ACCT-UB 3 - Financial Statement Analysis

Module 3 Homework

You will have a single opportunity to submit a single file (please submit a word or excel formatted file) with your
answers. Re-submissions will not be permitted. Feel free to type in your answers after each question below and submit
this same file. Before submitting your file make sure it is titled: [your last name] Mod X HW (substitute the “X” for the
appropriate module number).

If you complete the homework in a group (maximum 4 students per group), each student must submit the same file and
at the top of the file you should specify that it is a group solution, giving the names of all students in the group.

Please provide all answers to the following questions:

Q1. The purchase of treasury stock (commonly called stock buybacks) is being done with increasing frequency in lieu of
dividend payments.
Required:
a. Explain why stock buy backs are similar to dividends from the company’s viewpoint.

Ans: - Stock buybacks are similar to dividends because from a company’s perspective, the company is handing out
cash to investors. In both situations, the cash assets of the company are falling, the only key difference being that
in the case of dividends, the company is paying a cash amount to all stockholders, whereas in the case of stock
repurchases, they are paying a cash amount to all the people who sell their shares back to the company.

b. Explain why managers might prefer the purchase of treasury shares to the payment of dividends.

Ans: - Managers might prefer the purchase of treasury shares to the payment of dividends because the repurchase
of shares reduces the total number of shares outstanding and therefore improves the EPS (earnings-per-share),
cash-flow-per-share and return on equity of the company. EPS, cash-flow-per-share and RoE are measures used by
shareholders to evaluate the company’s profitability and performance and a higher metrics will drive share price
i[ over time, therefore resulting in capital gains for the shareholders. Additionally, a smaller outstanding equity
base would increase the manager’s control over the company and improve the decision-making process as less
shares are now owned by the public.

c. Explain why investors might prefer that firms use excess cash to purchase treasury shares rather than pay dividends.

Ans: - Investors will prefer that firms use excess cash to purchase treasury stocks over dividends because buybacks
are a more cash efficient wat to return capital to shareholders, because the investor doesn’t incur any additional
tax on the buyback sale process, as tax is only applicable on the actual sale of shares, whereas dividends attract tax
in the range of 15%-20%. Additionally, dividends return cash to all shareholders, whereas share buybacks return
cash to self-selected shareholders only. Therefore, it allows investors the opportunity of changing their
shareholding pattern.

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Q2. Westfield Capital Management Co.’s equity investment strategy is to invest in companies with low price-to-book
ratios, while considering differences in solvency and asset utilization. Westfield is considering investing in the shares of
either Jerry’s Departmental Stores (JDS) or Miller Stores (MLS). Selected financial data for both companies follow:

Required:
a. Compute each of the following ratios for both JDS and MLS:
(1) Price-to-book ratio

Ans: - Price-to-book ratio = (Market price per common share / Book value per common share)

Book value (JDS) = equity / no. of shares = 6000 / 250 = $24 per share
Book value (MLS) = 7500 / 400 = $18.75 per share

Therefore, Price-to-book (JDS) = $51.50 / $24 = 2.146 and Price-to-book (MLS) = $49.50 / $18.75 = 2.64

(2) Total-debt-to-equity ratio

Ans: - total-debt-to-equity ratio = total liabilities / shareholders equity

Therefore, debt-to-equity ratio (JDS) = $ 2700 / $ 6000 = 0.45
debt-to-equity ratio (MLS) = $ (1000+2500) / $ 7500 = 0.4667

(3) Fixed-asset-utilization (turnover)

Ans: - FAT = Net sales / Average fixed assets

Therefore, FAT (JDS) = $ 21250 / $ 5700 = 3.728

FAT (MLS) = $ 18500 / $ 5500 = 3.363

b. Select the company that better meets Westfield’s criteria.

Ans: - The company that better meets Westfield’s criteria would be Jerry’s Departmental Store as it has a lower price-to-
book ratio, lower debt-to-equity and a higher fixed asset utilization ratio.