.#K
e. :.K
ROE Answer: c Diff: " R
$8
. Sel7er /nc. sells all its merchandise on credit. /t has a profit margin
of 1 percent, days sales outstanding equal to 8# days, receivables of
>1$#,###, total assets of > million, and a debt ratio of #.81. *hat is
the firm’s return on equity 3.,54? Assume a 8$)day year.
a. :.1K
b. .1K
c. .1K
d. :1.#K
Chapter 3  Page 17
e. ;.1K
Chapter 3  Page 18
ROE Answer: b Diff: "
$:
. A firm has a debtAequity ratio of $# percent. "urrently, it has interest
expense of >$##,### on >$,###,### of total debt outstanding. /ts tax rate
is 1# percent. /f the firm’s .,A is 8 percent, by how many percentage
points is the firm’s .,5 greater than its .,A?
a. #.#K
b. .#K
c. $.K
d. :.1K
e. <.#K
ROE Answer: d Diff: "
$;
. Assume Heyer "orporation is 1## percent equity financed. "alculate the
return on equity, given the following informationF
5arnings before taxes >1,$##
Sales >$,###
0ividend payout ratio 8#K
+otal assets turnover .#
+ax rate #K
a. $K
b. #K
c. $K
d. 1K
e. $#K
ROE Answer: c Diff: "
$<
. +he Amer "ompany has the following characteristicsF
Sales >1,###
+otal assets >1,###
+otal debtA+otal assets $.##K
&asic earning power 3&5!4 ratio #.##K
+ax rate 1#.##K
/nterest rate on total debt 1.$:K
*hat is Amer’s .,5?
a. 11.#1K
b. 1.1K
c. 18.<<K
d. ;.1K
e. #.::K
Chapter 3  Page 19
E$uity !ultiplier Answer: d Diff: "
8#
. A firm that has an equity multiplier of 1.# will have a debt ratio of
a. 1.##
b. .##
c. 1.##
d. #.:$
e. #.$
%(E ratio Answer: e Diff: "
81
. Alumbat "orporation has >;##,### of debt outstanding, and it pays an
interest rate of 1# percent annually on its ban% loan. Alumbat’s annual
sales are >,##,###, its average tax rate is 1# percent, and its net
profit margin on sales is 8 percent. /f the company does not maintain a
+/5 ratio of at least 1 times, its ban% will refuse to renew its loan,
and ban%ruptcy will result. *hat is Alumbat’s current +/5 ratio?
a. .1
b. .1
c. .8
d. 1.#
e. $.#
%(E ratio Answer: b Diff: " N
8
. Hoss Hotors has >; billion in assets, and its tax rate is 1# percent. +he
company’s basic earning power 3&5!4 ratio is 1 percent, and its return
on assets 3.,A4 is  percent. *hat is Hoss’ times interest earned 3+/54
ratio?
a. .$
b. 1.:1
c. 1.##
d. 1.
e. .$#
%(E ratio Answer: b Diff: "
8
. Jancaster Hotors has total assets of ># million. /ts basic earning power
is $ percent, its return on assets 3.,A4 is 1# percent, and the
company’s tax rate is 1# percent. *hat is Jancaster’s +/5 ratio?
a. .$
b. .#
c. 1.$
d. 1.
e. #.8
Chapter 3  Page 20
%(E ratio Answer: d Diff: " N
81
. .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 3.,A4 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.;1
b. 1.<
c. .;
d. .;
e. 1.1:
E)(%DA coverage ratio Answer: a Diff: " N
8$
. !eterson !ac%aging "orp. has >< billion in total assets. +he company’s
basic earning power 3&5!4 ratio is < percent, and its times interest
earned 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. .#8
b. 1.$
c. .$
d. 1.1#
e. .::
Debt ratio Answer: c Diff: "
88
. @ansas ,ffice Supply had >1,###,### in sales last year. +he company’s
net income was >1##,###, its total assets turnover was 8.#, and the
company’s .,5 was 1$ percent. +he company is financed entirely with debt
and 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
debtAtotal assets B #.$ and total assets turnover B .;. *hat is the
profit margin?
a. .1;K
b. $.1K
c. 8.<8K
d. .1$K
Chapter 3  Page 21
e. 1.;K
inancial state!ent analysis Answer: e Diff: " R
8;
. "ollins "ompany had the following partial balance sheet and complete
income statement information for ##F
!artial &alance SheetF
"ash > #
AA. 1,###
/nventories ,###
+otal current assets > ,##
6et fixed assets ,<;#
+otal assets > 8,###
/ncome StatementF
Sales >1#,###
"ost of goods sold <,##
5&/+ > ;##
/nterest 31#K4 1##
5&+ > 1##
+axes 31#K4 18#
6et income > 1#
+he industry average 0S, is # 3assuming a 8$)day year4. "ollins plans
to 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 or
cost 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 debtA+otal
assets4 be after the change in 0S, is reflected in the balance sheet?
a. .K
b. 1$.;K
c. $.:$K
d. 8#.##K
e. 8$.8$K
inancial state!ent analysis Answer: b Diff: " R
8<
. +aft +echnologies has the following relationshipsF
Annual sales >1,##,###.##
"urrent liabilities > :$,###.##
0ays sales outstanding 30S,4 38$)day year4 1#.##
/nventory turnover ratio 1.;#
"urrent ratio 1.#
+he company’s current assets consist of cash, inventories, and accounts
receivable. =ow much cash does +aft have on its balance sheet?
a. )> ;,
b. > 8;,1<
c. >1$,###
d. >##,###
Chapter 3  Page 22
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 1# percent. *hat is the company’s
basic earning power 3&5!4?
a. 11.1K
b. 18.8:K
c. 1:.K
d. #.8:K
e. .$#K
#'E ratio and stoc& price Answer: e Diff: "
:1
. 0ean &rothers /nc. recently reported net income of >1,$##,###. +he
company 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 the
company also anticipates issuing an additional 1##,### shares of stoc%, so
that one year from now the company will have 1##,### shares of common
stoc%. Assuming the company’s priceAearnings 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 1## Accruals 1##
+otal current assets > ;## +otal current liabilities > 1##
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$)day basis4 is 1#, which is above the industry
average of #. Assume that !arcells is able to reduce its 0S, to the
industry average without reducing sales, and the company ta%es the freed)
up cash and uses it to reduce its outstanding long)term bonds. /f this
occurs, what will be the new current ratio?
a. 1.:$
b. 1.
Chapter 3  Page 23
c. .
d. 1.$
e. 1.8:
Current ratio Answer: c Diff: " N
:
. "artwright &rothers has the following balance sheet 3all numbers are
expressed 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 30S,4 is well above the industry
average of 1$. "artwright is implementing a plan that is designed to
reduce its 0S, to 1$ without reducing its sales. /f successful the plan
will 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 the
current 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
:1
. ?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 $##,### 6otes payable ##,###
6et fixed assets 1,##,### Jong)term debt :##,###
"ommon equity ;##,###
+otal liabilities
+otal assets >,###,### and equity >,###,###
?efferson wants to improve its inventory turnover ratio so that it equals
the industry average of 1#.#×. +he company would li%e to accomplish this
goal without reducing sales. /f successful, the company would ta%e the
freed)up cash from the reduction in inventories and use half of it to
reduce notes payable and the other half to reduce common equity. *hat
will be ?efferson’s current ratio, if it is able to accomplish its goal
of improving its inventory management?
a. 1.1
b. 1.$#
c. .$#
d. .##
Chapter 3  Page 24
e. 1.#
Chapter 3  Page 25
Credit policy and ROE Answer: c Diff: " R
:$
. 0aggy "orporation has the following simplified balance sheetF
"ash > $,### "urrent liabilities >##,###
/nventories 1<#,###
Accounts receivable 1$,### Jong)term debt ##,###
6et fixed assets 8#,### "ommon equity ##,###
+otal assets >:##,### +otal claims >:##,###
+he company has been advised that their credit policy is too generous and
that they should reduce their days sales outstanding to 8 days 3assume a
8$)day year4. +he increase in cash resulting from the decrease in
accounts receivable will be used to reduce the company’s long)term debt.
+he interest rate on long)term debt is 1# percent and the company’s tax
rate is # percent. +he tighter credit policy is expected to reduce the
company’s sales to >:#,### and result in 5&/+ of >:#,###. *hat is the
company’s expected .,5 after the change in credit policy?
a. 11.;;K
b. 18.8K
c. 1$.;8K
d. 1;.;K
e. 18.$K
Du #ont e$uation Answer: d Diff: "
:8
. Austin N "ompany has a debt ratio of #.$, a total assets turnover ratio
of #.$, and a profit margin of 1# percent. +he &oard of 0irectors is
unhappy with the current return on equity 3.,54, and they thin% it could
be doubled. +his could be accomplished 314 by increasing the profit
margin to 1 percent and 34 by increasing debt utili7ation. +otal
assets turnover will not change. *hat new debt ratio, along with the new
1 percent profit margin, would be required to double the .,5?
a. $$K
b. 8#K
c. 8$K
d. :#K
e. :$K
*ales and e+tended Du #ont e$uation Answer: a Diff: "
::
. Shepherd 5nterprises has an .,5 of 1$ percent, a debt ratio of 1#
percent, and a profit margin of $ percent. +he company’s total assets
equal >;## million. *hat are the company’s sales? 3Assume that the
company has no preferred stoc%.4
a. >1,11#,###,###
b. >,1##,###,###
c. > 1#,###,###
d. > 8#,###,###
e. > <8#,###,###
Chapter 3  Page 26
Net inco!e and Du #ont e$uation Answer: c Diff: " N
:;
. Samuels 5quipment has >1# million in sales. /ts .,5 is 1$ percent and
its total assets turnover is .$×. +he company is 1## percent equity
financed. *hat is the company’s net income?
a. >1,$##,###
b. >,;$:,11
c. > 1;,$:1
d. >,,
e. > $,$##
Tough:
ROE Answer: c Diff: %
:<
. .oland N "ompany has a new management team that has developed an
operating plan to improve upon last year’s .,5. +he new plan would place
the debt ratio at $$ percent, which will result in interest charges of
>:,### per year. 5&/+ is proGected to be >$,### on sales of >:#,###,
it expects to have a total assets turnover ratio of .#, and the average
tax rate will be 1# percent. *hat does .oland N "ompany expect its
return on equity to be following the changes?
a. 1:.8$K
b. 1.;K
c. 8.8:K
d. 11.11K
e. $1.$K
Chapter 3  Page 27
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 $##,###
"urrent assets >1,8##,###
+otal debt >1,###,###
6et fixed assets 1,1##,### +otal equity ,###,###
+otal assets >8,###,### +otal claims >8,###,###
/ncome StatementF
Sales >,###,###
,perating costs 1,8##,###
,perating income 35&/+4 >1,1##,###
/nterest 1##,###
+axable income 35&+4 >1,###,###
+axes 31#K4 1##,###
6et income > 8##,###
+he company’s interest cost is 1# percent, so the company’s interest
expense each year is 1# percent of its total debt.
*hile the company’s financial performance is quite strong, its "2, 3"hief
2inancial ,fficer4 is always loo%ing for ways to improve. +he "2, has
noticed that the company’s inventory turnover ratio is considerably
wea%er than the industry average, which is 8.#. As an exercise, the "2,
as%s what would the company’s .,5 have been last year if the following
had occurredF
• +he company maintained the same sales, but was able to reduce
inventories enough to achieve the industry average inventory turnover
ratio.
• +he cash that was generated from the reduction in inventories was
used to reduce part of the company’s outstanding debt. So, the
company’s total debt would have been >1 million less the freed)up
cash from the improvement in inventory policy. +he company’s
interest expense would have been 1# percent of new total debt.
• Assume equity does not change. 3+he company pays all net income as
dividends.4
Cnder this scenario, what would have been the company’s .,5 last year?
a. :.#K
b. <.$K
c. #.K
d. 1.$K
e. .#K
Chapter 3  Page 28
ROE and financing Answer: a Diff: %
;1
. Savelots Stores’ current financial statements are shown belowF
&alance SheetF
/nventories > $## Accounts payable > 1##
,ther current assets 1## Short)term notes payable :#
2ixed assets :# "ommon equity ;##
+otal assets >1,:# +otal liab. and equity >1,:#
/ncome StatementF
Sales >,###
,perating costs 1,;1
5&/+ > 1$:
/nterest :
5&+ > 1#
+axes 31#K4 1;
6et income > :
A recently released report indicates that Savelots’ current ratio of 1.<
is in line with the industry average. =owever, its accounts payable,
which have no interest cost and are due entirely to purchases of
inventories, amount to only # percent of inventories versus an industry
average of 8# percent. Suppose Savelots too% actions to increase its
accounts payable to inventories ratio to the 8# percent industry average,
but it 314 %ept all of its assets at their present levels 3that is, the
asset side of the balance sheet remains constant4 and 34 also held its
current ratio constant at 1.<. Assume that Savelots’ tax rate is 1#
percent, that its cost of short)term debt is 1# percent, and that the
change in payments will not affect operations. /n addition, common equity
will not change. *ith the changes, what will be Savelots’ new .,5?
a. 1#.$K
b. :.;K
c. <.#K
d. 1.K
e. 1.#K
Chapter 3  Page 29
ROE and refinancing Answer: d Diff: %
;
. Aurillo 5quipment "ompany 3A5"4 proGected that its .,5 for next year
would be Gust 8 percent. =owever, the financial staff has determined
that the firm can increase its .,5 by refinancing some high interest
bonds currently outstanding. +he firm’s total debt will remain at
>##,### and the debt ratio will hold constant at ;# percent, but the
interest rate on the refinanced debt will be 1# percent. +he rate on the
old debt is 11 percent. .efinancing will not affect sales, which are
proGected to be >##,###. 5&/+ will be 11 percent of sales and the
firm’s tax rate is 1# percent. /f A5" refinances its high interest
bonds, what will be its proGected new .,5?
a. .#K
b. ;.K
c. 1#.#K
d. 1$.8K
e. 1;.:K
%(E ratio Answer: d Diff: %
;
. Jombardi +ruc%ing "ompany has the following dataF
Assets >1#,###
!rofit margin .#K
+ax rate 1#K
0ebt ratio 8#.#K
/nterest rate 1#.#K
+otal assets turnover .#
*hat is Jombardi’s +/5 ratio?
a. #.<$
b. 1.:$
c. .1#
d. .8:
e. .1$
Current ratio Answer: e Diff: %
;1
. 9ictoria 5nterprises has >1.8 million of accounts receivable on its
balance sheet. +he company’s 0S, is 1# 3based on a 8$)day year4, its
current assets are >.$ million, and its current ratio is 1.$. +he
company plans to reduce its 0S, from 1# to the industry average of #
without causing a decline in sales. +he resulting decrease in accounts
receivable will free up cash that will be used to reduce current
liabilities. /f the company succeeds in its plan, what will 9ictoria’s
new current ratio be?
a. 1.$#
b. 1.<:
c. 1.8
d. #.:
Chapter 3  Page 30
e. 1.88
#'E ratio and stoc& price Answer: b Diff: %
;$
. EDO’s balance sheet and income statement are given belowF
&alance SheetF
"ash > $# Accounts payable > 1##
AA. 1$# 6otes payable #
/nventories ## Jong)term debt 31#K4 :##
2ixed assets $## "ommon equity 3# shares4 ##
+otal assets >1,### +otal liabilities and equity >1,###
/ncome StatementF
Sales >1,###
"ost of goods sold ;$$
5&/+ > 11$
/nterest :#
5&+ > :$
+axes 3.K4 $
6et income > $#
+he industry average inventory turnover is $, the interest rate on the
firm’s long)term debt is 1# percent, # shares are outstanding, and the
stoc% sells at a !A5 of ;.#. /f EDO changed its inventory methods so as
to operate at the industry average inventory turnover, if it used the
funds 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 of
goods sold, and the !A5 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 debt
ratio? 3=intF &egin by loo%ing at the 0u !ont equation.4
a. $.#K
b. $.#K
c. $#.#K
d. $.$K
e. 8$.#K
Chapter 3  Page 31
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 cutting
overtime pay and reducing cost of goods sold. !rior to the change, the
following data appliedF
+otal assets >;,###
0ebt ratio 1$K
+ax rate $K
&5! ratio 1.1$K
5&+ >8##
Sales >1$,###
+hese data have been constant for several years, and all income is paid
out as dividends. Sales, the tax rate, and the balance sheet will remain
constant. *hat is the company’s cost of debt? 3=intF *or% only with
old data.4
a. 1.<K
b. 1.K
c. 1.$1K
d. 1.:$K
e. 11.##K
E)(% Answer: e Diff: %
;;
. Jone Star !lastics has the following dataF
Assets >1##,###
!rofit margin 8.#K
+ax rate 1#K
0ebt ratio 1#.#K
/nterest rate ;.#K
+otal assets turnover .#
*hat is Jone Star’s 5&/+?
a. > ,##
b. >1,###
c. >1;,###
d. >#,###
e. >,##
Chapter 3  Page 32
*ales increase needed Answer: b Diff: % N
;<
. .icardo 5ntertainment recently reported the following income statementF
Sales >1,###,###
"ost of goods sold :,$##,###
5&/+ > 1,$##,###
/nterest 1,$##,###
5&+ > ,###,###
+axes 31#K4 1,##,###
6et income > 1,;##,###
+he company’s "2,, 2red Hert7, wants to see a $ percent increase in net
income 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&/+ASales4 was :.$ percent this past
year. Hert7 expects that next year this margin will increase to
1# percent.
• .icardo’s interest expense is expected to remain constant.
• .icardo’s tax rate is expected to remain at 1# 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. :.<K
b. <.;K
c. .$#K
d. 1;.11K
e. $.##K
Multiple Part:
(The following information applies to the next two problems.)
2ama’s 2rench &a%ery has a return on assets 3.,A4 of 1# percent and a return
on equity 3.,54 of 11 percent. 2ama’s total assets equal total debt plus
common equity 3that is, there is no preferred stoc%4. 2urthermore, we %now
that the firm’s total assets turnover is $.
Debt ratio and Du #ont analysis Answer: c Diff: " N
<#
. *hat is 2ama’s debt ratio?
a. 11.<K
b. ;.##K
c. ;.$:K
d. $$.$8K
e. :1.1K
Chapter 3  Page 33
#rofit !argin and Du #ont analysis Answer: a Diff: E N
<1
. *hat is 2ama’s profit margin?
a. .##K
b. 1.##K
c. 1.K
d. $.K
e. 8.##K
(The following information applies to the next two problems.)
Hiller +echnologies recently reported the following balance sheet in its
annual report 3all numbers are in millions of dollars4F
"ash > 1## Accounts payable > ##
Accounts receivable ## 6otes payable $##
/nventory $## +otal current liabilities > ;##
+otal current assets > <## Jong)term debt 1,$##
+otal debt >,##
"ommon stoc% $##
.etained earnings 1##
6et fixed assets ,## +otal common equity > <##
+otal assets >,## +otal liabilities and equity >,##
Hiller also reported sales revenues of >1.$ billion and a # percent .,5 for
this same year.
ROA Answer: d Diff: " N
<
. *hat is Hiller’s .,A?
a. .$##K
b. .1$K
c. 1.8$K
d. $.8$K
e. :.;8K
Current ratio Answer: b Diff: " N
<
. Hiller +echnologies is always loo%ing for ways to expand their business.
A plan has been proposed that would entail issuing >## million in notes
payable to purchase new fixed assets 3for this problem, ignore
depreciation4. /f this plan were carried out, what would Hiller’s
current ratio be immediately following the transaction?
a. #.1$$
b. #.;1;
c. 1.#<1
d. 1.1$
e. 1.;##
Chapter 3  Page 34
(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 1$# :##
/nventories ;$# 8##
+otal current assets >1,<$# >1,;##
6et fixed assets ,1$# ,##
+otal assets >1,1## >1,###
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,<##
+otal liabilities and equity >1,1## >1,###
"iscellaneous concepts Answer: e Diff: E N
<1
. *hich of the following statements is most correct?
a. +he company’s current ratio was higher in ## than it was in ##1.
b. +he company’s debt ratio was higher in ## than it was in ##1.
c. +he company issued new common stoc% during ##.
d. Statements a and b are correct.
e. Statements a and c are correct.
Net inco!e Answer: b Diff: E N
<$
. +he total dividends paid to the company’s common stoc%holders during ##
was >$# million. *hat was the company’s net income during the year ##?
a. > $# million
b. >1$# million
c. >$# million
d. >$# million
e. >1$# million
Chapter 3  Page 35
*ales, D*O, and inventory turnover Answer: b Diff: " N
<8
. *hen reviewing the company’s performance for ##, its "2, observed that
the company’s inventory turnover ratio was below the industry average
inventory turnover ratio of 8.#. /n addition, the company’s 0S, 3days
sales outstanding, calculated on a 8$)day basis4 was less than the
industry average of $# 3that is, 0S, P $#4. ,n the basis of this
information, what is the most li%ely estimate of the company’s sales 3in
millions of dollars4 for ##?
a. > ,<1#
b. > $,#;
c. > :,$#
d. >1#,;8
e. >#,:8$
(The following information applies to the next two problems.)
&elow are the ##1 and ## year)end balance sheets for @ewell &oomerangsF
## ##1
"ash > 1##,### > ;$,###
Accounts receivable 1,### $#,###
/nventories 1,###,### :##,###
+otal current assets >1,$,### >1,1$,###
6et fixed assets ,###,### ,;##,###
+otal assets >1,$,### >,<$,###
Accounts payable > :##,### > $1$,###
6otes payable ;##,### <##,###
+otal current liabilities >1,$##,### >1,11$,###
Jong)term debt 1,##,### 1,##,###
"ommon stoc% 1,$##,### 1,###,###
.etained earnings ,### <#,###
+otal common equity >1,;,### >1,<#,###
+otal liabilities and equity >1,$,### >,<$,###
@ewell &oomerangs has never paid a dividend on its common stoc%. @ewell issued
>1,##,### of long)term debt in 1<<:. +his debt was non)callable and is
scheduled to mature in #:. As of the end of ##, none of the principal on
this debt has been repaid. Assume that ##1 and ## sales were the same in
both years.
Chapter 3  Page 36
inancial state!ent analysis Answer: a Diff: E N
<:
. *hich of the following statements is most correct?
a. @ewell’s current ratio in ## was higher than it was in ##1.
b. @ewell’s inventory turnover ratio in ## was higher than it was in
##1.
c. @ewell’s debt ratio in ## was higher than it was in ##1.
d. All of the statements above are correct.
e. 6one of the statements above is correct.
Current ratio Answer: c Diff: " N
<;
. 0uring ##, @ewell’s days sales outstanding 30S,4 was 1# days. +he
industry average 0S, was # days. Assume instead that in ##, @ewell
had been able to achieve the industry)average 0S, without reducing its
sales, and that the freed)up cash would have been used to reduce accounts
payable. /f this reduction in 0S, had successfully occurred, what would
have been @ewell’s new current ratio in ##? 3Assume @ewell uses a 8$)
day accounting year.4
a. 1.#1;
b. 1.#1
c. 1.#
d. 1.#:
e. 1.#
Chapter 3  Page 37
Chapter 3  Page 38
CHAPTE !
A"%+E% A"D %'#,T&'"%
1 Current ratio Answer: a Diff: E
.emember, the current ratio is "AA"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 current liability, so if they increase the current ratio
declines. So, statement b is false. 6et fixed assets are long)term
assets, not current assets, so they will not affect the current ratio. So,
statement c is false.
 Current ratio Answer: d Diff: E
!epsi "orporationF
&eforeF "urrent ratio B >$#A>1## B #.$#.
AfterF "urrent ratio B >1$#A>## B #.:$.
"o%e "ompanyF
&eforeF "urrent ratio B >1$#A>1## B 1.$#.
AfterF "urrent ratio B >$#A>## 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
being depreciated each year. Liven that depreciation is a non)cash expense
and is used to reduce taxable income, the change would result in less
depreciation expense and higher taxes for the year. Since taxes are paid
with cash, the companyQs cash flow would decrease. /n addition, decreasing
accounts payable results in using cash to pay off the accounts payable
balance.
1 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
lower taxable 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
income will 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 less because 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
still have 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
could be 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
59A B 3.,5 ) %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 by
increasing its .,5, decreasing its cost of equity, or by increasing its
equity investment. Any of these three changes would increase 59A, not Gust
the increase 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 3.,5 ) %4 × +otal
equity. So, if % is larger 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, so it 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
.,5
0
R .,5
&
I 59A
0
P 59A
&
.
59A can be calculated with  different equationsF
314 59A B 5&/+31 ) +4 )
1
]
1
¸
,
_
¸
¸
×
"apital ,perating
Supplied ) /nvestor +otal
*A"" .
34 59A B 6/ S 3%
S
× 5quity4.
34 59A B 3.,5 ) %
S
4 × 5quity.
Since 0evon has a higher .,5, but its 59A is lower, the only things that
could explain 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 3.,5 ) %
S
4 would be
lower, and 59A would be lower. +herefore, statement b is true. A higher
5&/+ would lead to a higher 59A, so statement c is false.
<  Ratio analysis
Answer: b Diff: E
&edford B 0I &ree7ewood B O.
+A
0
B +A
O
I .,A
0
B .,A
O
I +
0
B +
O
I 0AA
0
R 0AA
O
I /6+
0
R /6+
O
I .,A B 6/A+A.
/f both companies have the same .,A and total assets, then they must both
have the same net incomes. +herefore, 6/
0
B 6/
O
.
2irst, compare &5!s. &5! B 5&/+A+A. *or% bac%ward up the income statement.
/f both companies have the same 6/ and tax rate, then they must both have
the same 5&+. =owever, &edford has higher interest payments, so its 5&/+
must be higher than &ree7ewood’s. 3.ememberF 5&+ T / B 5&/+.4 +herefore,
statement c is false. /n addition, &edford’s &5! is higher than
&ree7ewood’s, so statements a, d, and e are all false. Statement b must be
true for the following reason. "ompare .,5s. .,5 B
.,A × 5H and 5H B
A A 0 1
1
−
.
&edford has a higher 0AA ratio than &ree7ewoodI therefore, it has a higher
5H than &ree7ewood. /f its 5H is higher and its .,A is the same, then
&edford’s .,5 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/A5quityI .,A B 6/A+AI 59A B 6/ ) %
s
× 5quity.
*e %now nothing about the debt ratio or equity multiplier of either
company. .emember, .,A B .,5A5H 35H B equity multiplier4. Since we don’t
have 5H, we don’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 of either 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 is higher 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 is false. Since statements a, b, and c are false,
the correct choice must be statement e.
1 inancial state!ent analysis Answer: e Diff: E
2rom the first sentence, both firms have the same net income, sales, and
assets. Since A has more debt, it must have less equity. +hus, its .,5
3calculated as 6et incomeA5quity4 is higher than &’s. So statement a is
correct. 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
A has 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 is
statement e.
1 inancial state!ent analysis Answer: d Diff: E N
+he correct answer is statement d. Although 5&/+ is unchanged, interest
expense 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&/+A/6+4 will increase. +herefore, statement b is correct. /f the
stoc% issue has no effect on the company’s total assets, but 6/ has
increased 3see statement a4, then .,A 36/A+A4 will increase. +herefore,
statement c is also correct.
11 "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
does not explain the ratios discussed. +herefore, only statement a
explains the observed ratios.
1$ "iscellaneous ratios Answer: e Diff: E R
"urrent ratio B "urrent assetsA"urrent liabilities. +his transaction will
reduce current liabilities, which results in a higher current ratio. So
statement a is false. +he basic earning power ratio B 5&/+A+A. Since
neither the firm’s operating income 35&/+4 or total assets have changed,
its &5! ratio remains unchanged. So statement b is false. +/5 B
5&/+A/nterest. 5&/+ will be unaffected, but we may see interest costs fall
due to the firm having less debt. +his will result in an increase in the
+/5 ratio. So statement c is false. 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 more equity, so the equity multiplier
3AssetsA5quity4 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
ratio because 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
the current ratio will increase.
1: Current ratio Answer: e Diff: "
1; Ratio analysis Answer: c Diff: "
1< Ratio analysis Answer: c Diff: " N
+A
0
B +A
"
.
+A+,
0
B +A+,
"
so, SA+A
0
B SA+A
"
.
.,5
0
B .,5
"
.
.,A
0
R .,A
"
.
Since +A+, is the same for both, and since +A is the same for both, sales
must be the same for both 3since +A+, B SalesA+A4. .emember the 0u !ont
equationF .,5 B !H × +A+, × 5H. 0rysdale and "ommerce have the same +A+,.
So, if 0rysdale has a higher !H and a higher 5H 3if the debt ratio is
higher, the 5H is higher4, then its .,5 must be higher. =owever, the problem
states that the companies have the same .,5. +herefore, statement a is
incorrect. /f 0rysdale’s !H and debt ratio are lower than "ommerce’s and
both have the same +A+,, 0rysdale would have a lower .,5. +he problem states
that the companies have the same .,5, so statement b is incorrect. Joo%ing
again at the 0u !ont equationF .,5 B !H × +A+, × 5H. /f the .,5s are the
same and the +A+,s are the same, then 3!H × 5H4 must be the same for the two
companies. /f 0rysdale has a higher !H and a lower 5H, then 3!H × 5H4 could
be the same for both. +herefore, statement c could explain the ratios in
the problem. /f 0rysdale has lower 6/ and more common equity 3higher +54,
then its .,5 would be lower. +herefore, statement d is incorrect. +he !A5
ratio is irrelevant. +he stoc% price cannot explain what is going on with
the two companies’ ratios.
# Ratio analysis Answer: a Diff: %
Statement a is correctI the others are false. /f "ompany E has a higher
total assets turnover 3SalesA+A4 but the same total assets, it must have
higher sales than D. /f E has higher sales and also a higher profit margin
36/ASales4 than D, it must follow that E has a higher net income than D.
Statement b is false. .,5 B 6/A5U 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 determine given 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 !ont equation that .,A B !rofit margin × +otal assets
turnover B 6/AS × SA+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 debt
provides tax benefits to the corporations that issue debt, not to the
investors 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 interest
expense 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
even though 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/AS × SA+A × +AA5 B .,5. *e %now SA+A and .,5 are the same for both.
Since the 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 also true. Liven Hills’ higher net income, both the profit margin
and the .,A for Hills are also higher than =arte’s.
1 Leverage and financial ratios Answer: e Diff: "
+A+, B SalesA+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, it must have higher salesI thus, A has a higher total assets turnover
ratio than &. +herefore, statement a is true. .,5 B 6/A5quity. &oth
companies have the same total assets and net income, but A has more debt
and thus less equity than &. +herefore, A has a higher .,5 than &.
+herefore, statement b is true. &5! B 5&/+A+A. *e %now that A has higher
interest payments than & but the same 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 ratio than &. +herefore, statement c is true.
Since statements a, b, and c are true, the correct choice is statement e.
$ 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
has higher 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 lower 5&+, then "ompany A pays less in taxes than "ompany &.
+here is a positive relationship between the debt ratio and the equity
multiplier, which means that "ompany A has a higher equity multiplier than
& because A’s debt ratio is higher 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 is
below average. 5H is above average because a high debt ratio implies a
high 5H. +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/ S 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+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 be correct. 3*e are given information in the question
stating that the firm’s debt ratio is 1# percent.4 +herefore, statement c
is also false. .,5 B 6/A5quity. .ewrite the 59A equation by substituting
into it 59A B #, and you getF 6/ B %
s
× 5quity. 0ivide both sides by 5quity
and you obtain the following equationF 6/A5quity B %
s
. +hus .,5 B 11K.
Statement e would give a negative 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 positive
59A, 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.
< "iscellaneous ratios Answer: b Diff: "
Statement b is correct. 5&/+ B 5&+ T /nterest. Statement c is incorrect
because higher interest expense doesn’t necessarily imply greater debt. 2or
this statement to be correct, A’s amount of debt would have to be greater
than &’s.
# "iscellaneous ratios Answer: e Diff: "
Statements b and c are correct. .,A B 6/A+A. An increase in the debt ratio
will result in an increase in interest expense, and a reduction in 6/. +hus
.,A will fall. 5H B AssetsA5quity. As debt increases, the amount of equity
in the denominator decreases, thus causing the equity multiplier 35H4 to
increase. +herefore, statement e is the correct choice.
1 "iscellaneous ratios Answer: d Diff: "
Since E has a lower .,A 36/A+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 a
higher .,5 36/A5U4 than D, even though its net income is lower.
"onsequently, E must have less equity than D, and therefore, more debt than
D. So statement a is false. Since E has a higher total assets turnover
ratio 3SalesA+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 lower profit margin 36/ASales4 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 3.,5 ) %
s
4
× +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 3.,5 ) %
s
4 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
interest payments will be lower than &’s, so its 5&/+ will be higher.
Another way to write the 59A formula is 59A B 5&/+ 31 S +4 S V"ost of
capital × /nvestor)supplied capital employedW. So, a higher 5&/+ will lead
to a higher 59A. /n addition, 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 that this 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+A. "ompany " has
higher interest expense than "ompany 0I therefore, it must have lower net
income. Since the two firms have the same total assets, .,A
"
P .,A
0
.
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 .,5 because its equity multiplier would be greater than
company 0Qs. Statement c is false as +/5 B 5&/+A/nterest, and " has higher
interest than 0 but the same 5&/+I therefore, +/5
"
P +/5
0
. Statement e is
falseI they have the same &5! B 5&/+A+A from the facts as given in this
problem.
1 Ratio analysis Answer: d Diff: %
*e can conclude that E has a lower 6/, because it has a lower 5&/+ and
higher interest 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
assets turnover ratio 3+A+, B SalesA+A4. +herefore, since E has a lower 6/
and same sales as D, it must follow that it has a lower profit margin
36/ASales4.
$  Ratio analysis and Du #ont e$uation
Answer: d Diff: %
.,A
J
B .,A
D
I SA+A
J
R SA+A
D
I 5H
J
R 5H
D
, or AA5
J
R AA5
D
.
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 assets
turnover is greater than Dor%’s then Jancaster’s profit margin must be lower
than Dor%’s. +herefore, statement a is true. +he debt ratio is calculated
as 1 ) 1A5quity multiplier. So, if Jancaster has a higher equity multiplier
than Dor%, 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
assets turnover × 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 must
have 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 31#K4 1##,###
6et income > 8##,###
.,A
,ld
B
1#.;K B
>$,###,###
>$1#,###
Assets
6/
·
I
6ew
.,5
B
1#K. B
>8,###,###
>8##,###
+herefore, .,A falls.
.,5
,ld
B
1.$K
>1,###,###
>$1#,###
5quity
6/
· ·
I .,5
6ew
B
1$.#K.
>1,###,###
>8##,###
·
Since net income increases, .,A falls and .,5 increases, statement d is the
correct choice.
: "iscellaneous ratios Answer: c Diff: %
Step 1F Cse the ratios and data to arrive at alternative relationships to
answer the questionF
+A+, B SalesA+A
B 6/A+A × SA6/
B .,A × 1A!H.
0AA B +0A+A
B 3+A ) 5U4A+A
B 3+AA+A4 ) 35UA+A4
B 1 ) 35UA6/4 × 36/A+A4
B 1 ) 3.,AA.,54.
.,A B 6/A+A
6/ B +A × .,A.
Step F Substitute the data given with the alternative relationships
obtained in Step 1F
=emmingway 2it7gerald
+A+, B .,AA!H B #.#<A#.#1 B #.#;A#.#
B .$X. B .8:X.
0AA B 1 ) 3.,AA.,54 B 1 ) 3#.#<A#.1;4 B 1 ) 3#.#;A#.14
B #.$. B #.88:.
6/ B +A × .,A B × #.#< B 1.$ × #.#;
B >#.1; billion. 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+A
#.1$ B 5&/+A>1##,###,###
5&/+ B >1$,###,###.
.,A B 6/A+A
#.#< B 6/A>1##,###,###
6/ B ><,###,###.
5&+ B 6/A31 ) +4
5&+ B ><,###,###A#.8
5&+ B >1$,###,###.
+herefore interest expense B >#.
< "ar&et price per share Answer: b Diff: E
+otal mar%et value B >1,$#31.$4 B >1,;:$.
Har%et value per share B >1,;:$A$ B >:$.
Alternative solutionF
&oo% value per share B >1,$#A$ B >$#.
Har%et value per share B >$#31.$4 B >:$.
1# "ar&et price per share Answer: c Diff: E
6umber of shares B >##,###A>.## B 1##,###.
&oo% value per share B >,###,###A1##,### B >#.
Har%et value B #.3&oo% value4 B #.3>#4 B >1.## per share.
11
 "ar&et'boo& ratio Answer: c Diff: E
shares. ,###,###
shares ;# > ## >18#,###,#
# >1#,###,##
shares ;# >
# . 1
&9
shares share per !rice
&
H
·
× ·
×
·
×
·
1 "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 HA& B ?
&oo% value B
### , ### , ##
### , ### , ## , 1 >
B >1.##.
HA& B
## . 1 >
## . # >
B $.#.
1 ROA Answer: d Diff: E
6et income B #.1$3>#,###,###4 B >,###,###.
.,A B >,###,###A>,$##,### B 1.K.
11 %(E ratio Answer: b Diff: E
+/5 B 5&/+A/6+
: B 3>## T /6+4A/6+
:/6+ B >## T /6+
8/6+ B >##
/6+ B >$#.
1$ ROE Answer: c Diff: E
5quity B #.$3>8,###4 B >1,$##.
"urrent .,5 B
5
6/
B
>1,$##
>1#
B 18K.
6ew .,5 B
>1,$##
>##
B #.# B #K.
∆.,5 B #K ) 18K B 1K.
18 #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 B
Sales
6/
B
>1#,###
>1# T >1#
B #.#1$# B 1.$K.
1: Du #ont e$uation Answer: a Diff: E
2irst, calculate the profit margin, which equals 6/ASalesF
.,A B 6/A+A B #.#1.
SalesA+otal assets B SA+A B .
!H B 36/A+A43+AAS4 B #.#13#.$4 B #.#. V+AAS B 1A B #.$.W
6ext, find the debt ratio by finding the equity ratioF
5A+A B 35A6/436/A+A4. V.,5 B 6/A5 and .,A B 6/A+A.W
5A+A B 31A.,543.,A4 B 31A#.#843#.#14 B #.88:, or 88.:K equity.
+herefore, 0A+A must be #. B .K.
1; #'E ratio and stoc& price Answer: b Diff: E
5!S B >1$,###A1#,### B >1.$#.
!A5 B $.# B !A>1.$#.
! B >:.$#.
1< #'E ratio and stoc& price Answer: e Diff: E
5!S B >:$#,###A1##,### B >:.$#.
!A5 B !riceA5!S B ;.
+hus, !rice B ; × >:.$# B >8#.##.
$# Current ratio and inventory Answer: b Diff: E N
*ith the numbers provided, we can see that /%en &erry 2arms has a current
ratio of 1.8: 3"AA"J B >$A> B 1.8:4. /f notes payable are going to be
raised to buy inventories, both the numerator and the denominator of the
ratio will increase. *e can increase current liabilities >1 million before
the current ratio reaches 1.$.
. ### , ### , 1 > E
E ### , ### , 1 >
E $ . # ### , $## >
E $ . 1 ### , $## , 1 > E ### , ### , $ >
$ . 1
E ### , ### ,  >
E ### , ### , $ >
$ . 1
E "J
E "A
≤
≥
≥
+ ≥ +
≥
+
+
≥
+
+
$1 Accounts receivable increase Answer: b Diff: " R
0S, B >11,#<8A3>$#,###A8$4 B 8# days.
6ew AA. B V3>$#,###431.$4A38$4W38#431.$4 B ><,188.
=ence, increase in receivables B ><,188 ) >11,#<8 B >$1,:#.
$ Accounts receivable Answer: a Diff: " R
2irst solve for current annual sales using the 0S, equation as followsF $#
B >1,###,###A3SalesA8$4 to find annual sales equal to >:,##,###.
/f sales fall by 1#K, the new sales level will be >:,##,###3#.<4 B
>8,$:#,###. Again, using the 0S, equation, solve for the new accounts
receivable figure as followsF  B A.A3>8,$:#,###A8$4 or A. B >$:8,###.
$ ROA Answer: a Diff: "
5quity multiplier B 1A31 ) 0AA4 B 1A31 ) #.14 B 1.8:.
.,5 B .,A × 5quity multiplier
1;K B 3.,A431.8:4
.,A B 1#.;K.
$1 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#,###,###A#.1, or >1## million.
Step F 6/A+A B .,A, so now we need to find net income. 6et income is
found by wor%ing through the income statement 3in millions4F
5&/+ >1#
/nterest $ 3from +/5 ratioF ; B 5&/+A/nt4
5&+ >$
+axes 31#K4 11
6/ >1
Step F .,A B >1A>1## B #.#$$ B $.$K.
$$  ROA
Answer: c Diff: " N
&5! B 5&/+A+A B #.1#, so 5&/+ B #.1# × >$##,### B >$#,###.
+/5 B 5&/+A/6+ B $, so /6+ B >$#,###A$ B >1#,###.
5&/+ >$#,###
/nt )1#,###
5&+ >1#,###
+axes 31#K4 )18,###
6/ >1,###
.,A B 6/A+A B >1,###A>$##,### B #.#1;, or 1.;K.
$8 ROE Answer: c Diff: " R
3Sales per day430S,4 B AA.
3SalesA8$438#4 B >1$#,###
Sales B ><1,$##.
!rofit margin B 6et incomeASales.
6et income B #.#13><1,$##4 B >8,$##.
0ebt ratio B #.81 B +otal debtA>,###,###.
+otal debt B >1,<#,###.
+otal equity B >,###,### ) >1,<#,### B >1,#;#,###.
.,5 B >8,$##A>1,#;#,### B .;K ≈ .1K.
$: 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 ><##,###.
.,5 B ><##,###A>1#,###,### B <K.
.,5 ) .,A B <K ) 8K B K.
$; ROE Answer: d Diff: "
!rofit margin B 3>1,$##31 ) #.44A>$,### B 1K.
5quity multiplier B 1.# since firm is 1##K equity financed.
.,5 B 3!rofit margin43Assets turnover435quity multiplier4
B 31K43.#431.#4 B 1K.
$< ROE Answer: c Diff: "
"alculate debt, equity, and 5&/+F
0ebt B 0AA × +A B #.$3>1,###4 B >$#.
5quity B +A ) 0ebt B >1,### ) >$# B >8$#.
5&/+ B +A × &5! B >1,###3#.#4 B >##.
"alculate net income and .,5F
6et income B 35&/+ ) /431 ) +4 B V>## ) #.#1$:3>$#4W3#.84 B >11#.1.
.,5 B >11#.1A>8$# B 18.<<K.
8# E$uity !ultiplier Answer: d Diff: "
5quity multiplier B 1.# B +otal assetsA+otal equity B 1A1.
Assets B 0ebt T 5quity
1 B 0ebt T 1
0ebt B .
0ebtAAssets B A1 B #.:$.
81 %(E ratio Answer: e Diff: "
+/5 B 5&/+A/, so find 5&/+ and /.
/nterest B >;##,### × #.1 B >;#,###.
6et income B >,##,### × #.#8 B >1<,###.
!re)tax income B >1<,###A31 ) +4 B >1<,###A#.8 B >#,###.
5&/+ B >#,### T >;#,### B >1##,###.
+/5 B >1##,###A>;#,### B $.#×.
8 %(E ratio Answer: b Diff: " N
+A B >;,###,###,###I + B 1#KI 5&/+A+A B 1KI .,A B KI +/5 ?
. ### , ### , <8# > 5&/+
1 . #
,### >;,###,###
5&/+
·
·
. ### , ### , 1# > 6/
# . #
,### >;,###,###
6/
·
·
6ow use the income statement format to determine interest so you can
calculate the firm’s +/5 ratio.
5&/+ ><8#,###,### See above.
/6+ $8#,###,###
5&+ >1##,###,### 5&+ B >1#,###,###A#.8
+axes 31#K4 18#,###,###
6/ >1#,###,### See above.
/6+ B 5&/+ S 5&+
B ><8#,###,### ) >1##,###,###
+/5 B 5&/+A/6+
B ><8#,###,###A>$8#,###,###
B 1.:11 ≈ 1.:1.
8 %(E ratio Answer: b Diff: "
.emember, +/5 B 5&/+A/nterest. *e need to find 5&/+ and /nterest.
+A B >#,###,###I &5! B $KI .,A B 1#KI + B 1#K.
&5! B 5&/+A+A
$K B 5&/+A>#,###,###
>$,###,### B 5&/+.
.,A B 6/A+A
1#K B 6/A>#,###,###
>,###,### B 6/.
6/ B 35&/+ ) /431 ) +4
>,###,### B 3>$,###,### ) /431 ) #.14
>,###,### B 3>$,###,### ) /43#.84
>,, B >$,###,### ) /
>1,888,88: B /.
+herefore, +/5 B 5&/+A/
B >$,###,###A>1,888,88:
B .#×.
81 %(E ratio Answer: d Diff: " N
+he times interest earned 3+/54 ratio is calculated as the ratio of 5&/+
and interest expense. *e can find 5&/+ from the &5! ratio and total assets
given in the problem.
&5! B
+A
5&/+
$K B
>,###,###
5&/+
5&/+ B >:$#,###.
/nterest expense can be obtained from the income statement by simply
wor%ing your 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/
1K B
>,###,###
6/
6/ B >8#,###.
Solving for 5&+ and then interest, we findF
5&+ B
+4 ) 31
6/
5&+ B
4 $ . # 1 3
### , 8# >
−
5&+ B >$$,;18.
5&/+ S /6+ B 5&+
>:$#,### S /6+ B >$$,;18
/6+ B >1<8,1$1.
*e can now calculate the +/5 as followsF
+/5 B
/6+
5&/+
+/5 B
1$1 , 1<8 >
### , :$# >
+/5 B .;×.
8$ E)(%DA coverage ratio Answer: a Diff: " N
+A B ><,###,###,###I 5&/+A+A B <KI +/5 B I 0A B >1,###,###,###I Jease
payments B >8##,###,###I !rincipal payments B >##,###,###I 5&/+0A coverage
B ?
5&/+A><,###,###,### B #.#<
5&/+ B >;1#,###,###.
 B 5&/+A/6+
 B >;1#,###,###A/6+
/6+ B >:#,###,###.
5&/+0A B 5&/+ T 0A
B >;1#,###,### T >1,###,###,###
B >1,;1#,###,###.
5&/+0A coverage ratio B
pmts Jease pmts !rinc. /6+
payments Jease 5&/+0A
+ +
+
B
### , ### , 8## > ### , ### , ## > ### , ### , :# >
### , ### , 8## > ### , ### , ;1# , 1 >
+ +
+
B
### , ### , 1:# , 1 >
### , ### , 11# , >
B .#$<; ≈ .#8.
88 Debt ratio Answer: c Diff: "
0ebt ratio B 0ebtA+otal assets.
SalesA+otal assets B 8
+otal assets B >1,###,###A8 B >1,###,###.
.,5 B 6/A5quity
5quity B 6/A.,5 B >1##,###A#.1$ B >,888,88:.
0ebt B +otal assets ) 5quity B >1,###,### ) >,888,88: B >1,,.
0ebt ratio B >1,,A>1,###,### B #..
8: #rofit !argin Answer: a Diff: "
5quity multiplier B 1A31 ) #.$4 B 1.$;$.
.,5 B 3!rofit margin43Assets utili7ation435quity multiplier4
1$K B 3!H43.;431.$;$4
!H B .1;K.
8; inancial state!ent analysis Answer: e Diff: " R
"urrent 0S, B
$ >1#,###A8
>1,###
B 8.$ days. /ndustry average 0S, B # days.
.educe receivables by 38.$ S #4
,
_
¸
¸
8$
>1#,###
B >1:;.#;.
0ebt B >1##A#.1# B >1,###.
+A
+0
B
>1:;.#; ) >8,###
>1:;.#; ) >1,###
B 8$.8$K.
8< inancial state!ent analysis Answer: b Diff: " R
2irst, find the amount of current assetsF
"urrent ratio B "urrent assetsA"urrent liabilities
"urrent assets B 3"urrent liabilities43"urrent ratio4
B >:$,###31.4 B >1$#,###.
6ext, find the accounts receivablesF
0S, B A.A3SalesA8$4
A. B 0S,3Sales431A8$4
B 31#43>1,##,###431A8$4 B >11,$#8.;$.
6ext, find the inventoriesF
/nventory turnover B SalesA/nventory
/nventory B SalesA/nventory turnover
B >1,##,###A1.; B >$#,###.
2inally, find the amount of cashF
"ash B "urrent assets ) A. ) /nventory
B >1$#,### ) >11,$#8.;$ ) >$#,### B >8;,1<.1$ ≈ >8;,1<.
:# )asic earning power Answer: d Diff: "
Liven .,A B 1#K and net income of >$##,###, total assets must be >$,###,###.
.,A B
A
6/
1#K B
+A
>$##,###
+A B >$,###,###.
+o calculate &5!, we still need 5&/+. +o calculate 5&/+ construct a
partial income statementF
5&/+ >1,#, 3>##,### T >;,4
/nterest ##,### 3Liven4
5&+ > ;, >$##,###A#.8
+axes 31#K4 ,
6/ > $##,###
&5! B
+A
5&/+
B
>$,###,###
>1,#,
B #.#8: B #.8:K.
:1 #'E ratio and stoc& price Answer: e Diff: "
+he current 5!S is >1,$##,###A##,### shares or >$. +he current !A5 ratio
is then >8#A>$ B 1. +he new number of shares outstanding will be 1##,###.
+hus, the new 5!S B >,$##,###A1##,### B >8.$. /f the shares are selling
for 1 times 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, B
Sales 0aily Average
s .eceivable
.
/f 0S, changes while sales remain the same, then receivables must
change.
1# B
Sales 0aily Average
1## >
>1# B Average 0aily Sales.
Step F 0etermine the new level of receivables required for !arcells to
achieve the industry average 0S,.
# B
>1#
s .eceivable
>## 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 >:##.
Since the >1## cash freed up is used to reduce long)term bonds, cur)
rent liabilities remain at >1##. "urrent ratio B >:##A>1## B 1.:$.
: Current ratio Answer: c Diff: " N
"urrentlyF
0S, B A.AAverage 0aily Sales
B >$#A>1#
B $ days.
6ow, "artwright wants to reduce 0S, to 1$. +he firm needs to reduce
accounts receivable because it doesn’t want to reduce average daily sales.
So, we can calculate the new A. balance as followsF
0S, B A.AAverage 0aily Sales
1$ B A.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)up cash will be used to reduce notes payable, and the
other half will be used to reduce 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 "AA"J
B 3"ash T A. T /nv.4A36otes !ayable T Accounts !ayable4
B 3>$# T >1$# T >$#4A3>$# T >$#4
B >8$#A>$##
B 1.#×.
:1 Current ratio Answer: b Diff: " N
Step 1F "alculate the firm’s current inventory turnover.
/nv. turnover B SalesA/nv.
B >,###,###A>$##,###
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 SalesA/nv.
1#× B > millionA/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 AA.
B >1##,### T >##,### T >##,###
B >8##,###.
=alf of the >##,### that is freed up will be used to reduce notes payable,
and the other half will be used to reduce common equity. +herefore, notes
payable will be reduced by >1##,### to a new level of >1##,###.
Step 1F "alculate the firm’s new liabilities level.
"J B AA! T Accruals T 6otes payable
B >##,### T >1##,### T >1##,###
B >1##,###.
Step $F "alculate the firm’s new current ratio with the improved inventory
management.
". B "AA"J
B >8##,###A>1##,###
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 A.A3>:#,###A8$4 or A. B >:,###. +hus, >1$,### ) >:,### B
>$,### is the cash freed up by reducing 0S, to 8 days. .etiring >$,###
of long)term debt leaves >1:,### in long)term debt. Liven a 1#K interest
rate, interest expense is now >1:,###3#.14 B >1,:##. +hus, 5&+ B 5&/+ )
/nterest B >:#,### ) >1,:## B >1$,##. 6et income is >1$,##31 ) #.4 B
>1,:1#. +hus, .,5 B >1,:1#A>##,### B 1$.;8K.
:8 Du #ont e$uation Answer: d Diff: "
&eforeF 5quity multiplier B 1A31 ) 0AA4 B 1A31 ) #.$4 B .#.
.,5 B 3!H43Assets turnover435H4 B 31#K43#.$43.#4 B $K.
AfterF V.,5 B 3$K4 B 1#KWF
1#K B 31K43#.$435H4
5H B . B AA5.
5AA B 1A. B #..
0AA B 1 S #. B #.: B :#K.
:: *ales and e+tended Du #ont e$uation Answer: a Diff: "
6/A5 B 1$KI 0AA B 1#KI 5AA B 8#KI AA5 B 1A#.8 B 1.888:I 6/AS B $K.
Step 1F 0etermine total assets turnover from the extended 0u !ont
equationF
6/AS × SA+A × AA5 B .,5
3$K43SA+A431.888:4 B 1$K
#.#; SA+A B 1$K
SA+A B 1.;.
Step F 0etermine sales from the total assets turnover ratioF
SA+A B 1.;
SA>;## B 1.;
S B >1,11# 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 SalesA+A
.$× B
Assets
### , ### , 1# >
Assets B >,;$:,11.;$:1.
Step F "alculate net income.
+here is no debt, so Assets B 5quity B >,;$:,11.;$:1.
.,5 B 6/AS × SA+A × +AA5
#.1$ B 6/A>1#,###,### × .$ × 1
#.1$ B
### , ### , 1# >
6/ $ . 
>1,$##,### B .$6/
>1;,$:1.1;8 B 6/.
:< ROE Answer: c Diff: %
LivenF 6ew 0AA B #.$$ /nterest B >:,###
5&/+ B >$,### +ax rate B 1#K
Sales B >:#,### +A+, B .#
.ecall the 0u !ont equationF .,5 B 3!H43+A+,435H4.
.,5 B 3.,A435H4.
.,5 B 6/A5quity.
5&/+ >$,###
/nterest :,### 3Liven4
5&+ >1;,###
+axes 31#K4 :,## 3>1;,### × 1#K4
6/ >1#,;##
+A+, B SalesA+otal assets
+otal assets B SalesA+A+, B >:#,###A B ><#,###.
5quity B V1 ) 30AA4W3+otal assets4
5quity B V1 ) #.$$W3+otal assets4
5quity B #.1$3><#,###4 B >1#,$##.
.,5 B 6/A5quity B >1#,;##A>1#,$## B 8.8:K.
;# ROE Answer: d Diff: %
/ndustry average inventory turnover B 8 B SalesA/nventories.
+o match this levelF /nventories B SalesA8
>,###,###A8 B >$##,###.
"urrent inventories B >1,###,###. .eduction in inventories B >1,###,### )
>$##,### B >$##,###. +his >$##,### is to be used to reduce debt.
6ew debt level B >1,###,### ) >$##,### B >,$##,###.
/nterest on this level of debt B >,$##,### × #.1 B >$#,###.
Joo% at the income statement to determine net incomeF
5&/+ >1,1##,###
/nterest $#,###
5&+ >1,#$#,###
+axes 31#K4 1#,###
6/ > 8#,###
.,5 B 6et incomeA5quity B >8#,###A>,###,### B #.1$# or 1.$#K.
;1 ROE and financing Answer: a Diff: %
+he firm is not using its 'free( trade credit 3that is, accounts payable
3AA!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 than
necessary.
"alculate the increase in payablesF
"urrent 3AA!4A/nventories ratio B >1##A>$## B #.#.
+arget AA! B #.8#3/nventories4 B #.8#3>$##4 B >##.
/ncrease in AA! B >## ) >1## B >##.
Since the current ratio and total assets remain constant, total liabilities
and equity must be unchanged. +he increase in accounts payable must be
matched by an equal decrease in interest)bearing notes payable. 6otes
payable decline by >##. /nterest expense decreases by >## × #.1# B >#.
"onstruct comparative /ncome StatementsF
,ld 6ew
Sales >,### >,###
,perating costs 1,;1 1,;1
5&/+ > 1$: > 1$:
/nterest : 1:
5&+ > 1# > 11#
+axes 31#K4 1; $8
6et income 36/4 > : > ;1
.,5 B 6/A5quity B >:A>;## B <K. >;1A>;## B 1#.$K.
6ew .,5 B 1#.$K.
; ROE and refinancing Answer: d Diff: %
.elevant informationF ,ld .,5 B 6/A5quity B #.#8 B 8K.
Sales B >##,###I 5&/+ B #.113Sales4 B #.113>##,###4 B >,###.
0ebt B >##,###I 0AA B #.;# B ;#K.
+ax rate B 1#K.
/nterest rate changeF ,ld bonds 11KI new bonds 1#K.
"alculate total assets and equity amountsF
Since debt B >##,###, total assets B >##,###A#.;# B >$#,###.
5quity B 1 ) 0AA B 1 ) #.;# B #.#.
5quity B 5A+A × +A B #.# × >$#,### B >$#,###.
"onstruct comparative /ncome Statements from 5&/+, and calculate new .,5F
,ld 6ew
5&/+ >,### >,###
/nterest ;,### #,###
5&+ > $,### >1,###
+axes 31#K4 ,### $,##
6et income > ,### > :,;##
6ew .,5 B 6/A5quity B >:,;##A>$#,### B #.1$8# B 1$.8K.
; %(E ratio Answer: d Diff: %
+/5 B
/
5&/+
B ?
+A +urnover B SAA B
SA>1#,### B
S B >#,###.
+A
+0
B #.8I
+0 B #.83>1#,###4
0ebt B >8,###.
/ B >8,###3#.14 B >8##.
!H B
S
6/
B K
!H B
>#,###
6/
B #.#
6/ B >8##.
5&+ B
#.14 ) 31
>8##
B >1,###.
5&/+ >1,8##
/nterest 8##
5&+ >1,###
+axes 31#K4 1##
6/ > 8##
+/5 B >1,8##A>8## B .8:.
;1 Current ratio Answer: e Diff: %
,ld 0S, B 1#I "A B >,$##,###I "AA"J B 1.$I A. B >1,8##,###.
Step 1F "alculate average daily salesF
0S, B A.AAverage daily sales
1# B >1,8##,###AAverage daily sales
>1#,### B Average daily sales.
Step F "alculate the new level of accounts receivable when 0S, B #F
# B A.A>1#,###
>1,##,### B A..
So, the change in receivables will be >1,8##,### S >1,##,### B
>1##,###.
Step F "alculate the old level of current liabilitiesF
"urrent ratio B "AA"J
1.$ B >,$##,###A"J
>1,888,88: B "J.
Step 1F "alculate the new current ratioF
+he change in receivables will cause a reduction in current assets
of >1##,### and a reduction in current liabilities of >1##,###.
"A new B >,$##,### ) >1##,### B >,1##,###.
"J new B >1,888,88: ) >1##,### B >1,88,88:.
". new B >,1##,###A>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 >$#A# B >.$#.
Stoc% price B >.$#3;4 B >#.
/f EDO had the industry average inventory turnover, its inventory balance
would beF
+urnover B $ B
/nv
Sales
B
/nv
>1,###
/nv B >1,###A$ 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 !riceAshar
available 2unds
B
>#
>1##
B $ shares.
+hus, the new 5!S would beF
6ew 5!S B
g outstandin Shares
income 6et
B
$ ) #
>$#
B >..
+he new stoc% price would beF
6ew price B 6ew 5!S3!A54 B >.3;4 B >8.8:.
Stoc% price increase B >8.8: ) >#.## B >8.8:.
;8 Du #ont e$uation and debt ratio Answer: e Diff: %
5U
A
A
S
S
6/
× × B .,5.
0ata for AF
#.:3>$##4
>$##
>$##
>1,###
>1,###
6/
× × B #.1$
#.:3>$##4
6/
B #.1$ B 6/ B >$.$#.
∴.,5 B
S
6/
B
>1,###
>$.$#
B #.#$$ B $.$K.
0ata for &F
5U
A
A
S
S
6/
× × B #.#
#.#$$ × ×
5U
>$##
B #.#
#.1#$# ×
5U
>$##
B #.#
5U
>$##
B .;$:1
5quity B >1:$.
0ebt B >$## ) >1:$ B >$.
+herefore, 0AA B >$A>$## B #.8$ or 8$K.
;: inancial state!ent analysis Answer: a Diff: %
Sales >1$,###
"ost of goods sold MMMMMMM
5&/+ > 1,#8$
/nterest 18$
5&+ > 8##
+axes 3$K4 1#
6/ > <#
&5! B
+A
5&/+
B
>;,###
5&/+
B #.11$I 5&/+ B >1,#8$.
6ow fill inF 5&/+ B >1,#8$.
/nterest B 5&/+ ) 5&+ B >1,#8$ ) >8## B >18$.
A
0
B
>;,###
0
B #.1$I 0 B #.1$3>;,###4 B >,8##.
/nterest rate B
0ebt
/nterest
B
>,8##
>18$
B #.1< B 1.<K.
;; E)(% Answer: e Diff: %
*rite down equations with given data, then find un%nownsF
!rofit margin B
S
6/
B #.#8.
0ebt ratio B
A
0
B
>1##,###
0
B #.1I 0 B >1#,###.
+A turnover B
A
S
B .# B
>1##,###
S
B I S B >##,###.
6ow plug sales into profit margin ratio to find 6/F
>##,###
6/
B #.#8I 6/ B >1;,###.
6ow set up an income statementF
Sales >##,###
"ost of goods sold MMMMMMMM
5&/+ > ,## 35&/+ B 5&+ T /nterest4
/nterest ,## 3>1#,###3#.#;4 B >,##4
5&+ > #,### 35&+ B >1;,###A31 ) +4 B >#,###4
+axes 31#K4 1,###
6/ > 1;,###
;< *ales increase needed Answer: b Diff: % N
Dou need to wor% bac%wards through the income statement to solve this
problem.
+he new 6/ will beF 3>1,;##,###431.$4 B >,$#,###.
6ow find 5&+F
35&+431 ) +4 B 6/
5&+ B 6/A31 ) +4
B >,$#,###A31 ) #.14
B >,:$#,###.
6ow find 5&/+F
5&/+ ) / B 5&+
5&/+ B 5&+ T /
5&/+ B >,:$#,### T >1,$##,###
B >$,$#,###.
6ow find SalesF
3Sales43,perating Hargin4 B 5&/+
Sales B 5&/+A,perating Hargin
B >$,$#,###A#.1
B >1,1$,###.
+herefore, sales need to rise to >1,1$,###. =ow much of an increase is
this?
>1,1$,###A>1,###,### B 1.#<:$. +herefore, sales have gone up by <.:$K
3rounded to <.;K4.
<# Debt ratio and Du #ont analysis Answer: c Diff: " N
+he 0u !ont analysis of return on equity gives usF
.,5 B .,A × 5H
11K B 1#K × 5H
1.1 B 5H.
2rom the equity multiplier 3AA54, we can calculate the debt ratioF
1.1 B AA5
5AA B 1A1.1
5AA B #.:11.
0AA B 1 S 5AA
0AA B 1 S #.:11
0AA B #.;$: B ;.$:K.
<1 #rofit !argin and Du #ont analysis Answer: a Diff: E N
Csing the 0u !ont analysis again, we can calculate the profit margin.
.,5 B !H × +A+, × 5H
11K B !H × $ × 1.1
11K B !H × :
K B !H.
< ROA Answer: d Diff: " N
.,A B 6/AAssets. +otal assets B >,##,###,### 3from the balance sheet4.
*e, %now .,5 B 6/A"ommon equity B #.#, with "ommon equity B ><##,###,###
3from the balance sheet4.
#.# B 6/A><##,###,###
6/ B >1;#,###,###.
So, .,A B >1;#,###,###A>,##,###,### B #.#$8$, or $.8$K.
< Current ratio Answer: b Diff: " N
.ecall the current ratio is "AA"J B ><##,###,###A>;##,###,### B 1.1$.
+he plan loo%s li%e thisF 0ebit 2ixed assets >##,###,###
"redit 6otes payable >##,###,###
So, current liabilities increase by >## million, while current assets do
not change.
So, the new current ratio is ><##,###,###A3>;##,###,### T >##,###,###4 B
><##,###,###A>1,1##,###,### B #.;1;.
<1 "iscellaneous concepts Answer: e Diff: E N
+he correct answer is statement e. +he current ratio in ## was 1.::, while
the current ratio in ##1 was 1.81. =ence, the current ratio was higher in
##. +he debt ratio was #.1:: in ## and #.$$# in ##1, so the debt ratio
decreased from ##1 to ##. +he firm issued >## million in new common stoc%
in ##.
<$ Net inco!e Answer: b Diff: E N
+o determine ## net income, use the following equationF
5nding retained earnings B &eginning .5 T 6/ S 0ividends paid
>;##,###,### B >:##,###,### T 6/ S >$#,###,###
>1$#,###,### B 6/.
<8 *ales, D*O, and inventory turnover Answer: b Diff: " N
Step 1F ,ne of our initial conditions is that inventory turnover 3SA/nv.4
P 8.#, henceF
SalesA/nventory P 8.#
SalesA>;$#,###,### P 8.#
Sales P >$,1##,###,###.
Step F ,ur second initial condition is that 0S, P $#, henceF
A.A3SalesA8$4 P $#.#
>1$#,###,###A3SalesA8$4 P $#.#
V3>1$#,###,###438$4WASales P $#.#
3>1$#,###,###48$ P $#3Sales4
V3>1$#,###,###438$4WA$# P Sales
Sales R >,;$,###,###.
So, the most li%ely estimate of the firm’s ## sales would fall between
>,;$,###,### and >$,1##,###,###. ,nly statement b meets this requirement.
<:  inancial state!ent analysis
Answer: a Diff: E N
+he correct answer is statement a. +he current ratio in ## is 1.#,
while in ##1 it is #.:;$. So, statement a is correct. 2or statement b,
assume that sales are E. +he inventory turnover ratio for ## is EA
>1,###,### and EA>:##,### in ##1. So, the inventory turnover ratio for
##1 is higher than in ##. 3/f that’s not clear, try E B >$##,### or any
other number.4 +hus, statement b is incorrect. +he debt ratio in ## is
#.$<8, while in ##1 it’s #.8:, so statement c is incorrect.
<;  Current ratio
Answer: c Diff: " N
Step 1F 0etermine actual ## salesF
0S, B A.A3SalesA8$4
1# B >1,###A3SalesA8$4
1#3Sales4A8$ B >1,###
1#3Sales4 B >1$:,8;#,###
Sales B >,<1,###.
Step F 0etermine new accounts receivable balance if 0S, B # and sales
remain the sameF
# B A.A3>,<1,###A8$4
# B A.A>1#,;##
A. B >1,###.
Step F 0etermine the amount of freed)up cash and the new level of
accounts payable.
2reed)up cash B >1,### ) >1,### B >1#;,###.
6ew A! B >:##,### ) >1#;,### B >$<,###.
Step 1F 0etermine the new current ratioF
". B 3>1##,### T >1,### T >1,###,###4A3>$<,### T >;##,###4
B >1,11,###A>1,<,###
B 1.#.
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