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

)
Multiple Choice: Conceptual
Easy:
Current ratio Answer: a Diff: E
1
. All else being equal, which of the following will increase a company’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
2
. Pepsi Corporation’s current ratio is 0.5, while Coke Company’s current
ratio is 1.5. Both 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. Which of the statements below
best describes the actual results of these transactions?
a. The transactions will have no effect on the current ratios.
b. The current ratios of both firms will be increased.
c. The current ratios of both firms will be decreased.
d. Only Pepsi Corporation’s current ratio will be increased.
e. Only Coke Company’s current ratio will be increased.
Cash flows Answer: a Diff: E
3
. Which of the following alternatives could potentially result in a net
increase in a company’s cash flow for the current year?
a. Reduce the days sales outstanding ratio.
b. Increase the number of years over which fixed assets are depreciated.
c. Decrease the accounts payable balance.
d. Statements a and b are correct.
e. All of the statements above are correct.
Chapter 3 - Page 1
CHAPTER 3
ANALYSIS OF FINANCIAL STATEMENTS
Leverage and financial ratios Answer: d Diff: E
4
. Stennett Corp.’s CFO has proposed that the company issue new debt and use
the proceeds to buy back common stock. Which of the following are likely
to occur if this proposal is adopted? (Assume that the proposal would
have no effect on the company’s operating income.)
a. Return on assets (ROA) will decline.
b. The times interest earned ratio (TIE) will increase.
c. Taxes paid will decline.
d. Statements a and c are correct.
e. None of the statements above is correct.
Leverage and profitability ratios Answer: e Diff: E
5
. Amazon Electric 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. Which of the following will occur if the
company increases its debt ratio?
a. Its ROA will fall.
b. Its ROE will increase.
c. Its basic earning power (BEP) will stay unchanged.
d. Statements a and c are correct.
e. All of the statements above are correct.
EVA Answer: b Diff: E N
6
. Which of the following statements is most correct?
a. A company that has positive net income must also have positive EVA.
b. If a company’s ROE is greater than its cost of equity, its EVA is
positive.
c. If a company increases its EVA, its ROE 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
7
. Which of the following statements is most correct about Economic Value
Added (EVA)?
a. If a company has no debt, its EVA equals its net income.
b. If a company has positive ROE, its EVA must also be positive.
c. A company’s EVA will be positive whenever the cost of equity exceeds
the ROE.
d. All of the statements above are correct.
e. None of the statements above is correct.
Chapter 3 - Page 2
ROE and EVA Answer: b Diff: E
8
. Devon Inc. has a higher ROE than Berwyn Inc. (17 percent compared to 14
percent), but it has a lower EVA than Berwyn. Which of the following
factors could explain the relative performance of these two companies?
a. Devon is much larger than Berwyn.
b. Devon is riskier, has a higher WACC, and a higher cost of equity.
c. Devon has a higher operating income (EBIT).
d. Statements a and b are correct.
e. All of the statements above are correct.
Ratio analysis Answer: b Diff: E
9
. Bedford Hotels and Breezewood Hotels both have $100 million in total
assets and a 10 percent return on assets (ROA). Each company has a 40
percent tax rate. Bedford, however, has a higher debt ratio and higher
interest expense. Which of the following statements is most correct?
a. The two companies have the same basic earning power (BEP).
b. Bedford has a higher return on equity (ROE).
c. Bedford has a lower level of operating income (EBIT).
d. Statements a and b are correct.
e. All of the statements above are correct.
Financial statement analysis Answer: a Diff: E
10
. Company J and Company K each recently reported the same earnings per
share (EPS). Company J’s stock, however, trades at a higher price. Which
of the following statements is most correct?
a. Company J must have a higher P/E ratio.
b. Company J must have a higher market to book ratio.
c. Company J must be riskier.
d. Company J must have fewer growth opportunities.
e. All of the statements above are correct.
Financial statement analysis Answer: e Diff: E
11
. Company A’s ROE is 20 percent, while Company B’s ROE is 15 percent. Which
of the following statements is most correct?
a. Company A must have a higher ROA than Company B.
b. Company A must have a higher EVA than Company B.
c. Company A must have a higher net income than Company B.
d. All of the statements above are correct.
e. None of the statements above is correct.
Chapter 3 - Page 3
Financial statement analysis Answer: e Diff: E
12
. Company A and Company B have the same total assets, return on assets
(ROA), and profit margin. However, Company A has a higher debt ratio and
interest expense than Company B. Which of the following statements is
most correct?
a. Company A has a higher ROE (return on equity) than Company B.
b. Company A has a higher total assets turnover than Company B.
c. Company A has a higher operating income (EBIT) than Company B.
d. Statements a and b are correct.
e. Statements a and c are correct.
Financial statement analysis Answer: d Diff: E N
13
. Nelson Company is thinking about issuing new common stock. The proceeds
from the stock issue will be used to reduce the company’s outstanding
debt and interest expense. The stock issue will have no effect on the
company’s total assets, EBIT, or tax rate. Which of the following is
likely to occur if the company goes ahead with the stock issue?
a. The company’s net income will increase.
b. The company’s times interest earned ratio will increase.
c. The company’s ROA will increase.
d. All of the above statements are correct.
e. None of the above statements is correct.
Miscellaneous ratios Answer: a Diff: E
14
. Companies A and B have the same profit margin and debt ratio. However,
Company A has a higher return on assets and a higher return on equity
than Company B. Which of the following can explain these observed ratios?
a. Company A must have a higher total assets turnover than Company B.
b. Company A must have a higher equity multiplier than Company B.
c. Company A must have a higher current ratio than Company B.
d. Statements b and c are correct.
e. All of the statements above are correct.
Miscellaneous ratios Answer: e Diff: E R
15
. Bichette Furniture Company recently issued new common stock and used the
proceeds to reduce its short-term notes payable and accounts payable.
This action had no effect on the company’s total assets or operating
income. Which of the following effects did occur as a result of this
action?
a. The company’s current ratio decreased.
b. The company’s basic earning power ratio increased.
c. The company’s time interest earned ratio decreased.
d. The company’s debt ratio increased.
e. The company’s equity multiplier decreased.
Chapter 3 - Page 4
Medium:
Current ratio Answer: d Diff: M
16
. Van Buren Company has a current ratio = 1.9. Which of the following
actions will increase the company’s current ratio?
a. Use cash to reduce short-term notes payable.
b. Use cash to reduce accounts payable.
c. Issue 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: M
17
. Which of the following actions can a firm take to increase its current
ratio?
a. Issue short-term debt and use the proceeds to buy back long-term debt
with a maturity of more than one year.
b. Reduce the company’s days sales outstanding to the industry average
and use the resulting cash savings to purchase plant and equipment.
c. Use cash to purchase additional inventory.
d. Statements a and b are correct.
e. None of the statements above is correct.
Ratio analysis Answer: c Diff: M
18
. 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 likely prefer?
Current Debt
ratio TIE ratio
a. 0.5 0.5 0.33
b. 1.0 1.0 0.50
c. 1.5 1.5 0.50
d. 2.0 1.0 0.67
e. 2.5 0.5 0.71
Ratio analysis Answer: c Diff: M N
19
. Drysdale Financial Company and Commerce Financial Company have the same
total assets, the same total assets turnover, and the same return on
equity. However, Drysdale has a higher return on assets than Commerce.
Which of the following can explain these ratios?
a. Drysdale has a higher profit margin and a higher debt ratio than
Commerce.
b. Drysdale has a lower profit margin and a lower debt ratio than
Commerce.
c. Drysdale has a higher profit margin and a lower debt ratio than
Commerce.
d. Drysdale has lower net income but more common equity than Commerce.
Chapter 3 - Page 5
e. Drysdale has a lower price earnings ratio than Commerce.
Ratio analysis Answer: a Diff: M
20
. You are an analyst following two companies, Company X and Company Y. You
have collected the following information:
• The two companies have the same total assets.
• Company X has a higher total assets turnover than Company Y.
• Company X has a higher profit margin than Company Y.
• Company Y has a higher inventory turnover ratio than Company X.
• Company Y has a higher current ratio than Company X.
Which of the following statements is most correct?
a. Company X must have a higher net income.
b. Company X must have a higher ROE.
c. Company Y must have a higher ROA.
d. Statements a and b are correct.
e. Statements a and c are correct.
Effects of leverage Answer: a Diff: M
21
. Which 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. The 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.
Financial statement analysis Answer: a Diff: M
22
. Which 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 DSO, other things held constant, would generally
lead to an increase in the total assets turnover ratio.
c. An increase in the DSO, other things held constant, would generally
lead to an increase in the ROE.
d. In 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 markets.
e. It is more important to adjust the debt ratio than the inventory
turnover ratio to account for seasonal fluctuations.
Chapter 3 - Page 6
Financial statement analysis Answer: d Diff: M N
23
. Harte Motors and Mills Automotive each have the same total assets, the
same level of sales, and the same return on equity (ROE). Harte Motors,
however, has less equity and a higher debt ratio than does Mills
Automotive. Which of the following statements is most correct?
a. Mills Automotive has a higher net income than Harte Motors.
b. Mills Automotive has a higher profit margin than Harte Motors.
c. Mills Automotive has a higher return on assets (ROA) than Harte
Motors.
d. All of the statements above are correct.
e. None of the statements above is correct.
Leverage and financial ratios Answer: e Diff: M
24
. Company A and Company B have the same total assets, tax rate, and net
income. Company A, however, has a lower profit margin than Company B.
Company A also has a higher debt ratio and, therefore, higher interest
expense than Company B. Which of the following statements is most correct?
a. Company A has a higher total assets turnover.
b. Company A has a higher return on equity.
c. Company 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: M N
25
. Company A and Company B have the same tax rate, total assets, and basic
earning power. Both companies have positive net incomes. Company A has a
higher debt ratio, and therefore, higher interest expense than Company B.
Which of the following statements is true?
a. Company A has a higher ROA than Company B.
b. Company A has a higher times interest earned (TIE) ratio than Company B.
c. Company A has a higher net income than Company B.
d. Company A pays less in taxes than Company B.
e. Company A has a lower equity multiplier than Company B.
Du Pont equation Answer: b Diff: M R
26
. You observe that a firm’s profit margin is below the industry average,
while its return on equity and debt ratio exceed the industry average.
What can you conclude?
a. Return on assets must be above the industry average.
b. Total assets turnover must be above the industry average.
c. Total assets turnover must be below the industry average.
d. Statements a and b are correct.
e. None of the statements above is correct.
Chapter 3 - Page 7
ROE and EVA Answer: d Diff: M
27
. Huxtable Medical’s CFO recently estimated that the company’s EVA for the
past year was zero. The company’s cost of equity capital is 14 percent,
its cost of debt is 8 percent, and its debt ratio is 40 percent. Which
of the following statements is most correct?
a. The company’s net income was zero.
b. The company’s net income was negative.
c. The company’s ROA was 14 percent.
d. The company’s ROE was 14 percent.
e. The company’s after-tax operating income was less than the total
dollar cost of capital.
ROE and EVA Answer: b Diff: M
28
. Which of the following statements is most correct?
a. If two firms have the same ROE and the same level of risk, they must
also have the same EVA.
b. If a firm has positive EVA, this implies that its ROE exceeds its cost
of equity.
c. If a firm has positive ROE, this implies that its EVA is also
positive.
d. Statements b and c are correct.
e. All of the statements above are correct.
Miscellaneous ratios Answer: b Diff: M
29
. Which of the following statements is most correct?
a. If Firms A and B have the same earnings per share and market to book
ratio, they must have the same price earnings ratio.
b. Firms A and B have the same net income, taxes paid, and total assets.
If Firm A has a higher interest expense, its basic earnings power
ratio (BEP) must be greater than that of Firm B.
c. Firms A and B have the same net income. If Firm A has a higher
interest expense, its return on equity (ROE) must be greater than that
of Firm B.
d. All of the statements above are correct.
e. None of the statements above is correct.
Chapter 3 - Page 8
Miscellaneous ratios Answer: e Diff: M
30
. Reeves Corporation forecasts that its operating income (EBIT) and total
assets will remain the same as last year, but that the company’s debt
ratio will increase this year. What can you conclude about the company’s
financial ratios? (Assume that there will be no change in the company’s
tax rate.)
a. The company’s basic earning power (BEP) will fall.
b. The company’s return on assets (ROA) will fall.
c. The company’s equity multiplier (EM) will increase.
d. All of the statements above are correct.
e. Statements b and c are correct.
Miscellaneous ratios Answer: d Diff: M
31
. Company X has a higher ROE than Company Y, but Company Y has a higher ROA
than Company X. Company X also has a higher total assets turnover ratio
than Company Y; however, the two companies have the same total assets.
Which of the following statements is most correct?
a. Company X has a lower debt ratio than Company Y.
b. Company X has a lower profit margin than Company Y.
c. Company X has a lower net income than Company Y.
d. Statements b and c are correct.
e. All of the statements above are correct.
Tough:
ROE and EVA Answer: a Diff: T
32
. Division A has a higher ROE than Division B, yet Division B creates more
value for shareholders and has a higher EVA than Division A. Both
divisions, however, have positive ROEs and EVAs. What could explain these
performance measures?
a. Division A is riskier than Division B.
b. Division A is much larger (in terms of equity capital employed) than
Division B.
c. Division A has less debt than Division B.
d. Statements a and b are correct.
e. All of the statements above are correct.
Chapter 3 - Page 9
Ratio analysis Answer: d Diff: T
33
. You have collected the following information regarding Companies C and D:
• The two companies have the same total assets.
• The two companies have the same operating income (EBIT).
• The two companies have the same tax rate.
• Company C has a higher debt ratio and interest expense than Company D.
• Company C has a lower profit margin than Company D.
On the basis of this information, which of the following statements is
most correct?
a. Company C must have a higher level of sales.
b. Company C must have a lower ROE.
c. Company C must have a higher times interest earned (TIE) ratio.
d. Company C must have a lower ROA.
e. Company C must have a higher basic earning power (BEP) ratio.
Ratio analysis Answer: d Diff: T
34
. An analyst has obtained the following information regarding two
companies, Company X and Company Y:
• Company X and Company Y have the same total assets.
• Company X has a higher interest expense than Company Y.
• Company X has a lower operating income (EBIT) than Company Y.
• Company X and Company Y have the same return on equity (ROE).
• Company X and Company Y have the same total assets turnover (TATO).
• Company X and Company Y have the same tax rate.
On the basis of this information, which of the following statements is
most correct?
a. Company X has a higher times interest earned (TIE) ratio.
b. Company X and Company Y have the same debt ratio.
c. Company X has a higher return on assets (ROA).
d. Company X has a lower profit margin.
e. Company X has a higher basic earning power (BEP) ratio.
Ratio analysis and Du Pont equation Answer: d Diff: T
35
. Lancaster Co. and York Co. both have the same return on assets (ROA).
However, Lancaster has a higher total assets turnover and a higher equity
multiplier than York. Which of the following statements is most correct?
a. Lancaster has a lower profit margin than York.
b. Lancaster has a lower debt ratio than York.
c. Lancaster has a higher return on equity (ROE) than York.
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: T
36
. Blair Company has $5 million in total assets. The company’s assets are
financed with $1 million of debt and $4 million of common equity. The
company’s income statement is summarized below:
Operating income (EBIT) $1,000,000
Interest 100,000
Earnings before taxes (EBT) $ 900,000
Taxes (40%) 360,000
Net income $ 540,000
The company wants to increase its assets by $1 million, and it plans to
finance this increase by issuing $1 million in new debt. This action
will double the company’s interest expense but its operating income will
remain at 20 percent of its total assets, and its average tax rate will
remain at 40 percent. If the company takes this action, which of the
following will occur:
a. The company’s net income will increase.
b. The company’s return on assets will fall.
c. The company’s return on equity will remain the same.
d. Statements a and b are correct.
e. All of the statements above are correct.
Miscellaneous ratios Answer: c Diff: T
37
. Some key financial data and ratios are reported in the table below for
Hemmingway Hotels and for its competitor, Fitzgerald Hotels:
Ratio Hemmingway Hotels Fitzgerald Hotels
Profit margin 4% 3%
ROA 9% 8%
Total assets $2.0 billion $1.5 billion
BEP 20% 20%
ROE 18% 24%
On the basis of the information above, which of the following statements
is most correct?
a. Hemmingway has a higher total assets turnover than Fitzgerald.
b. Hemmingway has a higher debt ratio than Fitzgerald.
c. Hemmingway has higher net income than Fitzgerald.
d. Statements a and b are correct.
e. All of the statements above are correct.
Chapter 3 - Page 11
Multiple Choice: Problems
Easy:
Financial statement analysis Answer: a Diff: E
38
. Russell Securities has $100 million in total assets and its corporate tax
rate is 40 percent. The company recently reported that its basic earning
power (BEP) ratio was 15 percent and its return on assets (ROA) was 9
percent. What was the company’s interest expense?
a. $ 0
b. $ 2,000,000
c. $ 6,000,000
d. $15,000,000
e. $18,000,000
Market price per share Answer: b Diff: E
39
. You are given the following information: Stockholders’ equity = $1,250;
price/earnings ratio = 5; shares outstanding = 25; and market/book ratio
= 1.5. Calculate the market price of a share of the company’s stock.
a. $ 33.33
b. $ 75.00
c. $ 10.00
d. $166.67
e. $133.32
Market price per share Answer: c Diff: E
40
. Given the following information, calculate the market price per share of
WAM Inc.:
Net income $200,000.00
Earnings per share $2.00
Stockholders’ equity $2,000,000.00
Market/Book ratio 0.20
a. $20.00
b. $ 8.00
c. $ 4.00
d. $ 2.00
e. $ 1.00
Market/book ratio Answer: c Diff: E
41
. Meyersdale Office Supplies has common equity of $40 million. The
company’s stock price is $80 per share and its market/book ratio is 4.0.
How many shares of stock does the company have outstanding?
a. 500,000
b. 125,000
c. 2,000,000
Chapter 3 - Page 12
d. 800,000,000
e. Insufficient information.
Market/book ratio Answer: e Diff: E N
42
. Strack Houseware Supplies Inc. has $2 billion in total assets. The other
side of its balance sheet consists of $0.2 billion in current liabilities,
$0.6 billion in long-term debt, and $1.2 billion in common equity. The
company has 300 million shares of common stock outstanding, and its stock
price is $20 per share. What is Strack’s market/book ratio?
a. 1.25
b. 2.65
c. 3.15
d. 4.40
e. 5.00
ROA Answer: d Diff: E
43
. A firm has a profit margin of 15 percent on sales of $20,000,000. If the
firm has debt of $7,500,000, total assets of $22,500,000, and an after-
tax interest cost on total debt of 5 percent, what is the firm’s ROA?
a. 8.4%
b. 10.9%
c. 12.0%
d. 13.3%
e. 15.1%
TIE ratio Answer: b Diff: E
44
. Culver Inc. has earnings after interest but before taxes of $300. The
company’s times interest earned ratio is 7.00. Calculate the company’s
interest charges.
a. $42.86
b. $50.00
c. $40.00
d. $60.00
e. $57.93
Chapter 3 - Page 13
ROE Answer: c Diff: E
45
. Tapley Dental Supply Company has the following data:
Net income $240
Sales $10,000
Total assets $6,000
Debt ratio 75%
TIE ratio 2.0
Current ratio 1.2
BEP ratio 13.33%
If Tapley could streamline operations, cut operating costs, and raise net
income to $300 without affecting sales or the balance sheet (the
additional profits will be paid out as dividends), by how much would its
ROE increase?
a. 3.00%
b. 3.50%
c. 4.00%
d. 4.25%
e. 5.50%
Profit margin Answer: c Diff: E
46
. Your company had the following balance sheet and income statement
information for 2002:
Balance Sheet:
Cash $ 20
A/R 1,000
Inventories 5,000
Total current assets $6,020 Debt $4,000
Net fixed assets 2,980 Equity 5,000
Total assets $9,000 Total claims $9,000
Income Statement:
Sales $10,000
Cost of goods sold 9,200
EBIT $ 800
Interest (10%) 400
EBT $ 400
Taxes (40%) 160
Net income $ 240
The industry average inventory turnover is 5. You think 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. The cash generated from reducing inventories
will be used to buy tax-exempt securities that have a 7 percent rate of
return. What will your profit margin be after the change in inventories
is reflected in the income statement?
a. 2.1%
b. 2.4%
c. 4.5%
Chapter 3 - Page 14
d. 5.3%
e. 6.7%
Du Pont equation Answer: a Diff: E
47
. The Wilson Corporation has the following relationships:
Sales/Total assets 2.0×
Return on assets (ROA) 4.0%
Return on equity (ROE) 6.0%
What is Wilson’s profit margin and debt ratio?
a. 2%; 0.33
b. 4%; 0.33
c. 4%; 0.67
d. 2%; 0.67
e. 4%; 0.50
P/E ratio and stock price Answer: b Diff: E
48
. The Charleston Company is a relatively small, privately owned firm. Last
year the company had net income of $15,000 and 10,000 shares were
outstanding. The owners were trying to determine the equilibrium market
value for the stock prior to taking the company public. A similar firm
that is publicly traded had a price/earnings ratio of 5.0. Using only
the information given, estimate the market value of one share of
Charleston’s stock.
a. $10.00
b. $ 7.50
c. $ 5.00
d. $ 2.50
e. $ 1.50
P/E ratio and stock price Answer: e Diff: E
49
. Cleveland Corporation has 100,000 shares of common stock outstanding, its
net income is $750,000, and its P/E is 8. What is the company’s stock
price?
a. $20.00
b. $30.00
c. $40.00
d. $50.00
e. $60.00
Chapter 3 - Page 15
Current ratio and inventory Answer: b Diff: E N
50
. Iken Berry Farms has $5 million in current assets, $3 million in current
liabilities, and its initial inventory level is $1 million. The company
plans to increase its inventory, and it will raise additional short-term
debt (that will show up as notes payable on the balance sheet) to
purchase the inventory. Assume that the value of the remaining current
assets will not change. The company’s bond covenants require it to
maintain a current ratio that is greater than or equal to 1.5. What is
the maximum amount that the company can increase its inventory before it
is restricted by these covenants?
a. $0.50 million
b. $1.00 million
c. $1.33 million
d. $1.66 million
e. $2.33 million
Medium:
Accounts receivable increase Answer: b Diff: M R
51
. Cannon Company has enjoyed a rapid increase in sales in recent years,
following a decision to sell on credit. However, the firm has noticed a
recent increase in its collection period. Last year, total sales were $1
million, and $250,000 of these sales were on credit. During the year, the
accounts receivable account averaged $41,096. It is expected that sales
will increase in the forthcoming year by 50 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 50 percent.
If the resulting increase in accounts receivable must be financed
externally, how much external funding will Cannon need? Assume a 365-day
year.
a. $ 41,096
b. $ 51,370
c. $ 47,359
d. $106,471
e. $ 92,466
Accounts receivable Answer: a Diff: M R
52
. Ruth Company currently has $1,000,000 in accounts receivable. Its days
sales outstanding (DSO) is 50 days. The company wants to reduce its DSO
to the industry average of 32 days by pressuring more of its customers to
pay their bills on time. The company’s CFO estimates that if this policy
is adopted the company’s average sales will fall by 10 percent. Assuming
that the company adopts this change and succeeds in reducing its DSO to 32
days and does lose 10 percent of its sales, what will be the level of
accounts receivable following the change? Assume a 365-day year.
a. $576,000
b. $633,333
c. $750,000
Chapter 3 - Page 16
d. $900,000
e. $966,667
ROA Answer: a Diff: M
53
. A fire has destroyed a large percentage of the financial records of the
Carter Company. You have the task of piecing together information in
order to release a financial report. You have found the return on equity
to be 18 percent. If sales were $4 million, the debt ratio was 0.40, and
total liabilities were $2 million, what would be the return on assets
(ROA)?
a. 10.80%
b. 0.80%
c. 1.25%
d. 12.60%
e. Insufficient information.
ROA Answer: e Diff: M
54
. Humphrey Hotels’ operating income (EBIT) is $40 million. The company’s
times interest earned (TIE) ratio is 8.0, its tax rate is 40 percent, and
its basic earning power (BEP) ratio is 10 percent. What is the company’s
return on assets (ROA)?
a. 6.45%
b. 5.97%
c. 4.33%
d. 8.56%
e. 5.25%
ROA Answer: c Diff: M N
55
. Viera Company has $500,000 in total assets. The company’s basic
earning power (BEP) is 10 percent, its times interest earned (TIE)
ratio is 5, and the company’s tax rate is 40 percent. What is the
company’s return on assets (ROA)?
a. 3.2%
b. 4.0%
c. 4.8%
d. 6.0%
e. 7.2%
ROE Answer: c Diff: M R
56
. Selzer Inc. sells all its merchandise on credit. It has a profit margin
of 4 percent, days sales outstanding equal to 60 days, receivables of
$150,000, total assets of $3 million, and a debt ratio of 0.64. What is
the firm’s return on equity (ROE)? Assume a 365-day year.
a. 7.1%
b. 33.4%
c. 3.4%
d. 71.0%
Chapter 3 - Page 17
e. 8.1%
Chapter 3 - Page 18
ROE Answer: b Diff: M
57
. A firm has a debt/equity ratio of 50 percent. Currently, it has interest
expense of $500,000 on $5,000,000 of total debt outstanding. Its tax rate
is 40 percent. If the firm’s ROA is 6 percent, by how many percentage
points is the firm’s ROE greater than its ROA?
a. 0.0%
b. 3.0%
c. 5.2%
d. 7.4%
e. 9.0%
ROE Answer: d Diff: M
58
. Assume Meyer Corporation is 100 percent equity financed. Calculate the
return on equity, given the following information:
Earnings before taxes $1,500
Sales $5,000
Dividend payout ratio 60%
Total assets turnover 2.0
Tax rate 30%
a. 25%
b. 30%
c. 35%
d. 42%
e. 50%
ROE Answer: c Diff: M
59
. The Amer Company has the following characteristics:
Sales $1,000
Total assets $1,000
Total debt/Total assets 35.00%
Basic earning power (BEP) ratio 20.00%
Tax rate 40.00%
Interest rate on total debt 4.57%
What is Amer’s ROE?
a. 11.04%
b. 12.31%
c. 16.99%
d. 28.31%
e. 30.77%
Chapter 3 - Page 19
Equity multiplier Answer: d Diff: M
60
. A firm that has an equity multiplier of 4.0 will have a debt ratio of
a. 4.00
b. 3.00
c. 1.00
d. 0.75
e. 0.25
TIE ratio Answer: e Diff: M
61
. Alumbat Corporation has $800,000 of debt outstanding, and it pays an
interest rate of 10 percent annually on its bank loan. Alumbat’s annual
sales are $3,200,000, its average tax rate is 40 percent, and its net
profit margin on sales is 6 percent. If the company does not maintain a
TIE ratio of at least 4 times, its bank will refuse to renew its loan,
and bankruptcy will result. What is Alumbat’s current TIE ratio?
a. 2.4
b. 3.4
c. 3.6
d. 4.0
e. 5.0
TIE ratio Answer: b Diff: M N
62
. Moss Motors has $8 billion in assets, and its tax rate is 40 percent. The
company’s basic earning power (BEP) ratio is 12 percent, and its return
on assets (ROA) is 3 percent. What is Moss’ times interest earned (TIE)
ratio?
a. 2.25
b. 1.71
c. 1.00
d. 1.33
e. 2.50
TIE ratio Answer: b Diff: M
63
. Lancaster Motors has total assets of $20 million. Its basic earning power
is 25 percent, its return on assets (ROA) is 10 percent, and the
company’s tax rate is 40 percent. What is Lancaster’s TIE ratio?
a. 2.5
b. 3.0
c. 1.5
d. 1.2
e. 0.6
Chapter 3 - Page 20
TIE ratio Answer: d Diff: M N
64
. Roll’s Boutique currently has total assets of $3 million in operation.
Over this year, its performance yielded a basic earning power (BEP) of 25
percent and a return on assets (ROA) of 12 percent. The firm’s earnings
are subject to a 35 percent tax rate. On the basis of this information,
what is the firm’s times interest earned (TIE) ratio?
a. 1.84
b. 1.92
c. 2.83
d. 3.82
e. 4.17
EBITDA coverage ratio Answer: a Diff: M N
65
. Peterson Packaging Corp. has $9 billion in total assets. The company’s
basic earning power (BEP) ratio is 9 percent, and its times interest
earned ratio is 3.0. Peterson’s depreciation and amortization expense
totals $1 billion. It has $0.6 billion in lease payments and $0.3
billion must go towards principal payments on outstanding loans and long-
term debt. What is Peterson’s EBITDA coverage ratio?
a. 2.06
b. 1.52
c. 2.25
d. 1.10
e. 2.77
Debt ratio Answer: c Diff: M
66
. Kansas Office Supply had $24,000,000 in sales last year. The company’s
net income was $400,000, its total assets turnover was 6.0, and the
company’s ROE was 15 percent. The company is financed entirely with debt
and common equity. What is the company’s debt ratio?
a. 0.20
b. 0.30
c. 0.33
d. 0.60
e. 0.66
Profit margin Answer: a Diff: M
67
. The Merriam Company has determined that its return on equity is 15
percent. Management is interested in the various components that went into
this calculation. You are given the following information: total
debt/total assets = 0.35 and total assets turnover = 2.8. What is the
profit margin?
a. 3.48%
b. 5.42%
c. 6.96%
d. 2.45%
Chapter 3 - Page 21
e. 12.82%
Financial statement analysis Answer: e Diff: M R
68
. Collins Company had the following partial balance sheet and complete
income statement information for 2002:
Partial Balance Sheet:
Cash $ 20
A/R 1,000
Inventories 2,000
Total current assets $ 3,020
Net fixed assets 2,980
Total assets $ 6,000
Income Statement:
Sales $10,000
Cost of goods sold 9,200
EBIT $ 800
Interest (10%) 400
EBT $ 400
Taxes (40%) 160
Net income $ 240
The industry average DSO is 30 (assuming a 365-day year). Collins plans
to change its credit policy so as to cause its DSO to equal the industry
average, and this change is expected to have no effect on either sales or
cost of goods sold. If the cash generated from reducing receivables is
used to retire debt (which was outstanding all last year and has a 10
percent interest rate), what will Collins’ debt ratio (Total debt/Total
assets) be after the change in DSO is reflected in the balance sheet?
a. 33.33%
b. 45.28%
c. 52.75%
d. 60.00%
e. 65.65%
Financial statement analysis Answer: b Diff: M R
69
. Taft Technologies has the following relationships:
Annual sales $1,200,000.00
Current liabilities $ 375,000.00
Days sales outstanding (DSO) (365-day year) 40.00
Inventory turnover ratio 4.80
Current ratio 1.20
The company’s current assets consist of cash, inventories, and accounts
receivable. How much cash does Taft have on its balance sheet?
a. -$ 8,333
b. $ 68,493
c. $125,000
d. $200,000
Chapter 3 - Page 22
e. $316,667
Basic earning power Answer: d Diff: M
70
. Aaron Aviation recently reported the following information:
Net income $500,000
ROA 10%
Interest expense $200,000
The company’s average tax rate is 40 percent. What is the company’s
basic earning power (BEP)?
a. 14.12%
b. 16.67%
c. 17.33%
d. 20.67%
e. 22.50%
P/E ratio and stock price Answer: e Diff: M
71
. Dean Brothers Inc. recently reported net income of $1,500,000. The
company has 300,000 shares of common stock, and it currently trades at $60
a share. The company continues to expand and anticipates that one year
from now its net income will be $2,500,000. Over the next year the
company also anticipates issuing an additional 100,000 shares of stock, so
that one year from now the company will have 400,000 shares of common
stock. Assuming the company’s price/earnings ratio remains at its current
level, what will be the company’s stock price one year from now?
a. $55
b. $60
c. $65
d. $70
e. $75
Current ratio and DSO Answer: a Diff: M
72
. Parcells Jets has the following balance sheet (in millions):
Cash $ 100 Notes payable $ 100
Inventories 300 Accounts payable 200
Accounts receivable 400 Accruals 100
Total current assets $ 800 Total current liabilities $ 400
Net fixed assets 1,200 Long-term bonds 600
Total debt $1,000
______ Total common equity 1,000
Total assets $2,000 Total liabilities and equity $2,000
Parcells’ DSO (on a 365-day basis) is 40, which is above the industry
average of 30. Assume that Parcells is able to reduce its DSO to the
industry average without reducing sales, and the company takes the freed-
up cash and uses it to reduce its outstanding long-term bonds. If this
occurs, what will be the new current ratio?
a. 1.75
b. 1.33
Chapter 3 - Page 23
c. 2.33
d. 1.25
e. 1.67
Current ratio Answer: c Diff: M N
73
. Cartwright Brothers has the following balance sheet (all numbers are
expressed in millions of dollars):
Cash $ 250 Accounts payable $ 300
Accounts receivable 250 Notes payable 300
Inventories 250 Long-term debt 600
Net fixed assets 1,250 Common stock 800
Total assets $2,000 Total claims $2,000
Cartwright’s average daily sales are $10 million. Currently,
Cartwright’s days sales outstanding (DSO) is well above the industry
average of 15. Cartwright is implementing a plan that is designed to
reduce its DSO to 15 without reducing its sales. If 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. What will be the
current ratio if Cartwright fully succeeds in implementing this plan?
a. 1.00
b. 0.63
c. 1.30
d. 1.25
e. 1.50
Current ratio Answer: b Diff: M N
74
. Jefferson Co. has $2 million in total assets and $3 million in sales. The
company has the following balance sheet:
Cash $ 100,000 Accounts payable $ 200,000
Accounts receivable 200,000 Accruals 100,000
Inventories 500,000 Notes payable 200,000
Net fixed assets 1,200,000 Long-term debt 700,000
Common equity 800,000
Total liabilities
Total assets $2,000,000 and equity $2,000,000
Jefferson wants to improve its inventory turnover ratio so that it equals
the industry average of 10.0× . The company would like to accomplish
this goal without reducing sales. If successful, the company would take
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. What
will be Jefferson’s current ratio, if it is able to accomplish its goal
of improving its inventory management?
a. 1.43
b. 1.50
c. 2.50
d. 2.00
Chapter 3 - Page 24
e. 1.20
Chapter 3 - Page 25
Credit policy and ROE Answer: c Diff: M R
75
. Daggy Corporation has the following simplified balance sheet:
Cash $ 25,000 Current liabilities $200,000
Inventories 190,000
Accounts receivable 125,000 Long-term debt 300,000
Net fixed assets 360,000 Common equity 200,000
Total assets $700,000 Total claims $700,000
The company has been advised that their credit policy is too generous and
that they should reduce their days sales outstanding to 36 days (assume a
365-day year). The increase in cash resulting from the decrease in
accounts receivable will be used to reduce the company’s long-term debt.
The interest rate on long-term debt is 10 percent and the company’s tax
rate is 30 percent. The tighter credit policy is expected to reduce the
company’s sales to $730,000 and result in EBIT of $70,000. What is the
company’s expected ROE after the change in credit policy?
a. 14.88%
b. 16.63%
c. 15.86%
d. 18.38%
e. 16.25%
Du Pont equation Answer: d Diff: M
76
. Austin & Company has a debt ratio of 0.5, a total assets turnover ratio
of 0.25, and a profit margin of 10 percent. The Board of Directors is
unhappy with the current return on equity (ROE), and they think it could
be doubled. This could be accomplished (1) by increasing the profit
margin to 12 percent and (2) by increasing debt utilization. Total
assets turnover will not change. What new debt ratio, along with the new
12 percent profit margin, would be required to double the ROE?
a. 55%
b. 60%
c. 65%
d. 70%
e. 75%
Sales and extended Du Pont equation Answer: a Diff: M
77
. Shepherd Enterprises has an ROE of 15 percent, a debt ratio of 40
percent, and a profit margin of 5 percent. The company’s total assets
equal $800 million. What are the company’s sales? (Assume that the
company has no preferred stock.)
a. $1,440,000,000
b. $2,400,000,000
c. $ 120,000,000
d. $ 360,000,000
e. $ 960,000,000
Chapter 3 - Page 26
Net income and Du Pont equation Answer: c Diff: M N
78
. Samuels Equipment has $10 million in sales. Its ROE is 15 percent and
its total assets turnover is 3.5× . The company is 100 percent equity
financed. What is the company’s net income?
a. $1,500,000
b. $2,857,143
c. $ 428,571
d. $2,333,333
e. $ 52,500
Tough:
ROE Answer: c Diff: T
79
. Roland & Company has a new management team that has developed an
operating plan to improve upon last year’s ROE. The new plan would place
the debt ratio at 55 percent, which will result in interest charges of
$7,000 per year. EBIT is projected to be $25,000 on sales of $270,000,
it expects to have a total assets turnover ratio of 3.0, and the average
tax rate will be 40 percent. What does Roland & Company expect its
return on equity to be following the changes?
a. 17.65%
b. 21.82%
c. 26.67%
d. 44.44%
e. 51.25%
Chapter 3 - Page 27
ROE Answer: d Diff: T
80
. Georgia Electric reported the following income statement and balance
sheet for the previous year:
Balance Sheet:
Cash $ 100,000
Inventories 1,000,000
Accounts receivable 500,000
Current assets $1,600,000
Total debt $4,000,000
Net fixed assets 4,400,000 Total equity 2,000,000
Total assets $6,000,000 Total claims $6,000,000
Income Statement:
Sales $3,000,000
Operating costs 1,600,000
Operating income (EBIT) $1,400,000
Interest 400,000
Taxable income (EBT) $1,000,000
Taxes (40%) 400,000
Net income $ 600,000
The company’s interest cost is 10 percent, so the company’s interest
expense each year is 10 percent of its total debt.
While the company’s financial performance is quite strong, its CFO (Chief
Financial Officer) is always looking for ways to improve. The CFO has
noticed that the company’s inventory turnover ratio is considerably
weaker than the industry average, which is 6.0. As an exercise, the CFO
asks what would the company’s ROE have been last year if the following
had occurred:
• The company maintained the same sales, but was able to reduce
inventories enough to achieve the industry average inventory
turnover ratio.
• The 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 $4 million less the freed-up
cash from the improvement in inventory policy. The company’s
interest expense would have been 10 percent of new total debt.
• Assume equity does not change. (The company pays all net income as
dividends.)
Under this scenario, what would have been the company’s ROE last year?
a. 27.0%
b. 29.5%
c. 30.3%
d. 31.5%
e. 33.0%
Chapter 3 - Page 28
ROE and financing Answer: a Diff: T
81
. Savelots Stores’ current financial statements are shown below:
Balance Sheet:
Inventories $ 500 Accounts payable $ 100
Other current assets 400 Short-term notes payable 370
Fixed assets 370 Common equity 800
Total assets $1,270 Total liab. and equity $1,270
Income Statement:
Sales $2,000
Operating costs 1,843
EBIT $ 157
Interest 37
EBT $ 120
Taxes (40%) 48
Net income $ 72
A recently released report indicates that Savelots’ current ratio of 1.9
is in line with the industry average. However, its accounts payable,
which have no interest cost and are due entirely to purchases of
inventories, amount to only 20 percent of inventories versus an industry
average of 60 percent. Suppose Savelots took actions to increase its
accounts payable to inventories ratio to the 60 percent industry average,
but it (1) kept all of its assets at their present levels (that is, the
asset side of the balance sheet remains constant) and (2) also held its
current ratio constant at 1.9. Assume that Savelots’ tax rate is 40
percent, that its cost of short-term debt is 10 percent, and that the
change in payments will not affect operations. In addition, common equity
will not change. With the changes, what will be Savelots’ new ROE?
a. 10.5%
b. 7.8%
c. 9.0%
d. 13.2%
e. 12.0%
Chapter 3 - Page 29
ROE and refinancing Answer: d Diff: T
82
. Aurillo Equipment Company (AEC) projected that its ROE for next year
would be just 6 percent. However, the financial staff has determined
that the firm can increase its ROE by refinancing some high interest
bonds currently outstanding. The firm’s total debt will remain at
$200,000 and the debt ratio will hold constant at 80 percent, but the
interest rate on the refinanced debt will be 10 percent. The rate on the
old debt is 14 percent. Refinancing will not affect sales, which are
projected to be $300,000. EBIT will be 11 percent of sales and the
firm’s tax rate is 40 percent. If AEC refinances its high interest
bonds, what will be its projected new ROE?
a. 3.0%
b. 8.2%
c. 10.0%
d. 15.6%
e. 18.7%
TIE ratio Answer: d Diff: T
83
. Lombardi Trucking Company has the following data:
Assets $10,000
Profit margin 3.0%
Tax rate 40%
Debt ratio 60.0%
Interest rate 10.0%
Total assets turnover 2.0
What is Lombardi’s TIE ratio?
a. 0.95
b. 1.75
c. 2.10
d. 2.67
e. 3.45
Current ratio Answer: e Diff: T
84
. Victoria Enterprises has $1.6 million of accounts receivable on its
balance sheet. The company’s DSO is 40 (based on a 365-day year), its
current assets are $2.5 million, and its current ratio is 1.5. The
company plans to reduce its DSO from 40 to the industry average of 30
without causing a decline in sales. The resulting decrease in accounts
receivable will free up cash that will be used to reduce current
liabilities. If the company succeeds in its plan, what will Victoria’s
new current ratio be?
a. 1.50
b. 1.97
c. 1.26
d. 0.72
Chapter 3 - Page 30
e. 1.66
P/E ratio and stock price Answer: b Diff: T
85
. XYZ’s balance sheet and income statement are given below:
Balance Sheet:
Cash $ 50 Accounts payable $ 100
A/R 150 Notes payable 0
Inventories 300 Long-term debt (10%) 700
Fixed assets 500 Common equity (20 shares) 200
Total assets $1,000 Total liabilities and equity $1,000
Income Statement:
Sales $1,000
Cost of goods sold 855
EBIT $ 145
Interest 70
EBT $ 75
Taxes (33.333%) 25
Net income $ 50
The industry average inventory turnover is 5, the interest rate on the
firm’s long-term debt is 10 percent, 20 shares are outstanding, and the
stock sells at a P/E of 8.0. If XYZ 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 back common stock at the current
market price and thus to reduce common equity, and if sales, the cost of
goods sold, and the P/E ratio remained constant, by what dollar amount
would its stock price increase?
a. $ 3.33
b. $ 6.67
c. $ 8.75
d. $10.00
e. $12.50
Du Pont equation and debt ratio Answer: e Diff: T
86
. Company A has sales of $1,000, assets of $500, a debt ratio of 30
percent, and an ROE of 15 percent. Company B has the same sales, assets,
and net income as Company A, but its ROE is 30 percent. What is B’s debt
ratio? (Hint: Begin by looking at the Du Pont equation.)
a. 25.0%
b. 35.0%
c. 50.0%
d. 52.5%
e. 65.0%
Chapter 3 - Page 31
Financial statement analysis Answer: a Diff: T
87
. A company has just been taken over by new management that believes it can
raise earnings before taxes (EBT) from $600 to $1,000, merely by cutting
overtime pay and reducing cost of goods sold. Prior to the change, the
following data applied:
Total assets $8,000
Debt ratio 45%
Tax rate 35%
BEP ratio 13.3125%
EBT $600
Sales $15,000
These 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. What is the company’s cost of debt? (Hint: Work only with
old data.)
a. 12.92%
b. 13.23%
c. 13.51%
d. 13.75%
e. 14.00%
EBIT Answer: e Diff: T
88
. Lone Star Plastics has the following data:
Assets $100,000
Profit margin 6.0%
Tax rate 40%
Debt ratio 40.0%
Interest rate 8.0%
Total assets turnover 3.0
What is Lone Star’s EBIT?
a. $ 3,200
b. $12,000
c. $18,000
d. $30,000
e. $33,200
Chapter 3 - Page 32
Sales increase needed Answer: b Diff: T N
89
. Ricardo Entertainment recently reported the following income statement:
Sales $12,000,000
Cost of goods sold 7,500,000
EBIT $ 4,500,000
Interest 1,500,000
EBT $ 3,000,000
Taxes (40%) 1,200,000
Net income $ 1,800,000
The company’s CFO, Fred Mertz, wants to see a 25 percent increase in net
income over the next year. In other words, his target for next year’s
net income is $2,250,000. Mertz has made the following observations:
• Ricardo’s operating margin (EBIT/Sales) was 37.5 percent this past
year. Mertz expects that next year this margin will increase to
40 percent.
• Ricardo’s interest expense is expected to remain constant.
• Ricardo’s tax rate is expected to remain at 40 percent.
On the basis of these numbers, what is the percentage increase in sales
that Ricardo needs in order to meet Mertz’s target for net income?
a. 72.92%
b. 9.38%
c. 2.50%
d. 48.44%
e. 25.00%
Multiple Part:
(The following information applies to the next two problems.)
Fama’s French Bakery has a return on assets (ROA) of 10 percent and a return
on equity (ROE) of 14 percent. Fama’s total assets equal total debt plus
common equity (that is, there is no preferred stock). Furthermore, we know
that the firm’s total assets turnover is 5.
Debt ratio and Du Pont analysis Answer: c Diff: M N
90
. What is Fama’s debt ratio?
a. 14.29%
b. 28.00%
c. 28.57%
d. 55.56%
e. 71.43%
Chapter 3 - Page 33
Profit margin and Du Pont analysis Answer: a Diff: E N
91
. What is Fama’s profit margin?
a. 2.00%
b. 4.00%
c. 4.33%
d. 5.33%
e. 6.00%
(The following information applies to the next two problems.)
Miller Technologies recently reported the following balance sheet in its
annual report (all numbers are in millions of dollars):
Cash $ 100 Accounts payable $ 300
Accounts receivable 300 Notes payable 500
Inventory 500 Total current liabilities $ 800
Total current assets $ 900 Long-term debt 1,500
Total debt $2,300
Common stock 500
Retained earnings 400
Net fixed assets 2,300 Total common equity $ 900
Total assets $3,200 Total liabilities and equity $3,200
Miller also reported sales revenues of $4.5 billion and a 20 percent ROE for
this same year.
ROA Answer: d Diff: M N
92
. What is Miller’s ROA?
a. 2.500%
b. 3.125%
c. 4.625%
d. 5.625%
e. 7.826%
Current ratio Answer: b Diff: M N
93
. Miller Technologies is always looking for ways to expand their business.
A plan has been proposed that would entail issuing $300 million in notes
payable to purchase new fixed assets (for this problem, ignore
depreciation). If this plan were carried out, what would Miller’s
current ratio be immediately following the transaction?
a. 0.455
b. 0.818
c. 1.091
d. 1.125
e. 1.800
Chapter 3 - Page 34
(The following information applies to the next three problems.)
Dokic, Inc. reported the following balance sheets for year-end 2001 and 2002
(dollars in millions):
2002 2001
Cash $ 650 $ 500
Accounts receivable 450 700
Inventories 850 600
Total current assets $1,950 $1,800
Net fixed assets 2,450 2,200
Total assets $4,400 $4,000
Accounts payable $ 680 $ 300
Notes payable 200 600
Wages payable 220 200
Total current liabilities $1,100 $1,100
Long-term bonds 1,000 1,000
Common stock 1,500 1,200
Retained earnings 800 700
Total common equity $2,300 $1,900
Total liabilities and equity $4,400 $4,000
Miscellaneous concepts Answer: e Diff: E N
94
. Which of the following statements is most correct?
a. The company’s current ratio was higher in 2002 than it was in 2001.
b. The company’s debt ratio was higher in 2002 than it was in 2001.
c. The company issued new common stock during 2002.
d. Statements a and b are correct.
e. Statements a and c are correct.
Net income Answer: b Diff: E N
95
. The total dividends paid to the company’s common stockholders during 2002
was $50 million. What was the company’s net income during the year 2002?
a. $ 50 million
b. $150 million
c. $250 million
d. $350 million
e. $450 million
Chapter 3 - Page 35
Sales, DSO, and inventory turnover Answer: b Diff: M N
96
. When reviewing the company’s performance for 2002, its CFO observed that
the company’s inventory turnover ratio was below the industry average
inventory turnover ratio of 6.0. In addition, the company’s DSO (days
sales outstanding, calculated on a 365-day basis) was less than the
industry average of 50 (that is, DSO < 50). On the basis of this
information, what is the most likely estimate of the company’s sales (in
millions of dollars) for 2002?
a. $ 2,940
b. $ 5,038
c. $ 7,250
d. $10,863
e. $30,765
(The following information applies to the next two problems.)
Below are the 2001 and 2002 year-end balance sheets for Kewell Boomerangs:
2002 2001
Cash $ 100,000 $ 85,000
Accounts receivable 432,000 350,000
Inventories 1,000,000 700,000
Total current assets $1,532,000 $1,135,000
Net fixed assets 3,000,000 2,800,000
Total assets $4,532,000 $3,935,000
Accounts payable $ 700,000 $ 545,000
Notes payable 800,000 900,000
Total current liabilities $1,500,000 $1,445,000
Long-term debt 1,200,000 1,200,000
Common stock 1,500,000 1,000,000
Retained earnings 332,000 290,000
Total common equity $1,832,000 $1,290,000
Total liabilities and equity $4,532,000 $3,935,000
Kewell Boomerangs has never paid a dividend on its common stock. Kewell issued
$1,200,000 of long-term debt in 1997. This debt was non-callable and is
scheduled to mature in 2027. As of the end of 2002, none of the principal on
this debt has been repaid. Assume that 2001 and 2002 sales were the same in
both years.
Chapter 3 - Page 36
Financial statement analysis Answer: a Diff: E N
97
. Which of the following statements is most correct?
a. Kewell’s current ratio in 2002 was higher than it was in 2001.
b. Kewell’s inventory turnover ratio in 2002 was higher than it was in
2001.
c. Kewell’s debt ratio in 2002 was higher than it was in 2001.
d. All of the statements above are correct.
e. None of the statements above is correct.
Current ratio Answer: c Diff: M N
98
. During 2002, Kewell’s days sales outstanding (DSO) was 40 days. The
industry average DSO was 30 days. Assume instead that in 2002, Kewell
had been able to achieve the industry-average DSO without reducing its
sales, and that the freed-up cash would have been used to reduce accounts
payable. If this reduction in DSO had successfully occurred, what would
have been Kewell’s new current ratio in 2002? (Assume Kewell uses a 365-
day accounting year.)
a. 1.018
b. 1.021
c. 1.023
d. 1.027
e. 1.033
Chapter 3 - Page 37
Chapter 3 - Page 38
CHAPTER 3
ANSWERS AND SOLUTIONS
1. Current ratio Answer: a Diff: E
Remember, the current ratio is CA/CL. In 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. Net fixed assets are long-term assets, not current assets, so they
will not affect the current ratio. So, statement c is false.
2. Current ratio Answer: d Diff: E
Pepsi Corporation:
Before: Current ratio = $50/$100 = 0.50.
After: Current ratio = $150/$200 = 0.75.
Coke Company:
Before: Current ratio = $150/$100 = 1.50.
After: Current ratio = $250/$200 = 1.25.
3. Cash flows Answer: a Diff: E
Statement a is correct. The other statements are false. Increasing the years
over which fixed assets are depreciated results in smaller amounts being
depreciated each year. Given 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
company's cash flow would decrease. In addition, decreasing accounts payable
results in using cash to pay off the accounts payable balance.
4. Leverage and financial ratios Answer: d Diff: E
Statements a and c are correct. The increase in debt payments will reduce net
income and hence reduce ROA. Also, higher debt payments will result in lower
taxable income and less tax. Therefore, statement d is the best choice.
5. Leverage and profitability ratios Answer: e Diff: E
Statement a is true; higher debt will increase interest expense and net income
will decline, resulting in a lower ROA than before. Statement b is true; 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 ROE will actually
rise. Statement c is true; both EBIT and total assets remain the same.
Therefore, statement e is the best choice.
6. EVA Answer: b Diff: E N
The correct answer is statement b. A company can have positive NI and still
have negative EVA. Look at the following formula:
EVA = NI - (Cost of Equity)(Amount of Equity Capital).
If the cost of equity times the amount of equity is greater than NI, EVA could
be negative. Just because a company has a positive NI does not mean that it
is earning enough to adequately compensate its shareholders. Therefore,
statement a is not correct.
For statement b, look at the following formula:
EVA = (ROE - k)(Equity).
As long as ROE is greater than the cost of equity, EVA will be positive.
Therefore, statement b is correct.
From the formula above, you can see that a company can increase its EVA by
increasing its ROE, decreasing its cost of equity, or by increasing its equity
investment. Any of these three changes would increase EVA, not just the
increase in ROE. Therefore, statement c is incorrect.
7. ROE and EVA Answer: e Diff: E
EVA is the value added after both shareholders and debtholders have been paid.
Net income only takes payments to debtholders into account, not shareholders.
Therefore, statement a is false. EVA = (ROE - k) × Total equity. So, if k is
larger than ROE, EVA would be negative even if ROE is positive. The
shareholders are getting a return but not as much as they require. Therefore,
statement b is false. Statement c is exactly the opposite of what is true, so
it is false. EVA will be negative whenever the cost of equity exceeds the
ROE. Since statements a, b, and c are false, the correct choice is statement
e.
8. ROE and EVA Answer: b Diff: E
ROE
D
> ROE
B
; EVA
D
< EVA
B
.
EVA can be calculated with 3 different equations:
(1) EVA = EBIT(1 - T) -
]
]
]

,
`

.
|
×
Capital Operating
Supplied - Investor Total
WACC .
(2) EVA = NI – (k
S
× Equity).
(3) EVA = (ROE - k
S
) × Equity.
Since Devon has a higher ROE, but its EVA is lower, the only things that could
explain this is if (1) its k
s
were higher or (2) its equity (or size) were
lower.
Since statement a would have the opposite effect (increasing Devon’s EVA),
statement a is false. If the k
S
were higher, then (ROE - k
S
) would be lower,
and EVA would be lower. Therefore, statement b is true. A higher EBIT would
lead to a higher EVA, so statement c is false.
9 . Ratio analysis
Answer: b Diff: E
Bedford = D; Breezewood = Z.
TA
D
= TA
Z
; ROA
D
= ROA
Z
; T
D
= T
Z
; D/A
D
> D/A
Z
; INT
D
> INT
Z
; ROA = NI/TA.
If both companies have the same ROA and total assets, then they must both have
the same net incomes. Therefore, NI
D
= NI
Z
.
First, compare BEPs. BEP = EBIT/TA. Work backward up the income statement.
If both companies have the same NI and tax rate, then they must both have the
same EBT. However, Bedford has higher interest payments, so its EBIT must be
higher than Breezewood’s. (Remember: EBT + I = EBIT.) Therefore, statement
c is false. In addition, Bedford’s BEP is higher than Breezewood’s, so
statements a, d, and e are all false. Statement b must be true for the
following reason. Compare ROEs. ROE =
ROA × EM and EM =
A / D 1
1

.
Bedford has a higher D/A ratio than Breezewood; therefore, it has a higher EM
than Breezewood. If its EM is higher and its ROA is the same, then Bedford’s
ROE must be higher than Breezewood’s.
10. Financial statement analysis Answer: a Diff: E
11. Financial statement analysis Answer: e Diff: E
ROE = NI/Equity; ROA = NI/TA; EVA = NI - k
s
× Equity.
We know nothing about the debt ratio or equity multiplier of either company.
Remember, ROA = ROE/EM (EM = equity multiplier). Since we don’t have EM, we
don’t have enough information to say anything about ROA. Therefore, statement
a is false. We don’t know anything about the k
s
or the amount of equity of
either company. Therefore, we don’t know enough to determine which company’s
EVA is higher. Therefore, statement b is false. We know that A’s ROE is
higher than B’s. However, we don’t know how much equity either one has, so we
cannot say which one has a higher net income. Therefore, statement c is
false. Since statements a, b, and c are false, the correct choice must be
statement e.
12. Financial statement analysis Answer: e Diff: E
From the first sentence, both firms have the same net income, sales, and
assets. Since A has more debt, it must have less equity. Thus, its ROE
(calculated as Net income/Equity) is higher than B’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. If A
has higher interest expense than B but the same net income, this means that A
must have higher operating income (EBIT) than B. Therefore statement c is
correct. Since statements a and c are correct, the correct choice is
statement e.
13. Financial statement analysis Answer: d Diff: E N
The correct answer is statement d. Although EBIT is unchanged, interest
expense will go down, so NI will increase. Therefore, statement a is correct.
If EBIT is unchanged, but interest expense goes down, the TIE ratio (EBIT/INT)
will increase. Therefore, statement b is correct. If the stock issue has no
effect on the company’s total assets, but NI has increased (see statement a),
then ROA (NI/TA) will increase. Therefore, statement c is also correct.
14. Miscellaneous ratios Answer: a Diff: E
The Du Pont equation states: ROE = PM × TATO × EM.
The firms have the same profit margin and equity multiplier. The equity
multiplier is the same because both companies have the same debt ratio. If
Company A has a higher ROE than B, then from the Du Pont equation Company A
also has a higher total assets turnover ratio than B. The current ratio does
not explain the ratios discussed. Therefore, only statement a explains the
observed ratios.
15. Miscellaneous ratios Answer: e Diff: E R
Current ratio = Current assets/Current liabilities. This transaction will
reduce current liabilities, which results in a higher current ratio. So
statement a is false. The basic earning power ratio = EBIT/TA. Since neither
the firm’s operating income (EBIT) or total assets have changed, its BEP ratio
remains unchanged. So statement b is false. TIE = EBIT/Interest. EBIT will
be unaffected, but we may see interest costs fall due to the firm having less
debt. This will result in an increase in the TIE ratio. So statement c is
false. Statement d is also false for the same reasons as statements a and b.
Total debt is reduced but total assets remain the same. The firm now has more
equity, so the equity multiplier (Assets/Equity) will decrease, so statement e
is correct.
16. Current ratio Answer: d Diff: M
Statement d is the correct answer. For 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. In statement c only the
denominator goes down (long-term bonds are not in the current ratio), so the
current ratio will increase.
17. Current ratio Answer: e Diff: M
18. Ratio analysis Answer: c Diff: M
19. Ratio analysis Answer: c Diff: M N
TA
D
= TA
C
.
TATO
D
= TATO
C
so, S/TA
D
= S/TA
C
.
ROE
D
= ROE
C
.
ROA
D
> ROA
C
.
Since TATO is the same for both, and since TA is the same for both, sales must
be the same for both (since TATO = Sales/TA). Remember the Du Pont equation:
ROE = PM × TATO × EM. Drysdale and Commerce have the same TATO. So, if
Drysdale has a higher PM and a higher EM (if the debt ratio is higher, the EM
is higher), then its ROE must be higher. However, the problem states that the
companies have the same ROE. Therefore, statement a is incorrect. If
Drysdale’s PM and debt ratio are lower than Commerce’s and both have the same
TATO, Drysdale would have a lower ROE. The problem states that the companies
have the same ROE, so statement b is incorrect. Looking again at the Du Pont
equation: ROE = PM × TATO × EM. If the ROEs are the same and the TATOs are
the same, then (PM × EM) must be the same for the two companies. If Drysdale
has a higher PM and a lower EM, then (PM × EM) could be the same for both.
Therefore, statement c could explain the ratios in the problem. If Drysdale
has lower NI and more common equity (higher TE), then its ROE would be lower.
Therefore, statement d is incorrect. The P/E ratio is irrelevant. The stock
price cannot explain what is going on with the two companies’ ratios.
20. Ratio analysis Answer: a Diff: T
Statement a is correct; the others are false. If Company X has a higher total
assets turnover (Sales/TA) but the same total assets, it must have higher sales
than Y. If X has higher sales and also a higher profit margin (NI/Sales) than
Y, it must follow that X has a higher net income than Y. Statement b is false.
ROE = NI/EQ or ROE = ROA × Equity multiplier. In either case we need to know
the amount of equity that both firms have. This is impossible to determine
given the information in the question. Therefore, we cannot say that X must
have a higher ROE than Y. Statement c is false. Remember from the Du Pont
equation that ROA = Profit margin × Total assets turnover = NI/S × S/TA.
Since Company X has both a higher profit margin and total assets turnover than
Company Y, X’s ROA must also be higher than Y’s.
21. Effects of leverage Answer: a Diff: M
Statement a is correct. The other statements are false. The use of debt
provides tax benefits to the corporations that issue debt, not to the
investors who purchase debt (in the form of bonds). The basic earning power
ratio would be the same if the only thing that differed between the firms were
their debt ratios.
22. Financial statement analysis Answer: a Diff: M
Statement a is true because, if a firm takes on more debt, its interest
expense will rise, and this will lower its profit margin. Of course, there
will be less equity than there would have been, hence the ROE might rise even
though the profit margin declined.
23 . Financial statement analysis
Answer: d Diff: M N
The correct answer is statement d. Start with the Du Pont equation:
NI/S × S/TA × TA/E = ROE. We know S/TA and ROE are the same for both. Since
the equity of Mills is higher than Harte, its NI must also be higher to keep
ROE the same. So, statement a is correct. The other statements are then also
true. Given Mills’ higher net income, both the profit margin and the ROA for
Mills are also higher than Harte’s.
24. Leverage and financial ratios Answer: e Diff: M
TATO = Sales/TA. Both companies have the same total assets. However, since A
has a lower profit margin than B and its net income is the same as B’s, it
must have higher sales; thus, A has a higher total assets turnover ratio than
B. Therefore, statement a is true. ROE = NI/Equity. Both companies have the
same total assets and net income, but A has more debt and thus less equity
than B. Therefore, A has a higher ROE than B. Therefore, statement b is true.
BEP = EBIT/TA. We know that A has higher interest payments than B but the
same net income as B. Therefore, A must have a higher EBIT than B to cover
this extra interest. Thus, A must have a higher basic earning power ratio
than B. Therefore, statement c is true. Since statements a, b, and c are
true, the correct choice is statement e.
25. Leverage and financial ratios Answer: d Diff: M N
If BEP and total assets are equal, we know that EBIT is equal. Company A has
a higher debt ratio and higher interest expense than Company B.
Since Company A has lower net income, it must have a lower ROA (since total
assets are the same). If EBIT is the same for both A and B and Company A has
higher interest expense, Company A must have a lower TIE ratio than Company B.
Company A has a lower EBT and lower net income than Company B. If A has lower
EBT, then Company A pays less in taxes than Company B. There is a positive
relationship between the debt ratio and the equity multiplier, which means
that Company A has a higher equity multiplier than B because A’s debt ratio is
higher than B’s. Therefore, the correct choice is statement d.
26. Du Pont equation Answer: b Diff: M R
The Du Pont equation: ROE = (PM)(TATO)(EM). ROE is above average. PM is
below average. EM is above average because a high debt ratio implies a high
EM. Therefore, TATO must be higher for the equation to hold. Note that the
firm’s ROA does not have to be higher than the industry ROA for this equation
to hold.
27. ROE and EVA Answer: d Diff: M
EVA = NI – (k
s
× Equity). k
s
× Equity cannot be zero, therefore, net income
must be positive if EVA is zero. So statements a and b are false. ROA = NI/TA.
This equation really does not have anything to do with the EVA calculation.
Statement c is only correct if the firm has zero debt, which we know not to be
correct. (We are given information in the question stating that the firm’s
debt ratio is 40 percent.) Therefore, statement c is also false. ROE =
NI/Equity. Rewrite the EVA equation by substituting into it EVA = 0, and you
get: NI = k
s
× Equity. Divide both sides by Equity and you obtain the
following equation: NI/Equity = k
s
. Thus ROE = 14%. Statement e would give a
negative EVA and the problem states that the firm’s EVA is zero, so it is
false.
28. ROE and EVA Answer: b Diff: M
Statement a is false; EVA depends upon the amount of equity invested, which
could be different for the two firms. Statement b is correct; for positive
EVA, the ROE must exceed the cost of equity. Statement c is false; it is very
plausible to have a firm with positive ROE and a higher cost of equity,
resulting in negative EVA.
29. Miscellaneous ratios Answer: b Diff: M
Statement b is correct. EBIT = EBT + Interest. Statement c is incorrect
because higher interest expense doesn’t necessarily imply greater debt. For
this statement to be correct, A’s amount of debt would have to be greater than
B’s.
30. Miscellaneous ratios Answer: e Diff: M
Statements b and c are correct. ROA = NI/TA. An increase in the debt ratio
will result in an increase in interest expense, and a reduction in NI. Thus
ROA will fall. EM = Assets/Equity. As debt increases, the amount of equity in
the denominator decreases, thus causing the equity multiplier (EM) to increase.
Therefore, statement e is the correct choice.
31. Miscellaneous ratios Answer: d Diff: M
Since X has a lower ROA (NI/TA) than Y and both firms have the same assets, X
must have a lower net income than Y. So statement c is correct. X has a
higher ROE (NI/EQ) than Y, even though its net income is lower. Consequently,
X must have less equity than Y, and therefore, more debt than Y. So statement
a is false. Since X has a higher total assets turnover ratio (Sales/TA) than
Y and both firms have the same assets, X’s sales must be higher than Y’s.
This fact, combined with X’s lower net income, means that X must have a lower
profit margin (NI/Sales) than Y, so statement b is correct. Thus, statements
b and c are both correct. So, the correct choice is statement d.
32. ROE and EVA Answer: a Diff: T
The following formula will make this question much easier: EVA = (ROE - k
s
) ×
Total equity. If Division A is riskier than Division B, then A’s cost of
equity capital will be higher than B’s. If k
s
is higher, EVA will be lower.
So, statement a is true. If A is larger than B in terms of equity, then the
term (ROE - k
s
) will be multiplied by a much larger number for Division A.
Since A’s ROE is also higher than B’s, then its EVA would be higher than B’s.
Therefore, statement b is false. If A has less debt, then its interest
payments will be lower than B’s, so its EBIT will be higher. Another way to
write the EVA formula is EVA = EBIT (1 – T) – [Cost of capital × Investor-
supplied capital employed]. So, a higher EBIT will lead to a higher EVA. In
addition, a lower level of debt will make A less risky than B, so A’s cost of
equity will be lower than B’s. From the other EVA formula, we can see that
this would cause a higher EVA, not a lower one. So, statement c is false.
33. Ratio analysis Answer: d Diff: T
Statement d is correct; the others are false. ROA = NI/TA. Company C has
higher interest expense than Company D; therefore, it must have lower net
income. Since the two firms have the same total assets, ROA
C
< ROA
D
. Statement
a is false; we cannot tell what sales are. From the facts as stated above,
they could be the same or different. Statement b is false; Company C must
have lower equity than Company D, which could lead it to have a higher ROE
because its equity multiplier would be greater than company D's. Statement c
is false as TIE = EBIT/Interest, and C has higher interest than D but the same
EBIT; therefore, TIE
C
< TIE
D
. Statement e is false; they have the same BEP =
EBIT/TA from the facts as given in this problem.
34. Ratio analysis Answer: d Diff: T
We can conclude that X has a lower NI, because it has a lower EBIT and higher
interest than Y, but the same tax rate as Y. Sales for each company are the
same because they have the same total assets and the same total assets
turnover ratio (TATO = Sales/TA). Therefore, since X has a lower NI and same
sales as Y, it must follow that it has a lower profit margin (NI/Sales).
35 . Ratio analysis and Du Pont equation
Answer: d Diff: T
ROA
L
= ROA
Y
; S/TA
L
> S/TA
Y
; EM
L
> EM
Y
, or A/E
L
> A/E
Y
.
From the Du Pont equation we know that ROA = Profit margin × Total assets
turnover. If the 2 firms’ ROAs are equal, but Lancaster’s total assets
turnover is greater than York’s then Lancaster’s profit margin must be lower
than York’s. Therefore, statement a is true. The debt ratio is calculated as
1 - 1/Equity multiplier. So, if Lancaster has a higher equity multiplier than
York, its debt ratio must be higher too. So, statement b is false. From the
extended Du Pont equation we know that ROE = Profit margin × Total assets
turnover × Equity multiplier. We also know that ROA = Profit margin × Total
assets turnover. Since we know the
2 firms’ ROAs are equal and Lancaster has a higher equity multiplier it must
have a higher ROE too. Therefore, statement c is true. Since statements a and
c are true, the correct choice is statement d.
36. Leverage and financial ratios Answer: d Diff: T
The new income statement will be as follows:
Operating income (EBIT) $1,200,000 0.2 × $6,000,000
Interest expense 200,000
Earnings before taxes (EBT) $1,000,000
Taxes (40%) 400,000
Net income $ 600,000
ROA
Old
= 10.8% =
$5,000,000
$540,000
Assets
NI
· ;
New ROE
= 10%. =
$6,000,000
$600,000
Therefore, ROA falls.
ROE
Old
= 13.5%
$4,000,000
$540,000
Equity
NI
· · ; ROE
New
= 15.0%.
$4,000,000
$600,000
·
Since net income increases, ROA falls and ROE increases, statement d is the
correct choice.
37. Miscellaneous ratios Answer: c Diff: T
Step 1: Use the ratios and data to arrive at alternative relationships to
answer the question:
TATO = Sales/TA
= NI/TA × S/NI
= ROA × 1/PM.
D/A = TD/TA
= (TA - EQ)/TA
= (TA/TA) - (EQ/TA)
= 1 - (EQ/NI) × (NI/TA)
= 1 - (ROA/ROE).
ROA = NI/TA
NI = TA × ROA.
Step 2: Substitute the data given with the alternative relationships obtained
in Step 1:
Hemmingway Fitzgerald
TATO = ROA/PM = 0.09/0.04 = 0.08/0.03
= 2.25×. = 2.67×.
D/A = 1 - (ROA/ROE) = 1 - (0.09/0.18) = 1 - (0.08/0.24)
= 0.5. = 0.667.
NI = TA × ROA = 2 × 0.09 = 1.5 × 0.08
= $0.18 billion. = $0.12 billion.
From the calculations above, statement c is the correct choice.
38. Financial statement analysis Answer: a Diff: E
BEP = EBIT/TA
0.15 = EBIT/$100,000,000
EBIT = $15,000,000.
ROA = NI/TA
0.09 = NI/$100,000,000
NI = $9,000,000.
EBT = NI/(1 - T)
EBT = $9,000,000/0.6
EBT = $15,000,000.
Therefore interest expense = $0.
39. Market price per share Answer: b Diff: E
Total market value = $1,250(1.5) = $1,875.
Market value per share = $1,875/25 = $75.
Alternative solution:
Book value per share = $1,250/25 = $50.
Market value per share = $50(1.5) = $75.
40. Market price per share Answer: c Diff: E
Number of shares = $200,000/$2.00 = 100,000.
Book value per share = $2,000,000/100,000 = $20.
Market value = 0.2(Book value) = 0.2($20) = $4.00 per share.
41 4
. Market/book ratio Answer: c Diff: E
s h a r e s . 2 , 0 0 0 , 0 0 0
s h a r e s 8 0 $ 0 0 $ 1 6 0 , 0 0 0 , 0
0 $ 4 0 , 0 0 0 , 0 0
s h a r e s 8 0 $
0 . 4
B V
s h a r e s s h a r e p e r P r i c e
B
M
·
× ·
×
·
×
·
42. Market/book ratio Answer: e Diff: E N
TA = $2,000,000,000; CL = $200,000,000; LT debt = $600,000,000; CE =
$1,200,000,000; Shares outstanding = 300,000,000; P
0
= $20; M/B = ?
Book value =
000 , 000 , 300
000 , 000 , 200 , 1 $
= $4.00.
M/B =
00 . 4 $
00 . 20 $
= 5.0.
43. ROA Answer: d Diff: E
Net income = 0.15($20,000,000) = $3,000,000.
ROA = $3,000,000/$22,500,000 = 13.3%.
44. TIE ratio Answer: b Diff: E
TIE = EBIT/INT
7 = ($300 + INT)/INT
7INT = $300 + INT
6INT = $300
INT = $50.
45. ROE Answer: c Diff: E
Equity = 0.25($6,000) = $1,500.
Current ROE =
E
NI
=
$1,500
$240
= 16%.
New ROE =
$1,500
$300
= 0.20 = 20%.
∆ROE = 20% - 16% = 4%.
46. Profit margin Answer: c Diff: E
Current inventory turnover =
Inv
S
=
$5,000
$10,000
= 2.
New inventory turnover =
Inv
S
= 5; Inv =
5
S
=
5
$10,000
= $2,000.
Freed cash = $5,000 - $2,000 = $3,000.
Increase in NI = 0.07($3,000) = $210.
New Profit margin =
Sales
NI
=
$10,000
$210 + $240
= 0.0450 = 4.5%.
47. Du Pont equation Answer: a Diff: E
First, calculate the profit margin, which equals NI/Sales:
ROA = NI/TA = 0.04.
Sales/Total assets = S/TA = 2.
PM = (NI/TA)(TA/S) = 0.04(0.5) = 0.02. [TA/S = 1/2 = 0.5.]
Next, find the debt ratio by finding the equity ratio:
E/TA = (E/NI)(NI/TA). [ROE = NI/E and ROA = NI/TA.]
E/TA = (1/ROE)(ROA) = (1/0.06)(0.04) = 0.667, or 66.7% equity.
Therefore, D/TA must be 0.333 = 33.3%.
48. P/E ratio and stock price Answer: b Diff: E
EPS = $15,000/10,000 = $1.50.
P/E = 5.0 = P/$1.50.
P = $7.50.
49. P/E ratio and stock price Answer: e Diff: E
EPS = $750,000/100,000 = $7.50.
P/E = Price/EPS = 8.
Thus, Price = 8 × $7.50 = $60.00.
50. Current ratio and inventory Answer: b Diff: E N
With the numbers provided, we can see that Iken Berry Farms has a current
ratio of 1.67 (CA/CL = $5/$3 = 1.67). If notes payable are going to be raised
to buy inventories, both the numerator and the denominator of the ratio will
increase. We can increase current liabilities $1 million before the current
ratio reaches 1.5.
. 000 , 000 , 1 $ X
X 000 , 000 , 1 $
X 5 . 0 000 , 500 $
X 5 . 1 000 , 500 , 4 $ X 000 , 000 , 5 $
5 . 1
X 000 , 000 , 3 $
X 000 , 000 , 5 $
5 . 1
X CL
X CA



+ ≥ +

+
+

+
+
51. Accounts receivable increase Answer: b Diff: M R
DSO = $41,096/($250,000/365) = 60 days.
New A/R = [($250,000)(1.5)/(365)](60)(1.5) = $92,466.
Hence, increase in receivables = $92,466 - $41,096 = $51,370.
52. Accounts receivable Answer: a Diff: M R
First solve for current annual sales using the DSO equation as follows: 50 =
$1,000,000/(Sales/365) to find annual sales equal to $7,300,000.
If sales fall by 10%, the new sales level will be $7,300,000(0.9) =
$6,570,000. Again, using the DSO equation, solve for the new accounts
receivable figure as follows: 32 = AR/($6,570,000/365) or AR = $576,000.
53. ROA Answer: a Diff: M
Equity multiplier = 1/(1 - D/A) = 1/(1 - 0.4) = 1.67.
ROE = ROA × Equity multiplier
18% = (ROA)(1.67)
ROA = 10.8%.
54. ROA Answer: e Diff: M
Step 1: We must find TA. We are given BEP and EBIT.
BEP =
TA
EBIT
and TA =
BEP
EBIT
.
Therefore, TA = $40,000,000/0.1, or $400 million.
Step 2: NI/TA = ROA, so now we need to find net income. Net income is found
by working through the income statement (in millions):
EBIT $40
Interest 5 (from TIE ratio: 8 = EBIT/Int)
EBT $35
Taxes (40%) 14
NI $21
Step 3: ROA = $21/$400 = 0.0525 = 5.25%.
55 . ROA
Answer: c Diff: M N
BEP = EBIT/TA = 0.10, so EBIT = 0.10 × $500,000 = $50,000.
TIE = EBIT/INT = 5, so INT = $50,000/5 = $10,000.
EBIT $50,000
Int -10,000
EBT $40,000
Taxes (40%) -16,000
NI $24,000
ROA = NI/TA = $24,000/$500,000 = 0.048, or 4.8%.
56. ROE Answer: c Diff: M R
(Sales per day)(DSO) = A/R
(Sales/365)(60) = $150,000
Sales = $912,500.
Profit margin = Net income/Sales.
Net income = 0.04($912,500) = $36,500.
Debt ratio = 0.64 = Total debt/$3,000,000.
Total debt = $1,920,000.
Total equity = $3,000,000 - $1,920,000 = $1,080,000.
ROE = $36,500/$1,080,000 = 3.38% ≈ 3.4%.
57. ROE Answer: b Diff: M
Total equity = ($5,000,000)(2) = $10,000,000.
Total assets = $5,000,000 + $10,000,000 = $15,000,000.
Net income = (0.06)($15,000,000) = $900,000.
ROE = $900,000/$10,000,000 = 9%.
ROE - ROA = 9% - 6% = 3%.
58. ROE Answer: d Diff: M
Profit margin = ($1,500(1 - 0.3))/$5,000 = 21%.
Equity multiplier = 1.0 since firm is 100% equity financed.
ROE = (Profit margin)(Assets turnover)(Equity multiplier)
= (21%)(2.0)(1.0) = 42%.
59. ROE Answer: c Diff: M
Calculate debt, equity, and EBIT:
Debt = D/A × TA = 0.35($1,000) = $350.
Equity = TA - Debt = $1,000 - $350 = $650.
EBIT = TA × BEP = $1,000(0.20) = $200.
Calculate net income and ROE:
Net income = (EBIT - I)(1 - T) = [$200 - 0.0457($350)](0.6) = $110.4.
ROE = $110.4/$650 = 16.99%.
60. Equity multiplier Answer: d Diff: M
Equity multiplier = 4.0 = Total assets/Total equity = 4/1.
Assets = Debt + Equity
4 = Debt + 1
Debt = 3.
Debt/Assets = 3/4 = 0.75.
61. TIE ratio Answer: e Diff: M
TIE = EBIT/I, so find EBIT and I.
Interest = $800,000 × 0.1 = $80,000.
Net income = $3,200,000 × 0.06 = $192,000.
Pre-tax income = $192,000/(1 - T) = $192,000/0.6 = $320,000.
EBIT = $320,000 + $80,000 = $400,000.
TIE = $400,000/$80,000 = 5.0× .
62. TIE ratio Answer: b Diff: M N
TA = $8,000,000,000; T = 40%; EBIT/TA = 12%; ROA = 3%; TIE ?
. 0 0 0 , 0 0 0 , 9 6 0 $ E B I T
1 2 . 0
, 0 0 0 $ 8 , 0 0 0 , 0 0 0
E B I T
·
·
. 0 0 0 , 0 0 0 , 2 4 0 $ N I
0 3 . 0
, 0 0 0 $ 8 , 0 0 0 , 0 0 0
N I
·
·
Now use the income statement format to determine interest so you can calculate
the firm’s TIE ratio.
EBIT $960,000,000 See above.
INT 560,000,000
EBT $400,000,000 EBT = $240,000,000/0.6
Taxes (40%) 160,000,000
NI $240,000,000 See above.
INT = EBIT – EBT
= $960,000,000 - $400,000,000
TIE = EBIT/INT
= $960,000,000/$560,000,000
= 1.7143 ≈ 1.71.
63. TIE ratio Answer: b Diff: M
Remember, TIE = EBIT/Interest. We need to find EBIT and Interest.
TA = $20,000,000; BEP = 25%; ROA = 10%; T = 40%.
BEP = EBIT/TA
25% = EBIT/$20,000,000
$5,000,000 = EBIT.
ROA = NI/TA
10% = NI/$20,000,000
$2,000,000 = NI.
NI = (EBIT - I)(1 - T)
$2,000,000 = ($5,000,000 - I)(1 - 0.4)
$2,000,000 = ($5,000,000 - I)(0.6)
$3,333,333 = $5,000,000 - I
$1,666,667 = I.
Therefore, TIE = EBIT/I
= $5,000,000/$1,666,667
= 3.0× .
64. TIE ratio Answer: d Diff: M N
The times interest earned (TIE) ratio is calculated as the ratio of EBIT and
interest expense. We can find EBIT from the BEP ratio and total assets given
in the problem.
BEP =
TA
EBIT
25% =
$3,000,000
EBIT
EBIT = $750,000.
Interest expense can be obtained from the income statement by simply working
your way up the income statement. To do this, however, we must first
calculate net income from the data given for ROA.
ROA =
TA
NI
12% =
$3,000,000
NI
NI = $360,000.
Solving for EBT and then interest, we find:
EBT =
T) - (1
NI
EBT =
) 35 . 0 1 (
000 , 360 $

EBT = $553,846.
EBIT – INT = EBT
$750,000 – INT = $553,846
INT = $196,154.
We can now calculate the TIE as follows:
TIE =
INT
EBIT
TIE =
154 , 196 $
000 , 750 $
TIE = 3.82× .
65. EBITDA coverage ratio Answer: a Diff: M N
TA = $9,000,000,000; EBIT/TA = 9%; TIE = 3; DA = $1,000,000,000; Lease
payments = $600,000,000; Principal payments = $300,000,000; EBITDA coverage
= ?
EBIT/$9,000,000,000 = 0.09
EBIT = $810,000,000.
3 = EBIT/INT
3 = $810,000,000/INT
INT = $270,000,000.
EBITDA = EBIT + DA
= $810,000,000 + $1,000,000,000
= $1,810,000,000.
EBITDA coverage ratio =
pmts Lease pmts Princ. INT
payments Lease EBITDA
+ +
+
=
000 , 000 , 600 $ 000 , 000 , 300 $ 000 , 000 , 270 $
000 , 000 , 600 $ 000 , 000 , 810 , 1 $
+ +
+
=
000 , 000 , 170 , 1 $
000 , 000 , 410 , 2 $
= 2.0598 ≈ 2.06.
66. Debt ratio Answer: c Diff: M
Debt ratio = Debt/Total assets.
Sales/Total assets = 6
Total assets = $24,000,000/6 = $4,000,000.
ROE = NI/Equity
Equity = NI/ROE = $400,000/0.15 = $2,666,667.
Debt = Total assets - Equity = $4,000,000 - $2,666,667 = $1,333,333.
Debt ratio = $1,333,333/$4,000,000 = 0.3333.
67. Profit margin Answer: a Diff: M
Equity multiplier = 1/(1 - 0.35) = 1.5385.
ROE = (Profit margin)(Assets utilization)(Equity multiplier)
15% = (PM)(2.8)(1.5385)
PM = 3.48%.
68. Financial statement analysis Answer: e Diff: M R
Current DSO =
5 $10,000/36
$1,000
= 36.5 days. Industry average DSO = 30 days.
Reduce receivables by (36.5 – 30)

,
`

.
|
365
$10,000
= $178.08.
Debt = $400/0.10 = $4,000.
TA
TD
=
$178.08 - $6,000
$178.08 - $4,000
= 65.65%.
69. Financial statement analysis Answer: b Diff: M R
First, find the amount of current assets:
Current ratio = Current assets/Current liabilities
Current assets = (Current liabilities)(Current ratio)
= $375,000(1.2) = $450,000.
Next, find the accounts receivables:
DSO = AR/(Sales/365)
AR = DSO(Sales)(1/365)
= (40)($1,200,000)(1/365) = $131,506.85.
Next, find the inventories:
Inventory turnover = Sales/Inventory
Inventory = Sales/Inventory turnover
= $1,200,000/4.8 = $250,000.
Finally, find the amount of cash:
Cash = Current assets - AR - Inventory
= $450,000 - $131,506.85 - $250,000 = $68,493.15 ≈ $68,493.
70. Basic earning power Answer: d Diff: M
Given ROA = 10% and net income of $500,000, total assets must be $5,000,000.
ROA =
A
NI
10% =
TA
$500,000
TA = $5,000,000.
To calculate BEP, we still need EBIT. To calculate EBIT construct a partial
income statement:
EBIT $1,033,333 ($200,000 + $833,333)
Interest 200,000 (Given)
EBT $ 833,333 $500,000/0.6
Taxes (40%) 333,333
NI $ 500,000
BEP =
TA
EBIT
=
$5,000,000
$1,033,333
= 0.2067 = 20.67%.
71. P/E ratio and stock price Answer: e Diff: M
The current EPS is $1,500,000/300,000 shares or $5. The current P/E ratio is
then $60/$5 = 12. The new number of shares outstanding will be 400,000. Thus,
the new EPS = $2,500,000/400,000 = $6.25. If the shares are selling for 12
times EPS, then they must be selling for $6.25(12) = $75.
72 . Current ratio and DSO
Answer: a Diff: M
Step 1: Determine average daily sales using the old DSO.
DSO =
Sales Daily Average
s Receivable
.
If DSO changes while sales remain the same, then receivables must
change.
40 =
Sales Daily Average
400 $
$10 = Average Daily Sales.
Step 2: Determine the new level of receivables required for Parcells to
achieve the industry average DSO.
30 =
$10
s Receivable
$300 = Receivables.
Step 3: Calculate the new current ratio.
Receivables decline by $100, so current assets declined by $100.
Therefore, the new level of current assets is $800 - $100 = $700. Since
the $100 cash freed up is used to reduce long-term bonds, cur-rent
liabilities remain at $400. Current ratio = $700/$400 = 1.75.
73. Current ratio Answer: c Diff: M N
Currently:
DSO = AR/Average Daily Sales
= $250/$10
= 25 days.
Now, Cartwright wants to reduce DSO to 15. The firm needs to reduce accounts
receivable because it doesn’t want to reduce average daily sales. So, we can
calculate the new AR balance as follows:
DSO = AR/Average Daily Sales
15 = AR/$10
$150 million = AR.
If the firm reduces its DSO to the industry average, its AR will be $150
million, reduced by $100 million. Therefore, there must be an equal reduction
on the right side of the balance sheet. Half of this $100 million of freed-up
cash will be used to reduce notes payable, and the other half will be used to
reduce accounts payable. Therefore, notes payable will fall by $50 million to
$250 million, and accounts payable will fall by $50 million to $250 million.
Therefore, we can now calculate the firm’s new current ratio:
Current Ratio = CA/CL
= (Cash + AR + Inv.)/(Notes Payable + Accounts Payable)
= ($250 + $150 + $250)/($250 + $250)
= $650/$500
= 1.30× .
74. Current ratio Answer: b Diff: M N
Step 1: Calculate the firm’s current inventory turnover.
Inv. turnover = Sales/Inv.
= $3,000,000/$500,000
= 6.0× .
New Inv. turnover = 10.0× (but sales stay the same).
Step 2: Calculate what the firm’s inventory balance should be if the firm
maintains the industry average inventory turnover.
Inv. turnover = Sales/Inv.
10× = $3 million/Inv.
$300,000 = Inv.
The new inventory level will be $300,000, so inventories will be reduced by
$200,000 from the old level. This means that current assets will decrease by
$200,000.
Step 3: Calculate the firm’s new current assets level.
CA = Cash + Inv. + A/R
= $100,000 + $300,000 + $200,000
= $600,000.
Half of the $200,000 that is freed up will be used to reduce notes payable, and
the other half will be used to reduce common equity. Therefore, notes payable
will be reduced by $100,000 to a new level of $100,000.
Step 4: Calculate the firm’s new liabilities level.
CL = A/P + Accruals + Notes payable
= $200,000 + $100,000 + $100,000
= $400,000.
Step 5: Calculate the firm’s new current ratio with the improved inventory
management.
CR = CA/CL
= $600,000/$400,000
= 1.5× .
75. Credit policy and ROE Answer: c Diff: M R
Use the DSO formula to calculate accounts receivable under the new policy as
36 = AR/($730,000/365) or AR = $72,000. Thus, $125,000 - $72,000 = $53,000 is
the cash freed up by reducing DSO to 36 days. Retiring $53,000 of long-term
debt leaves $247,000 in long-term debt. Given a 10% interest rate, interest
expense is now $247,000(0.1) = $24,700. Thus, EBT = EBIT - Interest = $70,000
- $24,700 = $45,300. Net income is $45,300(1 - 0.3) = $31,710. Thus, ROE =
$31,710/$200,000 = 15.86%.
76. Du Pont equation Answer: d Diff: M
Before: Equity multiplier = 1/(1 - D/A) = 1/(1 - 0.5) = 2.0.
ROE = (PM)(Assets turnover)(EM) = (10%)(0.25)(2.0) = 5%.
After: [ROE = 2(5%) = 10%]:
10% = (12%)(0.25)(EM)
EM = 3.33 = A/E.
E/A = 1/3.33 = 0.3.
D/A = 1 – 0.3 = 0.7 = 70%.
77. Sales and extended Du Pont equation Answer: a Diff: M
NI/E = 15%; D/A = 40%; E/A = 60%; A/E = 1/0.6 = 1.6667; NI/S = 5%.
Step 1: Determine total assets turnover from the extended Du Pont equation:
NI/S × S/TA × A/E = ROE
(5%)(S/TA)(1.6667) = 15%
0.0833 S/TA = 15%
S/TA = 1.8.
Step 2: Determine sales from the total assets turnover ratio:
S/TA = 1.8
S/$800 = 1.8
S = $1,440 million.
78. Net income and Du Pont equation Answer: c Diff: M N
Step 1: Calculate total assets from information given.
Sales = $10 million.
3.5× = Sales/TA
3.5× =
Assets
000 , 000 , 10 $
Assets = $2,857,142.8571.
Step 2: Calculate net income.
There is no debt, so Assets = Equity = $2,857,142.8571.
ROE = NI/S × S/TA × TA/E
0.15 = NI/$10,000,000 × 3.5 × 1
0.15 =
000 , 000 , 10 $
NI 5 . 3
$1,500,000 = 3.5NI
$428,571.4286 = NI.
79. ROE Answer: c Diff: T
Given: New D/A = 0.55 Interest = $7,000
EBIT = $25,000 Tax rate = 40%
Sales = $270,000 TATO = 3.0
Recall the Du Pont equation: ROE = (PM)(TATO)(EM).
ROE = (ROA)(EM).
ROE = NI/Equity.
EBIT $25,000
Interest 7,000 (Given)
EBT $18,000
Taxes (40%) 7,200 ($18,000 × 40%)
NI $10,800
TATO = Sales/Total assets
Total assets = Sales/TATO = $270,000/3 = $90,000.
Equity = [1 - (D/A)](Total assets)
Equity = [1 - 0.55](Total assets)
Equity = 0.45($90,000) = $40,500.
ROE = NI/Equity = $10,800/$40,500 = 26.67%.
80. ROE Answer: d Diff: T
Industry average inventory turnover = 6 = Sales/Inventories.
To match this level: Inventories = Sales/6
$3,000,000/6 = $500,000.
Current inventories = $1,000,000. Reduction in inventories = $1,000,000 -
$500,000 = $500,000. This $500,000 is to be used to reduce debt.
New debt level = $4,000,000 - $500,000 = $3,500,000.
Interest on this level of debt = $3,500,000 × 0.1 = $350,000.
Look at the income statement to determine net income:
EBIT $1,400,000
Interest 350,000
EBT $1,050,000
Taxes (40%) 420,000
NI $ 630,000
ROE = Net income/Equity = $630,000/$2,000,000 = 0.3150 or 31.50%.
81. ROE and financing Answer: a Diff: T
The firm is not using its “free” trade credit (that is, accounts payable
(A/P)) to the same extent as other companies. Since it is financing part of
its assets with 10% notes payable, its interest expense is higher than
necessary.
Calculate the increase in payables:
Current (A/P)/Inventories ratio = $100/$500 = 0.20.
Target A/P = 0.60(Inventories) = 0.60($500) = $300.
Increase in A/P = $300 - $100 = $200.
Since the current ratio and total assets remain constant, total liabilities
and equity must be unchanged. The increase in accounts payable must be
matched by an equal decrease in interest-bearing notes payable. Notes payable
decline by $200. Interest expense decreases by $200 × 0.10 = $20.
Construct comparative Income Statements:
Old New
Sales $2,000 $2,000
Operating costs 1,843 1,843
EBIT $ 157 $ 157
Interest 37 17
EBT $ 120 $ 140
Taxes (40%) 48 56
Net income (NI) $ 72 $ 84
ROE = NI/Equity = $72/$800 = 9%. $84/$800 = 10.5%.
New ROE = 10.5%.
82. ROE and refinancing Answer: d Diff: T
Relevant information: Old ROE = NI/Equity = 0.06 = 6%.
Sales = $300,000; EBIT = 0.11(Sales) = 0.11($300,000) = $33,000.
Debt = $200,000; D/A = 0.80 = 80%.
Tax rate = 40%.
Interest rate change: Old bonds 14%; new bonds 10%.
Calculate total assets and equity amounts:
Since debt = $200,000, total assets = $200,000/0.80 = $250,000.
Equity = 1 - D/A = 1 - 0.80 = 0.20.
Equity = E/TA × TA = 0.20 × $250,000 = $50,000.
Construct comparative Income Statements from EBIT, and calculate new ROE:
Old New
EBIT $33,000 $33,000
Interest 28,000 20,000
EBT $ 5,000 $13,000
Taxes (40%) 2,000 5,200
Net income $ 3,000 $ 7,800
New ROE = NI/Equity = $7,800/$50,000 = 0.1560 = 15.6%.
83. TIE ratio Answer: d Diff: T
TIE =
I
EBIT
= ?
TA Turnover = S/A = 2
S/$10,000 = 2
S = $20,000.

TA
TD
= 0.6;
TD = 0.6($10,000)
Debt = $6,000.
I = $6,000(0.1) = $600.
PM =
S
NI
= 3%
PM =
$20,000
NI
= 0.03
NI = $600.
EBT =
0.4) - (1
$600
= $1,000.
EBIT $1,600
Interest 600
EBT $1,000
Taxes (40%) 400
NI $ 600
TIE = $1,600/$600 = 2.67.
84. Current ratio Answer: e Diff: T
Old DSO = 40; CA = $2,500,000; CA/CL = 1.5; AR = $1,600,000.
Step 1: Calculate average daily sales:
DSO = AR/Average daily sales
40 = $1,600,000/Average daily sales
$40,000 = Average daily sales.
Step 2: Calculate the new level of accounts receivable when DSO = 30:
30 = AR/$40,000
$1,200,000 = AR.
So, the change in receivables will be $1,600,000 – $1,200,000 =
$400,000.
Step 3: Calculate the old level of current liabilities:
Current ratio = CA/CL
1.5 = $2,500,000/CL
$1,666,667 = CL.
Step 4: Calculate the new current ratio:
The change in receivables will cause a reduction in current assets of
$400,000 and a reduction in current liabilities of $400,000.
CA new = $2,500,000 - $400,000 = $2,100,000.
CL new = $1,666,667 - $400,000 = $1,266,667.
CR new = $2,100,000/$1,266,667 = 1.66.
85. P/E ratio and stock price Answer: b Diff: T
Here are some data on the initial situation:
EPS = $50/20 = $2.50.
Stock price = $2.50(8) = $20.
If XYZ had the industry average inventory turnover, its inventory balance
would be:
Turnover = 5 =
Inv
Sales
=
Inv
$1,000
Inv = $1,000/5 = $200.
Therefore, inventories would decline by $100.
The income statement would remain at the initial level. However, the company
could now repurchase and retire 5 shares of stock:
e Price/shar
available Funds
=
$20
$100
= 5 shares.
Thus, the new EPS would be:
New EPS =
g outstandin Shares
income Net
=
5 - 20
$50
= $3.33.
The new stock price would be:
New price = New EPS(P/E) = $3.33(8) = $26.67.
Stock price increase = $26.67 - $20.00 = $6.67.
86. Du Pont equation and debt ratio Answer: e Diff: T
EQ
A

A
S

S
NI
× × = ROE.
Data for A:
0.7($500)
$500

$500
$1,000

$1,000
NI
× × = 0.15

0.7($500)
NI
= 0.15 = NI = $52.50.
∴ROE =
S
NI
=
$1,000
$52.50
= 0.0525 = 5.25%.
Data for B:

EQ
A

A
S

S
NI
× × = 0.30
0.0525 × 2 ×
EQ
$500
= 0.30
0.1050 ×
EQ
$500
= 0.30

EQ
$500
= 2.8571
Equity = $175.
Debt = $500 - $175 = $325.
Therefore, D/A = $325/$500 = 0.65 or 65%.
87. Financial statement analysis Answer: a Diff: T
Sales $15,000
Cost of goods sold _______
EBIT $ 1,065
Interest 465
EBT $ 600
Taxes (35%) 210
NI $ 390
BEP =
TA
EBIT
=
$8,000
EBIT
= 0.133125; EBIT = $1,065.
Now fill in: EBIT = $1,065.
Interest = EBIT - EBT = $1,065 - $600 = $465.
A
D
=
$8,000
D
= 0.45; D = 0.45($8,000) = $3,600.
Interest rate =
Debt
Interest
=
$3,600
$465
= 0.1292 = 12.92%.
88. EBIT Answer: e Diff: T
Write down equations with given data, then find unknowns:
Profit margin =
S
NI
= 0.06.
Debt ratio =
A
D
=
$100,000
D
= 0.4; D = $40,000.
TA turnover =
A
S
= 3.0 =
$100,000
S
= 3; S = $300,000.
Now plug sales into profit margin ratio to find NI:
$300,000
NI
= 0.06; NI = $18,000.
Now set up an income statement:
Sales $300,000
Cost of goods sold ________
EBIT $ 33,200 (EBIT = EBT + Interest)
Interest 3,200 ($40,000(0.08) = $3,200)
EBT $ 30,000 (EBT = $18,000/(1 - T) = $30,000)
Taxes (40%) 12,000
NI $ 18,000
89. Sales increase needed Answer: b Diff: T N
You need to work backwards through the income statement to solve this problem.
The new NI will be: ($1,800,000)(1.25) = $2,250,000.
Now find EBT:
(EBT)(1 - T) = NI
EBT = NI/(1 - T)
= $2,250,000/(1 - 0.4)
= $3,750,000.
Now find EBIT:
EBIT - I = EBT
EBIT = EBT + I
EBIT = $3,750,000 + $1,500,000
= $5,250,000.
Now find Sales:
(Sales)(Operating Margin) = EBIT
Sales = EBIT/Operating Margin
= $5,250,000/0.4
= $13,125,000.
Therefore, sales need to rise to $13,125,000. How much of an increase is
this?
$13,125,000/$12,000,000 = 1.09375. Therefore, sales have gone up by 9.375%
(rounded to 9.38%).
90. Debt ratio and Du Pont analysis Answer: c Diff: M N
The Du Pont analysis of return on equity gives us:
ROE = ROA × EM
14% = 10% × EM
1.4 = EM.
From the equity multiplier (A/E), we can calculate the debt ratio:
1.4 = A/E
E/A = 1/1.4
E/A = 0.7143.
D/A = 1 – E/A
D/A = 1 – 0.7143
D/A = 0.2857 = 28.57%.
91. Profit margin and Du Pont analysis Answer: a Diff: E N
Using the Du Pont analysis again, we can calculate the profit margin.
ROE = PM × TATO × EM
14% = PM × 5 × 1.4
14% = PM × 7
2% = PM.
92. ROA Answer: d Diff: M N
ROA = NI/Assets. Total assets = $3,200,000,000 (from the balance sheet).
We, know ROE = NI/Common equity = 0.20, with Common equity = $900,000,000
(from the balance sheet).
0.20 = NI/$900,000,000
NI = $180,000,000.
So, ROA = $180,000,000/$3,200,000,000 = 0.05625, or 5.625%.
93. Current ratio Answer: b Diff: M N
Recall the current ratio is CA/CL = $900,000,000/$800,000,000 = 1.125.
The plan looks like this: Debit Fixed assets $300,000,000
Credit Notes payable $300,000,000
So, current liabilities increase by $300 million, while current assets do not
change.
So, the new current ratio is $900,000,000/($800,000,000 + $300,000,000) =
$900,000,000/$1,100,000,000 = 0.818.
94. Miscellaneous concepts Answer: e Diff: E N
The correct answer is statement e. The current ratio in 2002 was 1.77, while the
current ratio in 2001 was 1.64. Hence, the current ratio was higher in 2002.
The debt ratio was 0.4773 in 2002 and 0.5250 in 2001, so the debt ratio decreased
from 2001 to 2002. The firm issued $300 million in new common stock in 2002.
95. Net income Answer: b Diff: E N
To determine 2002 net income, use the following equation:
Ending retained earnings = Beginning RE + NI – Dividends paid
$800,000,000 = $700,000,000 + NI – $50,000,000
$150,000,000 = NI.
96. Sales, DSO, and inventory turnover Answer: b Diff: M N
Step 1: One of our initial conditions is that inventory turnover (S/Inv.) <
6.0, hence:
Sales/Inventory < 6.0
Sales/$850,000,000 < 6.0
Sales < $5,100,000,000.
Step 2: Our second initial condition is that DSO < 50, hence:
AR/(Sales/365) < 50.0
$450,000,000/(Sales/365) < 50.0
[($450,000,000)(365)]/Sales < 50.0
($450,000,000)365 < 50(Sales)
[($450,000,000)(365)]/50 < Sales
Sales > $3,285,000,000.
So, the most likely estimate of the firm’s 2002 sales would fall between
$3,285,000,000 and $5,100,000,000. Only statement b meets this requirement.
97 . Financial statement analysis
Answer: a Diff: E N
The correct answer is statement a. The current ratio in 2002 is 1.02, while
in 2001 it is 0.785. So, statement a is correct. For statement b, assume
that sales are X. The inventory turnover ratio for 2002 is X/$1,000,000 and
X/$700,000 in 2001. So, the inventory turnover ratio for 2001 is higher than
in 2002. (If that’s not clear, try X = $500,000 or any other number.) Thus,
statement b is incorrect. The debt ratio in 2002 is 0.596, while in 2001 it’s
0.672, so statement c is incorrect.
98 . Current ratio
Answer: c Diff: M N
Step 1: Determine actual 2002 sales:
DSO = AR/(Sales/365)
40 = $432,000/(Sales/365)
40(Sales)/365 = $432,000
40(Sales) = $157,680,000
Sales = $3,942,000.
Step 2: Determine new accounts receivable balance if DSO = 30 and sales
remain the same:
30 = AR/($3,942,000/365)
30 = AR/$10,800
AR = $324,000.
Step 3: Determine the amount of freed-up cash and the new level of accounts
payable.
Freed-up cash = $432,000 - $324,000 = $108,000.
New AP = $700,000 - $108,000 = $592,000.
Step 4: Determine the new current ratio:
CR = ($100,000 + $324,000 + $1,000,000)/($592,000 + $800,000)
= $1,424,000/$1,392,000
= 1.023.

Leverage and financial ratios
4

Answer: d

Diff: E

.

Stennett Corp.’s CFO has proposed that the company issue new debt and use the proceeds to buy back common stock. Which of the following are likely to occur if this proposal is adopted? (Assume that the proposal would have no effect on the company’s operating income.) a. b. c. d. e. Return on assets (ROA) will decline. The times interest earned ratio (TIE) will increase. Taxes paid will decline. Statements a and c are correct. None of the statements above is correct. Answer: e Diff: E

Leverage and profitability ratios
5

.

Amazon Electric 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 beforetax cost of debt financing. Which of the following will occur if the company increases its debt ratio? a. b. c. d. e. Its ROA will fall. Its ROE will increase. Its basic earning power (BEP) will stay unchanged. Statements a and c are correct. All of the statements above are correct. Answer: b Which of the following statements is most correct? a. A company that has positive net b. If a company’s ROE is greater positive. c. If a company increases its EVA, d. Statements a and b are correct. e. All of the above statements are income must also have positive EVA. than its cost of equity, its EVA is its ROE must also increase. correct. Answer: e Diff: E Diff: E N

EVA
6

.

ROE and EVA
7

.

Which of the following statements is most correct about Economic Value Added (EVA)? a. If a company has no debt, its EVA equals its net income. b. If a company has positive ROE, its EVA must also be positive. c. A company’s EVA will be positive whenever the cost of equity exceeds the ROE. d. All of the statements above are correct. e. None of the statements above is correct.

Chapter 3 - Page 2

ROE and EVA
8

Answer: b

Diff: E

.

Devon Inc. has a higher ROE than Berwyn Inc. (17 percent compared to 14 percent), but it has a lower EVA than Berwyn. Which of the following factors could explain the relative performance of these two companies? a. b. c. d. e. Devon is much larger than Berwyn. Devon is riskier, has a higher WACC, and a higher cost of equity. Devon has a higher operating income (EBIT). Statements a and b are correct. All of the statements above are correct. Answer: b Diff: E

Ratio analysis
9

.

Bedford Hotels and Breezewood Hotels both have $100 million in total assets and a 10 percent return on assets (ROA). Each company has a 40 percent tax rate. Bedford, however, has a higher debt ratio and higher interest expense. Which of the following statements is most correct? a. b. c. d. e. The two companies have the same basic earning power (BEP). Bedford has a higher return on equity (ROE). Bedford has a lower level of operating income (EBIT). Statements a and b are correct. All of the statements above are correct. Answer: a Diff: E

Financial statement analysis
10

.

Company J and Company K each recently reported the same earnings per share (EPS). Company J’s stock, however, trades at a higher price. Which of the following statements is most correct? a. b. c. d. e. Company J must have a higher P/E ratio. Company J must have a higher market to book ratio. Company J must be riskier. Company J must have fewer growth opportunities. All of the statements above are correct. Answer: e Diff: E

Financial statement analysis
11

.

Company A’s ROE is 20 percent, while Company B’s ROE is 15 percent. Which of the following statements is most correct? a. b. c. d. e. Company A must have a higher ROA than Company B. Company A must have a higher EVA than Company B. Company A must have a higher net income than Company B. All of the statements above are correct. None of the statements above is correct.

Chapter 3 - Page 3

Financial statement analysis 12 Answer: e Diff: E . equity multiplier decreased. Company A must have a higher current ratio than Company B. Answer: a Diff: E Miscellaneous ratios 14 .Page 4 . e. The company’s net income will increase. The proceeds from the stock issue will be used to reduce the company’s outstanding debt and interest expense. Company A has a higher debt ratio and interest expense than Company B. d. c. However. All of the above statements are correct. correct. c. Statements b and c are correct. debt ratio increased. None of the above statements is correct. total assets turnover than Company B. or tax rate. d. Bichette Furniture Company recently issued new common stock and used the proceeds to reduce its short-term notes payable and accounts payable. e. The stock issue will have no effect on the company’s total assets. The company’s times interest earned ratio will increase. Answer: d Diff: E N Financial statement analysis 13 . b. operating income (EBIT) than Company B. b. c. time interest earned ratio decreased. Companies A and B have the same profit margin and debt ratio. Answer: e Diff: E R Miscellaneous ratios 15 . The company’s ROA will increase. Company A and Company B have the same total assets. e. basic earning power ratio increased. EBIT. Company A has a higher return on assets and a higher return on equity than Company B. Which of the following can explain these observed ratios? a. Which of the following statements is most correct? a. Company A must have a higher total assets turnover than Company B. c. Nelson Company is thinking about issuing new common stock. d. The The The The The company’s company’s company’s company’s company’s current ratio decreased. b. Chapter 3 . b. d. This action had no effect on the company’s total assets or operating income. and profit margin. e. Which of the following is likely to occur if the company goes ahead with the stock issue? a. return on assets (ROA). Which of the following effects did occur as a result of this action? a. However. All of the statements above are correct. Company A has a higher Company A has a higher Company A has a higher Statements a and b are Statements a and c are ROE (return on equity) than Company B. correct. Company A must have a higher equity multiplier than Company B.

c. Van Buren Company has a current ratio = 1. Drysdale has a higher return on assets than Commerce. d.0 c. Answer: e Diff: M Current ratio 17 . Drysdale has a higher profit margin Commerce.5 b. Which of the following actions can a firm take to increase its current ratio? a. and the same return on equity. Statements b and c are correct. 2. 1.5 1. c.Medium: Current ratio 16 Answer: d Diff: M . the same total assets turnover. 1. Issue short-term debt and use the proceeds to buy back long-term debt with a maturity of more than one year. Chapter 3 .71 Answer: c Diff: M N Ratio analysis 19 . As a short-term creditor concerned with a company’s ability to meet its financial obligation to you. None of the statements above is correct.5 TIE 0. Which of the following actions will increase the company’s current ratio? a.Page 5 .50 0.50 0. 0. e.0 1.5 1. Use cash to reduce accounts payable. Drysdale has a higher profit margin Commerce. c. b.0 0. b. Use cash to purchase additional inventory. which one of the following combinations of ratios would you most likely prefer? Current ratio a.0 e.5 d. d.33 0. However. Reduce the company’s days sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. Statements a and b are correct. Drysdale Financial Company and Commerce Financial Company have the same total assets. Which of the following can explain these ratios? a. d. Drysdale has a lower profit margin Commerce. All of the statements above are correct. e.5 Debt ratio 0. b. Use cash to reduce short-term notes payable. Drysdale has lower net income but more and a higher debt ratio than and a lower debt ratio than and a lower debt ratio than common equity than Commerce. Ratio analysis 18 Answer: c Diff: M .9. Issue long-term bonds to repay short-term notes payable.67 0. 2.

one would expect to find lower profit margins for airlines. b. e. An increase in the DSO.Page 6 . d. Financial statement analysis 22 Answer: a Diff: M . Answer: a Diff: M Effects of leverage 21 . A firm with financial leverage has a larger equity multiplier than an otherwise identical firm with no debt in its capital structure. where all firms earn similar returns on equity. Which of the following statements is most correct? a. You have collected the following information: • • • • • The two Company Company Company Company companies have X has a higher X has a higher Y has a higher Y has a higher the same total assets. e. Company Y must have a higher ROA. current ratio than Company X. c. All of the statements above are correct. with no changes in its sales and operating costs. An increase in a firm’s debt ratio. c. Statements a and b are correct. Which of the following statements is most correct? a. could be expected to lower its profit margin on sales. All else equal. which require a lot of fixed assets relative to sales. inventory turnover ratio than Company X. Statements a and c are correct. The use of debt in a company’s capital structure results in tax benefits to the investors who purchase the company’s bonds. e. Statements a and c are correct. Ratio analysis Answer: a 20 Diff: M . b. Drysdale has a lower price earnings ratio than Commerce. than for fresh fish markets. An increase in the DSO. It is more important to adjust the debt ratio than the inventory turnover ratio to account for seasonal fluctuations. b. d. profit margin than Company Y. You are an analyst following two companies. c. total assets turnover than Company Y. d. other things held constant. would generally lead to an increase in the total assets turnover ratio. Which of the following statements is most correct? a. In a competitive economy. other things held constant. Company X and Company Y. Company X must have a higher ROE. Company X must have a higher net income. Chapter 3 . a firm with a higher debt ratio will have a lower basic earning power ratio.e. would generally lead to an increase in the ROE.

Total assets turnover must be above the industry average. higher interest expense than Company B. while its return on equity and debt ratio exceed the industry average. Answer: b Diff: M R Du Pont equation 26 . Both companies have positive net incomes. Mills Automotive has a higher net income than Harte Motors. and therefore. Company A has a higher basic earning power ratio. Company A has a higher return on equity. Total assets turnover must be below the industry average. has less equity and a higher debt ratio than does Mills Automotive. d. All of the statements above are correct.Page 7 . e. What can you conclude? a. the same level of sales. total assets. Mills Automotive has a higher profit margin than Harte Motors. Company A has a higher debt ratio. has a higher net income than Company B. however. Company A also has a higher debt ratio and. however. Company A has a higher total assets turnover. d. c. Harte Motors. and the same return on equity (ROE). has a lower profit margin than Company B. e. higher interest expense than Company B. e. Statements a and b are correct. therefore. and net income. Which of the following statements is most correct? a. Harte Motors and Mills Automotive each have the same total assets. has a higher times interest earned (TIE) ratio than Company B. None of the statements above is correct. Which of the following statements is most correct? a. Statements a and b are correct. d. tax rate. Company A and Company B have the same total assets. pays less in taxes than Company B. Answer: d Diff: M N Leverage and financial ratios 25 . Chapter 3 . b. b. has a lower equity multiplier than Company B. Return on assets must be above the industry average. d. Harte Leverage and financial ratios 24 Answer: e Diff: M . None of the statements above is correct. Company A. b. e.Financial statement analysis 23 Answer: d Diff: M N . c. All of the statements above are correct. Mills Automotive has a higher return on assets (ROA) than Motors. You observe that a firm’s profit margin is below the industry average. Company A and Company B have the same tax rate. b. c. Which of the following statements is true? a. Company Company Company Company Company A A A A A has a higher ROA than Company B. c. and basic earning power.

this implies that its ROE exceeds its cost of equity. its basic earnings power ratio (BEP) must be greater than that of Firm B. and its debt ratio is 40 percent. Firms A and B have the same net income.ROE and EVA 27 Answer: d Diff: M . Huxtable Medical’s CFO recently estimated that the company’s EVA for the past year was zero. All of the statements above are correct. they must also have the same EVA. percent. b. b. Which of the following statements is most correct? a. c. they must have the same price earnings ratio. If a firm has positive ROE. Chapter 3 . was negative. operating income was less than the total Answer: b Diff: M ROE and EVA 28 . d. e. c. Miscellaneous ratios 29 Answer: b Diff: M . Statements b and c are correct. If Firm A has a higher interest expense. If Firms A and B have the same earnings per share and market to book ratio.Page 8 . If a firm has positive EVA. d. d. The company’s net income The company’s net income The company’s ROA was 14 The company’s ROE was 14 The company’s after-tax dollar cost of capital. All of the statements above are correct. The company’s cost of equity capital is 14 percent. b. its return on equity (ROE) must be greater than that of Firm B. e. was zero. percent. Which of the following statements is most correct? a. If Firm A has a higher interest expense. If two firms have the same ROE and the same level of risk. and total assets. taxes paid. None of the statements above is correct. its cost of debt is 8 percent. c. Which of the following statements is most correct? a. Firms A and B have the same net income. this implies that its EVA is also positive. e.

Company X has a lower net income than Company Y. Division A has a higher ROE than Division B. Statements b and c are correct. have positive ROEs and EVAs. Answer: d Diff: M Miscellaneous ratios 31 . Statements a and b are correct. Company X has a lower profit margin than Company Y. Company X also has a higher total assets turnover ratio than Company Y. All of the statements above are correct. d. Tough: ROE and EVA 32 Answer: a Diff: T .Page 9 . e. Division A is much larger (in terms of equity capital employed) than Division B. c. Company X has a higher ROE than Company Y. The company’s equity multiplier (EM) will increase. b. d. however. Company X has a lower debt ratio than Company Y. Reeves Corporation forecasts that its operating income (EBIT) and total assets will remain the same as last year. yet Division B creates more value for shareholders and has a higher EVA than Division A. The company’s return on assets (ROA) will fall. b. Both divisions. The company’s basic earning power (BEP) will fall.Miscellaneous ratios 30 Answer: e Diff: M . Division A has less debt than Division B. What can you conclude about the company’s financial ratios? (Assume that there will be no change in the company’s tax rate. c. What could explain these performance measures? a. Which of the following statements is most correct? a. Chapter 3 . Division A is riskier than Division B.) a. All of the statements above are correct. d. c. Statements b and c are correct. but Company Y has a higher ROA than Company X. b. but that the company’s debt ratio will increase this year. e. the two companies have the same total assets. e. however. All of the statements above are correct.

a higher return on assets (ROA). which of the following statements is most correct? a.Page 10 . a higher debt ratio and interest expense than Company D. Company Y have the same debt ratio. Answer: d information Diff: T two Ratio analysis 34 . both have the same return on assets (ROA). Lancaster has a lower profit margin than York. Company Y have the same total assets turnover (TATO). Company Company Company Company Company C C C C C must must must must must have have have have have a a a a a higher level of sales. which of the following statements is most correct? a. a higher interest expense than Company Y. e. lower ROA. lower ROE. b. higher basic earning power (BEP) ratio. However. Lancaster Co. d. Company Y have the same return on equity (ROE). e. Statements a and c are correct. You have collected the following information regarding Companies C and D: • The two • The two • The two Company C has • Company companies have the same total assets. b. An analyst has obtained the following companies. and York Co. companies have the same operating income (EBIT). c. b. a higher basic earning power (BEP) ratio. higher times interest earned (TIE) ratio. companies have the same tax rate. Company X and Company Y: • • • • • • Company Company Company Company Company Company X X X X X X and has has and and and regarding Company Y have the same total assets. d. Lancaster has a higher return on equity (ROE) than York. C has a lower profit margin than Company D. a lower profit margin. Lancaster has a lower debt ratio than York. Chapter 3 . e. Company Company Company Company Company X X X X X has and has has has a higher times interest earned (TIE) ratio. c.Ratio analysis 33 Answer: d Diff: T . d. Which of the following statements is most correct? a. Answer: d Diff: T Ratio analysis and Du Pont equation 35 . a lower operating income (EBIT) than Company Y. On the basis of this information. Lancaster has a higher total assets turnover and a higher equity multiplier than York. c. All of the statements above are correct. • On the basis of this information. Company Y have the same tax rate.

All of the statements above are correct. which of the following statements is most correct? a.000 360. d. The company’s net income will increase. The company’s return on assets will fall. b. Fitzgerald Hotels: Ratio Profit margin ROA Total assets BEP ROE Hemmingway Hotels 4% 9% $2. and it plans to finance this increase by issuing $1 million in new debt. a and b are correct. has higher net income than Fitzgerald. Chapter 3 . and its average tax rate will remain at 40 percent. e.Leverage and financial ratios 36 Answer: d Diff: T . Hemmingway Hemmingway Hemmingway Statements All of the has a higher total assets turnover than Fitzgerald. This action will double the company’s interest expense but its operating income will remain at 20 percent of its total assets. Statements a and b are correct.000. If the company takes this action. c.000 $ 900. has a higher debt ratio than Fitzgerald.0 billion 20% 18% Fitzgerald Hotels 3% 8% $1. which of the following will occur: a.5 billion 20% 24% On the basis of the information above. e. c.Page 11 . Answer: c Diff: T Miscellaneous ratios 37 . The company’s return on equity will remain the same. Some key financial data and ratios are reported in the table below for Hemmingway Hotels and for its competitor.000 $ 540.000 The company wants to increase its assets by $1 million. statements above are correct. b.000 100. Blair Company has $5 million in total assets. The company’s income statement is summarized below: Operating income (EBIT) Interest Earnings before taxes (EBT) Taxes (40%) Net income $1. The company’s assets are financed with $1 million of debt and $4 million of common equity. d.

shares outstanding = 25.00 $2. calculate the market price per share of WAM Inc. e.000 $18.00 $ 8. and market/book ratio = 1.250. b.000.00 $ 1. c. b. b.000. d.00 Answer: c Diff: E $200.000 2.00 0.000 $15.000.0.00 $166.000.5.00 $ 10.000 Answer: b Diff: E Market price per share 39 .000. c. e.000. Meyersdale Office Supplies has common equity of $40 million.000 125. e.00 $2. The company recently reported that its basic earning power (BEP) ratio was 15 percent and its return on assets (ROA) was 9 percent. $ 33. Russell Securities has $100 million in total assets and its corporate tax rate is 40 percent. Given the following information. d. Calculate the market price of a share of the company’s stock.: Net income Earnings per share Stockholders’ equity Market/Book ratio a. The company’s stock price is $80 per share and its market/book ratio is 4.000. You are given the following information: Stockholders’ equity = $1. $20. a. price/earnings ratio = 5.33 $ 75. b. c. How many shares of stock does the company have outstanding? a.Multiple Choice: Problems Easy: Financial statement analysis 38 Answer: a Diff: E . c.00 $ 2. What was the company’s interest expense? a.67 $133.Page 12 .20 Market/book ratio 41 .00 $ 4.32 Answer: c Diff: E Market price per share 40 .000 $ 6. d. 500. $ 0 $ 2.000.000 Chapter 3 .

93 Chapter 3 .000. $0.86 $50. c.2 billion in current liabilities.1% Answer: b Diff: E TIE ratio 44 . Market/book ratio 42 Answer: e Diff: E N .000 e.3% 15. c.00 Answer: d Diff: E ROA 43 . has earnings after interest but before taxes of $300.9% 12. Culver Inc. b.d.00 $57. 8.00.Page 13 .40 5. If the firm has debt of $7. $42. and its stock price is $20 per share. what is the firm’s ROA? a. Insufficient information.15 4. total assets of $22. A firm has a profit margin of 15 percent on sales of $20.00 $40.2 billion in common equity. Calculate the company’s interest charges. d. b.25 2. Strack Houseware Supplies Inc. d. d.000.4% 10. e. e.00 $60. c.500. 800.000. b.6 billion in long-term debt. has $2 billion in total assets. e. and $1. and an aftertax interest cost on total debt of 5 percent. 1. The company’s times interest earned ratio is 7.0% 13. What is Strack’s market/book ratio? a.500.000. The other side of its balance sheet consists of $0. a.000.65 3. The company has 300 million shares of common stock outstanding.

2 13.000 5.25% 5.000 Debt Equity Total claims $10.50% 4. by how much would its ROE increase? a. cut operating costs.0 1.200 $ 800 400 $ 400 160 $ 240 $4. Your company had the information for 2002: Balance Sheet: Cash A/R Inventories Total current assets Net fixed assets Total assets statement $ 20 1.Page 14 . You think you can change your inventory control system so as to cause your turnover to equal the industry average. d. 2.4% c.33% Diff: E .000 $6.ROE 45 Answer: c Tapley Dental Supply Company has the following data: Net income Sales Total assets Debt ratio TIE ratio Current ratio BEP ratio $240 $10.000 Income Statement: Sales Cost of goods sold EBIT Interest (10%) EBT Taxes (40%) Net income The industry average inventory turnover is 5.00% 3. What will your profit margin be after the change in inventories is reflected in the income statement? a.020 2. e.000 $9.00% 4. The cash generated from reducing inventories will be used to buy tax-exempt securities that have a 7 percent rate of return.1% b.000 $6. and this change is expected to have no effect on either sales or cost of goods sold. and raise net income to $300 without affecting sales or the balance sheet (the additional profits will be paid out as dividends).000 75% 2.50% Answer: c following balance sheet and income Diff: E Profit margin 46 .000 9. 2.000 5. 4. b.5% Chapter 3 . If Tapley could streamline operations. 3.980 $9. c.

0. c. $10. A similar firm that is publicly traded had a price/earnings ratio of 5. privately owned firm. d.50 Answer: b Diff: E P/E ratio and stock price 48 . d. c.0× 4. The Charleston Company is a relatively small.3% e.00 $40.50 $ 5.33 0.00 $60. e. b.000 shares were outstanding.67 0.7% Du Pont equation 47 Answer: a Diff: E . What is the company’s stock price? a. a.0.000.00 $50. estimate the market value of one share of Charleston’s stock.00 Chapter 3 . $20. Cleveland Corporation has 100.00 $ 7.67 0. Using only the information given. e. b. and its P/E is 8.000 and 10. 2%.000 shares of common stock outstanding.Page 15 . The owners were trying to determine the equilibrium market value for the stock prior to taking the company public. d. its net income is $750. 2%.50 $ 1. Last year the company had net income of $15.00 $ 2. 4%.00 $30. c. 4%. 4%. e. 6.0% 6.50 Answer: e Diff: E P/E ratio and stock price 49 .d.33 0. b. The Wilson Corporation has the following relationships: Sales/Total assets Return on assets (ROA) Return on equity (ROE) 2.0% What is Wilson’s profit margin and debt ratio? a. 5.

the accounts receivable account averaged $41. what will be the level of accounts receivable following the change? Assume a 365-day year.096.000. b.50 $1. b. and it will raise additional short-term debt (that will show up as notes payable on the balance sheet) to purchase the inventory. What is the maximum amount that the company can increase its inventory before it is restricted by these covenants? a. Its days sales outstanding (DSO) is 50 days. Assuming that the company adopts this change and succeeds in reducing its DSO to 32 days and does lose 10 percent of its sales.33 million million million million million Medium: Accounts receivable increase 51 Answer: b Diff: M R .5.000 Chapter 3 . $633. Assume that the value of the remaining current assets will not change. d.Current ratio and inventory 50 Answer: b Diff: E N .466 Answer: a Diff: M R Accounts receivable 52 . a.333 c. how much external funding will Cannon need? Assume a 365-day year. The company’s CFO estimates that if this policy is adopted the company’s average sales will fall by 10 percent. $3 million in current liabilities. $0.000 in accounts receivable.Page 16 . If the resulting increase in accounts receivable must be financed externally. d.096 $ 51. The company wants to reduce its DSO to the industry average of 32 days by pressuring more of its customers to pay their bills on time. Iken Berry Farms has $5 million in current assets. it is expected that the days sales outstanding will also increase by 50 percent. During the year. Cannon Company has enjoyed a rapid increase in sales in recent years. Ruth Company currently has $1. the firm has noticed a recent increase in its collection period. The company’s bond covenants require it to maintain a current ratio that is greater than or equal to 1. while credit sales should continue to be the same proportion of total sales. and. e.000 b.000 of these sales were on credit. $ 41. However. following a decision to sell on credit.370 $ 47. c. total sales were $1 million.00 $1.359 $106. e.33 $1.471 $ 92. $576. Last year. c. a.66 $2. It is expected that sales will increase in the forthcoming year by 50 percent. and its initial inventory level is $1 million. $750. The company plans to increase its inventory. and $250.

0% Chapter 3 . You have found the return on equity to be 18 percent.000 in total assets. 3. 6. The company’s times interest earned (TIE) ratio is 8. It has a profit margin of 4 percent.97% 4. receivables of $150.8% 6.25% d.56% 5. $900. its tax rate is 40 percent. 33.80% c. d. c.Page 17 .1% b. sells all its merchandise on credit.45% 5.80% b. 0. its times interest earned (TIE) ratio is 5. 1. and its basic earning power (BEP) ratio is 10 percent. The company’s basic earning power (BEP) is 10 percent. b.0% 4. If sales were $4 million. Viera Company has $500.ROA 53 d.4% c.33% 8.0.60% e. A fire has destroyed a large percentage of the financial records of the Carter Company. e. 71. What is the firm’s return on equity (ROE)? Assume a 365-day year. Selzer Inc. ROA 54 Answer: e Diff: M . 10. days sales outstanding equal to 60 days. and the company’s tax rate is 40 percent.40.667 Answer: a Diff: M . Insufficient information. c. e. total assets of $3 million.000. and a debt ratio of 0.64. b.000 e. the debt ratio was 0.0% 7. d. What is the company’s return on assets (ROA)? a. 12. 3. 7. Humphrey Hotels’ operating income (EBIT) is $40 million. and total liabilities were $2 million.2% Answer: c Diff: M R ROE 56 . $966.4% d.25% Diff: M N ROA 55 Answer: c . You have the task of piecing together information in order to release a financial report. a. what would be the return on assets (ROA)? a. What is the company’s return on assets (ROA)? a.2% 4.

8.e.1% Chapter 3 .Page 18 .

500 $5.77% $1. Currently.00% 4. Assume Meyer Corporation is 100 percent equity financed.2% 7.00% 40. d.Page 19 . return on equity. e. given the following information: Earnings before taxes Sales Dividend payout ratio Total assets turnover Tax rate a. If the firm’s ROA is 6 percent. Its tax rate is 40 percent. c.57% Diff: M .00% 20.0% 5. A firm has a debt/equity ratio of 50 percent. e.000 of total debt outstanding.04% 12. b. by how many percentage points is the firm’s ROE greater than its ROA? a. c.31% 30.0% 3.4% 9.99% 28. d.0 30% Calculate the ROE 59 Answer: c The Amer Company has the following characteristics: Sales Total assets Total debt/Total assets Basic earning power (BEP) ratio Tax rate Interest rate on total debt What is Amer’s ROE? a. b.000. it has interest expense of $500.31% 16.000 60% 2.000 on $5. e. 25% 30% 35% 42% 50% $1. b. Chapter 3 .000 35. 11.ROE 57 Answer: b Diff: M .000 $1.0% ROE 58 Answer: d Diff: M . d. c. 0.

0 Answer: b Diff: M N TIE ratio 62 . and the company’s tax rate is 40 percent. 2. e. e. its average tax rate is 40 percent.4 3.0 will have a debt ratio of a. its return on assets (ROA) is 10 percent. c.5 1.00 0.4 3.75 0.2 0. If the company does not maintain a TIE ratio of at least 4 times.71 1. 2. d. Alumbat’s annual sales are $3. b. b.000 of debt outstanding. Alumbat Corporation has $800. 2. and it pays an interest rate of 10 percent annually on its bank loan. Lancaster Motors has total assets of $20 million.6 Chapter 3 .33 2. c. Its basic earning power is 25 percent. e.50 Answer: b Diff: M TIE ratio 63 . c. d.6 4. and bankruptcy will result. A firm that has an equity multiplier of 4. e.0 5.000. b. What is Alumbat’s current TIE ratio? a.5 3. its bank will refuse to renew its loan.Page 20 . and its return on assets (ROA) is 3 percent.00 1.Equity multiplier 60 Answer: d Diff: M . and its net profit margin on sales is 6 percent. The company’s basic earning power (BEP) ratio is 12 percent. What is Lancaster’s TIE ratio? a. 4.00 3. Moss Motors has $8 billion in assets. What is Moss’ times interest earned (TIE) ratio? a.25 1. and its tax rate is 40 percent. b. d.00 1. d.200.25 Answer: e Diff: M TIE ratio 61 . c.0 1.

84 1. e. 1. b.3 billion must go towards principal payments on outstanding loans and longterm debt.0. Peterson Packaging Corp.30 0.TIE ratio 64 Answer: d Diff: M N .52 2.83 3. The Merriam Company has determined that its return on equity is 15 percent.000. and the company’s ROE was 15 percent.96% 2.48% 5.Page 21 .82 4. It has $0. has $9 billion in total assets. e. 2. The company’s net income was $400.35 and total assets turnover = 2.06 1. b. 3. and its times interest earned ratio is 3. What is Peterson’s EBITDA coverage ratio? a.25 1. its total assets turnover was 6. d.10 2. Kansas Office Supply had $24. b.45% Chapter 3 . Management is interested in the various components that went into this calculation. Peterson’s depreciation and amortization expense totals $1 billion. Roll’s Boutique currently has total assets of $3 million in operation.8. You are given the following information: total debt/total assets = 0. its performance yielded a basic earning power (BEP) of 25 percent and a return on assets (ROA) of 12 percent. what is the firm’s times interest earned (TIE) ratio? a.92 2. c. 0.000. e.60 0.6 billion in lease payments and $0. c. d. What is the company’s debt ratio? a.77 Answer: c Diff: M Debt ratio 66 . b. c.0. What is the profit margin? a.20 0. c.000 in sales last year. The company is financed entirely with debt and common equity. The company’s basic earning power (BEP) ratio is 9 percent. Over this year. d. The firm’s earnings are subject to a 35 percent tax rate.33 0.17 Answer: a Diff: M N EBITDA coverage ratio 65 .42% 6. d.66 Answer: a Diff: M Profit margin 67 . On the basis of this information.

$ 68. Collins plans to change its credit policy so as to cause its DSO to equal the industry average. what will Collins’ debt ratio (Total debt/Total assets) be after the change in DSO is reflected in the balance sheet? a. $125.000. d.000 Chapter 3 .020 2. Collins Company had the following partial balance sheet and complete income statement information for 2002: Partial Balance Sheet: Cash A/R Inventories Total current assets Net fixed assets Total assets Income Statement: Sales Cost of goods sold EBIT Interest (10%) EBT Taxes (40%) Net income $ 20 1. -$ 8. 12.000 $10. 33.00 Days sales outstanding (DSO) (365-day year) 40.00 Current liabilities $ 375.65% Answer: b Diff: M R Financial statement analysis 69 .200 $ 800 400 $ 400 160 $ 240 The industry average DSO is 30 (assuming a 365-day year).00% 65. e.75% 60.000 9.000 2.82% Financial statement analysis 68 Answer: e Diff: M R . How much cash does Taft have on its balance sheet? a.Page 22 . and this change is expected to have no effect on either sales or cost of goods sold.493 c.000.28% 52.33% 45. inventories.000 $ 3.200.000 d. c.e.20 The company’s current assets consist of cash.80 Current ratio 1. b.333 b. If the cash generated from reducing receivables is used to retire debt (which was outstanding all last year and has a 10 percent interest rate). Taft Technologies has the following relationships: Annual sales $1.00 Inventory turnover ratio 4.980 $ 6. $200. and accounts receivable.

33 Chapter 3 . what will be the company’s stock price one year from now? a.000.000 1. e.500.000 shares of stock.500. d.33% 20. b. c.000 Notes payable Accounts payable Accruals Total current liabilities Long-term bonds Total debt Total common equity Total liabilities and equity $ 100 200 100 $ 400 600 $1. basic earning power (BEP)? a. The company continues to expand and anticipates that one year from now its net income will be $2. d.50% P/E ratio and stock price 71 Answer: e Diff: M .67% 17.000 $2. 14. If this occurs.e. which is above the industry average of 30. what will be the new current ratio? a. 1. e.000. c. Parcells Jets has the following balance sheet (in millions): Cash Inventories Accounts receivable Total current assets Net fixed assets Total assets $ 100 300 400 $ 800 1. Assume that Parcells is able to reduce its DSO to the industry average without reducing sales.667 Answer: d Diff: M Basic earning power 70 . $55 $60 $65 $70 $75 Answer: a Diff: M Current ratio and DSO 72 . 1. $316. Aaron Aviation recently reported the following information: Net income ROA Interest expense $500. Dean Brothers Inc. Over the next year the company also anticipates issuing an additional 100.12% 16.000 shares of common stock.000 shares of common stock.000 Parcells’ DSO (on a 365-day basis) is 40. b.000 What is the company’s The company’s average tax rate is 40 percent.000 10% $200. so that one year from now the company will have 400. and it currently trades at $60 a share.67% 22. and the company takes the freedup cash and uses it to reduce its outstanding long-term bonds.200 ______ $2. The company has 300. Assuming the company’s price/earnings ratio remains at its current level.75 b. recently reported net income of $1.Page 23 .

50 2.000 700. d. What will be the current ratio if Cartwright fully succeeds in implementing this plan? a.25 e.200.67 Current ratio 73 Answer: c Diff: M N .63 1.000. 1.00 0. If successful the plan will free up cash. the company would take 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. 2. if it is able to accomplish its goal of improving its inventory management? a. Cartwright’s days sales outstanding (DSO) is well above the industry average of 15. Currently.33 d.250 $2.Page 24 .000 $2.000 Accounts payable Accruals Notes payable Long-term debt Common equity Total liabilities and equity $ 200. d.000 500.000 Jefferson wants to improve its inventory turnover ratio so that it equals the industry average of 10. 1.25 1.50 Answer: b Diff: M N Current ratio 74 .50 2. e.000 100. Jefferson Co.30 1.000 200. If successful.000 1.000 $2. What will be Jefferson’s current ratio.000 Cartwright’s average daily sales are $10 million.43 1.000.000 800. c. 1.00 Chapter 3 . Cartwright Brothers has the following balance sheet (all numbers are expressed in millions of dollars): Cash Accounts receivable Inventories Net fixed assets Total assets $ 250 250 250 1. The company would like to accomplish this goal without reducing sales.000 200.0× . c. has $2 million in total assets and $3 million in sales.c.000 Accounts payable Notes payable Long-term debt Common stock Total claims $ 300 300 600 800 $2. b. half of which will be used to reduce notes payable and the other half will be used to reduce accounts payable. The company has the following balance sheet: Cash Accounts receivable Inventories Net fixed assets Total assets $ 100. 1. Cartwright is implementing a plan that is designed to reduce its DSO to 15 without reducing its sales. b.

e. 1.20 Chapter 3 .Page 25 .

000 Current liabilities Long-term debt Common equity Total claims $200.000 200. along with the new 12 percent profit margin.400. What are the company’s sales? (Assume that the company has no preferred stock.000 $ 360. What new debt ratio. d.000 $ 960. e. d.86% 18.000 The company has been advised that their credit policy is too generous and that they should reduce their days sales outstanding to 36 days (assume a 365-day year).5. and a profit margin of 10 percent.000 $2. and a profit margin of 5 percent.88% 16.000. c. The tighter credit policy is expected to reduce the company’s sales to $730.000 190.000 300.25.) a. Total assets turnover will not change.000 $700.000. a total assets turnover ratio of 0.000.440. Daggy Corporation has the following simplified balance sheet: Cash Inventories Accounts receivable Net fixed assets Total assets $ 25. b. b. c.000 and result in EBIT of $70.000. The interest rate on long-term debt is 10 percent and the company’s tax rate is 30 percent. would be required to double the ROE? a. The company’s total assets equal $800 million.Page 26 . 55% 60% 65% 70% 75% Answer: a Diff: M Sales and extended Du Pont equation 77 . What is the company’s expected ROE after the change in credit policy? a.Credit policy and ROE 75 Answer: c Diff: M R . d. c. The increase in cash resulting from the decrease in accounts receivable will be used to reduce the company’s long-term debt.38% 16. 14.63% 15. The Board of Directors is unhappy with the current return on equity (ROE).25% Answer: d Diff: M Du Pont equation 76 .000 $700.000 360. $1. e.000 $ 120. b. a debt ratio of 40 percent. and they think it could be doubled. e.000.000 Chapter 3 .000 125.000. Shepherd Enterprises has an ROE of 15 percent. This could be accomplished (1) by increasing the profit margin to 12 percent and (2) by increasing debt utilization. Austin & Company has a debt ratio of 0.

The company is 100 percent equity financed. c. d. What does Roland & Company expect its return on equity to be following the changes? a. EBIT is projected to be $25. it expects to have a total assets turnover ratio of 3.500 Tough: ROE 79 Answer: c Diff: T . e.0. What is the company’s net income? a.571 $2. which will result in interest charges of $7.000 on sales of $270.82% 26. c.44% 51. e. The new plan would place the debt ratio at 55 percent.333.857. Roland & Company has a new management team that has developed an operating plan to improve upon last year’s ROE.25% Chapter 3 . Samuels Equipment has $10 million in sales. and the average tax rate will be 40 percent.Net income and Du Pont equation 78 Answer: c Diff: M N .5× .67% 44.500. b.333 $ 52. 17.Page 27 .000 per year.000 $2.65% 21. $1. d. b. Its ROE is 15 percent and its total assets turnover is 3.000.143 $ 428.

000.000 $6.000 $1.5% 33. While the company’s financial performance is quite strong.000.000.000 4. b. so the company’s interest expense each year is 10 percent of its total debt. The cash that was generated from the reduction in inventories was used to reduce part of the company’s outstanding debt.0.400.0% Chapter 3 .000.0% 29. but was able to reduce inventories enough to achieve the industry average inventory turnover ratio.000 Total debt Total equity Total claims $3.000.000 400.000 2.000 500. The CFO has noticed that the company’s inventory turnover ratio is considerably weaker than the industry average. c.000 $ 600.000 $6.000 Income Statement: Sales Operating costs Operating income (EBIT) Interest Taxable income (EBT) Taxes (40%) Net income The company’s interest cost is 10 percent.000 1. what would have been the company’s ROE last year? a. d.000 400. Georgia Electric reported the following income statement and balance sheet for the previous year: Balance Sheet: Cash Inventories Accounts receivable Current assets Net fixed assets Total assets $ 100.ROE 80 Answer: d Diff: T . 27.000.000 $1.400. The company’s interest expense would have been 10 percent of new total debt. So.000.000 $1.) Under this scenario. its CFO (Chief Financial Officer) is always looking for ways to improve.3% 31.Page 28 . e. which is 6.600.000 1.600. Assume equity does not change.5% 30. the CFO asks what would the company’s ROE have been last year if the following had occurred: • • • The company maintained the same sales. the company’s total debt would have been $4 million less the freed-up cash from the improvement in inventory policy. (The company pays all net income as dividends. As an exercise.000 $4.

270 Income Statement: Sales Operating costs EBIT Interest EBT Taxes (40%) Net income $2.0% Chapter 3 . 9. Suppose Savelots took actions to increase its accounts payable to inventories ratio to the 60 percent industry average. amount to only 20 percent of inventories versus an industry average of 60 percent. Savelots Stores’ current financial statements are shown below: Balance Sheet: Inventories Other current assets Fixed assets Total assets $ 500 400 370 $1. and that the change in payments will not affect operations. common equity will not change. In addition. which have no interest cost and are due entirely to purchases of inventories. 13.843 $ 157 37 $ 120 48 $ 72 A recently released report indicates that Savelots’ current ratio of 1.0% d. its accounts payable.9.8% c. 7. but it (1) kept all of its assets at their present levels (that is. However. and equity $ 100 370 800 $1.270 Accounts payable Short-term notes payable Common equity Total liab. what will be Savelots’ new ROE? a. With the changes. the asset side of the balance sheet remains constant) and (2) also held its current ratio constant at 1.9 is in line with the industry average.Page 29 . Assume that Savelots’ tax rate is 40 percent.ROE and financing 81 Answer: a Diff: T . 12.5% b.2% e. that its cost of short-term debt is 10 percent. 10.000 1.

15.0% 40% 60.000 and the debt ratio will hold constant at 80 percent.67 3.26 0.5 million. 18. its current assets are $2.0% d.7% TIE ratio 83 Answer: d Diff: T . 10. b. but the interest rate on the refinanced debt will be 10 percent.0% b.6% e. If the company succeeds in its plan.50 1. b.0% 2. The firm’s total debt will remain at $200. Refinancing will not affect sales.75 2.000 3. what will be its projected new ROE? a.97 1. d. 8.72 Chapter 3 .Page 30 . The resulting decrease in accounts receivable will free up cash that will be used to reduce current liabilities. The rate on the old debt is 14 percent.2% c.10 2. Aurillo Equipment Company (AEC) projected that its ROE for next year would be just 6 percent. 0. and its current ratio is 1.000. 3. 1. c.5.0% 10.0 What is Lombardi’s TIE ratio? a. Lombardi Trucking Company has the following data: Assets Profit margin Tax rate Debt ratio Interest rate Total assets turnover $10. c. EBIT will be 11 percent of sales and the firm’s tax rate is 40 percent.ROE and refinancing 82 Answer: d Diff: T . However.6 million of accounts receivable on its balance sheet.45 Answer: e Diff: T Current ratio 84 . The company plans to reduce its DSO from 40 to the industry average of 30 without causing a decline in sales. what will Victoria’s new current ratio be? a. The company’s DSO is 40 (based on a 365-day year). the financial staff has determined that the firm can increase its ROE by refinancing some high interest bonds currently outstanding. d. If AEC refinances its high interest bonds.95 1. which are projected to be $300. e. Victoria Enterprises has $1.

assets of $500. e. and if sales. a debt ratio of 30 percent. c. XYZ’s balance sheet and income statement are given below: Balance Sheet: Cash A/R Inventories Fixed assets Total assets $ 50 150 300 500 $1. b.) a. the cost of goods sold.e. $ 3.0% Chapter 3 . What is B’s debt ratio? (Hint: Begin by looking at the Du Pont equation. and net income as Company A.00 $12. if it used the funds generated by this change to buy back common stock at the current market price and thus to reduce common equity. c. the interest rate on the firm’s long-term debt is 10 percent.75 $10.0.000 $1. assets.66 P/E ratio and stock price 85 Answer: b Diff: T . d. 1. b. and an ROE of 15 percent. 25. If XYZ changed its inventory methods so as to operate at the industry average inventory turnover. Company A has sales of $1.000. Company B has the same sales. but its ROE is 30 percent. by what dollar amount would its stock price increase? a.000 855 $ 145 70 $ 75 25 $ 50 The industry average inventory turnover is 5.50 Answer: e Diff: T Du Pont equation and debt ratio 86 . 20 shares are outstanding.0% 50.67 $ 8.0% 52.000 Income Statement: Sales Cost of goods sold EBIT Interest EBT Taxes (33.333%) Net income Accounts payable $ 100 Notes payable 0 Long-term debt (10%) 700 Common equity (20 shares) 200 Total liabilities and equity $1. and the stock sells at a P/E of 8.Page 31 . d.33 $ 6.0% 35. and the P/E ratio remained constant. e.5% 65.

c.3125% $600 $15.000 $33.000 $18. EBIT 88 12.000 $30. d.23% 13. $ 3.92% 13.0 What is Lone Star’s EBIT? a.) a. b.Page 32 . the following data applied: Total assets Debt ratio Tax rate BEP ratio EBT Sales $8. Prior to the change.00% Answer: e Diff: T . d. c.000 Profit margin 6. the tax rate.0% Total assets turnover 3.000 These data have been constant for several years.0% Interest rate 8.200 Chapter 3 .51% 13. merely by cutting overtime pay and reducing cost of goods sold.000 45% 35% 13.0% Tax rate 40% Debt ratio 40. b. and the balance sheet will remain constant.75% 14. A company has just been taken over by new management that believes it can raise earnings before taxes (EBT) from $600 to $1.200 $12. What is the company’s cost of debt? (Hint: Work only with old data. and all income is paid out as dividends. e.Financial statement analysis 87 Answer: a Diff: T . Lone Star Plastics has the following data: Assets $100. Sales. e.000.

Debt ratio and Du Pont analysis 90 Answer: c Diff: M N . Fama’s total assets equal total debt plus common equity (that is. 48.000. 2.000 1. On the basis of these numbers. we know that the firm’s total assets turnover is 5. • Ricardo’s interest expense is expected to remain constant.29% 28.000. wants to see a 25 percent increase in net income over the next year.92% b.00% Multiple Part: (The following information applies to the next two problems.500.38% c.Page 33 .000 $ 4. there is no preferred stock). 25. Fred Mertz. • Ricardo’s tax rate is expected to remain at 40 percent. 14. What is Fama’s debt ratio? a. b. Furthermore.000 The company’s CFO.800. d. 9. Mertz has made the following observations: • Ricardo’s operating margin (EBIT/Sales) was 37. e.000. c.000 $ 3.) Fama’s French Bakery has a return on assets (ROA) of 10 percent and a return on equity (ROE) of 14 percent.500.000 7.5 percent this past year.200. In other words.250. his target for next year’s net income is $2.Sales increase needed 89 Answer: b Diff: T N . what is the percentage increase in sales that Ricardo needs in order to meet Mertz’s target for net income? a. Ricardo Entertainment recently reported the following income statement: Sales Cost of goods sold EBIT Interest EBT Taxes (40%) Net income $12.00% 28.56% 71.000 $ 1. Mertz expects that next year this margin will increase to 40 percent.57% 55. 72.50% d.44% e.500.43% Chapter 3 .000 1.

c. If this plan were carried out.Page 34 .818 1. What is Fama’s profit margin? a.125% 4. d.00% (The following information applies to the next two problems. what would Miller’s current ratio be immediately following the transaction? a.33% 6.125 1.00% 4.091 1. b. c.500% 3.) Miller Technologies recently reported the following balance annual report (all numbers are in millions of dollars): Cash Accounts receivable Inventory Total current assets $ $ 100 300 500 900 sheet in $ its Net fixed assets Total assets 2. d. A plan has been proposed that would entail issuing $300 million in notes payable to purchase new fixed assets (for this problem. e.625% 5. ROA 92 Answer: d What is Miller’s ROA? a.800 Chapter 3 . 2. e.33% 5.455 0.300 500 400 $ 900 $3. ignore depreciation).500 $2. 2. c. Current ratio 93 Diff: M N . e.00% 4.826% Answer: b Diff: M N . b. b.300 $3.Profit margin and Du Pont analysis 91 Answer: a Diff: E N .625% 7.200 Miller also reported sales revenues of $4.200 Accounts payable Notes payable Total current liabilities Long-term debt Total debt Common stock Retained earnings Total common equity Total liabilities and equity 300 500 $ 800 1. Miller Technologies is always looking for ways to expand their business. 0.5 billion and a 20 percent ROE for this same year. d.

500 800 $2. d. Answer: b Diff: E N Net income 95 .950 2.400 Answer: e 2001 $ 500 700 600 $1. c.100 1.400 $ 680 200 220 $1.Page 35 . Statements a and b are correct.450 $4. e.) Dokic. Which of the following statements is most correct? a.100 1. The company’s debt ratio was higher in 2002 than it was in 2001. What was the company’s net income during the year 2002? a. $ 50 $150 $250 $350 $450 million million million million million Chapter 3 .000 Diff: E N . c. e.000 1.300 $4. The company issued new common stock during 2002. Inc. b. The total dividends paid to the company’s common stockholders during 2002 was $50 million.800 2.000 1. Statements a and c are correct. reported the following balance sheets for year-end 2001 and 2002 (dollars in millions): Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets Accounts payable Notes payable Wages payable Total current liabilities Long-term bonds Common stock Retained earnings Total common equity Total liabilities and equity Miscellaneous concepts 94 2002 $ 650 450 850 $1.200 700 $1.(The following information applies to the next three problems. d.200 $4. b. The company’s current ratio was higher in 2002 than it was in 2001.000 $ 300 600 200 $1.900 $4.

and inventory turnover 96 Answer: b Diff: M N .532. DSO < 50).000 $1. Assume that 2001 and 2002 sales were the same in both years.000 $3. This debt was non-callable and is scheduled to mature in 2027. In addition.000 1.000 1.000.000 1. As of the end of 2002.445.000 $3. $ 2.200.200. the company’s DSO (days sales outstanding. calculated on a 365-day basis) was less than the industry average of 50 (that is. e.000 of long-term debt in 1997.000 $4. DSO.000 $ $ 700.000 Kewell Boomerangs has never paid a dividend on its common stock. d.000 $4.290.532.940 $ 5.000 $1.000 $1.000 $1.0.800.000 $1.000 900.000 2.000 432. b.000 350. what is the most likely estimate of the company’s sales (in millions of dollars) for 2002? a.Page 36 . When reviewing the company’s performance for 2002. Kewell issued $1. Chapter 3 .832.000 2001 85.500.000 3.000 1. none of the principal on this debt has been repaid. its CFO observed that the company’s inventory turnover ratio was below the industry average inventory turnover ratio of 6.765 (The following information applies to the next two problems.935.038 $ 7.000.000 800.200.000 $1.000 290. On the basis of this information.000.863 $30.500.000 332.135.Sales.000 $ $ 545.000 700.) Below are the 2001 and 2002 year-end balance sheets for Kewell Boomerangs: Cash Accounts receivable Inventories Total current assets Net fixed assets Total assets Accounts payable Notes payable Total current liabilities Long-term debt Common stock Retained earnings Total common equity Total liabilities and equity 2002 100. c.935.250 $10.000 1.532.

Assume instead that in 2002. and that the freed-up cash would have been used to reduce accounts payable.Financial statement analysis 97 Answer: a Diff: E N .021 1. b. c.033 Chapter 3 . During 2002. e. 1. Kewell had been able to achieve the industry-average DSO without reducing its sales. Kewell’s current ratio in 2002 was higher than it was in 2001. Which of the following statements is most correct? a. If this reduction in DSO had successfully occurred. what would have been Kewell’s new current ratio in 2002? (Assume Kewell uses a 365day accounting year. Kewell’s days sales outstanding (DSO) was 40 days.) a. d.018 1.Page 37 . Kewell’s inventory turnover ratio in 2002 was higher than it was in 2001. d. The industry average DSO was 30 days.027 1. All of the statements above are correct. b. e. None of the statements above is correct. Current ratio 98 Answer: c Diff: M N .023 1. Kewell’s debt ratio in 2002 was higher than it was in 2001. c.

Page 38 .CHAPTER 3 ANSWERS AND SOLUTIONS Chapter 3 .

6. Since taxes are paid with cash. In addition. Increasing the years over which fixed assets are depreciated results in smaller amounts being depreciated each year. For statement b.50. Coke Company: Before: Current ratio = $150/$100 = 1. A company can have positive NI and still have negative EVA. both EBIT and total assets remain the same.75. Statement c is true. and if they increase the current ratio will increase. both net income and equity are going to decline. After: Current ratio = $250/$200 = 1. Given that depreciation is a non-cash expense and is used to reduce taxable income. resulting in a lower ROA than before.25. not current assets. After: Current ratio = $150/$200 = 0. statement b is false. Current ratio Answer: a Diff: E Remember. The increase in debt payments will reduce net income and hence reduce ROA. Therefore. either current assets must increase. EVA Answer: b Diff: E N The correct answer is statement b. Leverage and profitability ratios Answer: e Diff: E Statement a is true. so ROE will actually rise. If the cost of equity times the amount of equity is greater than NI.(Cost of Equity)(Amount of Equity Capital). Leverage and financial ratios Answer: d Diff: E Statements a and c are correct. decreasing accounts payable results in using cash to pay off the accounts payable balance. Look at the following formula: EVA = NI . The other statements are false. Net fixed assets are long-term assets. Cash flows Answer: a Diff: E Answer: d Diff: E Statement a is correct. or current liabilities must decrease. higher debt will increase interest expense and net income will decline. the change would result in less depreciation expense and higher taxes for the year. Just because a company has a positive NI does not mean that it is earning enough to adequately compensate its shareholders. 4. higher debt payments will result in lower taxable income and less tax. so they will not affect the current ratio. 5. the company's cash flow would decrease. 3.1. Accounts receivable are a current asset. EVA could be negative. the current ratio is CA/CL. Therefore. So.50. look at the following formula: . so if they increase the current ratio declines. but net income will decline less because the basic earning power exceeds the cost of debt. Also. Statement b is true. In order to increase the current ratio. Current ratio Pepsi Corporation: Before: Current ratio = $50/$100 = 0. statement a is not correct. statement d is the best choice. statement a is true. So. 2. statement e is the best choice. Accounts payable are a current liability. statement c is false. So. Therefore.

First. In addition. . 8. and e are all false. statement b is false. so statement c is false. the correct choice is statement e.EVA = (ROE . W A C C×   (2) EVA = NI – (kS × Equity). then they must both have the same EBT. A higher EBIT would lead to a higher EVA. Therefore. ROA = NI/TA. TD = TZ. From the formula above. the only things that could explain this is if (1) its ks were higher or (2) its equity (or size) were lower. statement b is correct.k)(Equity).T) . decreasing its cost of equity. BEP = EBIT/TA. Answer: b Diff: E   -r   T o t a lI n v e s t o S u p p l i e d . The shareholders are getting a return but not as much as they require. EVA will be negative whenever the cost of equity exceeds the ROE. Therefore. statement b is true. So. Statement c is exactly the opposite of what is true. compare BEPs. ROAD = ROAZ. Compare ROEs.kS) × Equity. EVA can be calculated with 3 different equations: (1) EVA = EBIT(1 . As long as ROE is greater than the cost of equity. Breezewood = Z.kS) would be lower. Therefore. Therefore. If both companies have the same ROA and total assets. EVAD < EVAB. d. NID = NIZ.k) × Total equity. not shareholders. If both companies have the same NI and tax rate. INTD > INTZ. then (ROE . However. EVA would be negative even if ROE is positive. not just the increase in ROE. Ratio analysis Answer: b Diff: E 9 Bedford = D. (3) EVA = (ROE . statement a is false. you can see that a company can increase its EVA by increasing its ROE. then they must both have the same net incomes. so statements a. Any of these three changes would increase EVA. statement c is false.) Therefore. ROE = . D/AD > D/AZ. ROE and EVA Answer: e Diff: E EVA is the value added after both shareholders and debtholders have been paid. statement a is false. O p e r a t i nC a p i t a l   g  Since Devon has a higher ROE. Therefore. and EVA would be lower. so its EBIT must be higher than Breezewood’s. so it is false. Since statements a. and c are false. 7. ROE and EVA ROED > ROEB. Statement b must be true for the following reason. Bedford has higher interest payments. Net income only takes payments to debtholders into account. EVA will be positive. statement c is incorrect. (Remember: EBT + I = EBIT. Bedford’s BEP is higher than Breezewood’s. Since statement a would have the opposite effect (increasing Devon’s EVA). if k is larger than ROE. TAD = TAZ. but its EVA is lower. b. EVA = (ROE . or by increasing its equity investment. If the kS were higher. Therefore. Work backward up the income statement.

b. Although EBIT is unchanged. so NI will increase. so we cannot say which one has a higher net income. statement a is false. Remember. 1 − D/A Bedford has a higher D/A ratio than Breezewood. 12. So statement b is false. interest expense will go down. and c are false. then from the Du Pont equation Company A also has a higher total assets turnover ratio than B. However. we don’t have enough information to say anything about ROA.ks × Equity. their total assets turnover ratios must be the same. If the stock issue has no effect on the company’s total assets. Financial statement analysis Answer: e Diff: E Answer: a Answer: e Diff: E Diff: E From the first sentence. both firms have the same net income. Financial statement analysis Financial statement analysis ROE = NI/Equity. If Company A has a higher ROE than B. 13. Since statements a and c are correct. If its EM is higher and its ROA is the same. sales. ROA = NI/TA. the correct choice is statement e. statement b is false. Answer: a Diff: E The firms have the same profit margin and equity multiplier. it has a higher EM than Breezewood. this means that A must have higher operating income (EBIT) than B. but interest expense goes down. only statement a explains the observed ratios. Therefore. Therefore statement c is correct. the correct choice must be statement e. EVA = NI . ROA = ROE/EM (EM = equity multiplier). The current ratio does not explain the ratios discussed. but NI has increased (see statement a). Since A has more debt. it must have less equity. statement c is also correct. and assets. Therefore. statement b is correct. . then ROA (NI/TA) will increase. then Bedford’s ROE must be higher than Breezewood’s. We know that A’s ROE is higher than B’s. So statement a is correct. Therefore. Since we don’t have EM. Therefore. Since statements a. 14. we don’t know how much equity either one has. therefore. Therefore. Therefore. statement c is false. Therefore. If A has higher interest expense than B but the same net income. 11. the TIE ratio (EBIT/INT) will increase. Financial statement analysis Answer: d Diff: E N The correct answer is statement d. we don’t know enough to determine which company’s EVA is higher. The equity multiplier is the same because both companies have the same debt ratio. Miscellaneous ratios The Du Pont equation states: ROE = PM × TATO × EM. We don’t know anything about the ks or the amount of equity of either company.ROA × EM and EM = 1 . statement a is correct. Thus. Therefore. its ROE (calculated as Net income/Equity) is higher than B’s. Since the two firms have the same total assets and sales. We know nothing about the debt ratio or equity multiplier of either company. 10. If EBIT is unchanged.

statement c could explain the ratios in the problem. So. Ratio analysis TAD = TAC. If the ROEs are the same and the TATOs are the same. then its ROE would be lower. so statement b is incorrect. Drysdale and Commerce have the same TATO. So statement a is false. then (PM × EM) could be the same for both. 16. If Drysdale’s PM and debt ratio are lower than Commerce’s and both have the same TATO. Therefore. So statement b is false. EBIT will be unaffected. statement d is incorrect. but we may see interest costs fall due to the firm having less debt. This will result in an increase in the TIE ratio. This transaction will reduce current liabilities. The stock price cannot explain what is going on with the two companies’ ratios. So statement c is false. Current ratio Answer: d Diff: M Statement d is the correct answer. 17. Total debt is reduced but total assets remain the same. If Drysdale has lower NI and more common equity (higher TE). The firm now has more equity. Answer: c Diff: M N Since TATO is the same for both. Therefore. . The problem states that the companies have the same ROE. if Drysdale has a higher PM and a higher EM (if the debt ratio is higher. If Drysdale has a higher PM and a lower EM. Therefore. However. ROED = ROEC. its BEP ratio remains unchanged. and since TA is the same for both. The P/E ratio is irrelevant. statement a is incorrect. ROAD > ROAC. which results in a higher current ratio. 18. Looking again at the Du Pont equation: ROE = PM × TATO × EM. Miscellaneous ratios Answer: e Diff: E R Current ratio = Current assets/Current liabilities. the EM is higher). In statement c only the denominator goes down (long-term bonds are not in the current ratio). Remember the Du Pont equation: ROE = PM × TATO × EM. then its ROE must be higher. sales must be the same for both (since TATO = Sales/TA). For 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. The basic earning power ratio = EBIT/TA. the problem states that the companies have the same ROE. TIE = EBIT/Interest. Current ratio Ratio analysis Answer: e Answer: c Diff: M Diff: M 19. so the current ratio will increase. Statement d is also false for the same reasons as statements a and b.15. so the equity multiplier (Assets/Equity) will decrease. Since neither the firm’s operating income (EBIT) or total assets have changed. so statement e is correct. S/TAD = S/TAC. Drysdale would have a lower ROE. TATOD = TATOC so. then (PM × EM) must be the same for the two companies.

X’s ROA must also be higher than Y’s. if a firm takes on more debt. A must have a higher EBIT than B to cover this extra interest. Both companies have the same total assets. Therefore. Financial statement analysis Answer: d Diff: M N The correct answer is statement d. there will be less equity than there would have been. In either case we need to know the amount of equity that both firms have. This is impossible to determine given the information in the question. BEP = EBIT/TA. The other statements are false. Of course. The other statements are then also true. Statement b is false. We know S/TA and ROE are the same for both. A has a higher ROE than B. hence the ROE might rise even though the profit margin declined. Start with the Du Pont equation: NI/S × S/TA × TA/E = ROE. If X has higher sales and also a higher profit margin (NI/Sales) than Y. 21. and this will lower its profit margin. Since the equity of Mills is higher than Harte. Ratio analysis Answer: a Diff: T Statement a is correct. Effects of leverage Answer: a Diff: M Statement a is correct. but A has more debt and thus less equity than B. Since statements a. Therefore. not to the investors who purchase debt (in the form of bonds). and c are true. ROE = NI/EQ or ROE = ROA × Equity multiplier. So. Remember from the Du Pont equation that ROA = Profit margin × Total assets turnover = NI/S × S/TA. Leverage and financial ratios Answer: e Diff: M TATO = Sales/TA. 23 . ROE = NI/Equity. Thus. it must have higher sales than Y. Since Company X has both a higher profit margin and total assets turnover than Company Y. The use of debt provides tax benefits to the corporations that issue debt. Both companies have the same total assets and net income. the others are false. statement a is correct. its interest expense will rise. 24. statement b is true. thus. it must have higher sales. A has a higher total assets turnover ratio than B. We know that A has higher interest payments than B but the same net income as B. we cannot say that X must have a higher ROE than Y. statement c is true. However. the correct choice is statement e. b. . since A has a lower profit margin than B and its net income is the same as B’s. A must have a higher basic earning power ratio than B. 22. Financial statement analysis Answer: a Diff: M Statement a is true because. statement a is true. Therefore. The basic earning power ratio would be the same if the only thing that differed between the firms were their debt ratios. Therefore. Therefore. Given Mills’ higher net income. its NI must also be higher to keep ROE the same. If Company X has a higher total assets turnover (Sales/TA) but the same total assets. Statement c is false. it must follow that X has a higher net income than Y. both the profit margin and the ROA for Mills are also higher than Harte’s. Therefore.20.

resulting in negative EVA. ks × Equity cannot be zero. Note that the firm’s ROA does not have to be higher than the industry ROA for this equation to hold. There is a positive relationship between the debt ratio and the equity multiplier. which we know not to be correct. the correct choice is statement d. then Company A pays less in taxes than Company B. If EBIT is the same for both A and B and Company A has higher interest expense. Thus ROE = 14%. Therefore. statement c is also false. Rewrite the EVA equation by substituting into it EVA = 0. TATO must be higher for the equation to hold. Company A must have a lower TIE ratio than Company B. For this statement to be correct. Thus ROA will fall. Leverage and financial ratios Answer: d Diff: M N If BEP and total assets are equal. Company A has a higher debt ratio and higher interest expense than Company B. Divide both sides by Equity and you obtain the following equation: NI/Equity = ks. the ROE must exceed the cost of equity. therefore. So statements a and b are false. EBIT = EBT + Interest.25. it must have a lower ROA (since total assets are the same). thus causing the equity multiplier (EM) to increase. we know that EBIT is equal. statement e is the correct choice. The Du Pont equation: ROE = (PM)(TATO)(EM). PM is below average. and a reduction in NI. which could be different for the two firms. and you get: NI = ks × Equity. 28. If A has lower EBT. ROA = NI/TA. ROE and EVA Answer: b Diff: M Statement a is false. . Statement c is only correct if the firm has zero debt. Statement e would give a negative EVA and the problem states that the firm’s EVA is zero. Statement c is false. A’s amount of debt would have to be greater than B’s. Statement b is correct.) Therefore. EVA depends upon the amount of equity invested. net income must be positive if EVA is zero. 29. Miscellaneous ratios Answer: e Diff: M Statements b and c are correct. This equation really does not have anything to do with the EVA calculation. for positive EVA. ROA = NI/TA. Therefore. it is very plausible to have a firm with positive ROE and a higher cost of equity. Miscellaneous ratios Answer: b Diff: M Statement b is correct. EM = Assets/Equity. Since Company A has lower net income. Du Pont equation Answer: b Diff: M R 27. Statement c is incorrect because higher interest expense doesn’t necessarily imply greater debt. Therefore. An increase in the debt ratio will result in an increase in interest expense. Company A has a lower EBT and lower net income than Company B. which means that Company A has a higher equity multiplier than B because A’s debt ratio is higher than B’s. 30. so it is false. (We are given information in the question stating that the firm’s debt ratio is 40 percent. 26. ROE = NI/Equity. the amount of equity in the denominator decreases. ROE is above average. EM is above average because a high debt ratio implies a high EM. As debt increases. ROE and EVA Answer: d Diff: M EVA = NI – (ks × Equity).

32. and therefore. Consequently. it must follow that it has a lower profit margin (NI/Sales). Statement c is false as TIE = EBIT/Interest. so statement b is correct. . If A has less debt. so its EBIT will be higher. a lower level of debt will make A less risky than B.ks) will be multiplied by a much larger number for Division A. So. In addition. the others are false. we can see that this would cause a higher EVA. TIEC < TIED. they could be the same or different. So. a higher EBIT will lead to a higher EVA. the correct choice is statement d. Another way to write the EVA formula is EVA = EBIT (1 – T) – [Cost of capital × Investorsupplied capital employed]. ROA C < ROAD. 34. then its EVA would be higher than B’s. Since A’s ROE is also higher than B’s. EVA will be lower. Since X has a higher total assets turnover ratio (Sales/TA) than Y and both firms have the same assets. Sales for each company are the same because they have the same total assets and the same total assets turnover ratio (TATO = Sales/TA). they have the same BEP = EBIT/TA from the facts as given in this problem. Therefore. more debt than Y. then A’s cost of equity capital will be higher than B’s. therefore. X must have less equity than Y. Ratio analysis Answer: d Diff: T We can conclude that X has a lower NI. 33. So. Statement b is false. so A’s cost of equity will be lower than B’s. it must have lower net income. not a lower one. Ratio analysis Answer: d Diff: T Statement d is correct. but the same tax rate as Y. because it has a lower EBIT and higher interest than Y. therefore. X must have a lower net income than Y. Therefore. statement c is false. X has a higher ROE (NI/EQ) than Y. and C has higher interest than D but the same EBIT. since X has a lower NI and same sales as Y. Company C must have lower equity than Company D. Statement a is false. So. Statement e is false. ROE and EVA Answer: a Diff: T The following formula will make this question much easier: EVA = (ROE . statement b is false. even though its net income is lower. So statement a is false. X’s sales must be higher than Y’s. then its interest payments will be lower than B’s. From the other EVA formula.ks) × Total equity. we cannot tell what sales are. which could lead it to have a higher ROE because its equity multiplier would be greater than company D's. This fact. means that X must have a lower profit margin (NI/Sales) than Y. From the facts as stated above. ROA = NI/TA. If Division A is riskier than Division B. then the term (ROE . Company C has higher interest expense than Company D. Miscellaneous ratios Answer: d Diff: M Since X has a lower ROA (NI/TA) than Y and both firms have the same assets. Thus. statement a is true. Since the two firms have the same total assets.31. combined with X’s lower net income. If ks is higher. statements b and c are both correct. If A is larger than B in terms of equity. So statement c is correct.

1/Equity multiplier. Since net income increases.000 400. 000 ROENew = $600. the correct choice is statement d. or A/EL > A/EY. ROA falls. So.000. The debt ratio is calculated as 1 . S/TAL > S/TAY.000 $1. Leverage and financial ratios The new income statement will Operating income (EBIT) Interest expense Earnings before taxes (EBT) Taxes (40%) Net income ROAOld = NI As s et s = $ 54 0 .000 $4. . If the 2 firms’ ROAs are equal. statement a is true. $6. So.000 $54 0. ROEOld = NI E quity = = 13. Therefore. $ 5. if Lancaster has a higher equity multiplier than York.000 $600. Since we know the 2 firms’ ROAs are equal and Lancaster has a higher equity multiplier it must have a higher ROE too.5% . We also know that ROA = Profit margin × Total assets turnover.0 0 0 Answer: d be as follows: $1. 00 0. Diff: T From the Du Pont equation we know that ROA = Profit margin × Total assets turnover.000 0. but Lancaster’s total assets turnover is greater than York’s then Lancaster’s profit margin must be lower than York’s.000. Therefore.000 $ 600.35 . 36.200. 8 % . statement b is false.2 × $6. From the extended Du Pont equation we know that ROE = Profit margin × Total assets turnover × Equity multiplier. Ratio analysis and Du Pont equation Answer: d ROAL = ROAY.000 200. $4.0 0 0 ROE New = = 10%. statement d is the correct choice. ROA falls and ROE increases. Since statements a and c are true.000 Therefore. its debt ratio must be higher too.000 Diff: T = 1 0.000 = 15. EML > EMY. statement c is true.0%. 00 0 .000.000.

1 . 2 × 0.000. 1 .09 $0.08/0.5.000.000.09/0. EBT = NI/(1 . statement c is the correct choice.000.04 2.18 billion.000.000 NI = $9.08 $0.09/0. 38.000/0. Step 2: Substitute the data given with the alternative relationships obtained in Step 1: TATO = ROA/PM D/A = 1 . Financial statement analysis BEP = EBIT/TA 0.(ROA/ROE). ROA = NI/TA 0. 1.12 billion.000.24) 0. Therefore interest expense = $0.EQ)/TA (TA/TA) .5 × 0.09 = NI/$100.000 EBIT = $15.37. Answer: a Diff: E .(0. ROA = NI/TA NI = TA × ROA.15 = EBIT/$100. D/A = = = = = TD/TA (TA .6 EBT = $15.25×.000.(EQ/TA) 1 .T) EBT = $9.(ROA/ROE) NI = TA × ROA = = = = = = Hemmingway 0.18) 0.667.08/0.67×.000. From the calculations above.(EQ/NI) × (NI/TA) 1 . = = = = = = Fitzgerald 0.(0.000. Miscellaneous ratios Step 1: Answer: c Diff: T Use the ratios and data to arrive at alternative relationships to answer the question: TATO = Sales/TA = NI/TA × S/NI = ROA × 1/PM.03 2.

000. M/B = ? Book value = $1 200 . TIE ratio TIE 7 7INT 6INT INT = = = = = EBIT/INT ($300 + INT)/INT $300 + INT $300 $50. 4 41 .000. P0 = $20. Alternative solution: Book value per share = $1.000. Shares outstanding = 300. ROA $20 .000.15($20.000.000.000.0 = $ 4 0 . 000 . 44.500.000. ROE Equity = 0.000. 0 0 $ 1 6 0 . 000 = $4. 0 0 0 .000. 0= 0s0h a r e s . 42.875.00. ROA = $3.000) = $1.3%.000.2(Book value) = 0.500. Market value = 0. $4.00 = 5.5) = $1. Answer: b Diff: E 40.39. 0$8 0 × s h a r e s = 2 . Answer: c Diff: E .875/25 = $75. Book value per share = $2.00 per share.000/$22.000) = $3.200.2($20) = $4.000.250/25 = $50.000.0. M/B = 43.00 Answer: d Diff: E Net income = 0.000. Market value per share = $50(1.000. Market price per share Answer: c Diff: E Number of shares = $200.250(1. CL = $200. Market/book ratio Answer: e Diff: E N CE = TA = $2. 000 300 . Market price per share Total market value = $1. Market value per share = $1.000 = $20.00 = 100. 0 0 00.000 = 13.5) = $75.000.000. 000 . LT debt = $600. 0 0000.000/100. . $1. Market/book ratio Answer: c Diff: E M P r i c p e rs h a r×e s h a r e s e = B BV $8 0 × s h a r e s 4.000/$2. Answer: b Diff: E 45.25($6.

000.5. calculate the profit margin.20 = 20%. We can increase current liabilities $1 million before the current ratio reaches 1.50.000.000 Sales 47.04) = 0.67 (CA/CL = $5/$3 = 1.67). or 66. P/E ratio and stock price EPS = $750.5%. find the debt ratio by finding the equity ratio: E/TA = (E/NI)(NI/TA).] Next.000 = $7.000 . 46.50 = $60.333 = 33. Sales/Total assets = S/TA = 2. [TA/S = 1/2 = 0.] E/TA = (1/ROE)(ROA) = (1/0.000 S = = 2.00. If notes payable are going to be raised to buy inventories. $240 + $210 NI New Profit margin = = = 0. D/TA must be 0. Du Pont equation Answer: a Diff: E First. P/E = Price/EPS = 8.000 = $3. Profit margin Current inventory turnover = Answer: c Diff: E $10. Answer: e Diff: E Answer: b Diff: E 50.0 = P/$1. $5. Price = 8 × $7. Therefore.000 = $1.$2.000/100.500 E $300 = 0.0450 = 4. we can see that Iken Berry Farms has a current ratio of 1. which equals NI/Sales: ROA = NI/TA = 0.000) = $210. P/E = 5.667. P = $7.5. 49.50. Inv = = = $2. 48. both the numerator and the denominator of the ratio will increase.16% = 4%.7% equity.Current ROE = New ROE = $240 NI = = 16%.5) = 0. Thus. $1. Increase in NI = 0. PM = (NI/TA)(TA/S) = 0.02. $1.3%.04.500 ∆ROE = 20% .04(0.50. [ROE = NI/E and ROA = NI/TA. Current ratio and inventory Answer: b Diff: E N With the numbers provided.000 S New inventory turnover = = 5. .07($3. 5 5 Inv Freed cash = $5.000/10.000 Inv S $10. $10.50. P/E ratio and stock price EPS = $15.06)(0.

Again. or $400 million.5X 0.000. .570.300. New A/R = [($250.466.300. BEP Therefore. ROE = ROA × Equity multiplier 18% = (ROA)(1.096 = $51. NI/TA = ROA. ROA Step 1: We must find TA. Hence.370. Net income is found by working through the income statement (in millions): EBIT Interest $40 5 (from TIE ratio: 8 = EBIT/Int) . Answer: b Diff: M R Accounts receivable increase DSO = $41. 000 000 + X $500. the new sales level will be $7.000/365) or AR = $576. 53.000. . We are given BEP and EBIT. 000 000 .5 ≥ ≥ ≥ ≤ $4 500. 000 + X $5. increase in receivables = $92.000.67) ROA = 10. .9) = $6.5) = $92.466 .5)/(365)](60)(1.000/(Sales/365) to find annual sales equal to $7.000. . . 52.$41. Answer: a Diff: M 54.000/365) = 60 days.000. Answer: e Diff: M EBIT BEP = TA Step 2: and TA = EBIT .D/A) = 1/(1 .1. TA = $40.CA + X CL + X $5. If sales fall by 10%.8%. Accounts receivable Answer: a Diff: M R First solve for current annual sales using the DSO equation as follows: 50 = $1.5 ≥ 1.4) = 1. 000 000 + X $3 000.67.000/0. .0.570. 000 000 X 51. 000 $1. 000 + 1.5X X $1. so now we need to find net income.000)(1.000(0.096/($250. ≥ 1. solve for the new accounts receivable figure as follows: 32 = AR/($6. using the DSO equation. ROA Equity multiplier = 1/(1 .

000.0)(1. equity.000. Answer: b Diff: M Answer: c Diff: M R 58.500(1 .000. 56.64 = Total debt/$3.4%.000/$500.6% = 3%. ROE .000 ROA = NI/TA = $24.000.8%.000.000. EBIT Int EBT Taxes (40%) NI $50.3))/$5.000 = $1. ROE Total equity = ($5. Total equity = $3.04($912.0525 = 5.000 .500.000/5 = $10. Equity multiplier = 1.000.048.000 $24.920.000 = 9%. ROE (Sales per day)(DSO) = A/R (Sales/365)(60) = $150. ROE = $36. Answer: c Diff: M .ROA = 9% .000. 59.000 $40.000.000 = $50.000 = 0.EBT Taxes (40%) NI Step 3: 55 .000) = $900. Total debt = $1.000. Total assets = $5.000 = 3.080.000.000.10 × $500.500/$1. ROE Answer: d Diff: M Profit margin = ($1.Debt = $1.06)($15.000.000.$350 = $650.000.0) = 42%.500) = $36.000)(2) = $10. ROA Answer: c Diff: M N BEP = EBIT/TA = 0.0.500.10. Profit margin = Net income/Sales.000 Sales = $912.000 -16. Equity = TA .000 = 21%. and EBIT: Debt = D/A × TA = 0.920.38% ≈ 3. ROE Calculate debt. Debt ratio = 0.000.35($1. so EBIT = 0. so INT = $50.25%. ROE = $900. TIE = EBIT/INT = 5.$1. $35 14 $21 ROA = $21/$400 = 0.000 + $10. Net income = (0.000.000 .000 -10. 57.080.000) = $350. Net income = 0.0 since firm is 100% equity financed. or 4.000 = $15. ROE = (Profit margin)(Assets turnover)(Equity multiplier) = (21%)(2.000/$10.

T) = [$200 .75.000. 60.0 0 .000. Now use the income statement format to determine interest so you can calculate the firm’s TIE ratio. T = 40%. Debt/Assets = 3/4 = 0. 62. 61. Equity multiplier Answer: d Diff: M Equity multiplier = 4.000/0.000.000 0 .EBIT = TA × BEP = $1..6) = $110. Assets = Debt + Equity 4 = Debt + 1 Debt = 3. 0 0 0 .0 3 $ 8 .000/(1 . TIE ratio Answer: e Diff: M TIE = EBIT/I.000 = 5.0. Interest = $800.0× .99%.6 = $320.000/$80. EBIT = $320.000 × 0.4/$650 = 16. Calculate net income and ROE: Net income = (EBIT . E B I T= $9 6 . TIE ? EBIT = 0.000.0457($350)](0.06 = $192.1 = $80.0 0 0 0 0 .200. 0 0 0 000 N I = $2 4 .I)(1 .0 0 . EBIT/TA = 12%. ROA = 3%. TIE = $400.4.0 0 0 0 0 . ROE = $110.1 2 $8.000. Net income = $3. so find EBIT and I.0 = Total assets/Total equity = 4/1.000 = $400. TIE ratio Answer: b Diff: M N TA = $8.000.20) = $200.T) = $192.000 × 0.000. .000. NI = 0. Pre-tax income = $192.000(0.000 + $80.

000 = NI.000. TIE ratio Answer: d Diff: M N The times interest earned (TIE) ratio is calculated as the ratio of EBIT and interest expense.000 $400.4) ($5.000.000.666. TIE = EBIT/Interest.000. ROA = NI/TA 10% = NI/$20.0× . 63.000.667 = = = = = (EBIT .000.000.T) ($5.000 $2. BEP = 25%. Interest expense can be obtained from the income statement by simply working your way up the income statement.000 EBIT = $750.000 $3.000 = EBIT. TIE = EBIT/INT = $960. BEP = 25% = EBIT TA EBIT $3.000/$560. TIE = EBIT/I = $5. BEP = EBIT/TA 25% = EBIT/$20. T = 40%.000.000 560.000. We can find EBIT from the BEP ratio and total assets given in the problem.000 .000 $240.000.0.000/$1.I I.000.000.000.333 $1. however.7143 ≈ 1.000.71.667 = 3.6) $5.000 EBT = $240. INT = EBIT – EBT = $960. To do this.000. ROA = N I T A .000.000.000. We need to find EBIT and Interest. 64.000.000 $2.000.6 See above.000.000. TA = $20.I)(0.I)(1 .000/0. NI $2.$400. we must first calculate net income from the data given for ROA.666.333.EBIT INT EBT Taxes (40%) NI $960.000.000.000 .000 $5.000 .000 See above. TIE ratio Answer: b Diff: M Remember. Therefore.000 .I)(1 .000 = 1. ROA = 10%.000 160.

12% =

NI $3,000,000 NI = $360,000.

Solving for EBT and then interest, we find:

NI (1 - T) $360, 000 EBT = (1 − 0.35) EBT = $553,846.
EBT = EBIT – INT = EBT $750,000 – INT = $553,846 INT = $196,154. We can now calculate the TIE as follows: TIE = TIE =

EBIT INT

$750, 000 $196 , 154 TIE = 3.82× .

65.

EBITDA coverage ratio

Answer: a

Diff: M

N

TA = $9,000,000,000; EBIT/TA = 9%; TIE = 3; DA = $1,000,000,000; Lease payments = $600,000,000; Principal payments = $300,000,000; EBITDA coverage = ? EBIT/$9,000,000,000 = 0.09 EBIT = $810,000,000. 3 = EBIT/INT 3 = $810,000,000/INT INT = $270,000,000. EBITDA = EBIT + DA = $810,000,000 + $1,000,000,000 = $1,810,000,000. EBITDA coverage ratio =

EBITDA + Lease payments INT + Princ. pmts + Lease pmts $1 810, , 000, 000 + $600, 000, 000 = $270, 000, 000 + $300, 000, 000 + $600, 000, 000

= 66. Debt ratio

$2 410 , , 000 , 000 $1 170 , , 000 , 000

= 2.0598 ≈ 2.06. Answer: c Diff: M

Debt ratio = Debt/Total assets. Sales/Total assets = 6 Total assets = $24,000,000/6 = $4,000,000. ROE = NI/Equity Equity = NI/ROE = $400,000/0.15 = $2,666,667. Debt = Total assets - Equity = $4,000,000 - $2,666,667 = $1,333,333. Debt ratio = $1,333,333/$4,000,000 = 0.3333. 67. Profit margin Equity multiplier = 1/(1 - 0.35) = 1.5385. ROE = (Profit margin)(Assets utilization)(Equity multiplier) 15% = (PM)(2.8)(1.5385) PM = 3.48%. Answer: a Diff: M

68.

Financial statement analysis Current DSO =

Answer: e

Diff: M

R

$1,000 = 36.5 days. $10,000/365

Industry average DSO = 30 days.

Reduce receivables by (36.5 – 30)  Debt = $400/0.10 = $4,000. $4,000 - $178.08 T D = = 65.65%. $6,000 - $178.08 T A 69. Financial statement analysis

 $10,000  = $178.08.  365 

Answer: b

Diff: M

R

First, find the amount of current assets: Current ratio = Current assets/Current liabilities Current assets = (Current liabilities)(Current ratio) = $375,000(1.2) = $450,000. Next, DSO = AR = = find the accounts receivables: AR/(Sales/365) DSO(Sales)(1/365) (40)($1,200,000)(1/365) = $131,506.85.

Next, find the inventories: Inventory turnover = Sales/Inventory

Inventory = Sales/Inventory turnover = $1,200,000/4.8 = $250,000. Finally, find the amount of cash: Cash = Current assets - AR - Inventory = $450,000 - $131,506.85 - $250,000 = $68,493.15 ≈ $68,493.

70.

Basic earning power

Answer: d

Diff: M

Given ROA = 10% and net income of $500,000, total assets must be $5,000,000.

NI A $500,000 10% = TA
ROA = TA = $5,000,000. To calculate BEP, we still need EBIT. income statement: EBIT $1,033,333 Interest 200,000 EBT $ 833,333 Taxes (40%) 333,333 NI $ 500,000 BEP = = To calculate EBIT construct a partial

($200,000 + $833,333) (Given) $500,000/0.6

EBIT TA

$1,033,333 $5,000,000 = 0.2067 = 20.67%.
71. P/E ratio and stock price Answer: e Diff: M

75. the new EPS = $2.$100 = $700.000 = $6. Step 2: Determine the new level of receivables required for Parcells to achieve the industry average DSO.000/400. 72 . Since the $100 cash freed up is used to reduce long-term bonds. Receivable s 30 = $10 $300 = Receivables. If the shares are selling for 12 times EPS.25.500.000 shares or $5.25(12) = $75. cur-rent liabilities remain at $400. so current assets declined by $100. then receivables must change. the new level of current assets is $800 . Receivable s DSO = . Answer: c Diff: M N Step 3: 73.000. Average Daily Sales Diff: M If DSO changes while sales remain the same. The new number of shares outstanding will be 400. $400 40 = Average Daily Sales $10 = Average Daily Sales. Current ratio and DSO Answer: a Step 1: Determine average daily sales using the old DSO. The current P/E ratio is then $60/$5 = 12. then they must be selling for $6.500.000/300.The current EPS is $1. Therefore. Current ratio = $700/$400 = 1. Thus. Calculate the new current ratio. Receivables decline by $100. Current ratio Currently: DSO = AR/Average Daily Sales .

reduced by $100 million. 74. Calculate the firm’s new current ratio with the improved inventory Step 5: . Therefore. turnover = Sales/Inv. Now. and the other half will be used to reduce accounts payable.000.000 from the old level. so inventories will be reduced by $200. CA = Cash + Inv. CL = A/P + Accruals + Notes payable = $200.000 = Inv.000 + $200. turnover = 10. = $3.000 + $100.000 = $400. its AR will be $150 million. Current ratio Answer: b Diff: M Step 1: Calculate the firm’s current inventory turnover. Step 2: Calculate what the firm’s inventory balance should be if the firm maintains the industry average inventory turnover. Therefore.000. If the firm reduces its DSO to the industry average. The firm needs to reduce accounts receivable because it doesn’t want to reduce average daily sales.000 that is freed up will be used to reduce notes payable. notes payable will fall by $50 million to $250 million. Step 3: Calculate the firm’s new current assets level.000 + $100. So. + A/R = $100.000 + $300. and accounts payable will fall by $50 million to $250 million. we can now calculate the firm’s new current ratio: Current Ratio = CA/CL = (Cash + AR + Inv. notes payable will be reduced by $100. New Inv. there must be an equal reduction on the right side of the balance sheet.000.000.0× (but sales stay the same).000. Step 4: Calculate the firm’s new liabilities level.000. 10× = $3 million/Inv.30× . Inv. N The new inventory level will be $300. Cartwright wants to reduce DSO to 15.= $250/$10 = 25 days. Half of the $200.0× . Inv. Therefore.000/$500.)/(Notes Payable + Accounts Payable) = ($250 + $150 + $250)/($250 + $250) = $650/$500 = 1. $300. turnover = Sales/Inv. Half of this $100 million of freed-up cash will be used to reduce notes payable.000 = $600. we can calculate the new AR balance as follows: DSO = AR/Average Daily Sales 15 = AR/$10 $150 million = AR. and the other half will be used to reduce common equity.000 = 6. This means that current assets will decrease by $200.000 to a new level of $100. Therefore.

300(1 . Answer: c Diff: M N Step 2: 78.25)(EM) EM = 3.8.33 = A/E. EBT = EBIT . 000. Credit policy and ROE Answer: c Diff: M R Use the DSO formula to calculate accounts receivable under the new policy as 36 = AR/($730.710/$200.000. Given a 10% interest rate. D/A = 40%.5× . Thus.$72. 75.5) = 2.0.000/365) or AR = $72. E/A = 1/3.0) = 5%. Thus.000 = 15.86%. Step 2: Calculate net income.7 = 70%.33 = 0.000/$400. Determine sales from the total assets turnover ratio: S/TA = 1. Sales = $10 million.8 S = $1.0833 S/TA = 15% S/TA = 1. Thus.857.3) = $31. Net income is $45. E/A = 60%. D/A = 1 – 0.Interest = $70.D/A) = 1/(1 .5× = Sales/TA $10. Step 1: Determine total assets turnover from the extended Du Pont equation: NI/S × S/TA × A/E = ROE (5%)(S/TA)(1. Sales and extended Du Pont equation Answer: a Diff: M NI/E = 15%.142.000 of long-term debt leaves $247.8571. After: [ROE = 2(5%) = 10%]: 10% = (12%)(0. ROE = $31. $125.6667.000 = $53.management.700. .5× = Assets Assets = $2.000(0. CR = CA/CL = $600. 3. 77. interest expense is now $247.440 million.6667) = 15% 0.300. A/E = 1/0.710. 000 3. Retiring $53. ROE = (PM)(Assets turnover)(EM) = (10%)(0.$24.0. 76.0.000 .3 = 0.000 = 1.000 in long-term debt. NI/S = 5%.8 S/$800 = 1.1) = $24. Net income and Du Pont equation Step 1: Calculate total assets from information given.6 = 1. Du Pont equation Before: Answer: d Diff: M Equity multiplier = 1/(1 .3.000 is the cash freed up by reducing DSO to 36 days.000 .25)(2.700 = $45.

ROE Given: New D/A = 0.500.000.3150 or 31.$500.(D/A)](Total assets) Equity = [1 .000.000 is to be used to reduce debt.800 (Given) ($18. Look at the income statement to determine net income: EBIT $1.000 = $3.000.000.5NI 0.000.000 Interest 350.000 EBT $1.500.571.000 × 0. .0 ROE = (PM)(TATO)(EM).000 Taxes (40%) 420.000 = 0. ROE = NI/Equity = $10.142. 79. so Assets = Equity = $2.500.000 × 40%) TATO = Sales/Total assets Total assets = Sales/TATO = $270.000 Interest = $7. Answer: c Diff: T Recall the Du Pont equation: ROE = (ROA)(EM).500 = 26.000 $500.000.400.000/6 = $500.000 ROE = Net income/Equity = $630. This $500.15 = NI/$10.55](Total assets) Equity = 0.000 7.45($90.000 × 3.000.000 . Reduction in inventories = $1.000. Current inventories = $1. EBIT Interest EBT Taxes (40%) NI $25. 000 $1.800/$40.857.500.000 7.15 = $10.50%.000/3 = $90. ROE = NI/Equity.8571.0.000) = $40. 80.000/$2.000.000 NI $ 630.5NI $428.5 × 1 3. ROE Answer: d Diff: T Industry average inventory turnover = 6 = Sales/Inventories. To match this level: Inventories = Sales/6 $3. Interest on this level of debt = $3.1 = $350.000 = $500. 000 .67%.000 $18.55 EBIT = $25.200 $10. New debt level = $4.000. ROE = NI/S × S/TA × TA/E 0.000 = 3.4286 = NI.There is no debt.000 Sales = $270. Equity = [1 .050.000.000 Tax rate = 40% TATO = 3.000.

= 0.000 $13.0.11($300.000.20.80 = $250.000 $33.000. and calculate new ROE: Old New EBIT $33.000.$100 = $200. ROE and financing Answer: a Diff: T The firm is not using its “free” trade credit (that is. its interest expense is higher than necessary.10 = $20.81.000 = $50. Notes payable decline by $200. Since the current ratio and total assets remain constant. EBIT Debt = $200.20. Calculate total assets and equity amounts: Since debt = $200.000.000 20.11(Sales) = 0. Answer: d Diff: T Old ROE = NI/Equity = 0.D/A = 1 . Construct comparative Income Statements from EBIT. Construct comparative Income Statements: Old Sales $2. Calculate the increase in payables: Current (A/P)/Inventories ratio = $100/$500 = 0. Since it is financing part of its assets with 10% notes payable.000 Interest 28.000 .000) = $33.80 = 0.000. Target A/P = 0.000. Old bonds 14%. total liabilities and equity must be unchanged.80 = 80%. Equity = E/TA × TA = 0.60(Inventories) = 0. New ROE = 10. 82.60($500) = $300. accounts payable (A/P)) to the same extent as other companies. total assets = $200.000/0. Interest rate change: New $2. ROE and refinancing Relevant information: Sales = $300. The increase in accounts payable must be matched by an equal decrease in interest-bearing notes payable. Increase in A/P = $300 .000 EBT $ 5.06 = 6%.20 × $250.000 Operating costs 1. Equity = 1 .843 $ 157 17 $ 140 56 $ 84 $84/$800 = 10. Interest expense decreases by $200 × 0.843 EBIT $ 157 Interest 37 EBT $ 120 Taxes (40%) 48 Net income (NI) $ 72 ROE = NI/Equity = $72/$800 = 9%. D/A = Tax rate = 40%. new bonds 10%.5%.000 1. 0.5%.

000 NI = $600. NI = 3% S NI PM = = 0. I = $6.0.000 5. (1 . .600/$600 = 2.800/$50. TD = 0.1) = $600.Taxes (40%) Net income 2. 83.800 New ROE = NI/Equity = $7.000.67. PM = EBT = $600 = $1.4) $1.000.000.6($10.000 $ 3.600 600 $1.6%. TIE ratio TIE = Answer: d = ? Diff: T EBIT I TA Turnover = S/A = 2 S/$10.1560 = 15.000 = 0. T D T A = 0.6.000 400 $ 600 EBIT Interest EBT Taxes (40%) NI TIE = $1.200 $ 7.000 = 2 S = $20.000) Debt = $6.03 $20.000(0.

000.000 – $1. Answer: b Diff: T Step 3: Step 4: 85.000.000 = $1.500.666.000/$1. inventories would decline by $100.200.000/CL $1.000 = average daily sales: AR/Average daily sales $1.67.600. So. its inventory balance would be: Turnover = 5 = Sales $1. Stock price = $2.000 = $400.000 = AR. Step 2: Calculate the new level of accounts receivable when DSO = 30: 30 = AR/$40. the new EPS would be: Net income $50 New EPS = = = $3. Calculate the new current ratio: The change in receivables will cause a reduction in current assets of $400.5. Du Pont equation and debt ratio However.200.666. P/E ratio and stock price Here are some data on the initial situation: EPS = $50/20 = $2.500. Current ratio Answer: e Diff: T Old DSO = 40.33.000/5 = $200. Answer: e Diff: T .500.266. Shares outstandin g 20 .000 = $2. Therefore.50(8) = $20.50.00 = $6.000.667. Stock price increase = $26.5 The new stock price would be: New price = New EPS(P/E) = $3.$400.600. CA/CL = 1.600.100. Calculate the old level of current liabilities: Current ratio = CA/CL 1.000 $1.33(8) = $26.667 = 1. CA = $2. If XYZ had the industry average inventory turnover.667 = CL.000 = Inv Inv Inv = $1. CA new = $2. the company 86. Price/shar e $20 Thus. CR new = $2. the change in receivables will be $1.5 = $2.000 and a reduction in current liabilities of $400.66. Step 1: Calculate DSO = 40 = $40.100. AR = $1.$20.$400.67 .000.000/Average daily sales Average daily sales.67.000 .667 .84. CL new = $1. could now repurchase and retire 5 shares of stock: Funds available $100 = = 5 shares.266.000. The income statement would remain at the initial level.

45($8.8571 = $175.30 = 0.065.000) = $3.$600 = $465.7($500) $52. Therefore.0525 × 2 × EQ $500 0.0525 = 5.65 or 65%.000 S Data for B: NI S A × × S A EQ $500 0.50 NI ∴ ROE = = = 0.25%. S . 0. D = 0. Financial statement analysis Sales Cost of goods sold EBIT Interest EBT Taxes (35%) NI BEP = $15. S A EQ Data for A: NI $1. Debt = $500 .000 Now fill in: EBIT = $1. EBIT = $1.7($500) NI = 0.92%. D/A = $325/$500 = 0. $8.$175 = $325.15 = NI = $52.1050 × EQ $500 EQ Equity = 0.000 $500 0.065 .600.600 Debt 88. EBIT Answer: e Diff: T Write down equations with given data. $8.065.000 A $465 Interest Interest rate = = = 0.15 $1.EBT = $1.000 _______ $ 1. then find unknowns: NI Profit margin = = 0. $3.45. Interest = EBIT .065 465 $ 600 210 $ 390 Answer: a Diff: T EBIT TA = EBIT = 0.30 = 2.000 $500 × × = 0. 87.NI S A × × = ROE.30 = 0. D D = = 0.06.1292 = 12.133125.50. $1.

000.000 = 1.250.D D = = 0.200 EBT $ 30. From the equity multiplier (A/E).T) $2.500. The Du Pont analysis of return on equity gives us: ROE = ROA × EM 14% = 10% × EM 1.125.4) $3. Debt ratio and Du Pont analysis How much of an increase is Therefore. we can calculate the debt ratio: .000/0.000)(1. NI = $18.000/$12.000/(1 .000.000/(1 . sales have gone up by 9.375% Answer: c Diff: M N 90.38%).000.T) = EBT = = = Now find EBIT .250.200) (EBT = $18.125. sales need to rise to $13.750.000. NI NI/(1 . $100.000(0.000 NI $ 18. Sales increase needed (EBIT = EBT + Interest) ($40.4 = $13.25) = $2. EBIT: = EBT = EBT + I = $3. $300.125.000.800. The new NI will be: Now find EBT: (EBT)(1 .0 = = 3.I EBIT EBIT ($1. (rounded to 9.000 + $1.000 Taxes (40%) 12.T) = $30.000 A Debt ratio = Now plug sales into profit margin ratio to find NI: NI = 0.000) Answer: b Diff: T N You need to work backwards through the income statement to solve this problem. Now find Sales: (Sales)(Operating Margin) = EBIT Sales = EBIT/Operating Margin = $5.4.06.200 Interest 3.250.000 Cost of goods sold ________ EBIT $ 33. D = $40.000. Therefore.250.09375.08) = $3.000. $100.750.0.4 = EM.000. S = $300.000.000 = $5.000 89.000 A S S TA turnover = = 3. this? $13.000 Now set up an income statement: Sales $300.

000 (from the balance sheet). ROA = $180.000 So.000.625%.000.000.100. The current ratio in 2002 was 1. or 5. We.7143.000. 0. The plan looks like this: Debit Credit Fixed assets $300.5250 in 2001.000 Notes payable $300.77.05625. D/A = 1 – E/A D/A = 1 – 0. So. we can calculate the profit margin.000.000. The firm issued $300 million in new common stock in 2002.000.000. while the current ratio in 2001 was 1.000/$3.4 E/A = 0.000 = 0.000.000. Miscellaneous concepts Answer: e Diff: E N The correct answer is statement e.000 = 0.818.64. the new current ratio is $900.000 NI = $180.000/$1.000 + $300.200. 91.000 = 1.20 = NI/$900. know ROE = NI/Common equity = 0.57%. so the debt ratio decreased from 2001 to 2002.1.000.20.000/($800.000 + NI – $50.000. . the current ratio was higher in 2002.000. = = = = PM × TATO × EM PM × 5 × 1.000. use the following equation: Ending retained earnings = Beginning RE + NI – Dividends paid $800. The debt ratio was 0.000 $150.4773 in 2002 and 0.000 (from the balance sheet).2857 = 28.200.4 PM × 7 PM. Answer: d Diff: M N Total assets = $3.7143 D/A = 0.000.4 = A/E E/A = 1/1. Hence. Profit margin and Du Pont analysis Answer: a Diff: E N Using the Du Pont analysis again.000.000 = NI. ROE 14% 14% 2% 92.125. Net income Answer: b Diff: E N To determine 2002 net income.000. Current ratio Answer: b Diff: M N Recall the current ratio is CA/CL = $900. 94.000. ROA ROA = NI/Assets. with Common equity = $900. 93.000.000. So. 95. while current assets do not change.000/$800. current liabilities increase by $300 million.000 = $700.000) = $900.

0 $450.000.000. Step 2: .000.000 or any other number.000 and X/$700.000.000.000.285.0.) Thus. Step 2: So.000. 97 .000)(365)]/Sales < 50.000.942. Determine new accounts receivable balance if DSO = 30 and sales remain the same: 30 = AR/($3.100.000. hence: Sales/Inventory < 6.000.000)(365)]/50 < Sales Sales > $3. For statement b. try X = $500. statement b is incorrect.0 Sales/$850. hence: AR/(Sales/365) < 50.96.000 in 2001.942.000/(Sales/365) < 50.000. Our second initial condition is that DSO < 50. 98 .000. DSO.285. The inventory turnover ratio for 2002 is X/$1.02.000. the inventory turnover ratio for 2001 is higher than in 2002. Sales.000)365 < 50(Sales) [($450.000. So. Only statement b meets this requirement.000 and $5. so statement c is incorrect.000/(Sales/365) 40(Sales)/365 = $432. and inventory turnover Step 1: Answer: b Diff: M N One of our initial conditions is that inventory turnover (S/Inv. statement a is correct. assume that sales are X.800 AR = $324.000 < 6.000 40(Sales) = $157.0 ($450. The current ratio in 2002 is 1.) < 6.785. the most likely estimate of the firm’s 2002 sales would fall between $3. So. while in 2001 it’s 0.680. Financial statement analysis Answer: a Diff: E N The correct answer is statement a. The debt ratio in 2002 is 0.100.000 Sales = $3.596. Current ratio Answer: c Diff: M N Step 1: Determine actual 2002 sales: DSO = AR/(Sales/365) 40 = $432. (If that’s not clear. while in 2001 it is 0.000/365) 30 = AR/$10.0 Sales < $5.0 [($450.672.000.

000 + $324.000 = $108.$108. Determine the new current ratio: CR = ($100.000 + $800.000.000/$1. Step 4: .023. New AP = $700.$324.000) = $1.392.000.000 = 1.424.Step 3: Determine the amount of freed-up cash and the new level of accounts payable.000)/($592.000. Freed-up cash = $432.000 + $1.000 .000 .000 = $592.

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