CHAPTER 2: FINANCIAL ANALYSIS

1. Calculating Ratios. Here are simplified financial statements of Phone

Corporate recent year:
INCOME STATEMENT
(figures in millions of dollars)
Net sales 13,194
Cost of goods sold 4,060
Other expenses 4,049
Depreciation 2,518
Earnings before interest and taxes (EBIT) 2,566
Interest expenses 685
Income before tax 1,881
Taxes 570
Net income 1,311
Dividends 856

BALANCE SHEET
(figures in millions of dollars)
End of Start of
Year Year
Assets
Cash and marketable securities 89 158
Receivables 2,382 2,490
Inventories 187 238
Other current assets 867 932
Total current assets 3,525 3,818
Net property, plant, and equipment 19,973 19,915
Other long-term assets 4,216 3,770
Total assets 27,714 27,503
 Liabilities and shareholders’ equity
Payables 2,564 3,040
Short-term debt 1,419 1,573
Other current liabilities 811 787
Total current liabilities 4,794 5,400
Long-term debt and leases 7,018 6,833
Other long-term liabilities 6,178 6,149
Shareholders’ equity 9,724 9,121
Total liabilities and shareholders’ equity 27,714 27,503
Calculate the all the financial ratios you have learnt.
Current ratio = current assets/current liability = 3,525 / 4,794 = 0.735 (end of the
year)
= 3,818 / 5,400 = 0.707 (start of the
year)
Quick ratio = (current asset – stocks) / current liability
= (3,525 – 187) / 4,794 = 0.696 (end of the year)
= (3,818 – 238) / 5,400 = 0.663 (start of the year)
Cash ratio = cash & cash equivalents / current liabilities = 89 / 4,794 = 0.018 (End
year)
= 158/5,400 = 0.029 (Start
year)
Stock turnover ratio = Cost of sale / Average inventory = 4,060 / (187+238):2
= 19,106
Debtor turnover ratio = net sales / average debtors = 13,194 / [(1,419+1,573)/2]
= 8.819
Creditor turnover ratio = total supplier purchases / average account payables
= 4,060 / [(2,564+3,040)/2]
 = 1.449
Asset turnover ratio = revenue / average total assets = 1,881 / [(27,714+27,503)/2]
= 0.068
Gross profit margin = gross profit / revenue = (revenue – COGS) / revenue
= (1,881 – 4,060) / 1,881
Net profit percentage = net profit / sales
Return on capital employed = EBIT / capital employed
= EBIT / (total assets – current liabilities) = 2,566 / (27,503 – 5,400) = 0.116
Return on asset = net income / total asset = 1,311 / [(27,503+27,714)/2] = 0.047

1,311
Return on equity = ( 9,724+ 9,121 ) :2 = 0,1391

Debt to equity ratio = total debt / total equity

= (short term debt + long term debt + leases) / total equity
= (1,496 + 6,925.5) / 9,422.5 = 0.89
Debt to asset ratio = total debt / total asset = 8,421.5 / 27,608.5 = 0.30

2. Defining Ratios. There are no universally accepted definitions of financial

ratios, but some of the following ratios make no sense at all. Substitute the
correct definitions.
long-term debt
a. Debt-equity ratio =
long-term debt + equity
 Correct definition: Debt- equity ratio = Total liabilities / Total
shareholders’ equity
 EBIT – tax
b. Return on equity =
average equity
 Correct definition: Return on equity = Net income/ Average equity
net income + interest
c. Profit margin =
sales
 Correct definition: Profit margin = EBIT/ Sales
total assets
d. Inventory turnover =
average inventory
 Correct definition: Inventory turnover = Cost of goods sold /
average inventory
current liabilities
e. Current ratio =
current assets
 Correct definition: Current ratio = current assets/ current liabilities

current assets – inventories

f. Interval measure =
average daily expenditure from operations
 Correct definition: Interval measure =
Sales
g. Average collection period =
average receivables/365
 Correct definition:
 Average collection period = average receivables x365/ sales

cash + marketable securities + receivables

h. Quick ratio =
current liabilities
 Correct definition = (current asset – stocks) / current liability
3. Current Liabilities. Suppose that at year-end Pepsi had unused lines of credit
which would have allowed it to borrow a further $300 million. Suppose also that
it used this line of credit to borrow $300 million and invested the proceeds in
marketable securities. Would the company have appeared to be (a) more or less
liquid, (b) more or less highly leveraged? Calculate the appropriate ratios.
a)
4. Current Ratio. How would the following actions affect a firm’s current ratio?
a. Inventory is sold at cost assets decrease  Current ratio decreases
b. The firm takes out a bank loan to pay its accounts due liabilities
increases  current ratio decrease
c. A customer pays its accounts receivable  assets increase  Current ratio
increases
d. The firm uses cash to purchase additional inventories no change
5. Liquidity Ratios. A firm uses $1 million in cash to purchase inventories. What
will happen to its current ratio? Its quick ratio?
Both are increasing.

6. Receivables. Chik’s Chickens has average accounts receivable of $6,333. Sales

for the year were $9,800. What is its average collection period?
6,333 x365/ 9,800 = 235,8719
7. Inventory. Salad Daze maintains an inventory of produce worth $400. Its total
bill for produce over the course of the year was $73,000. How old on average is
the lettuce it serves its customers?
 400x365/73.000 = 2
8. Inventory Turnover. If a firm’s inventory level of $10,000 represents 30 days’
sales, what is the annual cost of goods sold? What is the inventory turnover ratio?

9. Leverage Ratios. Lever Age pays an 8 percent coupon on outstanding debt with
face value $10 million. The firm’s EBIT was $1 million.
a. What is times interest earned? 1.000.000 / (10.000.000x8%) = 1.25
b. If depreciation is $200,000, what is cash coverage?
c. If the firm must retire $300,000 of debt for the sinking fund each year, what
is its “fixed-payment cash-coverage ratio” (the ratio of cash flow to interest
plus other fixed debt payments)?
10.Leverage. A firm has a long-term debt-equity ratio of .4. Shareholders’ equity is
$1 million. Current assets are $200,000 and the current ratio is 2.0. The only
current liabilities are notes payable. What is the total debt ratio?
Current liabilities = 200.000/2 =100.000
Long-term liabilities = 0.4x total equity
Total debt ratio
11.Leverage Ratios. A firm has a debt-to-equity ratio of .5 and a market-to-book
ratio of 2.0. What is the ratio of the book value of debt to the market value of
equity?
12.Using Financial Ratios. For each category of financial ratios discussed in this
material, give some examples of who would be likely to examine these ratios and
why.
13.Financial Statements. As you can see, someone has spilled ink over some of the
entries in the balance sheet and income statement of Transylvania Railroad. Can
you use the following information to work out the missing entries:
Long-term debt ratio 0.4
Times interest earned 8.0
Current ratio 1.4
 Quick ratio 1.0
Cash ratio 0.2
Return on assets 18%
Return on equity 41%
Inventory turnover 5.0
Average collection period 71.2 days
INCOME STATEMENT
(figures in millions of dollars)
Net sales 9.02
Cost of goods sold •••
Selling, general, and administrative expenses 10
Depreciation 20
Earnings before interest and taxes (EBIT) •••
Interest expense •••
Income before tax •••
Tax •••
Net income •••
BALANCE SHEET
(figures in millions of dollars)
This Year Last Year
Assets
Cash and marketable securities ••• 20
Receivables ••• 34
Inventories ••• 26
Total current assets 77 80
Net property, plant, and equipment 38 25
Total assets 115 105
Liabilities and shareholders’ equity •••
 Accounts payable 25 20
Notes payable 30 35
Total current liabilities 55 55
Long-term debt 46 20
Shareholders’ equity 14 30
Total liabilities and shareholders’ equity 115 105

Total assets = total liabilities and equity = 115

Total current liabilities = Accounts payable+ Notes payable = 55

Current ratio = current assets/current liabilities

 current assets = 55x1.4 = 77

Net property, plant, and equipment = 115-77=38

Long-term debt ratio = Long-term debt/ total assets

 Long-term debt = 0.4x115 = 46

 Shareholders’ equity=115-46-55=14

Return on equity = Net income/ Average equity  Net income = 0.41x(14+30)/2

= 9.02
CHAPTER 3. NET PRESENT AND OTHER CRITE
Problems 1–9 refer to two projects with the following cash flows:
Year Project A Project B
1 –$100 –$100
2 40 50
3 40 50
4 40 ---
1. IRR/NPV. If the opportunity cost of capital is 11 percent, which of these projects
is worth pursuing?

2. Mutually Exclusive Investments. Suppose that you can choose only one of
these projects. Which would you choose? The discount rate is still 11 percent.
3. IRR/NPV. Which project would you choose if the opportunity cost of capital
were 16 percent?
4. IRR. What are the internal rates of return on projects A and B?
5. Investment Criteria. In light of your answers to problems 2–4, is there any
reason to believe that the project with the higher IRR is the better project?
6. Profitability Index. If the opportunity cost of capital is 11 percent, what is the
profitability index for each project? Does the profitability index rank the projects
correctly?
7. Payback. What is the payback period of each project?
8. Investment Criteria. Considering your answers to problems 2, 3, and 7, is there
any reason to believe that the project with the lower payback period is the better
project?
9. Book Rate of Return. Accountants have set up the following depreciation
schedules for the two projects:
Year: 1 2 3 4
Project A $25 $25 $25 $25
Project B 33 33 33 34
Calculate book rates of return for each year. Are these book returns the same as the
IRR?
10.NPV and IRR. A project that costs $3,000 to install will provide annual cash
flows of $800 for each of the next 6 years. Is this project worth pursuing if the
discount rate is 10 percent? How high can the discount rate be before you would
reject the project?
11.Payback. A project that costs $2,500 to install will provide annual cash flows of
$600 for the next 6 years. The firm accepts projects with payback periods of less
than 5 years. Will the project be accepted? Should this project be pursued if the
discount rate is 2 percent?
What if the discount rate is 12 percent? Will the firm’s decision change as the
discount rate changes?
12.Profitability Index. What is the profitability index of a project that costs
$10,000 and provides cash flows of $3,000 in Years 1 and 2 and $5,000 in Years
3 and 4? The discount rate is 10 percent.
13.NPV. A proposed nuclear power plant will cost $2.2 billion to build and then
will produce cash flows of $300 million a year for 15 years. After that period (in
Year 15), it must be decommissioned at a cost of $900 million. What is project
NPV if the discount rate is 6 percent? What if it is 16 percent?
14.NPV/IRR. Consider projects A and B:
Cash Flows, Dollars
Project C0 C1 C2 NPV at 10%
A –30,000 21,000 21,000 +$6,446
B –50,000 33,000 33,000 +$7,273
Calculate IRRs for A and B. Which project does the IRR rule suggest is best? Which
project is really best?
15.IRR. You have the chance to participate in a project that produces the following
cash flows:
C0 C1 C2
+$5,000 +$4,000 –$11,000
The internal rate of return is 13.6 percent. If the opportunity cost of capital is 12
percent, would you accept the offer?
16.NPV/IRR.
a. Calculate the net present value of the following project for discount rates of
0, 50, and 100 percent:
C0 C1 C2
–$6,750 +$4,500 +$18,000
b. What is the IRR of the project?
17.IRR. Marielle Machinery Works forecasts the following cash flows on a project
under consideration. It uses the internal rate of return rule to accept or reject
projects. Should this project be accepted if the required return is 12 percent?
C0 C1 C2 C3
–$10,000 0 +$7,500 +$8,500
18.NPV/IRR. A new computer system will require an initial outlay of $20,000 but it
will increase the firm’s cash flows by $4,000 a year for each of the next 8 years.
Is the system worth installing if the required rate of return is 9 percent? What if it
is 14 percent? How high can the discount rate be before you would reject the
project?
19.Investment Criteria. If you insulate your office for $1,000, you will save $100 a
year in heating expenses. These savings will last forever.
a. What is the NPV of the investment when the cost of capital is 8 percent? 10
percent?
b. What is the IRR of the investment?
c. What is the payback period on this investment?
20.NPV versus IRR. Here are the cash flows for two mutually exclusive projects:
Project C0 C1 C2 C3
A –$20,000 +$8,000 +$8,000 +$8,000
B –$20,000 0 0 +$25,000
 a. At what interest rates would you prefer project A to B? Hint: Try drawing
the NPV profile of each project.
b. What is the IRR of each project?
21.IRR/NPV. Consider this project with an internal rate of return of 13.1 percent.
Should you accept or reject the project if the discount rate is 12 percent?
Year Cash Flow
0 +$100
1 –60
2 –60
22.Payback and NPV.
a. What is the payback period on each of the following projects?
Cash Flows, Dollars
Project Time 0 1 2 3 4
A –5,000 +1,000 +1,000 +3,000 0
B –1,000 0 +1,000 +2,000 +3,000
C –5,000 +1,000 +1,000 +3,000 +5,000
b. Given that you wish to use the payback rule with a cutoff period of 2 years,
which projects would you accept?
c. If you use a cutoff period of 3 years, which projects would you accept?
d. If the opportunity cost of capital is 10 percent, which projects have positive NPVs?
e. “Payback gives too much weight to cash flows that occur after the cutoff date.”
True or false?
23.Book Rate of Return. Consider these data on a proposed project:
Original investment = $200
Straight-line depreciation of $50 a year for 4 years
Project life = 4 years
Year 0 1 2 3 4
Book value $200 — — — —
 Sales 100 110 120 130
Costs 30 35 40 45
Depreciation — — — —
Net income — — — —
a. Fill in the blanks in the table.
b. Find the book rate of return of this project in each year.
c. Find project NPV if the discount rate is 20 percent.
24.Book Rate of Return. A machine costs $8,000 and is expected to produce profit
before depreciation of $2,500 in each of Years 1 and 2 and $3,500 in each of
Years 3 and 4. Assuming that the machine is depreciated at a constant rate of
$2,000 a year and that there are no taxes, what is the average return on book?
25.Book Rate of Return. A project requires an initial investment of $10,000, and
over its 5-year life it will generate annual cash revenues of $5,000 and cash
expenses of $2,000. The firm will use straight-line depreciation, but it does not
pay taxes.
a. Find the book rates of return on the project for each year.
b. Is the project worth pursuing if the opportunity cost of capital is 8 percent?
c. What would happen to the book rates of return if half the initial $10,000
outlay were treated as an expense instead of a capital investment? Hint:
Instead of depreciating all of the $10,000, treat $5,000 as an expense in the
first year.
d. Does NPV change as a result of the different accounting treatment proposed in
(c)?
26.Capital Rationing. You are a manager with an investment budget of $8 million.
You may invest in the following projects. Investment and cash-flow figures are
in millions of dollars.
Projec Discount Rate , Investment Annual Cash Project Life, Years
t % Flow
A 10 3 1 5
 B 12 4 1 8
C 8 5 2 4
D 8 3 1.5 3
E 12 3 1 6
a. Why might these projects have different discount rates?
b. Which projects should the manager choose?
c. Which projects will be chosen if there is no capital rationing?
27.Profitability Index versus NPV. Consider these two projects:
Project C0 C1 C2 C3
A –$18 +$10 +$10 +$10
B –$50 +$25 +$25 +$25
a. Which project has the higher NPV if the discount rate is 10 percent?
b. Which has the higher profitability index?
c. Which project is most attractive to a firm that can raise an unlimited
amount of funds to pay for its investment projects? Which project is most
attractive to a firm that is limited in the funds it can raise?
28.Mutually Exclusive Investments. Here are the cash flow forecasts for two
mutually exclusive projects:
Cash Flows, Dollars
Year Project A Project B
0 –$100 –$100
1 130 49
2 50 49
3 70 49
a. Which project would you choose if the opportunity cost of capital is 2 percent?
b. Which would you choose if the opportunity cost of capital is 12 percent?
c. Why does your answer change?
29.Equivalent Annual Cost. A precision lathe costs $10,000 and will cost $20,000
a year to operate and maintain. If the discount rate is 12 percent and the lathe will
last for five years, what is the equivalent annual cost of the tool?
30.Equivalent Annual Cost. A firm can lease a truck for 4 years at a cost of
$30,000 annually. It can instead buy a truck at a cost of $80,000, with annual
maintenance expenses of $10,000. The truck will be sold at the end of 4 years for
$20,000. Which is the better option if the discount rate is 12 percent?
31.Multiple IRR. Consider the following cash flows:
C0 C1 C2 C3 C4
–22 +20 +20 +20 –40
a. Confirm that one internal rate of return on this project is (a shade above) 7
percent, and that the other is (a shade below) 34 percent.
b. Is the project attractive if the discount rate is 5 percent?
c. What if it is 20 percent? 40 percent?
d. Why is the project attractive at midrange discount rates but not at very high
or very low rates?
32.Equivalent Annual Cost. Econo-cool air conditioners cost $300 to purchase, result
in electricity bills of $150 per year, and last for 5 years. Luxury Air models cost
$500, result in electricity bills of $100 per year, and last for 8 years. The discount
rate is 21 percent.
a. What are the equivalent annual costs of the Econo-cool and Luxury Air
models?
b. Which model is more cost effective?
c. Now you remember that the inflation rate is expected to be 10 percent per
year for the foreseeable future. Redo parts (a) and (b).
33.Investment Timing. You can purchase an optical scanner today for $400. The
scanner provides benefits worth $60 a year. The expected life of the scanner is 10
years. Scanners are expected to decrease in price by 20 percent per year. Suppose
 the discount rate is 10 percent. Should you purchase the scanner today or wait to
purchase? When is the best purchase time?
34.Replacement Decision. You are operating an old machine that is expected to
produce a cash inflow of $5,000 in each of the next 3 years before it fails. You
can replace it now with a new machine that costs $20,000 but is much more
efficient and will provide a cash flow of $10,000 a year for 4 years. Should you
replace your equipment now? The discount rate is 15 percent.
35.Replacement Decision. A forklift will last for only 2 more years. It costs $5,000
a year to maintain. For $20,000 you can buy a new lift which can last for 10
years and should require maintenance costs of only $2,000 a year.
a. If the discount rate is 5 percent per year, should you replace the forklift?
b. What if the discount rate is 10 percent per year? Why does your answer change?
36.NPV/IRR. Growth Enterprises believes its latest project, which will cost $80,000
to install, will generate a perpetual growing stream of cash flows. Cash flow at
the end of this year will be $5,000, and cash flows in future years are expected to
grow indefinitely at an annual rate of 5 percent.
a. If the discount rate for this project is 10 percent, what is the project NPV?
b. What is the project IRR?
37.Multiple IRRs. Strip Mining Inc. can develop a new mine at an initial cost of $5
million. The mine will provide a cash flow of $30 million in 1 year. The land
then must be reclaimed at a cost of $28 million in the second year.
a. What are the IRRs of this project?
b. Should the firm develop the mine if the discount rate is 10 percent? 20
percent?